Managing Market Risk in Banks by yungtyriq


									Reserve Bank of Australia Bulletin                                                             December 1996

         Managing Market Risk in Banks

  Analysis of banks’ risk exposures is                     In this way they provide a summary measure
important both for management within banks                 of the risk exposure generated by a given
and for bank supervisors. Two major sources                portfolio. Draft guidelines1 released by the
of risk for banks are credit risk (the risk that           Reserve Bank in August 1996 give banks the
loans will not be repaid) and market risk (the             option (subject to supervisory approval) of
risk of losses arising from adverse movements              using VaR models to measure market risk on
in market prices). This article focuses on the             traded instruments in determining
analysis and management of market risk, an                 appropriate regulatory capital charges.
area that has received increasing attention                  VaR models can be developed to varying
from managers and supervisors in recent years              degrees of complexity. The simplest approach
as banks’ financial trading activities have                takes as its starting point estimates of the
grown. The article is based on a series of                 sensitivity of each of the components of a
seminars held in the first half of 1996 by the             portfolio to small price changes (for example,
Bank Supervision Department with                           a one basis point change in interest rates or a
participants from the banking and finance                  one per cent change in exchange rates), then
industry.                                                  assumes that market price movements follow
                                                           a particular statistical distribution (usually the
                                                           normal or log-normal distribution). This
Measuring Risk in Trading                                  simplifies the analysis by enabling a risk
Portfolios: Value at Risk                                  manager to use statistical theory to draw
                                                           inferences about potential losses with a given
                                                           degree of statistical confidence. For example
  Much of the debate in recent years                       on a given portfolio, it might be possible to
concerning the management of market risk                   show that there is a 99 per cent probability
within banks has focused on the                            that a loss over any one-week period will not
appropriateness of so-called Value-at-Risk                 exceed, say, $1 million.
(VaR) models. These models are designed to                   Elaborations to basic VaR models can allow
estimate, for a given trading portfolio, the               for correlations between different components
maximum amount that a bank could lose over                 of a portfolio by modelling the extent to which
a specific time period with a given probability.           prices in different markets tend to move

1. The draft guidelines are closely modelled on the market risk proposals issued by the Basle Committee on Banking
   Supervision in January this year. They are due to be implemented in December 1997.

Managing Market Risk in Banks                                                                            December 1996
together; in this way the method takes into                      In this regard the key assumption is probably
account possible effects of portfolio                            that market prices are generated from a
diversification. Still further elaborations                      normal distribution. In fact, there is strong
permit the measurement of more difficult                         evidence that large changes in market prices
aspects of risk such as the liquidity of the                     tend to occur more frequently than predicted
instruments making up the portfolio. Here the                    by a normal distribution. 2 For example,
issue is the ease with which an institution can                  statistical theory does not tend to predict price
liquidate or close risk positions. For some                      movements of the size seen in the 1987 share
instruments (such as US or Australian                            market collapse or in the bond markets in
government securities) large parcels can                         1994. This violation of the statistical
readily be sold at prevailing market prices. This                assumptions is a potential source of
might not be the case, however, for that part                    inaccuracy in parametric VaRs. In contrast,
of the portfolio comprising relatively poorly                    the simulation approach is considered to be
traded securities. Standard VaR methods take                     more accurate but is much more
no direct account of this, although it can be                    computationally demanding. It requires
indirectly taken into account by the choice of                   extensive daily calculation of simulated
the portfolio holding period: the more illiquid                  portfolio values using daily market price
the portfolio, the longer the holding period                     changes recorded over periods of a number
that should be applied and, hence, the more                      of years.
susceptible it will be to price changes. Leading                    Proponents of VaR approaches point to the
international banks have begun to model these                    benefits of being able to summarise, in a single
liquidity effects in more detail and incorporate                 figure, an estimated level of risk faced by an
them directly into their VaR models, although                    institution from its trading activities. There is
this work is still at a relatively early stage.                  no doubt that this characteristic makes VaR
   Closely related to the approaches described                   models a powerful management tool. The
above (known as parametric VaRs) are those                       obvious qualification is that by its nature, such
based on simulation of portfolios using                          a summary estimate does little more than
historical price data. The main difference is                    provide a bank’s higher management with a
that instead of using summary sensitivity                        guide to the size of potential losses and their
measures, or relying on statistical theory to                    expected frequency in normal circumstances.3
enable inferences to be drawn about possible                     A comprehensive risk management approach
price movements (as described above), the                        requires that these methods be supplemented
simulation method takes a more direct                            by an effective stress-testing program, to
approach. It takes a given portfolio, revalues                   examine methodically the potential impact of
it directly at current and previous market                       extreme market events or scenarios.
prices measured over a given time period, and                    Ultimately, it is these abnormally large price
then takes the more extreme observations –                       movements that pose the greatest risks to
the large simulated losses – as indicative of                    financial institutions, not those calculated by
what theoretically could be lost on the                          the typical VaR model.
portfolio.                                                          VaR methods have a number of
   Conceptually, the same or very similar                        shortcomings in dealing with large price
results should be delivered by the two                           movements. It is recognised that the models
approaches, as long as the underlying                            do not address all types of risk well (for
assumptions of the parametric VaR are valid.                     example, risk associated with options where

