Principles of Risk Management PDF

56 PRINCIPLES OF RISK MANAGEMENT If we consider together all the j assets of a portfolio, given the matrix of correlations, we have: 1. Maximizing the profit between assets and liabilities. 2. Modulating the exposure of these factors according to the future vision of: We obtain a correlated VaR of 3...

56 PRINCIPLES OF RISK MANAGEMENT If we consider together all the j assets of a portfolio, given the matrix of correlations, we have: 1. Maximizing the profit between assets and liabilities. 2. Modulating the exposure of these factors according to the future vision of: We obtain a correlated VaR of 3179 Euros. -- Market variables. -- New business opportunities. -- Customer behavior that could lead to transfers from one instrument to another. In summary, we have: Volatility Multiplier (95%) 1.91% 2.34% 1.64485363 1.64485363 1.593 € 1.963 € 100.00 % 59.30% 59.30% 100.00% VaR Correlation Correlated VaR -3,179 EUR 1 day VaR, 95% confidence level Historical Simulation -2.776 EUR MonteCarlo Simulation -3.042 EUR (5000 simulations) Parametric Normal -3.179 EUR 1.5 Asset liability risk 1.5.1 Definition Asset-Liabilities Management (ALM) is the strategic management of the balance sheet of financial institutions from the perspective of market and liquidity risks. The ALM function is complemented by the management or monitoring of trading positions, funding and equity planning. It affects all financial institutions that have a balance sheet subject to business risks as a result of credit operations, regardless of their trading activities. The fundamental objectives pursued are the measurement, analysis and management of the aforementioned risk factors by seeking: Also complying with banking regulations in terms of control, internal supervision, reporting and good capital management practices is part of ALM. 1.5.2 Types The banking business is based on three fundamental pillars, which are: Clients Margins Risk management. This last aspect interrelates numerous levers of the banking business, since in its field traditional banking activities are interrelated, with the most innovative in both commercial and wholesale banking. Depending on the type of banking business of each entity, the quantitative weight of these pillars may be different in the final income statement. In general, the financial risks that the balance sheet of the financial institution will face will be fundamentally: Credit risk. Interest rate risk. Liquidity risk. Exchange rate risk, if it has activity in various currencies. Operational risk. Legal risk. 57 Specifically, the risks that are understood as structural in the balance sheet of an institution are those of interest rates and liquidity. These risks will be addressed below. 1.5.3 Interest rate risk Interest rate risk is the risk that changes in interest rates will adversely affect an institution’s net interest margin or economic value. BIS definition: “IRRBB refers to the current or prospective risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions”. EBA definition: “The current or prospective risk to both the earnings and capital of institutions, in respect of the banking book only, arising from adverse movements in interest rates”. Interest rate risk in the banking book occurs in the so-called IRRBB portfolio; that is, in the bank’s items that are not trading books. Interest rate risk is the risk that changes in interest rates and will adversely affect an institution’s net interest margin or economic value. FIGURE 21 Interest rate risk on Balance Sheet There is no regulatory definition of the banking book – it is everything that is not a trading book. The trading book is defined as: short-term positions held with the intention of seeking a gain from short-term price movements to support market creation. 58 PRINCIPLES OF RISK MANAGEMENT The trading book is subject to prescriptive capital requirements by Pillar 1, while the banking book is subject only to requirements by Pillar 2. The trading book should be accounted for at market prices (MtM), while the banking book is normally accounted for at amortized cost. Focus on interest-rate sensitive assets and liabilities. The impact on interest rate movements occurs to the extent that assets and liabilities are linked to an interest rate; they are what we call sensitive assets and liabilities. The amount of interest-rate sensitive assets and liabilities could obviously be different in an entity. Assets: non-deductible from CET1 capital and excluding (i) fixed assets such as real estate or intangible assets, as well as (ii) equity exposures in the banking book. Liabilities: including all unremunerated deposits and liabilities other than CET1 capital under Basel III. Off balance Accounting aspects The potential impact of interest rate movements on financial statements depends on the book portfolio in which the balance sheet items are recorded. For items accounted for at amortized cost, changes in market interest rates do not significantly affect the value or accounting of profit. Income/costs in this type of assets, therefore, arise over time according to maturity-adjusted cash flows. For items accounted for at fair value, their value may vary significantly due to changes in external factors. These changes in value are recognized through P&G or net worth. The main interest rate sources are: Curve Linked to possible changes in its absolute situation or in its form/slope. It originates from unexpected movements or changes in interest rate trends, according to their term. It arises from changes in the slope of the yield curve. In other words, rates for different maturities move differently. Basis