1. FRM BoI-2001 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Financial Risk Management 2

2. Zvi WienerFRM-2 slide 2 Regulation of Financial Intermediaries take deposits, give loans very small equity capital, big leverage FDIC, CDIC, Israel - implicit domino effect Minimal capital requirements (8-9%)

3. Zvi WienerFRM-2 slide 3 Banks major increase of off-balance sheet in 80s 1988 Basle accord (88 BIS Accord) - international minimum capital guidelines (credit risk). 1996 Amendment - market risk + VaR. Amendment = BIS 98

4. Zvi WienerFRM-2 slide 4 Accord + Amendment assets to capital  20 eligible capital/risk weighted assets  8% minimal capital charge for market risk concentration risk:  positions of 10% must be reported  positions of 25% need special permission

5. Zvi WienerFRM-2 slide 5 Accord + Amendment regulators encourage banks to develop models. Banks must implement a RM infrastructure in their daily RM - limits, monitoring, etc. G-30 report, 1993.

6. Zvi WienerFRM-2 slide 6 G-30 policy recommendations The Role of senior management Marking to market Market valuation methods Identifying revenue sources Measuring market risk (VaR) Stress simulation Investing and funding forecasts

7. Zvi WienerFRM-2 slide 7 G-30 policy recommendations Independent risk management Practices by end-user Measuring credit exposure Master agreements Credit enhancements Promoting enforceability Professional expertise

8. Zvi WienerFRM-2 slide 8 G-30 policy recommendations Systems Authority Accounting practices Disclosures Recognizing netting Legal and regulatory uncertainty Tax treatment Accounting standards

9. Zvi WienerFRM-2 slide 9 1988 BIS Accord Developed by Basle committee Accepted by G-10: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, UK, USA. minimum asset to capital multiple risk based capital ratio

10. Zvi WienerFRM-2 slide 10 1988 BIS Accord risk based capital ratio - solvency ratio (Cooke ratio). Capital divided by risk weighted on- balance-sheet assets plus off-balance- sheet exposures. Weights are based on credit risk. No netting or portfolio effects! No market risk.

11. Zvi WienerFRM-2 slide 11 1988 BIS Accord The Assets-to-capital multiple  20 Bank’s total assets divided by its total capital. Some off-balance-sheet items, like letters of credit are accounted at nominal.

12. Zvi WienerFRM-2 slide 12 Weights in Cooke ratio On-balance-sheet items: 0%Cash, gold, OECD government claims, insured mortgages. 20%OECD banks, OECD public sector entities. 50%Uninsured residential mortgages. 100% All other claims.

13. Zvi WienerFRM-2 slide 13 Cooke ratio Off-balance-sheet credit equivalent. 1. Nonderivative exposure - conversion factor is set by regulators between 0 and 1. 2. Derivative exposure = Current replacement cost + Add-on amount Risk weighted amount =  Assets*W+  Credit equivalent*W

14. Zvi WienerFRM-2 slide 14 Cooke ratio Banks are required to maintain capital equal to at least 8% of their total risk weighted assets. (In Israel 9%.)

15. Zvi WienerFRM-2 slide 15 Capital Tier 1. Stock equity, preferred stock, minority equity interest in consolidated subsidiaries, less goodwill and other deductions. Tier 2. Cumulative perpetual preferred shares, 99 year debentures, some subordinated debt (  5y). Tier 3. Can be used to cover market risk only. Short term subordinated debt (  2y). Tier 1 + Tier 2  8%, and Tier 1 must be at least 50% of this amount.

16. Zvi WienerFRM-2 slide 16 Models Standard model. Internal models (based on VaR). (3*marketVaR 10d +4*creditVaR 10d )*trigger/8 trigger = 8 in North America and between 8 and 25 in the UK

17. Zvi WienerFRM-2 slide 17 Problems with the current approach No distinction between a loan of $100 and 100 loans of $1 each one. Turkish bank has lower capital requirements than General Electric. A loan to AA rated firm is treated as a loan to a B rated firm. Some similar contracts are treated differently.

18. Zvi WienerFRM-2 slide 18 New proposals BIS 2000 VaR based approach to credit risk.  CreditMetrics  CreditRisk+  KMV  Merton.

