capital- indusind bank

7/31/2019 Capital- Indusind Bank

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Market Risk

Internal Model Approach

K.G.Bhandari

IndusInd Bank Ltd.

March 15, 2010

Indian Banks Association

4th Annual summit 2010


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Basel Accord

Capital requirement were simplistic and rigid but did not reflectunderlying economic risks of banks / FIs

Now, capital requirements are more risk sensitive - reflectseconomic 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 directlytranslates 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 marketrisk was included later


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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 withineach 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


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IMA recognises

Risk Management models in use far moreadvanced than rigid rules

Banks can use their own VaR models as basis forcapital requirement for Market Risk

VaR is a robust Risk Measurement and

Management Practice


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IMA - Qualitative Criteria

Independent Risk Control Unit responsible for design and implementationof Banks risk management systems

Regular Back-Testing

Initial and on-going Validation of Internal Model

Banks Internal Risk Measurement Model must be integrated intoManagement decisions

Risk measurement system should be used in conjunction with Tradingand 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


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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 wellas across categories (FI and Fx, etc)

Market Risk charge : General Market Risk charge shall be Higher of previous days VaR or Avg VaR over last 60 businessdays X Multiplier factor K (absolute floor of 3)


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Market Risk Charge

Market Risk charge on any day t

SRC Specific Risk Charge

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


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Back testing

Possible cause and remedies of the "Yellow" zoneBasic Integrity of the modelDeficient model accuracyIntra day tradingBad luck


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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 willenable 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 profitor loss

Back Testing will help to refine the framework


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Time

Sop

histication

Mark to Market

Duration

Value at Risk

Stress Testing

Use of Statisticalanalysis todetermine

maximum losses

Use of What if

scenarios todetermine losses

in extremeeventsCashflow

analysis tomeasure thesensitivity offixed incomeinstruments

Revaluation ofthe portfolio to

measure notionalP/L

TimeTime

Sop

histication

Mark to Market

Duration

Value at Risk

Stress Testing

Use of statisticalanalysis todetermine

maximum losses

Use of What if

scenarios todetermine losses

in extremeeventsCashflow

analysis tomeasure thesensitivity offixed incomeinstruments

Revaluation ofthe portfolio to

measure notionalP/L

Market Risk Advanced Risk Measurement Techniquesenables Bank to effectively control the amount of market riskit assumes and allocate capital for the same

Measurement Techniques

Marking to Market

Duration, Convexity Price Value of a Basis Point

VaR - Forex (Spot & Forward)

Stress Testing

Scenario Analysis

Duration Limits

VaR Limits

Stop Loss Limits

Counterparty ExposureLimits

Country Exposure Limits

StandardizedModel

Internal Model

Know your risks Allocate CapitalControl Measures


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Market Risk Amendment

Paradigm becomes explicit

0

Stressloss

Frequency of loss

Amount of loss

Unexpected loss

Expectedloss


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Set up riskmanagement system

Formulate riskmanagement policies

and procedures

Involve ofthe board of directors

and high level management

Effective RiskManagement

3

4

Supporting Factors for Risk Management

Establish a unit to operaterisk management

2

1


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Limitations to Risk Management

Limitations

Involve of the board of directorsand high level management

Not enough cooperation

Low qualification

Lack of independence to make a decision

Not transparence

Formulate risk management

policy and procedures

Policies/ procedures not match with risks

Underdevelopment Infrastructure Rigid to implement

Communication failure

Establish a unit to operaterisk management

Lack of adequate structure

Staff has less experience

Lack of independence

Set up risk managementsystem

No follow up and control system

Not enough risk assessment/management

instruments

Database and IT system


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Supervisory objectives

better risk management

continual upgrading and encouragement ofinnovation in risk management methodology and

improved risk sensitivity and measures.


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Internal Model Framework

Policy Governance

Risk Strategy Accountability

Risk Appetite

Internalising

Risk Management Models ReportingProjection & Analys is 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


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Impact & Benefits

Best practice risk and capital management

In particular: Risk management - processes and controls

Capital management - eligible capital and quality ofcapital

Improved market perception: enhanced reputation

for risk management

Precise capital requirements and return on capital

Enhanced management information to supportmore optimal management decisions

Reduced costs: Operational efficiencies from

better risk management


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Internal model and its purpose

What is an internal model?