Linked to the above and derived imperfect correlation between the interest rates charged and paid in various instruments. The different indices/reference rates do not always move harmoniously. This originates from the imperfect correlation that may exist between the evolution of the reference interest rates charged and paid for different instruments, even when they have similar characteristics of repreciation. This situation can lead to unexpected changes in interest flows, generated by spreads between the rates of assets, liabilities and off-balance sheet instruments, given the various existing references for different items, including within the mortgage market, one of the key niches in the banking sector. Repricing Derived from the temporal differences in the setting of new applicable rates (variable rate instruments) or in maturity (fixed rate instruments). It is caused by differences at the time of maturity or reprising of active, liabilities and off-balance sheet transactions. For operations contracted at a fixed interest rate, the interest rate risk arises at the time of maturity, and in operations contracted at a variable interest rate it arises at the time of its repreciation or update. 59 Example Be an entity that grants a 10-year loan to a client at a variable interest rate that is broken down into a reference, for example the Euribor 12 months, and a margin or spread, of 1%. When the interest rate is variable, the fixing of the Euribor 12 months occurs at the initial moment of the loan, but then it must be updated, for example every 12 months. Optionality Inherent to the options that are explicitly or implicitly transferred to the clients of the entity through the instruments traded. It represents an asymmetric risk to the extent that the holder will have the right to execute them, usually against the interests of the issuer of those options. Example If initially the Euribor 12 months level was 0.5%, the loan will pay 1.5% per year (0.5% + 1%). If the Euribor has fallen to 0% over the next 12 months, the loan will pay only 1% (0%+1%) over the next 12 months, with the consequent impact on the income statement. Suppose now that the loan is granted at a fixed interest rate of 1.5%. Is there a risk of repreciation? It seems that the logical answer is no, because the interest rate does not vary with market interest rate movements (it does not affect that the Euribor12 moves). However, you would have to wonder what would happen 10 years from now... Of course, at the time of maturity (or if there are amortizations), that amount will have to be reinvested by the entity. At what interest rate will it be reinvested? At that time, therefore, there is a risk and that loan would have interest rate risk because the maturity, in the end, works as a revaluation. It is a sensitive asset. The optionalities can be explicit derivatives; for example, a floor of a loan. In that case, a drop in interest rates might not affect income (if, for example, the interest rate being paid was already that of the floor) and, therefore, would mitigate the interest risk, but also customer options, such as delinquency or amortizations in the case of loans (which would reduce expected interest income), or the behavior of passive customers, recovering their money deposited in advance, for example. 1.5.3.1 Interest rate risk metrics Given the two most relevant aspects of balance sheet management (financial margin and equity value), the metrics or measures used by financial institutions to measure interest risk are divided into measures focused on the impacts on margins and income statement, on the one hand, and the impacts on economic value, on the other. 60 PRINCIPLES OF RISK MANAGEMENT In addition, we can differentiate between static and dynamic indicators. FIGURE 22 Interest rate risk metrics Metrics have evolved over time and have been complemented to cover all the needs of quantification and capital endowment FIGURE 23 Methodologies 61 Interest rate Gap methodology This methodology measures the difference (mismatch) between assets and liabilities sensitive to interest rate movements at different time intervals. GAP analysis is a standard and simple method for measuring interest rate risk. It allows to calculate the impact on the financial margin (income statement) in short terms before certain movements of the interest rate curve. GAP analysis can be defined at two levels: Gap simplei = Asseti - Liabilityi The number of grouping time intervals and the time frame of each interval shall be determined. Usually, intervals of 1-3 months are used for the short term and annual for the long term. To assign the operations to the different time intervals, the term until the next date of revision of the interest rate of each flow of each operation must be considered. Only in case of fixed-rate operations will the residual life be used. At the end it will be a net Gap in which we can have basically 2 situations: Positive Gap: Assets exposure > Liabilities exposure In this case, there is a greater sensitivity for the assets. This means that the short term assets are funded with long term liabilities and in the event of a rise in interest rates the financial margin will increase. Negative Gap: Assets exposure < Liabilities exposure In this case, there is a greater sensitivity for the liabilities. This means that the long term assets are funded with short term liabilities and in the event of a rise in interest rates the financial margin will decrease. Exposure: Applies to sensitive balance sheet items, trying to calculate the net exposure between assets (investment generates interest in favor) and liabilities (financing