Brown Bag Learning Session 2015

Risk Management Overview

ETS Team
Aswani Nannapaneni
Amol Ashok Deodhar
Sanjay Siva Kumar
Amit Kumar Chopra
6th Feb 2015

Brown Bag Learning Session 2015

Agenda

Few Financial Disasters

Risk Definition and Types

Risk & its impact
Types of financial risk
Risk vs Return

Risk management and Value Creation

Way to managing key risks

Product Class & Risk Identification

Details- Market, Credit, Operational, Liquidity

Risk Mitigation Techniques

Efficient Frontier for Risk & Return

Typical Risk Organization

Brown Bag Learning Session 2015

Few Financial Disasters

Subprime mortgage crises

Extension of mortgages to sub-standard borrowers with an assumption that house prices can cover up any possible default amounts

Credit risk transfer on these mortgages using securitized products meant that all financial institutions / investors were exposed to
underlying risk

Home prices dropped and borrowers started defaulting. Severity was so intense that Lehman Brothers declared bankruptcy.

This lead to liquidity crises due to overall lack of confidence.

Financial bailout decisions & stimulus packages had to be introduced.

Northern Rock Banks Bank Run

Northern Rock bank used to borrow from money markets (short term) and fund mortgages using this money.

These mortgages were then securitized & sold in capital markets.

As demand for securitized products fell, re-payment of money market loans became impossible leading to liquidity crises.

People lined up to withdraw money from their accounts amid fears (bank run) when the Bank asked for support from Bank of
England.

Herstatt Banks crises leading to settlement risk

German regulators cancelled Banks license at 4:30 pm local time

The Bank stopped all dollar payments after 3:30 pm local time or 10:30 AM NY time

This led to settlement risk for counterparties who had paid Deutsche Marks to Herstatt Bank before 10:30 am & were awaiting for
dollar payments

LTCM Liquidation

Long Term Capital Management was a top profile hedge fund. Two Nobel Laureates were on the Board of the Fund.

All the major sell side firm were having LTCM as counterparty in several FI spread trading transactions

As spreads continually widened LTCM position became illiquid

LTCM was liquidated under the aegis of FED

Brown Bag Learning Session 2015

What is Risk?

Definition of Uncertainty & Risk

Uncertainty is unknown outcome / event in future

Risk is a technique of identifying different unknowns and accounting for negative outcomes
Risk is taken only because there is also a possibility of rewards due to uncertainty
Uncertainty drives risk (negative side of the event) as well as reward (desired element)

Risk & Return

Risk is a measure of variation of ex-ante returns (expected returns), ex-post returns are actual
returns
Focus of risk is to estimate possible negative ex-ante returns and drive decisions within acceptable
limits of negative ex-ante returns

Major categories of Risks

Financial Risks- Risks that lead to financial losses i.e. risks of reduction in commercial value of
assets
Non Financial Risks- Risks that do not DIRECTLY lead to financial losses.

Brown Bag Learning Session 2015

Risk vs. Expected Return

Maturity

Treasury
Yield

90D

0.93

180D

1.02

1.18

1.83

2.32

2.84

3.3

3.85

10

4.38

15

4.94

20

5.3

30

5.23

Investor demands premium (higher yield)

for higher risk

Brown Bag Learning Session 2015

Impact of Risk on Balance Sheet

Capital ( Own funds )

Fixed assets

- Share capital

- Preferred capital
- Reserves, Surplus

Financial assets
- Cash

Borrowed funds
- Short term borrowings

- Long term borrowings

- Traded liabilities
- Deposits ( Demand )
- Deposits ( Term )
Equity + Reserves = Tier 1 Capital
(Required to be 6% of RWA
Tier 2 Capital to be 2% of RWA

- Reserves with C.Bank

- Securities- Traded
- Retail Loans
- Corporate Loans
- Interbank Loans
- Govt. Bonds
- Derivatives

Conversion of all on & off balance sheet

assets to Risk Weighted Assets (RWA)

Brown Bag Learning Session 2015

Why is Risk important?

