Foundation in Risk Management

Chapter 1 Risk Management: A Helicopter View

Risk Arises from uncertainty in future losses or gains

Risk Management

Relates to sequence of activities which lead to either elimination or reduction in

expected losses
Manage unexpected variability

Risk taking It is the act of incremental risk to in order to generate incremental gains

Risk Management Process

Acronym i-qemp

Steps:

1. Identify the risks

2. Quantify the estimate the risk exposure or determine appropriate methods to transfer
the risk
3. Determine the collective Effects of the risk exposure or perform a cost benefit analysis
on risk transfer methods.
4. Develop a Risk Mitigation strategy - Avoid, transfer , mitigate or assume risk
5. Asses Performance and amend risk mitigation strategy as needed

Challenges in Risk Management(RM) Process

1. The Economy to be well diversified for RM to be beneficial

2. RM failed to identify market disruptions and account fraud
3. Derivatives are used to take high leverage and show less risk
4. M is a zero sum game. It can be only be transferred from one point to another

Measuring and Managing Risk

Quantitative Measures

VaR and Economic Capital

VaR effective when: normal conditions, short term and liquid position

Economic capital The minimum liquid capital required to face against a potential loss

Qualitative Measures

Stress Testing Financial outcome under a induced stress condition

Scenario Analysis Analyse potential risk factors when uncertainties are involved and factors
are non-quantifiable

Enterprise Risk Mgnt.

Considers entity wide risks and tries to integrate risk consideration into decision making.

Senior risk committee may exist within the entity to ensure that risks affecting the entity are
examined.

The Board of directors decide on the specific risk exposure limits

Expected loss Loss which is expected under normal business conditions

Unexpected Loss Loss which is expected under outside the normal course of business

Correlation Risk Unfavourable events happen together to intensify the potential loss

Example -1: Economic Recession leads to loan losses as the customers have reduced
disposable income during recession.

Example 2: Default risk of loan against real property rises when the recovery rate drops. This
risk occurring simultaneously could drive up the potential losses to unexpected levels.

Risk and Reward

Higher Risk higher potential reward.

Portion of the variability that is measurable as a probability function could be thought as risk
whereas the portion not measurable could be thought of as uncertainty.

Risk Classes

Market Risk Changes in Market prices and rates will result in investment losses

Equity Risk 1) General Market Risk changes in price of stock due to market indices 2)
Specific Risk changes in stock prices due to unique factors related to the company
Interest Rate Risk 1) Changes in the interest rates 2) Shift in the yield Curve 3) basis
Risk
Foreign Exchange Risk Arises because of unhedged for not fully hedged currency
positions
Commodity Price Risk Price volatility of different commodities. Few players holds
commodities who manipulate the prices of the commodity

Credit Risk - loss suffered by a party due to counterparty fails to meet its financial
obligations to the party under the contract.

Default Risk - non-payment of interest and/or principal on a loan by the borrower to

the lender
Bankruptcy Risk liquidation value of the collateral during bankruptcy is insufficient
to recover full lose
Downgrade Risk Creditworthiness of the counterparty decreases causing him to pay
higher interest rate which further leads to default
Settlement Risk the position in which the losing party in a transaction refuses to
pay on settlement

Liquidity Risk

Trading Liquidity Risk Not in position to find counterparty who is ready to take the
other side of the transaction
Funding Liquidity Risk Creditor not in position to raise capital for debt repayment or
financial obligation

Operation Risk Non financial problem, incompetent employees, inadequate technology,

insufficient internal control, fraud, human error and natural disaster
Legal and Regulatory Risk Legal risk could arise when one party sues the other to nullify
the transaction. Regulatory risk is when changes in the regulatory framework turn
unfavourable for the firm

Business Risk uncertainty regarding the firms income statement. Uncertainty on demand
for products and losses due to price set for the product.

Strategic Risk Large new business investment which carry a high degree of uncertainity
as to ultimate success and profitability. Or and Entity changing its Business Strategy

Reputation Risk 1) general trustworthiness that lies with the company by its creditors and
counterparties 2) Perception of fair dealing and conduct business in ethical manner
Chapter 2 Corporate Risk Management

Hedging Risk Exposure

Modigliani & Miller Conditions

Perfectly Competitive Capital Market

No Transactional Cost
No Taxes
Argument The value of the firm remains constant despite attempts to hedge risk

William Sharpe Conditions

Perfect Competition capital markets
No transactional cost on diversification
Argument Firm should only be concerned with systematic risk ( risk that is common to all
market participant). Shouldnt concern with unsystematic risk as it can be diversified using
a large investment portfolio

Assumption of hedging to be a zero sum game is not likely true as the derivatives which do
not have linear payoff are complex and not as accurately priced as the equity or bond.
Therefore are not likely to reflect all its risk factors.
The Theories doesnt consider the cost of financial distress and bankruptcy

