Market Risk

IMA approach
Basel Accord

• Capital requirement were simplistic and rigid – but did not reflect
underlying economic risks of banks / FIs

• Now, capital requirements are more risk sensitive - reflects

economic risk assumed

• These new standards are generally based on Value-at-Risk (VaR)

methods

• VaR is a measure of loss at given confidence level and directly

translates into measure of buffer capital

• Basel-I Accord sets Minimum Capital requirements to guard against

Credit Risk

• To control expanding Trading activities, Capital Charge for market

risk was included later
 Standardised Method – Capital Charge for Market Risk

• Based on pre-specified, standarised, ‘building – block approach’

• Market risk is computed for portfolios exposed to interest rate risk,

exchange risk, equity risk and commodity risk

• Takes into account Notional amount and market parameters

• Main drawback – ignores diversification across market risks – within

each category and across different categories

• Highly conservative – Adds up capital charge for each category

• Assumes that Worst Loss will hit all portfolios at the same time

• Does not reward prudent diversification

Internal Model Approach

IMA recognises –

 Risk Management models in use – far more advanced

than rigid rules

 Banks can use their own VaR models as basis for

capital requirement for Market Risk

 VaR is a robust Risk Measurement and Management

Practice
IMA - Qualitative Criteria
• Independent Risk Control Unit responsible for design and implementation of
Bank’s risk management systems

• Regular Back-Testing

• Initial and on-going Validation of Internal Model

• Bank’s Internal Risk Measurement Model must be integrated into Management

decisions

• Risk measurement system should be used in conjunction with Trading and

Exposure Limits.

• Stress Testing

• Risk measurement systems should be well documented

• Independent review of risk measurement systems by internal audit

• Board and senior management should be actively involved

 IMA - Quantitative criteria
Quantitative Parameters :

• VaR computation be based on following inputs :

– Horizon of 10 Trading days

– 99% confidence level
– Observation period – at least 1 year historical data

• Correlations : recognise correlation within Categories as well as

across categories (FI and Fx, etc)

• Market Risk charge : General Market Risk charge shall be – Higher

of previous day’s VaR or Avg VaR over last 60 business days X
Multiplier factor K (absolute floor of 3)
 Market Risk Charge

Market Risk charge on any day ‘t’

MRCt = Max (Avg VaR over 60 days, VaR t-1) + SRC

SRC – Specific Risk Charge

Back testing

Possible cause and remedies of the "Yellow" zone

• Basic Integrity of the model
• Deficient model accuracy
• Intra day trading
• Bad luck
 Internal Model Approach - Benefits
• Internal VaR system is more precise

• VaR account for correlations

• Market risk charge under IMA likely to be lower

• With improvements in risk measurement techniques, IMA will

enable capital charge to be more precise

• Market Risk charge needs to be computed and monitored daily

• Each day VaR is compared with the subsequent Trading profit or

loss

• Back Testing will help to refine the framework

Market Risk – Advanced Risk Measurement Techniques
enables Bank to effectively control the amount of market risk
it assumes and allocate capital for the same

‘Know’ your risks Control Measures

Allocate Capital
 Duration Limits
 VaR Limits  Standardized
Measurement Techniques  Stop Loss Limits Model
 Marking to Market  Counterparty Exposure  Internal Model
Limits
 Duration, Convexity
 Country Exposure Limits
 Price Value of a Basis Point
 VaR - Forex (Spot & Forward)
 Stress Testing
Sophistication
Stress Testing
 Scenario Analysis Value at Risk
Use of ‘What if’
scenarios to
Use of statistical
Statistical determine losses
Duration in extreme
analysis to
Cashflow determine events
analysis to maximum losses
Mark to Market measure the
sensitivity of
Revaluation of fixed income
the portfolio to instruments
measure notional
P/L

Time
 Market Risk Amendment

Paradigm becomes explicit

Frequency of loss

  
Expected Unexpected loss Stress
loss loss

0 Amount of loss
Supporting Factors for Risk Management

1 Involve of
the board of directors
and high level management

4 2
Effective Risk Formulate risk
Set up risk
Management management policies
management system
and procedures

Establish a unit to operate 3

risk management
Limitations to Risk Management
Involve of the board of directors
and high level management
Formulate risk management
policy and procedures
Establish a unit to operate
risk management
Set up risk management
system
Limitations
• Not enough cooperation
• Low qualification
• Lack of independence to make a decision
• Not transparence
• Policies/ procedures not match with risks
• Underdevelopment Infrastructure
• Rigid to implement
• Communication failure
• Lack of adequate structure
• Staff has less experience
• Lack of independence
• No follow up and control system
• Not enough risk assessment/
management
instruments
• Database and IT system
Internal Model Approach

Supervisory objectives

• better risk management

• continual upgrading and encouragement of

innovation in risk management methodology and

• improved risk sensitivity and measures.

