Theory questions Operational Risk What are the dimensions of market risk?

Securities Market: Positions in traded securities with systemic and non-systemic risks. Such volatilities may lead to losses. Interest Rate Risk: Interest rate risks are relevant for financing structures in bonds or similar interest products. Shifts in the interest rate curve impact the P & L as well as the A & L values. FX Exchange Risk: All P & L positions as well as A & L or eventually off-balance sheet positions may appear with lower/higher values due to FX exchange rate volatilities. Commodities: Commodities may be only traded positions or important for production, directly or indirectly. Volatilities may impact massively the P & L. What is one definition for operational risk management according Basel II? Operational risk management is managing the risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. What are the dimensions of credit risk? Credit Risk Quality: Credit risk is a potential loss due to a debtor's non payment of a loan or other credit form (either the capital or interest or both). The default events include all of either a delay in repayments, restructuring of borrower repayments, or bankruptcy. Counterparty Risk: Reduction of a counterparty rating which causes for the affected firm an increase of financial payments and for fixed income position holders a reduction in their assets due to a decrease in the market value of the position. Define the different terms of capital, what are the different approaches to calculate regulatory capital? What are the advantage and disadvantage of these approaches? Booked capital: Effective capital, equity in the books Economic capital: Risk-adjusted capital Regulatory capital: Basel I / II / III capital Target capital: In accordance with the future (see slide 16, presentation S. Schmid) Basic - standard - advanced approach: IRB approach: foundation/basic or advanced IRB approach Targets of Basel II? - Better handling of risks - No increase of overall capital in the market - Dealing appropriate with products/transactions - Fair competition

K = * GI
= 15%

K = (1-8 * GI)

CREDIT RISK K = PE * LGE * EI

PE: Probability of a loss event LGE: Loss given event EI: Exposure indicator Or: ACP = PD * LGD * EAD PD: Probability of default LGD: Loss given default EAD: exposure at default

= 12-18% per business line Alternate approach: K = (RB * 0.035 * LARB) LARB : total outstanding loans and advances avrg past 3y

MARKET RISK
K = VaR * factor (3-4x)

What is the role of the Basel Capital Accord? What are the 3 pillars of Basel II? The Basel Committee, established by the central-bank Governors of the Group of Ten countries at the end of 1974, meets regularly four times a year. The Committee does not possess any formal supranational supervisory authority. In 1988, the committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. This system provided guidelines for the implementation of a credit risk measurement framework with a minimum capital standard. The three pillars are 1. minimum capital allocation 2. supervisory review process a. Board management and oversight b. Sound capital assessment

c. Comprehensive capital assessment d. Monitoring and reporting e. Internal control review 3. market discipline and disclosure requirements. Minimum capital requirements consist of three components 1. Definition of capital / 2. Definition of RWA / 3. Minimum ratio of capital/RWA (8%) Changes to Basel I in treatment of credit risk and explicit treatment of op risk Supervisory review is based on a series of guiding principles, which point to the need for banks to assess their capital adequacy positions relative to their overall risks and for supervisors to review and take appropriate actions in response to those assessments. Market discipline or public disclosure encourages safe and sound banking practices through effective market disclosures of capital level and risk exposures. How is the overall risk-taking capacity composed? Overall Risk taking capacity = Tier 1 Capital + Reserves + Intangibles + Expected net gains + Other

What are the 4 parameters of credit risk in Basel II? Probability of default (PD): probability of default (regulatory definition of default event) of the borrowers in each risk grade/rating on a one year time horizon Loss given default (LGD): loss after the event of a default Exposure at default (EAD): outstanding amount at time of default Maturity (M): remaining effective maturity of EAD The three approaches differ in the source of parameters, either external/regulatory predetermined or an internal estimate. Calculate