generates interest against), Variability: the variation of the simulated yield curve (in bp) shall be applied directly to the net exposure without any sensitivity component involved that allows a differentiated treatment of the items according to their nature. In terms of flows, only expected cash flows sensitive to interest rate movements will be considered. Intensity: The calculated effect will be weighted according to the period between the time of application of the variation in rates (revision/maturity) and the moment the analysis ends. The original objective is to calculate the variation in the financial margin caused by parallel variations in the yield curve over a time horizon RISK = EXPOSURE x VARIABILITY x INTENSITY 1.5.4 Liquidity risk The analysis horizon (usually 12 months) will be divided into terms (usually 1 month) in which to distribute the sensitive balance according to its revision or maturity date. This will provide the exposure. Liquidity risk is associated with the differential that can naturally occur between investment and/or financing needs inherent in the gap between cash flows derived from asset and liability positions. Liquidity risk exists 62 PRINCIPLES OF RISK MANAGEMENT when short-term maturing liabilities are higher than maturing assets and cannot be refinanced. Liquidity risk is also considered when, in order to meet payments due in a given period, excessively expensive financing must be used. Like other risks, a tolerance to liquidity risk must be defined that will have a minimum threshold in the requirements defined by the supervisor and will have as relevant conditions the characteristics of the entity the appetite for risk and market access. The key objectives should have to be defined by the Management Board, which should establish a supervisory framework for liquidity measurement and management mechanisms. All this will allow to have a position against the liquidity risk in any time horizon. Usually, financial institutions usually have 2 financing channels for liquidity management. The first channel is the retail and is closely related to the commercial strategy through the ability to capture liabilities in the commercial network. The second channel is the one that is instrumental through wholesale activity mainly acting in the interbank market through discount in the central bank and, of course, with access to the capital markets to carry out short-, medium- and long-term bond issues, repos or asset sales in general. 1.5.4.1 Liquidity risk metrics -- Other ratios. -- Interbank indebtedness. -- Liquid assets. Other relevant ratios: Survival horizon: It aims to measure how long a financial institution would endure without having a liquidity deficit in stress scenarios. The liquidity deficit exists when the liquidity gap accumulated in a moment of time is negative. It is based on a daily liquidity gap with hypotheses of stressed outflows of funds or with liquidity losses on the asset side. -- Scenario with idiosyncratic (or name) stress. -- Systemic crisis scenario. -- Short-term or mixed stress scenario (with situations common to the previous two). The usual thing is to pretend to be in a survival horizon greater than 90 days, although depending on the hypotheses that are made, it can fluctuate. It is important that once the hypotheses are defined, they do not change each time the indicator is estimated, in order to be comparable over time. Loan to deposit: It is the ratio between the volume of credit investment (which is, generally, the main business of the entity) and the volume of retail deposits, including the accounts seen (which supposes the main financing of the entity). The main measures of liquidity risk are: -- Cash ratio (ECB regulatory measure): X% of computable liabilities. It is calculated on a monthly average (starting on the Wednesday following the ECB’s monthly meeting). -- Maturity gap: similar to the sensitivity gap, but in which maturity is considered and not repreciation. Short-term objective: positive gap. -- Simulations. With the introduction of the Basel III regulations (CRR and CRD IV), institutions were required to measure and report two liquidity indicators: one at the level of basic liquidity (known as LCR) and another at the level of structural liquidity (the NSFR). 63 The different developments of the regulations, among which are the new CRR II and the new CRD V, have allowed the entities to make a homogeneous estimate of them. The form of estimation and characteristics of the two ratios are then introduced. Liquidity coverage ratio RSF: weighted loans, portfolio of assets, and other assets based on their maturity and bankability. The amount of RSF is a function of the liquidity characteristics and residual maturities of its various assets and off-balance sheet positions. The amount of RSF is calculated by first assigning the book value of the institution’s assets to the listed categories. The amount allocated to each category is then multiplied by its associated required stable funding factor (RSF) (see next page) and the total RSF is the sum of the weighted amounts. Liquidity Gap methodology Stock of liquid assets: cash, reserves, government/ guaranteed paper, high ratings and corporate bonds with a cap of 50%. 