Internal Model Framework

Policy Governance
Risk Strategy Accountability
Risk Appetite

Internalising
Risk Managem ent Models Reporting
Projection & Analysis Models
Annual: planning, forecasting, budgeting Risk Monitoring
Risk Maps Risk Analysis
Economic Capital Pricing, capital management Risk Reporting
Sensitivity Measures & Analysis

External Factors
financial markets, competition, tax & regulation
Impact & Benefits
• Best practice risk and capital management
– In particular:
• Risk management - processes and controls
• Capital management - eligible capital and quality of capital
• Improved market perception: enhanced reputation for
risk management

• Precise capital requirements and return on capital

• Enhanced management information to support more

optimal management decisions

• Reduced costs: Operational efficiencies from better

risk management
Internal model and its purpose
• What is an internal model?
– “A risk management system developed by the Bank
to analyse the overall risk position, to quantify risks
and to determine the economic capital required to
meet those risks”

• What is the purpose of an internal model?

– To fully integrate processes of risk and capital
management within the Bank
Expected Benefits

• Improved risk sensitivity

• Better alignment of regulatory capital requirements with

economic capital

• Encouragement of innovation in risk management

methodology leading to higher competitiveness through
better risk management and hence lower costs of capital

• More effective pillar 2 discussion and familiarity of the

supervisor with more detailed exposure data

• Cost efficiencies through re-use of risk modeling

infrastructure for discussion with supervisors, rating
agencies, analysts and shareholders.
Particular issues for banks

• The regulatory requirements are not yet come

• There is a shortage of skills and expertise
• There are data limitations
• Low base in terms of use of models and risk management; in effect,
attempting to “jump a generation”
• The operating environment is undergoing fundamental change

However, none of these difficulties are insurmountable if one learns from

others

• Most difficult IRB qualifying criterion to meet is not in relation to the

models themselves but in relation to the use them - a major challenge
• It needs to be recognised that a robust risk management framework is
an essential prerequisite. Successful implementation, such as the use of
models, can only be achieved if they integrate into a sound framework
of systems and controls; in the case of certain banks, there may be
some gap vis-à-vis international best practice
Specification of Market Risk Factors
• For interest rates, there must be a set of risk factors corresponding to
interest rates in each currency in which the bank has interest-rate-
sensitive on- or off-balance sheet positions

• The risk measurement system should model the yield curve using one
of a number of generally accepted approaches

• The risk measurement system must incorporate separate risk factors

to capture spread risk

• For exchange rates (which may include gold), the risk measurement
system should incorporate risk factors corresponding to the individual
foreign currencies in which the bank’s positions are denominated

• For equity prices, there should be risk factors corresponding to each of

the equity markets in which the bank holds significant positions

• For commodity prices, there should be risk factors corresponding to

each of the commodity markets in which the bank holds significant
positions
Quantitative Standards
• “Value-at-risk” must be computed on a daily basis

• In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used

• “Holding period” will be ten trading days

• “Effective” historical observation period must be at least one year

• Banks should update their data sets no less frequently than once every three months and should also
reassess them whenever market prices are subject to material changes

• No particular type of model is prescribed – should captures all the material risks run by the bank

• Banks will have discretion to recognise empirical correlations within broad risk categories

• Banks’ models must accurately capture the unique risks associated with options within each of the
broad risk categories

• Each bank must meet, on a daily basis, a capital requirement expressed as the higher of
(i) its previous day’s value-at-risk number measured according to the parameters specified in this
section and
(ii) an average of the daily value-at-risk measures on each of the preceding sixty business days,
multiplied by a multiplication factor

• multiplication factor will be set by supervisory authorities on the basis of their assessment of the quality
of the bank’s risk management system, subject to an absolute minimum of 3.