What is the difference between Basel I, II and III? What has been improved? Basel II and III: Basel III Total regulatory capital ratio consists of Tier 1 Capital Ratio - a capital conservation buffer - a countercyclical buffer - additional capital requirement for systematically important banks What is economic capital? Economic capital is the level or amount of capital that a financial institution should hold to ensure it has sufficient buffer against unexpected losses (within a given level of confidence). This does not cover stress losses, against which it is too expensive to hold capital. What questions can Economic Capital answer? - Level of capitalization (Optimize capital) - Business unit performance (Optimize performance!) - Hedging and insurance programs (Optimize mitigation techniques!) - Asset attribution and ALM (Optimize risk/return rate!) What is credit value-at-risk and how are economic capital and rating connected? Credit value-at-risk is usually a Poisson distribution (never a normal distribution). The risk is the bigger, the higher probabilities of default / losses given default / asset value correlations and credit maturities. AA = 99.9% VAR, A = 99% VAR, BBB = 95% VAR What is the role of Economic Capital? - Aggregate risk with a single, consistent approach - Asses risk on a consistent basis across the firm for different risk drivers - Determine whether risk profile is in line with the risk-bearing capacity of firm - Complements specific risk measures - Provides increased risk transparency - Provides basis for risk-adjusted performance measures - Input into capital allocation process What are the benefits with use of economic capital? - Better risk management - Improved Credit Ratings - Improved Capital Management How did economic capital techniques evolve? Stage 1: Risk Analysis Stage 2: Capital attribution and limit setting Stage 3: Risk-adjusted Performance Measurement (RAPM) Stage 4: Forward-looking projection Name and qualify some approaches to calculate economic capital? Top down approaches: earning volatility approach, option theoretic approach Bottom up approaches: stress testing, risk based per risk type (with a distribution and convolution = similar to cross-correlation).

How can economic capital be allocated? - Stand-alone contribution - Incremental EC contrib. (subtracting from EC the individual BU, not additive!) - Marginal EC contributions (volatility based: VaR, ES) What is done to reflect true or economic risk? Risk-adjusted performance metrics (RAPM), based on standard accounting performance metrics, some adjustments are made to reflect true or economic risk. ROE or ROC are insufficient because - There is no risk premium - Capital costs per BU were not possible - The added-value (EVA) is unknown - Wrong signals may occur (high risk and capital contribut. not considered) Formula: RAPM (risk adj. perf. meas.) = Return Costs expected loss Economic Capital Return Costs expected loss Capital Net income Allocated Risk Capital

RAROC (risk adj. return on capital)=

RORAC (return on risk adj. capital) = RARORAC (risk adj. return on risk adjusted capital) =

What is the objective/benefit of a leverage ratio? A simple non-risk based measure based on gross exposure (!) thereby helping avoid destabilizing deleveraging processes. Name some possible risk applications? - Risk Identification - Risk Measurement and Performance - Risk Management - Risk Controlling and Reporting - Risk Processes - Risk Strategy - Risk Governance - Risk Capital - Risk Theory Some questions on tactical and strategic Value Based Risk Response? Tactical: - How risky is the customer? - How should we price different loans? - Which relationships are profitable? - Is the risk within its limits? Strategic: - What is the risk profile of my customers?

Which business units have favourable risk/return profile? Which business activities should be expanded? Do we have enough capital to support our risk?

What is the difference between a risk and uncertainty? Risks are events to which the decision-maker can assess probability distributions, whereas uncertainties are events that can not be expressed in terms of such probabilities. (PRMIA handbook)

CREDIT RISK FUNDAMENTALS Credit Risk Measurement - Key Facts What interdependencies exist for the default of two obligors? Mutually exclusive: rare circumstance, failure may increase market share of other Independent: occurrence of one has no influence on probability of other Positive Dependence: if one event occurs, the other is more likely Maximum Dependence: default of one obligor, causes default of another one What is the difference between Lending Risk and Counterparty risk characteristics? In lending risk, only one party takes a credit risk and the outstanding exposure is usually known and fixed. In counterparty risks, both parties take risk and the future outstanding exposure in unknown in magnitude and sign (driven by market risk factors). In the latter case, the quantification of the exposure is difficult to quantify and driven by volatility. What is the effect of collateralization and which risk determinants influence collateralized trades? In collateralization, the life of a trade risk is transformed into a short time horizon risk and credit risk is transformed into market risk. The risk determinants of collateralized trades: - Re margin period - Exposure volatility - Collateral volatility - Correlation risk - Gap risk - Liquidity and liquidation risk (only about 10% of average daily trading volume can be liquidated) Slides page 9, Credit Portfolio Modelling (Mathematics) What are the four main requirements towards a credit rating model? - Discriminatory power - User acceptance - Implementability - Cost/Benefit What are the four steps in a development of a scorecard credit rating model? - Data sourcing and sample preparation - Single-Factor analysis - Multi-Factor analysis - Calibration What are the four cornerstones of credit analysis or approval? - Rating / Expected loss - Credit Guidelines / Policies - Debt Capacity - Single Obligor Limit (exposure concentration limit) / Limit system