Practical Disadvantages of Hedging Practical Advantages of Hedging

Lose focus on the core business Cost of Capital decreases
Require special skill to hedge Less volatility in earning/cash flows aides in
greater debt taking capacity
Flawed hedging could result in greater loss Few restriction from lenders
than hedged
Compliance Cost related to disclosure and Control financial performance
accounting
Might reveal secret operational information Might improve operational results of the firm
Hedging might increase earning variability Swaps and options might be cheaper
instruments than insurance
Firm should be aware of its risk and return goals. They should be approved by
the Board of directors
The Role of Board of Directors
Mgnt. And Board should set and communicate the firms risk appetite in a
quantitative and qualitative manner
Explicitly state the risks which the firm could tolerate and the risks which it
cant tolerate
Use quantitative methods like VaR to convey maximum loss the firm
will tolerate for a given confidence interval and given time period
Using Stress Testing to consider possible but severely negative impact
situation and determine the level of losses

Potential issue in determining the risk appetite is due to the conflict

between debtholders and shareholders.
The goals set by board should be objectively clear and actionable on
performance evaluation and measurement perspective criteria
Clarity in terms of either accounting or economic profits to be hedged. No
possible to hedge both accounting and Economic Profits at the same time.
IF accounting profits are to be hedged then question about Short term vs
Long term profits
 Risk limits on the mgnt.
Consider time horizon when determining its risk mgnt goals for mgnt. To
achieve

Process of Risk Mapping

The firm should be clear about the risk and know which risks are insurable and non-
insurable and which risks are hedgeable and non-hedgeable. Apart from this thorough
analysis based on the Market risk, credit risk, business risk and operational risk the
company would be facing
Hedging Operational and Financial Risks
Operational Risk pertains to production and cost and mainly deal with income statement
of the firm
Financial Risk pertains to balance sheet

Pricing Risk Risk in uncertainty over input prices. Could be hedged using a forward or a
future contract.
Foreign Currency Risk
Use of
Currency put options
Forward contracts
Using foreign currency debts to offset foreign currency assets
Leaving it unhedged as sometime hedging could be very costly
Interest Rate Risk Interest rate swaps could be used to hedge this risk

Static vs Dynamic Hedging

Static Hedging Simple process. Risk investment position is determined initially and
appropriate hedging vehicle is match to position it as closely and as long as possible.
Dynamic Hedging A complex process. Recognises the attributed underlying risky position
changes. Higher transaction cost, time and monitoring efforts
Additional hedging considerations
Consider relevant time horizons and see to that performance evaluation
matches it
Asses the financial accounting implications of using complex financial
derivatives
Taxation of derivatives is key issue and is different in different parts of the
world which further increases significant costs

Risk Management Instruments

Exchange traded instruments / OTC instruments
Or Real options such in the case of foreign exchange risk u maintain assets and liabilities in
the same currency
 Chapter 3 Corporate Governance and Risk Management

Board of Directors ensures objectivity in decision making

Board of Directors should majorly consist of independent members
BoD should have sufficient knowledge about the firm and industry
BoD caters to the interest of stakeholders and should ensure Mgnt. Doesnt involve in
activities with high downside risk
The board should be aware of the agency risk. Compensation committee within the board
should design the remuneration of the management so that they are congruent with the
corporate goals
The Board should maintain its independence from management
CEO should not be given additional powers on the board
CRO part of the management but attend board meetings. Duty to link corporate
governance with the firms Risk Management

 Chapter 13 Principles For Effective Risk Data Aggregation and Risk Reporting

Benefits of effective risk data aggregation (RARR Risk Data aggregation and
risk reporting)

Risk data aggregation Defining, Gathering and Processing Risk data according to the
Banks risk reporting requirement to enable the bank to measure its performance against
the risk tolerance/risk appetite

AGGREGATION Breaking down, Sorting and Merging

Benefits:

