Market Risk

Definition Possibility of loss due to changes in the market factors Market risk affects the bank’s earnings Market risk reduces the capital position of banks Volatility of market values Affects bank’s ability to meet its obligations

Bank for International Settlements (BIS) Adverse change in value of balance sheet positions on balance sheet positions Off balance sheet positions Movements in Equity market Interest rate market Currency exchange rate Commodity prices

Focus of Market Risk Liquidity risk Market risk Interest rate risk Foreign exchange risk Commodity price risk Equity price risk

Organizational Structure of Market Risk Board of Directors Risk Management Committee Asset Liability Management Committee Market Risk Group

Structure of the Market Risk Group in Banks Board of Directors Risk Management Committee Asset Liability Management Committee Market Risk Group

Board of Directors Overall responsibility for market risk Risk Management Policy of the bank Setting of limits for Liquidity Interest rate Foreign exchange rate Commodity trade Equity trade

Risk Management Committee Board level sub committee Chief executive officer Head of credit Head of market Head of operations Strategy for integrating bank risk Responsible for Guidelines for market risk measurement Compliance with market price risk policy Review of market risk limits, triggers, stop-loss positions Effectiveness of market risk system Quality of staff

Asset Liability Management Committee Responsible for adherence of limits, targets, stop-loss orders Product prices for deposits and advances Decision on maturity profile of assets and liabilities of the bank Forecast interest rate views of the bank Decision on business strategies Review funding policy Decide the transfer pricing policy Review economic and political impact on balance sheet

Market Risk Group Responsible for analyzing risk Responsible for monitoring risk Responsible for reporting risk profiles to ALM Committee Preparation of forecasts Simulation models

Value-at-Risk Concept of Market Risk Potential gain or loss In a position In a portfolio Associated with a price movement Measured as a probability In relation to a time horizon

Value-at-Risk Requirement Instantaneous price shock for a specified holding period One tailed confidence interval of 99% Historical observation of at least one year Adjustments in terms of correlation Within risk factors Across risk factors

Capital Requirement for Market Risk Tier 1 capital Shareholders’ equity Retained earnings Tier 2 capital Supplementary capital Tier 3 capital Short term subordinated debt (Tertiary capital held by banks to meet part of market risk – undisclosed reserves and general loss reserves)

Requirements for Consideration of Tier 3 Capital Initial maturity of at least two years Limited to 250% of bank’s Tier 1 capital that is allocated to support market risk Tier 2 capital could be substituted for Tier 3 up to 250% Tier 3 capital subject to lock-in provisions

Difficulties in Implementing Market Risk Capital Adequacy Requirements Market price movements are not normally distributed Wide dispersion Fat tails Extreme events Event risk is difficult to account for Exceptional market scenarios Difficult to account for intra-day trading risks Historical representations may not repeat and market risk may be due to factors not encountered earlier