Slide page 16+17, how to measure the portfolio loss distribution (Intensity and structural models / Correlation of structural default) Name 3 differences between unexpected loss allocation and expected shortfall allocation? Allocation according to unexpected loss - Distributes the capital needed to cover large but not extreme loss events - Tends to penalize low credit quality, insensitive against concentration risk - Can lead to capital charges in excess of exposure - Is not guaranteed to recognize diversification effects correctly Allocation to expected shortfall - Distributes capital to cover extreme loss events - Sensitive against concentration risk - Diversification be being compliant with fundamental risk measure axioms - Choice of threshold depends on management objectives Example of a securitization process What are the benefits of credit portfolio management? How can it be organisationally integrated? - Reduce earnings volatility through hedging and 2nd market transactions - Improve portfolio value and liquidity - Help overcome existing market or policy constraints - Provide methodology and tool capabilities for credit portfolio modelling - Develop proposals for portfolio strategy, policy and risk appetite Slide 20 pre and post origination for valuing bonds and loans? Pre Origination - Liquid assets: CDS spreads - Illiquid assets: add illiquidity premium to liquid curves Post Origination - Liquid assets: Bond or CDS price - Illiquid assets: Cost to securitize (CTS) Transfer pricing (spread based pricing curves or hedging costs) can be used for both liquid and illiquid assets as well as for pre and post origination.

CREDIT RISK RATING AGENCIES What is a credit rating? A credit rating reflects the credit worthiness of a borrower. That is the willingness and ability of borrower to pay interest and repay credit.

RISK MANAGEMENT IN TURBULENT TIMES 4 decisions in risk management Decisions to take Policy How much risk to take? Investment Policy How much of this risk to retain and how much to insure or transfer? How much capital to keep as a buffer against losses due to this retained risk? How much liquid reserves to maintain? Risk Management Policy

Failure in risk mgmt Banks have taken too much risk Banks have retained too much risk Banks have kept to little capital Banks have kept too little liquidity

Financing Policy

Cash Management Policy

Specificities in turbulent times - Risks are larger and some of them are new (mutuality principle, correlation) - Managers accountability increases more and more (implement. of risk mgmt. policies, Sarbanes & Oxley Act, increased competition can make it difficult to cope with unexpected events) - Risks are more and more global and have to managed as such (consolidation of risk mgmt. is required instead of silo approach, global supply chains) Taxonomy of risks - Exogenous risk - Economic and financial risks 4 Necessary steps of risk management 1. IDENTIFICATION: Tools for Risk Mapping Risk classification table Risk Radar 2. QUANTIFICATION AND MODELLING: Risk Quantification Matrix (Severity/Frequ.) 3. LOSS PREVENTION & PROTECTION/Loss control is twofold: it consists in the reduction of the frequency of occurrence of unwanted events (prevention) and on the other hand, loss control deals with the reduction of the consequences of a risk after it has occurred (protection). 4. RISK FINANCING & TRANSFER/Allocation: If risk is kept, it can be self-insured (retention, not doing anything) or being financed by a special purpose vehicle (SPV), or partially or completely being transferred to another economic agent. Risk Mgmt Triangle 1 (single bearer) bank, supplier n (market) securitization, insurance/reinsurance, derivatives

Operational risks Strategic risks

(Society) war, natural catastrophes

Recently, rise of retention and larger fraction covered on financial markets. A captive is defined as reinsurance or insurance vehicle, owned by a corporation that will use it for the management of its own risks. Second, new types of instruments (finites and securitization): A finite risk insurance (short: finite) is a contract between a corporation (or an insurer who wants to transfer risk) and an insurer (or a reinsurer) which bundles risk transfer and risk financing. Risk Modelling

WHAT CAN GO WRONG WITH MODELS IN INSURANCE? ECONOMIC VALUATION 3 level of valuation: Level 1 traded and valuated, Level 2 (de)compose of Level 1, Level 3 assets and liabilities valued to a model e.g. mathematical reserves at an insurance Basically, there are 2 methods for bonds/debt valuation: 1. Discount the expected cash flow at the expected bond return; or 2. Discount the scheduled bond payments at the rating-adjusted yield-to-maturity Bonds Valuation t (B) = CFk * t (Zk) = CFk * (1+yt(k))-k