Anticipate Problem holistic view of the risk using aggregated data

Identify routes to return to Financial Health
Improved Resolvability
Increased efficiency, reduced the chances of loss and ultimately increases
profits
Governance
Basel Committee pushed for greater capital models and risk management
models to improve banks capability regarding the recognition and mgnt of bank wide
risks
Principle 1 Governance
Banks RA&RR should be consistent with the Basel norms according to
the committee
RA should be part of risk management framework and to give it
adequate resources they should be approved by the senior management
RARR practices should be
Fully documented
In event of new initiative, NPD, acquisition or divestiture. The
target firms RARR should be assessed by the bank and time frame should be
provided to integrate the process of two firms
The document to be independently reviewed and validated with
individuals expertise in IT and Risk reporting functions
Banks structure location/geographical presence , shouldnt affect
Banks RARR and RARR should be independent
Responsibility and accountability for RARR should be made with
discussion from Finance and HR functions. Strategic IT planning should also be
included in RARR
Supported by Board of Directors, who should remain aware of the banks
implementation of and compliance with the key governance principles set out by
the Basel committee
Data Architecture and IT Infrastructure
IT systems are expensive and RARR require significant amount of commitment from
Financial and HR. Benefits are realised over long term and Basel believes that the benefits
outweigh the investments in the long term
Principle II
Build and support Data Architecture and IT infrastructure with commitment from
Financial and HR not only in the normal situations but also during the time of crisis
and stress
RARR should be part of banks planning process and subject to business impact
analysis
Banks establish integrated data classification and architecture across the
banking group. Multiple data models may be used as long as there is a robust
 automated reconciliation measure in place. Data architecture should consist of data
characteristics and naming conventions for legal entities , counterparties, customers
and account data
Accountability , roles and responsibilities should be defined relative to the data.
Risk managers, Business managers and It functions are responsible for accurate
entries aligned with the data taxonomies and consistent with the bank policies

Risk Data Aggregation Capabilities

Principle 3 Accuracy and Integrity

Data should be generated on a large automated basis to minimize the probability of errors
and generate accurate and reliable data both during the normal and stress conditions
Data aggregation and reporting should be reliable and accurate
Robust controls similar to accounting data should be used for risk data
Effective controls should be placed if the bank relies on manual or desktop data
Data should be reconciled with other bank data to ensure accuracy
Bank should endeavour to have a single authoritative source of risk data for each specific
type of risk
Risk personnel should have access to data to prepare reports
Data should be recorded consistently across the bank and bank should maintain a
dictionary of risk data concepts and terms
There should be balance between manual and automated risk management systems
Bank supervisors expect banks to document manual and automated risk data aggregation
systems and explain when there are manual workarounds, why the work arounds are
critical for data accuracy and propose actions to minimize the impact of manual
workarounds
Banks should monitor the accuracy of the risk data and take step to correct poor data
quality

Principle 4 Completeness
Both on and off balance sheet risks should be aggregated
Risk measures and aggregations methods should be clear and specific enough that senior
managers and the board of directors can properly assess risk exposures
Bank risk data should be complete. If incomplete identify and explain the area of
incompleteness of the data
Principle 5 Timeliness
Risk data aggregation should be timely and should meet all the requirements of the
reporting. Bank supervisors will review the timeliness and specific frequency requirements
of the bank risk data in normal and stress/ crisis periods
Critical risk should be measured timely both in normal and stress conditions:
Aggregated credit exposure to large corporate borrowers
Counterparty credit risk exposures, including derivatives
Trading exposures, positions and operating limits
Market concentrations by region and sector
Liquidity risk indicators
Time-critical operational risk indicators
Principle 6 Adaptability
The bank should be able to generate the reports ad hoc basis according to the requirement of
different internal needs and request to meet supervisory queries
Requires:
The data aggregation should be adaptable and flexible. This helps the board and managers
to conduct stress testing and scenario analysis easily. Ad Hoc report generation to meet
the need for identifying emerging risks
Adaptability means:
 Aggregation process should be flexible and should allow bank managers to asses
wucikly for decision making process
Data should be customisable and should allow the user to investigate specific
risks in greater details
It should be possible to include newer aspects of the business and outside facors
that influence overall bank risk
Regulatory changes should be incorporated in the risk data aggregation
Bank should be able to pull out specifics from aggregated risk data

In addition, the bank should not have high standards for one principle at the expense of
another. Aggregated risk data should exhibit all of the features together, not in isolation

Effective Risk Reporting Practices

Includes
Clear, Complete, timely and accurate data
Risk data is reported to the right people at the right time

Principle 7 Accuracy
Risk Management reports should accurately and precisely convey aggregated risk data and
reflect the risk in an exact manner.

Report should be accurate and precise

Accuracy ensure:
Define processes used to create the risk reports
Create reasonableness checks of the data
Include descriptions of mathematical and logical relationships in the data that
should be verified
Create error reports
Bank should ensure the reliability, accuracy and timeliness of risk approximations
Board and senior manager should establish precision and accuracy requirements for
regular and stress/crisis risk reports. Criticality of the decisions made using the data should
be clearly stated
Banks require accuracy of risk data to be maintained as par with accounting data