• Banks using models will also be subject to a capital charge to cover specific risk (as defined under the
standardised approach for market risk) of interest rate related instruments and equity securities
Stress Testing
• Stress testing to identify events or influences that could greatly
impact banks is a key component of a bank’s assessment of its
capital position

• Stress scenarios need to cover a range of factors that can create

extraordinary losses or gains in trading portfolios, or make the control
of risk in those portfolios very difficult

• Stress tests should be both of a quantitative and qualitative nature,

incorporating both market risk and liquidity aspects of market
disturbances

• Banks should combine the use of supervisory stress scenarios with

stress tests developed by banks themselves to reflect their specific
risk characteristics

• Stress tests results should be reviewed periodically by senior

management and should be reflected in the policies and limits set by
management and the board of directors
External Validation

Validation of models’ accuracy by external auditors and/or

supervisory authorities should at a minimum include

 verifying the internal validation processes

 formulae used in the calculation process as well as for the pricing
of options and other complex instruments are validated by a
qualified unit - independent from the trading area
 Structure of internal models is adequate with respect to the bank’s
activities and geographical coverage
 results of the banks’ back-testing of its internal measurement
system
 data flows and processes associated with the risk measurement
system are transparent and accessible
The Standardized Method

Risk classification is arbitrary.

Ignores diversification : leads to high capital

requirements because risk charges are
systematically added up across difference
sources of risk

Captures Risk for positions as on the day and

not for the period.
The Standardized Approach

• Guidelines to compute
– Interest rates risk
– Exchange risk
– Equity risk
– Commodity risk

• The bank's total risk is computed as the summation of the 4 categories

– ignoring correlations

• Provide a robust measure of interest rate risk taking into account

– Systematic/Market risk
– duration
– basis risk across maturities

• Specific/Idiosyncratic risk
The Standardized Approach - Market Interest Rate Risk

• Market risk is defined via Maturity Bands

Specific Interest Risk Charge

The capital charge for specific risk is designed to protect against an

adverse movement in the price of an individual security owing to factors
related to the individual issuer

Capital Charge for Interest Rate Risk

Where,

= Capital Charge for Total Interest rate Risk

= Capital Charge for General Interest rate Risk

= Capital Charge for Specific Interest rate Risk

The Internal Model Approach (IMA)

• Rely on Internal Risk Management of the Bank

– for the first time Regulation recognized that
bank had developed trustable risk management
systems
– if this approach lead to lower Capital Charge,
Banks have incentives to develop sophisticated
and more accurate models
– However, need to be approved by Regulation

• sound and sufficient details on the VAR and

diversification models at qualitative and
quantitative levels
The Internal Model Approach (IMA) - Qualitative Requirements
• Independent Risk Control Unit
– The bank must a risk control that is independent
of trading and reports to senior management, to
minimize conflicts of interests
• Back testing
• Involvement
– senior
– sufficient resources
• Use of limits
• Stress Testing
• Compliance (to a documented set of policies)
• Independent Review
The Internal Model Approach (IMA) - Qualitative Requirements

• Requirement on risk factors :

– at least 6 factors for yield curve risk + separate risk factors to

model spread risk

– for equity, the model should at least consist of beta mapping on an

index, a more detailed approach could consist in adding industry
factors, as well as individual risk factor modeling

– for active trading in commodity, the model should account for for
movements in the spot plus convenient yields

– bank should also capture the non linear price characteristics of

options (gamma, vega , ...)

– Correlation within broad risk categories are recognized explicitly

The Internal Model Approach (IMA) - VAR
• Market Risk Charge = VAR
• Shall be computed every day
• for a10 days horizon
– Bank can use a daily VAR and scale it using the square root
time rule
• with a 99% confidence level
• with an observation period based on at least one year moving
window of historical data
• shall be set at the higher of the previous day's VAR, or the average
over the 60 business days,
• times a multiplicative factor k
– determined by regulator (in the range of 3 to 4) to prevent model
misspecifications
• a plus factor is added (depending on the performance of the model)
Stress Testing

Stress Testing can be described as a process to identify

and manage situations that could cause extraordinary
losses

Tools

– Scenarios Analysis
– Stressing Models
– Policy Response
Stress Testing - Scenarios Analysis
• Evaluating the portfolios
– under various states of the world
– evaluating the impact
• changing evaluation models
• volatilities and correlations
• Scenarios requiring no simulations
– analyzing large past losses
• Scenarios requiring simulations
– running simulations of the current portfolio subject to
large historical shocks e.g. 1987 crash, etc ...
• Bank specific scenario
– driven by the current position of the bank rather than
historical simulation
• Much more subjective than VAR
• Can help to identify undetected weakness in the bank's
portfolio
 Back testing

Statistical testing that consist of checking whether actual

trading losses are in line with the VAR forecasts
– The Basle back testing framework consists in recording
daily exception of the 99% VAR over the last year
– Even though capital requirements are based on 10 days
VAR, back testing uses a daily interval, which entails more
observations
– On average, one would expect 1% of 250 or 2.5 instances
of exceptions over the last year
– Too many exceptions indicate that
• either the model is understating VAR
• the Bank is unlucky
• How to decide ?
Statistical inference
 Basel Market Risk Charges

