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Agenda
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.
Northern Rock bank used to borrow from money markets (short term) and fund mortgages using this money.
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.
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
What is Risk?
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
Fixed assets
- Share capital
- Preferred capital
- Reserves, Surplus
Financial assets
- Cash
Borrowed funds
- Short term borrowings
P&L
Bank/IB
Management
Risk
Regulators, Creditors
Capital
Value based management calls for judicious allocation of capital to prudent risks.
7
Credit Risk
Issuer risk
Counterparty
risk
Market Risk
Liquidity
risk
Operational
risk
ExchangeTraded
OTCtraded
Loans
Portfolio Risk
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
Market Risk
Credit Risk
Credit Risk
Funding Liquidity
Risk
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.
Value Creation
Franchise Risk
Financial Risk
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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
Operational Risk
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
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Probability
Impact
Statistical Modelling
Normal conditions
vs. Stress
Scenarios
Risk
Identification
Risk
Measurement
Risk Reporting
& Monitoring
Key Risk Indicators
Risk Limits
Loss Data
Workflow
Management
Risk Mitigation
Avoid risks
Risk Transfer
Mitigate using
controls
Accept residual risk
13
14
Credit Risk
15
Counterparty Risk
Simulation based calculations for counterparty level exposures after taking into account
netting agreements
Account for wrong way risk (for example, positive correlation between exposure &
collateral)
16
Market Risk
Simpler Techniques
Sensitivities Analyses
Mark to Market values
Standard Deviation
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
Liabilities
Assets
Cash/Due from Banks/Deposits with Banks
$205,000
275,000
$130,000
266,000
26,000
66,000
290,000
493,000
Investments (CTI)
303,000
216,000
Loans
636,000
Brokerage Payable
Brokerage Receivable
Goodwill
25,000
57,000
122,000
Intangible Assets
5,000
Short-term borrowings
2,500
Long-term debts
221,000
Other Liabilities
65,000
Total Liabilities
1,696,000
Other Assets
130,000
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
(19,000)
Total Equity
Total Liabilities and equity
18
59,000
201,500
1,897,500
Liabilities
Assets
Cash/Due from Banks/Deposits with Banks
$205,000
275,000
$130,000
266,000
26,000
66,000
290,000
493,000
Investments (CTI)
303,000
216,000
Loans
636,000
Brokerage Payable
Brokerage Receivable
Goodwill
25,000
57,000
122,000
Intangible Assets
5,000
Short-term borrowings
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
(19,000)
Total Equity
Total Liabilities and equity
19
59,000
201,500
1,897,500
Operational Risk
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
.
.
.
.
.
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
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
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
Stress Testing
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.
22
23
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
Expected
Return
Efficient
Frontier
Investments
of Return
Red to Green: Return Optimization
Orange to Green: Risk Reduction
Orange to Blue: Return Optimization
25
Board of Directors
Modelling Team
26
Risk Operations
Thank you !!
27