Cant live without, cant live
with too much : since Ex. Ante
return and Risk are inseparable

P&L

Bank/IB
Management

Risk

Regulators, Creditors

Capital

Value based management calls for judicious allocation of capital to prudent risks.
7

Brown Bag Learning Session 2015

Types of Financial Risks

Capital market products
Description

Credit Risk

Issuer risk

Risk that issuer/borrower defaults and is not able

to fulfill the obligation (e.g. unable to make full
repayments)

Counterparty
risk

Default risk: risk that counterparty defaults and

transactions fails to pay
Replacement risk: after a default, risk that
replacing deal under same conditions is not
possible
Settlement risk: risk that party involved in the
settlement fails before transaction has completely
settled

Market Risk

Risk that value of investment decreases because

of change of market variables

Liquidity
risk

Risk that a given security or asset cannot be

traded promptly in the market (e.g. to prevent a
loss) or risk of inadequate funds to fulfil financial
obligation

Operational
risk

Risk of loss resulting from inadequate or failed

internal processes, people and systems or from
external events

ExchangeTraded

OTCtraded

Loans

Portfolio Risk

Main risk Categories

Brown Bag Learning Session 2015

Example
Genco Oil Company has issued bonds maturing on 31st Dec 2025 at an interest rate of 4%
p.a. whereas 10 year treasuries are yielding 1.99% p.a. Genco pays interest to bond investors
out of regular settlement of accounts receivables.
Description

Risk Type

Treasury bonds interest rate increases from 1.99% to

2.01%.

Market Risk

Rating of Genco Oil Company goes down

Credit Risk

Genco Oil Company declares bankruptcy

Credit Risk

Debtors of Genco default on paying money for a certain

period & as a result Genco is unable to pay interest

Funding Liquidity
Risk

Brown Bag Learning Session 2015

Risk management: Role in value creation

Value creation occurs when there is an additional value being added to the bottom line of a
business thanks to the creation and use of new methods to maximize the shareholders
wealth.

Effective risk management helps the firm to

Value Creation

Manage downside surprises

Optimize risk taking by using risk appetite to inform business decisions
Challenging the business to improve the rigor of risk selection
More efficient allocation of resources (capital, personnel and systems) to the activities with the
greatest risk-adjusted returns
Avoid bankruptcy related costs.

Franchise Risk

Financial Risk

Enterprise wide Holistic View

10

Brown Bag Learning Session 2015

Risk- A different Perspective of Expected Returns

11

Brown Bag Learning Session 2015

Key Financial Risks

Arises due to changes in market value of traded securities

First order risk, important in Trading books, can be largely hedged
Important element in liquid, financed trades, traded investments
Measured through VaR ( Value at Risk)

Credit
Default Risk

Arises due to changing credit quality of borrowers, issuers (Credit ratings change)
Important element of Banking books, held to maturity securities
Has limited opportunities in hedging except with Credit Derivatives
Collateral management /credit monitoring is the prime mitigation strategy

Counterparty
Risk

Derivatives are off-balance sheet transactions with consequences for profitability

Counterparty risk arises in OTC derivative segment
Can be viewed as a combination of market and credit risks
Needs sophisticated mark-to-future analytics over the life of trade

Operational Risk

Arises due to faulty processes, IT systems, human errors unintentional, otherwise

While credit and market are external risks, Op risk is internal
Difficult to measure and model
Large contributor to capital charge and ACTUAL loss history on P&L

Liquidity Risk

The risk that banks may run out of needed liquidity (funding risk) or an asset may not
traded at a fair price or in reasonable amount of time (asset liquidity risk)
A perfectly viable portfolio may become illiquid temporarily
Risk is assessed based on stressed cash flows (liquidity position under stress conditions)
LTCM is a classic example

Other risks

Market Risk factors are sometimes referred to by asset class or risk factor
Market Risk terminology includes interest rate risk, FX Risk, Equity Risk etc
Other common risk categories include concentration risk, Specific Risk, Sovereign Risk

Credit Risk

Market Risk

12

Brown Bag Learning Session 2015

Approaches to Key Risks

Credit Risk Approach

Collect Facility, Securities, and Obligor Data

Collect Ratings data and derive internal ratings

Measure credit risk
Products
Specific Events
Market / Economic /
Business Situation

Probability
Impact
Statistical Modelling
Normal conditions
vs. Stress
Scenarios

Risk
Identification

Risk aggregation at Counterparty level

Market Risk Approach

Collect trades / positions and sensitivities
Valuation of positions based on measurement
technique

Risk
Measurement

Risk aggregation by Portfolio

Risk Reporting
& Monitoring
Key Risk Indicators
Risk Limits
Loss Data
Workflow
Management

Operational Risk Approach

Collect events data (a major challenge)

Risk Mitigation

Avoid risks
Risk Transfer
Mitigate using
controls
Accept residual risk

Determine potential losses based on frequency /

probability & severity of events
Risk aggregation at business org level

Liquidity Risk Approach

Capture cash flows data
Run the data through stress models
Assessed at tenor bucket level
Produce Liquidity Ratios