2. In the risk literature, this is referred to as the problem of fat-tailed distributions. That is, there tends to be a larger
   number of extreme observations at the tails of the distributions than is implied by the statistical theory of normal
3. On average, for example, risk estimates based on a 95 per cent confidence interval will be exceeded once every
   20 trading days. Using a 99 per cent confidence interval reduces the uncertainty but still suggests that estimates of
   risk will be exceeded on average 2 or 3 times a year (assuming a normal distribution).

Reserve Bank of Australia Bulletin                                                                  December 1996
the relationship between an underlying asset
price and the associated option price is not                  Non-Traded Interest
linear). Most users of VaR models also                        Rate Risk
recognise that reliance on estimated
correlations across products and markets,
while producing theoretically more accurate                      A second and often larger source of market
measures of risk, requires that those                         risk for banks is non-traded interest rate risk.
relationships between prices and markets                      This source of risk is a direct consequence of
remain stable, even at times of market                        banks’ role as intermediaries. Banks carry a
disruption. Historical evidence suggests that                 wide mix of both fixed-rate and floating-rate
this might not always be the case. There is a                 assets and liabilities on their books, many of
strong view that, for stress-testing purposes                 which are subject to repricing when interest
at least, it may be desirable to assume that all              rates change. For example, a balance-sheet
correlations break down in order to calculate                 structure with predominantly short-term
risk estimates under worst-case assumptions.                  liabilities and long-term fixed-rate assets
  These problems lead many institutions to                    would be subject to losses when interest rates
rely on scenario-based approaches, where                      rise; a balance sheet with the reverse
portfolios are routinely subjected to a wide                  configuration would incur losses when rates
range of hypothetical price and volatility                    fall.
movements. Advocates of this approach tend                       The asset and liability management process
to downplay the benefits of a single VaR                      which takes place within banks is, in part,
estimate, arguing that it obscures the potential              about the determination of the interest rate
impact that different configurations of prices                sensitivity of the balance sheet and the
might have on a portfolio.                                    implementation of risk management practices
  Finally, it is recognised that any risk                     to hedge the potential effects of interest-rate
management system must be understood by,                      changes. This is a quite separate matter from
and consistent with, the activities of the risk               the analysis of any credit risk on the balance
takers themselves – those on the dealing desks.               sheet (the risk that counterparties may
Effective risk management systems are not                     default). The increasing complexity of bank
solely about restricting risks taken by trading               products, and especially the degree of
staff (though that is obviously important).                   optionality being introduced into retail and
They need also to be behaviour-altering in the                wholesale products has heightened the
sense that the process of identifying,                        complexity of risk measurement.4 For these
measuring and reporting risk fosters a                        reasons, and given the potential size of these
mentality of risk awareness throughout the                    balance-sheet risks, banks have begun to
institution. This can be achieved by ensuring                 devote significant resources to this area.
that, while the risk management function
                                                              Approaches to balance sheet
within an institution is independent of trading               management
activities, risk managers do not become too
                                                                 The traditional focus of asset and liability
divorced from the risk takers – that they
                                                              management has been the identification of
understand trading activity and culture and
                                                              maturity mismatches between assets and
are alert to the risk control issues that can arise
                                                              liabilities. An imbalance of assets over
within a dealing environment.
                                                              liabilities (or vice versa) over particular time

4. Optionality arises in balance sheets when products are offered which allow the institution or the customer to
   exercise some right in the future relating to the pricing, term or some other feature of the instrument; for example,
   the right of early repayment.