19. Zvi WienerFRM-2 slide 19 New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements

20. FRM BoI-2001 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html RM functions

21. Zvi WienerFRM-2 slide 21 Structuring RM functions Set firm-wide policies Develop methodology Set RM structure Risk communication

22. Zvi WienerFRM-2 slide 22 Integrated Risk Management Identify and avoid Monitor Limit Management Stress Market, Credit VaR Risk Analysis Allocate capital RAROC Active Risk Management

23. Zvi WienerFRM-2 slide 23 RAROC Risk Adjusted Rate of Return Performance measurement Marginal impact of any new transaction Consistent pricing

24. Zvi WienerFRM-2 slide 24 New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements

25. Zvi WienerFRM-2 slide 25 Goals and Instruments Risk Tolerance - “worst loss” Stop losses Capital allocation Credit risk policy Operational risk policy

26. Zvi WienerFRM-2 slide 26 Risk Measurement Consistent market based method Old  limits  duration, ALM VaR + Stress Backtesting

27. Zvi WienerFRM-2 slide 27 Systems Data bases  market  position  rules Risk measuring tool Reports and decision support

28. Zvi WienerFRM-2 slide 28 IT - Information Technology Unifying information from various units Unifying information from various markets Unifying information for various ownership Back office and execution control

29. Zvi WienerFRM-2 slide 29 Organizational structure Front office Middle office Back office

30. Zvi WienerFRM-2 slide 30 Front office execution risk taking marketing

31. Zvi WienerFRM-2 slide 31 Middle office risk management pricing economic forecasts

32. Zvi WienerFRM-2 slide 32 Back office verification booking reporting collection settlement

33. Zvi WienerFRM-2 slide 33 ALCO Assets Liability management committee responsible for  establishing  documenting  enforcing all policies involving market risk FX liquidity interest rate

34. Zvi WienerFRM-2 slide 34 Interdependence of RM Senior Management Risk Management Operations Trading Room Finance

35. Zvi WienerFRM-2 slide 35 Senior management Approves business plan and targets Sets risk tolerance Establishes policy Ensures performance

36. Zvi WienerFRM-2 slide 36 Trading Room Management Establishes and manages risk exposure Ensures timely and accurate deal capture Signs off on official P&L

37. Zvi WienerFRM-2 slide 37 Operations Books and settles the trades Reconciles front and back office positions Prepares and decomposes daily P&L Provides independent MTM Supports business needs

38. Zvi WienerFRM-2 slide 38 Finance Develops valuation and finance policy Ensures integrity of P&L Manages business planning process Supports business needs

39. Zvi WienerFRM-2 slide 39 Risk Management Develops risk policies Monitors compliance to limits Manages ALCO process Vets models and spreadsheets Provides independent view on risk Supports business needs

40. Zvi WienerFRM-2 slide 40 Risk Limits Global risk limit Risk limits for trading desks/units Dynamic monitoring and adjustment

41. Zvi WienerFRM-2 slide 41 Risk Approaches Accounting - reported P&L Economic - value Liquidity needs

42. Zvi WienerFRM-2 slide 42 Liquidity Rank Based on forecasts and potential availability of funds. Hot funds - can be withdrawn quickly. Stable funds - typically to maturity.

43. Zvi WienerFRM-2 slide 43 Israel 339 Definitions of risk types Relates to all banking institutions Management structure Exposure document Directors and policy Risk manager Internal audit

44. Zvi WienerFRM-2 slide 44 Israel 339 IR risk Market risk Risk audit unit

45. Zvi WienerFRM-2 slide 45 Israel 341 Capital requirements against market risk Risk measurement Trading portfolio Reporting Examples of standard approach and VaR

46. Zvi WienerFRM-2 slide 46 Israel 341 Capital requirements against market risk Risk measurement Trading portfolio Reporting Examples of standard approach and VaR

47. Zvi WienerFRM-2 slide 47 Qualitative Requirements An independent risk management unit Board of directors involvement Internal model as an integral part Internal controller and risk model Backtesting Stress test

48. Zvi WienerFRM-2 slide 48 Quantitative Requirements 99% confidence interval 10 business days horizon At least one year of historic data Data base revised at least every quarter All types of risk exposure Derivatives

49. Zvi WienerFRM-2 slide 49 Types of Assets and Risks Real projects - cashflow versus financing Fixed Income Optionality Credit exposure Legal, operational, authorities

50. Zvi WienerFRM-2 slide 50 Risk Factors There are many bonds, stocks and currencies. The idea is to choose a small set of relevant economic factors and to map everything on these factors. Exchange rates Interest rates (for each maturity and indexation) Spreads Stock indices

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54. Zvi WienerFRM-2 slide 54 Board of Directors (Basle, September 1998) periodic discussions with management concerning the effectiveness of the internal control system a timely review of evaluations of internal controls made by management, internal and external auditors periodic efforts to ensure that management has promptly followed up on recommendations and concerns expressed by auditors and supervisory authorities on internal control weaknesses a periodic review of the appropriateness of the bank’s strategy and risk limits.

55. Zvi WienerFRM-2 slide 55 Risk Management Issues Why only half of the bond was called? Why only 800,000 shares were protected? How to choose the protection level? When does it make sense to hedge?

56. Zvi WienerFRM-2 slide 56 New proposals BIS 2000 VaR based approach to credit risk.  CreditMetrics  CreditRisk+  KMV  Merton.