13

Brown Bag Learning Session 2015

Product Class & Risk Identification

14

Brown Bag Learning Session 2015

Credit Risk

Issuer / Borrower Risk

Measurement based on exposure calculations, ratings, and loss estimates in the events of rating
downgrades & defaults
Exposure at Default estimated based on simulations
Expected Loss (EL) is average loss mapped into simulated P&L profiles. Reserves are supposed
to cover EL.
Unexpected Loss (UL) is loss at a percentile (typically 99%) of simulated P&L profiles. Capital
provision is supposed to cover UL.
Mitigants play a vital role in determining capital requirement
Corporate / wholesale portfolio risked at individual deal level whereas retail loans risked at portfolio
level

Example of Ratings Transition Matrix

15

Brown Bag Learning Session 2015

Counterparty Risk

Relevant to OTC transactions

Simulation based calculations for counterparty level exposures after taking into account
netting agreements

Management of margin agreements to manage level of risk

Account for wrong way risk (for example, positive correlation between exposure &
collateral)

16

Brown Bag Learning Session 2015

Market Risk

Simpler Techniques
Sensitivities Analyses
Mark to Market values
Standard Deviation

Advanced Techniques based on VaR

Value at Risk (VaR) is interpreted as estimated maximum loss over a certain period of time (1 day,
10day, etc.) at certain confidence level (95%, 99%, etc.)
Variety of computation techniques
Approximation (Parametric) techniques- Delta Normal, Delta Gamma
P&L Profiles Simulation techniques- Historical simulations, Monte- Carlo simulations
Typically large Banks (like Citi) adopt combination of techniques

Typically Banks need to account for Risks Not in VaR (RNIV) as well
Where VaR model is exhaustive enough to accommodate specific risk factors
Exposure to those risk factors may be immaterial or less significant
High Yield sensitive portfolios which are impacted a lot by specific risk

17

Capital needs to be allocated based on market risk calculations under normal market
simulations as well as stressed market simulations

Brown Bag Learning Session 2015

Trading Account Assets / Trading View - Examples

USD $ In millions, unless otherwise specified

Liabilities

Assets
Cash/Due from Banks/Deposits with Banks

$205,000

Fed Funds Sold/Securities Borrowed

275,000

Non-interest bearing deposits in U.S.

Interest-bearing deposits in U.S.

$130,000
266,000

26,000

Non-interest bearing deposits in offices outside U.S.

66,000

Trading Accounts Assets

290,000

Interest-bearing deposits in the offices outside U.S.

493,000

Investments (CTI)

303,000

Fed Funds Purchases/Securities Loaned

216,000

Loans

636,000

Brokerage Payable

Brokerage Receivable

Goodwill

25,000

Trading Account Liabilities

57,000
122,000

Intangible Assets

5,000

Short-term borrowings

Mortgage Servicing Rights

2,500

Long-term debts

221,000

Other Liabilities

65,000

Total Liabilities

1,696,000

Other Assets

130,000

Traded Products Examples Trading Risk

1,897,500

Total Assets

Foreign Exchange

Stockholders Equity

Equities

Interest Rates

Commodities

Mortgage

Credit Derivatives

Preferred Stock

5,300

Common Stock

107,200

Retained Earnings

108,000

Accumulated Other Comprehensive Income (Loss)

(19,000)

Total Equity
Total Liabilities and equity

18

59,000

201,500
1,897,500

Brown Bag Learning Session 2015

Economic View (Trading + Investment)- Examples

USD $ In millions, unless otherwise specified

Liabilities

Assets
Cash/Due from Banks/Deposits with Banks

$205,000

Fed Funds Sold/Securities Borrowed

275,000

Non-interest bearing deposits in U.S.

Interest-bearing deposits in U.S.

$130,000
266,000

26,000

Non-interest bearing deposits in offices outside U.S.

66,000

Trading Accounts Assets

290,000

Interest-bearing deposits in the offices outside U.S.

493,000

Investments (CTI)

303,000

Fed Funds Purchases/Securities Loaned

216,000

Loans

636,000

Brokerage Payable

Brokerage Receivable

Goodwill

25,000

Trading Account Liabilities

57,000
122,000

Intangible Assets

5,000

Short-term borrowings

Mortgage Servicing Rights

2,500

Long-term debts

221,000

130,000

Other Liabilities

65,000

1,897,500

Total Liabilities

1,696,000

Other Assets

Economic Risk
Total Assets

Foreign Exchange

Stockholders Equity

Equities

Interest Rates

Commodities

Mortgage

Credit Derivatives

Preferred Stock

5,300

Common Stock

107,200

Retained Earnings

108,000

Accumulated Other Comprehensive Income (Loss)

(19,000)

Total Equity
Total Liabilities and equity

19

59,000

201,500
1,897,500

Brown Bag Learning Session 2015

Operational Risk

Mapped based on business to loss event type

Challenging to measure due to limited events data. Reliance on external sources for
events data
[1]
Event #
1
2
3
4
5
6
7
8
9
10
.
.
.
.
.
2701
2702
2703
2704