30-day cash flows in stress scenarios: 5% stable network deposits, 10% less stable deposits, 25% corporate deposits, 100% wholesale net funding (30 days). Net Stable funding ratio Long-term capacity >1 year. It is intended to ensure that a bank is adequately financed for each term (>1 year). Probably the most important indicator in the control and monitoring of liquidity is the liquidity gap. The simple static liquidity gap in a period of time t is the difference between the expected maturities of the asset and the liability in that period, depending on the contracts of the existing balance sheet items in the entity. The accumulated static liquidity gap is the sum of the simple static liquidity gap in all periods prior to that period. Gapt = CF (Assetst) - CF (Liabilitiest) It is an indicator that has advantages, but also disadvantages: ASF: equity, term debt, deposits, long-term liabilities. The proportion of own and external resources that are classified as reliable over the one-year time horizon. The amount of ASF is calculated by first assigning the book value of an entity’s own and external resources to one of the five existing categories. The amount allocated to each category is then multiplied by an ASF factor and the total ASF is the sum of the weighted amounts. -- It is easily interpreted (when it is negative in a period it is because there are more box outputs than inputs). However, at the static level no business hypotheses are made, so it is not a good management indicator. In order to use this indicator as a management indicator, behavioral hypotheses are incorporated into the bank’s balance sheet items, thus achieving what we 64 PRINCIPLES OF RISK MANAGEMENT call the dynamic liquidity gap. The dynamic liquidity gap implies the incorporation of the Entity’s budget with respect to the static liquidity gap. By incorporating hypotheses of customer behavior (amortizations, new concessions, line dispositions, entry into delinquency), it allows to make different scenarios. In fact, this indicator is the indicator that will serve to calculate another key indicator in the management of liquidity in stressful conditions: the survival horizon. Liquidity Stress test For banks to maintain a solid stress test framework, the following two factors must be taken into account: 1. The sector must expand the level of integration and consistency between factors such as liquidity stress test, performance measurement, capital stress test, risk measurement and monitoring, and regulatory reporting. 2. Banks must ensure a sustainable technology infrastructure to ensure liquidity stress testing in an effective and controlled manner. The liquidity problem caused by an inadequate liquidity risk management framework is as challenging for a financial institution as the actual inability to meet financial obligations. We consider the main components of stress testing, including: -- The appropriate scope and structure of the liquidity stress test throughout the institution. -- The development of scenarios. -- The development of critical assumptions. With Basel III, certain relevant ratios emerge. Some of them, such as the LCR, are related to liquidity stress. The CSF is a measure of whether a bank has enough high-quality liquid assets (HQLA) to survive a 30-day stress situation. An asset is considered HQLA when it can be traded on a market with enough participants so that the asset can be sold without materially affecting the type of market. The aim is to reduce the risk of liquidity shortages observed during the financial crisis. The liquidity stress test in Basel III is designed to prompt banks to take a more cautious approach by mimicking a systemic crisis in the banking sector. During the 30-day period, a series of assumptions are made around the withdrawal of deposits and the repayment of loans. These include: -- Withdrawal of deposits - defined by the type of investor. -- Contractual withdrawals resulting from a downgrade in the credit rating of the institution being tested. -- Increased market volatility leading to an increase in collateral requirements. -- Provision of unused credit facilities that the entity has issued to its customers. One of the interesting factors of these tests is the considerable difference in the percentage of withdrawal of deposits depending on the type of investor. For example, a company with a simple relationship with the bank is supposed to withdraw 75% of its deposits, while a company with an operating relationship is only supposed to withdraw 25%. This is a clear example that Basel III is creating greater connectivity within the sector, to encourage banks to offer a variety of services to their customers in order to increase “linkage”. 1.5.5 Limits definition The ALCO is the Committee in charge of proposing to the Board of Directors the limits of exposure to the entity’s balance sheet risks. 65 The Board of Directors approves these limits and must be informed if they are exceeded. The ALCO Support Group is the area responsible for monitoring and controlling compliance with the decisions adopted within ALCO and will report periodically to the Committee on the implementation (1) of the agreements adopted within ALCO. It is also the area in charge of monitoring the balance sheet risk limits established by the entity. Liquidity risk exposure limits. Interest rate risk exposure limits. Exchange rate risk exposure limits (if any). Equity risk exposure limits (if any). Global credit risk exposure limits (if any). The definition of a system of risk indicators and limits makes it easier for the Entity to identify risks and take prompt action. Regarding balance sheet risk we have: Type of Risk Issuer Credit Risk Liquidation Delivery Counterparty TABLE 3 Typical Metrics Remarks Maximum nominal per name PD-based analysis, LGD Maximum nominal per name Analysis based on PD, LGD, deadlines. - Amount Deadlines. - Nomial Market value Potential exposure PD-based analysis. LGD Estimated volatility of the underlying reference instruments. Concentration limits. Balance Sheet risk limits