Principle 8 Comprehensiveness
The risk reports should encircle all the risk areas within the organisations which should be
consistent with the complex operations and risk profile of the bank and as well as the
requirements of the recipients
Require:
Reports should contain position and risk exposure information for all relevant risks
Risk reports should be forward looking and should include forecasts and stress tests
Bank supervisor should be satisfied that risk reporting is sufficient in terms coverage,
analysis, compatibility across institutions
Principle 9 Clarity and usefulness
Reports should be tailored for end user and should assist them with Risk management and
decision making
Report will include
Risk data
Risk analysis
Interpretation of risks
Qualitative explanation of risks
The board should tell senior management if the risk management reports they get are not
insufficient or redundant
 Risk data should classified
Bank supervisors will confirm periodically that the risk data is clear, relevant and useful for
decision making
Principle 10 Frequency
Frequency of the reports will vary depending on th ereceipient , the type of risk and the
purpose of the report. The bank should periodically test whether reports can be accurately
produces in the established time frame during normal and in stress conditions
In stress conditions market risk, credit risk and liquidity risk reports may be required
immediately in order to react to the mounting risks
Principle 11 Distribution
Reports should be disseminated in a timely fashion while maintaining confidentiality where
required
Chpater 7 Deciphering the liquidity and Credit Crunch

Key factors leading to th ehouding bubble

Cheap credit
Increase in demand for US securities
Lax measure on interest rates post internet bubble
Decline in Lending Standards
Traditional lending methodology replaced with Originate to distribute model
loans lent where sliced into tranches and distributed for trade in the market
These two factors led to cheap money at low interest rates and lenient borrowing process
flood the real estate purchases

Banking Industry Trends and Liquidity Squeeze

Liquidity squeeze caused by two major banking trends
Risk transference through asset securitisation
Asset Liability maturity mismatch

Securitisation
Risk related to loans transferred to borrowers through securitisation CDO
Asset Liability maturity Mismatch
Sponsoring banks created Special Investment Vehicles (SIVs) which purchased long term
securities by giving away short term commercial papers and involving in repo transactions.
Liquidity backstop was created by a credit line to these banks. These credit remained an
off balance sheet item. This further led to funding liquidity risk in which the obligators
werent able to satisfy the short term money requirement
CDO
 Financial Disasters

Financial Disasters

Misleading reporting / Large Market Moves Customer Business

1) LTCM Bankers
Valuation Imaginary Hoarding Trust
Issue Trades - Liquidity
and Leverage
1) Chase Barings Subitamo - Tail Risk
Manhattan Bank Vs.
Allied Irish -
- collateral bank Convergence
Valuation Strategies
2) Kidder - Model Risk
Peabody
2)
- pricing of Mettagessels
forwards haft
3) UBS

- Basket of
Equity
options
1) Chase Manhattan and Drysdale Securities

Treasury Treasury
Securities Dealer Securitie Chase Manhattan Securitie Drysdale

Collateral Capital
300 20

Drysdale borrowed T-sec from securities dealer through Chase Manhattan

Chase Manhattan was an intermediary who was acting as broker simultaneous buying
securities from dealers and sell securities to Drysdale
Drysdale securities was indulged in an arbitrage trade
Strategy Selling short US treasury outright for the market price + accrued interest in
the G Sec market. At the same time borrowing US treasury at the market price only in
order to cover his shorts in the repo market. He was making money of the accrued
interest with no cost. Since at that time repo transactions were generally overnight
modelling accrued interest did not seem important.
The arbitrage strategy was good as it led to gain in 2 of the possible 3 scenarios,. If the
market goes up then loss otherwise profit in other two cases
 For borrowing the T-sec Drysdale has to post collateral with Chase Manhattan.
Collateral was valued didnt accrued interest
Market rallied and Drysdale could keep up with Coupons causing huge losses.
Although chase employee believed they were agents in transaction and were not taking
any direct risk on behalf of Drysdale. However, the legal documentation didnt support
the claim as they were acting as principals, thus making Chase Manhattan to pay
coupon to security dealers.
Drysdale exploited a flaw in the valuation of US securities

Lessons Learnt

The securities industry learned that there should be clearer method in computing Bond
valuations
Chase and other companies may have had similar control deficiency learned that and
new proposal should be approved by principle risk control functions

Kidder Peabody

Value of Forward Contract S*e^rt S

When bond is purchased and forwards are sold

No cash loss but stakeholders lost confidence in company

Kidder Peabody booked profits by artificial gains artificial reporting inflated profits
Jett accounting loopholes in forward contract valuation

Lessons Learnt
Always investigate a stream of unexpected profits thoroughly and make sure is completely
the source
Periodically review models and system. Changes in the model require changes in the
assumptions

Union Bank of Switzerland

Many reasons for its failure
Very Large stake in LTCM ( 40% direct stake and 60% indirect stake) concentration risk
Unusual independence to Equity derivates division
Senior Risk Manager was the head of Quantitative Analytics
Compensation tied to trading results
Wrong Valuation model for valuation of long-dated equity options. Since long dated equity
options didnt have liquidity they used mark to model instead of mark to market. This
value was not released later on
Bank warrants were inappropriately hedged
British tax law changes