20

[2]
Event
Code (1)
IF
EF
SY
SY
PD
IF
IF
EF
EE
EE
.
.
.
.
.
UA
UA
WS
SF

[3]
Event
Code (1)
12
31
22
11
11
32
22
31
17
27
.
.
.
.
.
8
3
17
26

[4]
Date
960116
960116
960116
960119
960120
960120
960122
960122
960122
960122
.
.
.
.
.
960146
960148
960150
960152

[5]
Cost
Center
10003
20003
33890
45359
11101
10003
20203
19767
19332
18897
.
.
.
.
.
10003
10003
33890
23223

[6]
Business
Line
RB
RB
CF
CF
CB
PS
AS
AS
TS
AS
.
.
.
.
.
RB
RB
CF
AM

[7]

[8]

[9]

[10]

Loss
19057.25
40905.04
10194.55
52831.68
36558.11
620537.37
10181.69
24783.17
11963.49
20086.56
.
.
.
.
.
14451.49
11010.46
24681.18
17963.66

Recoveries
0.00
0.00
3433.00
0.00
0.00
0.00
0.00
13556.00
0.00
0.00

Insurance
19057.25
40905.04
10194.55
52831.68
36558.11
620537.37
10181.69
24783.17
11963.49
20086.56
.
.
.
.
.
14451.49
11010.46
24681.18
17963.66

Event Description

0.00
0.00
0.00
16963.66

.
.
.
.
.

Estimation of frequency of losses and estimation of severity drive loss profiles

Brown Bag Learning Session 2015

Liquidity Risk

Key driver of 2008 crises- as a result new liquidity framework proposed by regulators
Measurement & Reporting of key ratios
Additional capital buffers for liquidity

Managing liquidity risk is one of the key activities in a bank known as ALM (Asset-Liability
Management)

Simply put liquidity risk assessment is analysis of sources of funds vs. use of funds

Duration analysis & Gap analysis are key techniques

Banking regulations require Banks to do liquidity risk analysis based on stressed cashflows

Intra-day liquidity management is a key function. Typically other risks are end-of-day
calculations

Integration with interest rate risk & treasury management is implied

Transfer pricing models
NII (Net Interest income) simulation

Liquid assets cushions, contingency funding plans are few of the key metrics provided to
management

Liquidity Coverage ratio (LCR) & Net Stable Funding Ratio (NSFR) are key ratios included
in Basel III recommendations

21

Brown Bag Learning Session 2015

Stress Testing

Checking behavior of portfolio under stressful market conditions

Business to define extreme but plausible stress scenarios (adverse conditions)

Banks also have to produce stress results for stress tests provided by regulators

Stress scenarios are simulated using full revaluation techniques for attaining accuracy

Examples- significant increase in interest rates, domino effect of counterparty ratings in particular geography, etc.

Capital requirement based on stress test results

Reverse stress testing is also a regulatory requirement

22

Define the situations which shall lead to failure / bankruptcy of a Bank

Arrive at specific market scenarios that potentially lead to such situations

Brown Bag Learning Session 2015

Risk Measurement Models Validation Technique- Backtesting

Validating estimated P&L against actual P&L

VaR vs Daily P&L comparison

Distinction between dirty P&L and clean P&L

Adverse impact on regulatory capital in cases of excessive incidents of inappropriate

estimations

23

Brown Bag Learning Session 2015

Risk Mitigation Techniques

Credit Risk
Credit Risk Mitigants (Guarantees, Collaterals)
Hedging via Credit derivatives like CDS
Using securitized products to transfer credit risk

Counterparty Risk
Use of margins and collaterals
Using central counterparty (CCP) for clearing
Use of Netting agreements

Market Risk
Hedging via derivatives- For example, buying interest rate swap to fix interest cashflows or buy
forward or futures contract to lock future prices

Operational Risk
Build & maintain internal controls
Exhaustive process for assessing & improving controls across people, processes & systems

Portfolio Risk
Holistic Portfolio level view of risk requires consolidated analysis of various risks faced by portfolio
and interactions between those risks
Diversification is a technique to mitigate portfolio level risk

24

Brown Bag Learning Session 2015

Efficient Frontier of Risky Investments

Expected
Return

Efficient
Frontier

Investments

of Return
Red to Green: Return Optimization
Orange to Green: Risk Reduction
Orange to Blue: Return Optimization
25

Brown Bag Learning Session 2015

Typical Risk Organization

Board of Directors

Chief Risk Officer

Risk Policy &

Methodology

Modelling Team

Risk Analysis &

Reporting

Risk IT & Project Management

26

Risk Exec Committee

Risk Operations

Brown Bag Learning Session 2015

Thank you !!

27