Managing Market Risk in Banks                                                      December 1996
periods is said to give rise to a net asset or      represent interest or non-interest cash flows.
liability position. This could be offset or         In theory, many balance-sheet components
hedged by writing new liabilities or assets with    could therefore be marked to market in the
a similar maturity or repricing profile.            same way that the price of a simple financial
Mismatches arising from a bank’s mix of             instrument can be readily re-estimated using
business activities could also be offset by         market information. The management issue
transactions conducted in the futures or            for the bank becomes the extent to which the
derivatives markets. This would ensure that         market value of the bank (which is equivalent
any losses incurred on the balance sheet from       to the market value of its capital) can or should
interest-rate changes would be offset by gains      be insulated from the effects of possible
from positions in those other markets.              interest-rate changes.
Alternatively, any risk generated out of a             Such an approach carries a number of
balance-sheet mismatch position could, as a         implications. Any decision to mark the entire
management decision, be left uncovered,             balance sheet to market would, in all
opening the bank to potential loss or gain in       likelihood, introduce greater volatility into
the event of rate changes.                          balance-sheet measurements, just as it does
   Analysis of this type (known as gap analysis)    when applied to traded financial instruments.
is still widely used within the banking system,     The more traditional accrual-based
but it is regarded as giving only an imprecise      measurement systems, in contrast, tend to
picture of interest-rate risk on the balance        dampen the effects of price fluctuations and
sheet. It has come to be supplemented,              spread them over time. One issue is whether
increasingly, by simulation analysis. This          greater volatility in the economic value of the
involves detailed forecasting of the entire         bank, if publicly disclosed through financial
balance sheet (typically for two or more years      statements, would affect share prices, which
ahead) and subjecting all the forecast cash         might also tend to be more volatile. What
flows making up the balance sheet to a variety      would be the implications for investors in the
of price shocks, which may involve parallel         bank? These are some of the issues which are
shifts, twists or rotations of the yield curve.     being debated under the broad heading of
The resulting potential exposures are then          balance-sheet management.
measured, often in terms of their impact on
                                                    Behavioural characteristics of assets
the bank’s net interest income. With this
                                                    and liabilities and the treatment of
information at hand, balance-sheet strategies       capital
can be put into place and interest-rate risks
hedged (or not hedged) as required.                    Some of the most complex issues in balance-
                                                    sheet management relate to the treatment of
   Stabilisation (or steady growth) of a bank’s
                                                    assets or liabilities which have no formal
net interest income is often viewed as a goal
                                                    repricing dates or where actual repricing
of asset and liability management. However,
                                                    behaviour differs from contractual repricing
it is also a relatively narrow and short-term
                                                    dates. For example, banks’ current deposits
focus, particularly given the relative growth
                                                    in theory have no repricing date as they are
in non-interest forms of revenue in banks.
                                                    repayable at call. Yet, analysis of the actual
Hence, the leading banks in this field have
                                                    behaviour of current accounts shows that only
come to look at balance-sheet management
                                                    a small proportion tend to be quite interest-
against much broader criteria – one of the
                                                    rate sensitive while the remainder exhibit little
most common being the maximisation of the
                                                    such sensitivity. This means that some part of
overall economic or market value of the
                                                    a bank’s current-account balances (those
institution. The central premise underlying
                                                    which are interest rate insensitive) actually
much of this newly emerging analysis is that
                                                    behave very much like fixed deposits and so
a bank’s balance sheet is in essence a collection
                                                    could notionally be considered as fixed
of current and future cash flows. Some
                                                    liabilities. As such, they would be effective
represent principal flows, while others
                                                    hedges against some fixed assets.Those which
Reserve Bank of Australia Bulletin                                                 December 1996
are highly sensitive to interest rate changes,      of interest rate risk on the balance sheet is
by similar logic, would not be suitable to hedge    also likely to become an increasing focus of
a bank’s fixed assets. The leading banks in the     international supervisory attention over the
area of balance-sheet management are seeking        next few years.
to analyse precisely the behaviour of current
accounts and determine the extent to which
                                                    Integration of Risk
they can be categorised into core (or ‘sticky’)
                                                    Management and
and non-core (more volatile) components for
                                                    Capital Allocation
the purposes of interest-rate risk
   On the asset side of the balance sheet, early      The increasing focus within banks on the
loan repayments can open unexpected                 management of market, credit and other risks
interest-rate positions on the balance sheet.       in recent years has had two additional
In Australia, in contrast to the US, banks’         consequences:
policy is to charge fees to compensate for the
                                                    • a tendency for much greater integration
effects of early repayment, though in practice
                                                        of risk management efforts within banks
such fees are often waived in the face of
                                                        and the application of similar techniques
competitive pressures. As a result, the more
                                                        across the different types of risk; and
advanced banks are analysing closely the
behaviour of customers in order to improve          • greater focus on the cost and allocation of
their ability to monitor and manage this source         capital, measured in true ‘economic’ terms,
of risk.                                                across the various business activities of a
                                                        bank – the ultimate objective being the
   One of the most contentious issues in the
                                                        development of risk-adjusted performance
area of balance-sheet management concerns
                                                        measures for individual business lines and
the treatment of capital. Capital serves as a
                                                        for the bank as a whole.
buffer against potential losses within a bank
and is a means of funding the asset side of the       Until recently, use of statistical approaches
balance sheet. But it is also a scarce resource     in risk management was restricted largely to
on which banks must generate an acceptable          the measurement of market risk. Banks have
rate of return for the owners. One of the most      come to recognise, however, that there is little
complex and undecided conceptual issues in          conceptual distinction between market, credit
balance-sheet management is how to reconcile        and indeed other types of risk – all subject an
those different roles played by a bank’s capital.   institution to the possibility of loss. Banks are
In practice a variety of approaches is adopted.     therefore beginning to look at using the
Some banks leave capital out of the calculation     measurement tools developed for the
entirely and focus only on the repricing            management of market risk more widely. For
behaviour of assets and tangible liabilities.       example, modern approaches to credit
Some take capital into account by focusing          analysis are aimed at supplementing
on its dividend stream, equating it to the          traditional judgmental approaches, where
return on other, more traditional, liabilities.     practicable, with more objective estimates of
Banks are still exploring these issues and no       probabilities of loss on exposures. Some of this
clear view has emerged on the appropriate           work has been assisted by improvements made
approach.                                           to risk-grading systems over recent years.
   Although work in the area of asset and             These methods are also being adapted to
liability management has been perceived in          the allocation of market-based capital within
the past as less glamorous than other areas,        banks. Until very recently, analysis by banks
that perception seems to be changing as the         of their own capital requirements was driven
significance of this area of risk management        mainly by the capital framework outlined in
for banks’ overall performance is more widely       the 1988 Basle Accord. Improved techniques
recognised. The measurement and treatment           have led, however, to reassessments of actual