Sample yield of a 1-year zero coupon bond: 1% yield of a 2-year zero coupon bond: 2% Price of a two-year bond (Z2)? (Z1) = = 0.990099 t (B) = 2000 (Z1)+102000 (Z2) (Z2) =
( ) ( )

= 0.960978

Forward rates ft (n,m) = ( t (Zn) t (Zm) ) 1/m-n - 1

Sample Nom. Value EUR 100000, term 5 y, i=4%, flat yield curve, bought at par Impact on PV when interest rate changes to 3% or 5%? t Total CF PV 3% PV 4% PV 5% 0 0 1 4000 3883.49 3846.15 3809.52 2 4000 3770.38 3698.22 3628.11 3 4000 3660.56 3555.98 3455.35 4 4000 3553.94 3419.21 3290.80 5 104000 89711.31 85480.41 81486.72 Total 120000 104579.70 100000.00 95670.52 Difference 4579.70 -4329.47 Macaulay Duration k * CFk * t (Zk) d(B) = CFk * t (Zk) Sample above, d(B) = 4.62

Considering Credit Risk by Survival Probabilities t Total CF Surv. P. R. adj. CF R. adj. 4% PV nom 8.37% 0 0 1.00 1 4000 0.98 3920 3769.23 3690.83 2 4000 0.95 3800 3513.31 3405.57 3 4000 0.91 3640 3235.94 3142.35 4 4000 0.86 3440 2940.52 2899.48 5 104000 0.81 84240 69239.13 69559.90 Total 120000 99040 82698.15 82698.15 Difference Markov Chain Representation: A firm's debt rating can change over time, and the value of future cash flows should take into account the possibility of one or more rating changes. In this regard, bond valuation can be modeled as a Markov Chain problem in which a transition matrix is constructed for the probabilities of the firm's debt moving from one rating to another. INSURANCE LIABILITIES

Sample Yearly payment EUR 12000, age 65 swiss male, techn. i = 2.5%, val. date 29.12.06

PRODUCTS AND THEIR RISKS -

STRESS TESTING, CAPITAL MANAGEMENT & REGULATION STRESS TESTING Stress testing is a form of testing that is used to determine the stability of a given system or entity. It involves testing beyond normal operational capacity (e.g. to identify what happens beyond VaR). Case study LTCM, where flight to safety and liquidity were not analysed and drive fund into collapse. CAPITAL MANAGEMENT What is the cost of equity capital? Investors expectations of rate of return, typically between 10% and 20% depending on business risk. WACC is most important figure for cost of capital WACC = * cost of debt * (1- tax rate) + * cost of equity

According theorem, cost of capital is independent of capital structure but tax deductibility favour debt capital. Additionally, the too big to fail options weakens the validity of the theorem. Equity is needed for financing goodwill and buffering risk. Internal charging for cost of capital can be done bottom up through risk aggregation or top down (whereas no standard method has evolved yet). Yield on capital is charged on limits approved and not on limit usages! Real world problem in the bottom up allocation are - correlation, - calculation of the marginal risk attribution of a portfolio, - quantification of operational risks, - focus on actual risk and not on potential earnings, - calculation time is not a big problem. Capital-at-risk (CaR) is used in capital management as common - currency for risk and for an effective capital allocation mechanism that means Credit and Market risk (from trading and treasury) can be compared - On business unit level - Monthly calculation - One common pair of confidence level and holding period Whereas VAR is used in risk management - Confidence level and holding period differ for different business - Single position level - Daily calculation Sample: VaR market risk 10d, 99% VaR credit risk 5y, 99.9% CaR 1y, 99.9% (CaR = CaR market risk + CaR credit risk) Normal distrib. PV changes, scaling confidence leve K(99.9%) = 1.4K(99%)

Scaling holding period with CaR VaR 60.2 (= 42 + 18.2) Market risk Credit risk 42 (=6.0 * 7) 18.2 (= ) 6.0 40.7 Scaling period 10d vs 250 trading d/year Scaling period * 1.4 = 7 Scaling factor confidence interval 1.4