• The Market Risk Charge

– Quantitative parameters
– Market risk charge
– Plus factor

• Stress Testing
– A process to identify and manage situations that
could cause extraordinary losses
– Scenarios requiring no simulation
– Scenarios requiring a simulation
– Bank-Specific scenarios
Basel Market Risk Charges

• Back testing
– A statistical testing framework that consists of
checking whether actual trading losses are in line
with VAR forecasts
– Exceptions
– The Penalty Zones
– Basic integrity of the model
– Deficient model accuracy
– Intraday trading
– Bad luck
The Internal Model Approach (IMA)

• Rely on Internal Risk Management of the Bank

– for the first time Regulation recognized that bank
had developed trustable risk management
systems
– if this approach lead to lower Capital Charge,
Banks have incentives to develop sophisticated
and more accurate models
– However, need to be approved by Regulation

• sound and sufficient details on the VAR and

diversification models at qualitative and
quantitative levels
The Internal Model Approach (IMA) - Qualitative Requirements

• Independent Risk Control Unit

– The bank must a risk control that is independent of
trading and reports to senior management, to
minimize conflicts of interests
• Back testing
• Involvement
– senior
– sufficient resources
• Use of limits
• Stress Testing
• Compliance (to a documented set of policies)
• Independent Review
The Internal Model Approach (IMA) - Qualitative Requirements

• Requirement on risk factors :

– at least 6 factors for yield curve risk + separate risk factors

to model spread risk

– for equity, the model should at least consist of beta mapping

on an index, a more detailed approach could consist in
adding industry factors, as well as individual risk factor
modeling

– for active trading in commodity, the model should account

for for movements in the spot plus convenient yields

– bank should also capture the non linear price characteristics

of options (gamma, vega , ...)

– Correlation within broad risk categories are recognized

explicitly
The Internal Model Approach (IMA) - VAR
• Market Risk Charge = VAR
• Shall be computed every day
• for a10 days horizon
– Bank can use a daily VAR and scale it using the square root
time rule
• with a 99% confidence level
• with an observation period based on at least one year moving
window of historical data
• shall be set at the higher of the previous day's VAR, or the average
over the 60 business days,
• times a multiplicative factor k
– determined by regulator (in the range of 3 to 4) to prevent model
misspecifications
• a plus factor is added (depending on the performance of the model)
Stress Testing

Stress Testing can be described as a process to

identify and manage situations that could cause
extraordinary losses

Tools
– Scenarios Analysis
– Stressing Models
– Policy Response
Stress Testing - Scenarios Analysis
• Evaluating the portfolios
– under various states of the world
– evaluating the impact
• changing evaluation models
• volatilities and correlations

• Scenarios requiring no simulations

– analyzing large past losses

• Scenarios requiring simulations

– running simulations of the current portfolio subject to large
historical shocks
• e.g. 1987 crash, etc ...
• Bank specific scenario
– driven by the current position of the bank rather than historical
simulation
• Much more subjective than VAR
• Can help to identify undetected weakness in the bank's portfolio
Back testing

Statistical testing that consist of checking whether actual

trading losses are in line with the VAR forecasts
– The Basle back testing framework consists in recording
daily exception of the 99% VAR over the last year
– Even though capital requirements are based on 10 days
VAR, back testing uses a daily interval, which entails
more observations
– On average, one would expect 1% of 250 or 2.5
instances of exceptions over the last year
– Too many exceptions indicate that
• either the model is understating VAR
• the Bank is unlucky
• How to decide ?
Statistical inference
Basel Market Risk Charges

• The Market Risk Charge

– Quantitative parameters
– Market risk charge
– Plus factor

• Stress Testing
– A process to identify and manage situations
that could cause extraordinary losses
– Scenarios requiring no simulation
– Scenarios requiring a simulation
– Bank-Specific scenarios
Basel Market Risk Charges

• Back testing
– A statistical testing framework that consists of
checking whether actual trading losses are in
line with VAR forecasts
– Exceptions
– The Penalty Zones
– Basic integrity of the model
– Deficient model accuracy
– Intraday trading
– Bad luck
Internal Model Approach - VaR

Qualitative Requirements :

• To use IMA, banks need to satisfy Qualitative

Requirements

• Robust risk measurement systems in place –

must be integrated into Management Decisions

• Conduct Stress Tests regularly

• Independent Risk Monitoring Framework