Managing Market Risk in Banks                                                       December 1996
capital needs by banks, both at the aggregate        regulatory capital. As outlined above, this
and disaggregated business levels. A number          process has already begun with the release of
of Australian banks are now routinely                the market risk guidelines.
estimating capital requirements based on the
perceived economic need for capital in the
various business units, not necessarily the          Conclusion
amounts specified by bank supervisors. Here
the focus is not only on the possible short-term
losses that might be incurred (as typically
estimated through the use of VaR or                    There is no doubt that risk management has
comparable methods), but also on the                 become increasingly complex not only in
institution’s own view of the losses it could        relation to financial trading activities but also
reasonably sustain over a long period of time.       in relation to the risk found on traditional bank
That process of allocating capital has focused       balance sheets. Risk management is therefore
attention on the risk-adjusted performance of        becoming a much more skilled activity than
banking activities. Analysis of this type has        in the past. Much has also been made of the
even spilled down to issues associated with          challenges posed by the quantitative
remuneration practices within institutions,          developments in risk management, but it is
with salaries and bonuses being considered           equally important not to underplay the
not only against profits achieved but also the       significance of more practical issues. The
risks taken to earn them.                            failure of Barings in early 1995 and the
  The calculation of ‘economic’ capital              circumstances surrounding the discovery of
requirements is still in its infancy in Australian   large trading losses at Daiwa in NewYork later
banks but will become more important over            in that year, as well as the more recent
time, especially as banking becomes more             experience of losses at Sumitomo, show that
competitive and increased focus is directed          risk management must be made to work in
to returns on risk-adjusted capital. Such            practice as well as in theory. The ongoing task
trends have implications for the evolution of        for banks’ management, and for bank
current regulatory-capital requirements,             supervisors, is to ensure that those involved
including the extent to which banks’ own             in risk-management activities are alert to
capital allocation models might be viewed as         potential operational deficiencies and act
acceptable as a basis for the calculation of         quickly to rectify any that exist.


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