Sample: Top down capital allocation Alternative 1: BU2 shall be developed and gets all capital (strategy-based decision) Alternative 2: Decision based on bids/assured yields (BU1 assures 15%, BU2 10%) The available capital of 100 is split to cover needs of BU1 60.2 and give the rest 39.8 to BU2. BU2 will be charged 15% * 60.2 = 9.03, whereas BU2 is charged 10%, 3.98. REGULATION Each firm is regulated in its financials: accounting rules, tax provisions, disclosure requirements for investors and other stakeholders. Systematic consequences (externalities, which market participants will not take into account when making decisions) are the reason why we have regulations. The Merton call: incentive for shareholders to increase volatility. Managers and owner fully participate in the upside but are limited on the downside. Tax payers are short a Merton call, shareholders suffer from asymmetric information. The too-big-tofail option exacerbates this asymmetry. A default of a bank affects the whole economy. The second-best solution is regulation - Sufficient capital Backup risk with equity capital - Compensation Reward the upside, tie to the downside - Liquidity Find trade-off between liqu. transformation and risk of ill. - Bankruptcy Controlled restructuring or liquidation Two approaches to capital regulation 1. Capital = Risk Weighted Assets (RWA), follows from role as risk buffer, based on models 2. Capital = Assets, corporate finance approach, calculation of a model-free leverage ratio The large part of higher costs of equity probably will paid by shareholders and not borrowers. Higher capital makes investment for shareholder less risky, a higher capital buffer may reduce credit spreads on debts and non-value adding loans may be cut. Regulation of compensation: RoE-linked compensation schemes fostered excessive risk taking, capital regulation mitigates problem, compensation regulation is only 3rd best solution.

Liquidity regulation: transformation of different terms is key driver, cost of liquidity risk mitigation makes long term funding of long term loans more expensive and may lead to holding of high-quality as liquidity buffer without using them (making investors switch to riskier assets) Micro- and macro-prudential regulation: micro-prudential is the protection of depositors of an individual institution, macro-prudential is the protection of the systems. Tier 1 capital: Principal, disclosed reserves, hybrid capital and other Tier 2 capital: Non-disclosed reserves, subordinated debt and other The amount of Tier 2 includable in total regulatory capital is limited to 100% of Tier 1. Formula for Credit and Market risk, see lecture 1. Logic of the Internal Rating based approaches: Risk weights = F1 x F2 x F3 F1 unexpected losses (in %, time horizon 1 y) F2 scaling factor for maturity F3 scaling factor for the first two factors IRB formula

Basel 2.5 Higher capital requirement for market risk as of 2011: - Stressed VaR - Unsystematic risk = residual risk + event risk Incremental risk charge (IRC) for event risk, aligned to reg. credit risk model Hole to move assets between credit and trading book has been closed 4 drawbacks of Basel II Complex. / Relying on risk weighted assets only / Pro-cyclicality / Liquid. not covered Whats new in Basel III: equity capital Basel III heightens the level of required capital and tighten its definition Level of required capital: - Capital charge for market risk up to three times higher

Higher capital charge for credit risk through stressed inputs, increased correlations and penalties on OTC deals Definition of available capital: Tier 1 to ensure a going concern, Tier 2 to protect depositors in case of insolvency (gone concern) Capital hierarchy Senior debt Subordinated debt Hybrid (no tier) Tier 2 Other tier e.g. Hybrid Common equity (Core Tier 1) highest loss absorption capacity Contingent convertible (CoCo) is treated as Tier 1 capital (but not as core Tier 1) if - Non maturing (e.g. perpetual bonds) - Conversion triggers depend on regulat. capital quotes or inject. by publ. authority - Either conversion into common equity or write-down, see below - No possibility of subsequent write up in the latter case Tier 1 Coco, conversion: as some prof. Investors are not allowed to invest in cross asset class, this must be circumvented by SPV. Equity to be sold after conversion Existing equity holders may sell stocks in fear of dilution. Pressure on stock prices. Tier 1 Coco, write-off: should be assessed as bond instrument by investors. Exclusion of subsequent write-up makes instrument riskier than conversion bonds or even than equity itself. Such instrument may not be marketable at reasonable prices. Definition of trigger: due to dependency of local regulatory decision, investors carry reg. risk. If trigger depends on other criteria, they must be clear, effect. and mang. Capital requirements in Switzerland