A risk management system developed by theBank to analyse the overall risk position, toquantify risks and to determine the economiccapital required to meet those risks

What is the purpose of an internal model?

To fully integrate processes of risk and capitalmanagement within the Bank


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Expected Benefits

Improved risk sensitivity

Better alignment of regulatory capital requirements witheconomic capital

Encouragement of innovation in risk management methodology

leading to higher competitiveness through better riskmanagement and hence lower costs of capital

More effective pillar 2 discussion and familiarity of thesupervisor with more detailed exposure data

Cost efficiencies through re-use of risk modeling infrastructurefor discussion with supervisors, rating agencies, analysts andshareholders.


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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 learnsfrom others

Most difficult IRB qualifying criterion to meet is not in relation tothe models themselves but in relation to the use them - a majorchallenge

It needs to be recognised that a robust risk managementframework is an essential prerequisite. Successful implementation,such as the use of models, can only be achieved if they integrateinto a sound framework of systems and controls; in the case ofcertain banks, there may be some gap vis--vis international bestpractice


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Specification of Market Risk Factors

For interest rates, there must be a set of risk factors corresponding tointerest 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 ofa 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 measurementsystem should incorporate risk factors corresponding to the individualforeign currencies in which the banks positions are denominated

For equity prices, there should be risk factors corresponding to each ofthe equity markets in which the bank holds significant positions

For commodity prices, there should be risk factors corresponding toeach of the commodity markets in which the bank holds significantpositions

Q tit ti St d d


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Quantitative Standards

Value-at-riskmust be computed on a daily basis

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

Holdingperiodwill be ten trading days

Effectivehistoricalobservation period must be at least one year

Banks should update their data setsno less frequently than once every three months and shouldalso reassess them whenever market prices are subject to material changes

No particular type of modelis prescribed should captures all the material risks run by the bank

Banks will have discretion to recognise empirical correlationswithin broad risk categories

Banks models must accurately capture the unique risks associated with optionswithin each ofthe broad risk categories

Each bank must meet, on a daily basis, a capital requirementexpressed as the higher of(i) its previous days 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 businessdays, multiplied by a multiplication factor

multiplication factorwill be set by supervisory authorities on the basis of their assessment of thequality of the banks 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 equitysecurities


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Stress Testing

Stress testing to identify events or influences that could greatlyimpact banks is a key component of a banks assessment of its capitalposition

Stress scenarios need to cover a range of factors that can createextraordinary losses or gains in trading portfolios, or make the controlof 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 marketdisturbances

Banks should combine the use of supervisory stress scenarios withstress tests developed by banks themselves to reflect their specificrisk characteristics

Stress tests results should be reviewed periodically by seniormanagement and should be reflected in the policies and limits set bymanagement and the board of directors


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External Validation

Validation ofmodels accuracy by external auditors and/orsupervisory authorities should at a minimum include

verifying the internal validation processes

formulaeused in the calculation process as well as for the pricingof options and other complex instruments are validated by aqualified unit - independent from the trading area

Structureof internal models is adequate with respect to the banksactivities and geographical coverage

results of the banks back-testing of its internal measurementsystem

data flows and processes associated with the risk measurement

system are transparent and accessible


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The Standardized Method

Risk classification is arbitrary.

Ignores diversification : leads to high capitalrequirements because risk charges are systematicallyadded up across difference sources of risk

Captures Risk for positions as on the day and not forthe period.


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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 4categories ignoring correlations

Provide a robust measure of interest rate risk taking into account Systematic/Market risk

duration basis risk across maturities

Specific/Idiosyncratic risk


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The Standardized Approach - Market Interest Rate Risk

Market risk is defined via Maturity Bands


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Specific Interest Risk Charge

The capital charge for specific risk is designed to protect against anadverse movement in the price of an individual security owing to factorsrelated 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


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The Internal Model Approach (IMA)

Rely on Internal Risk Management of the Bank

for the first time Regulation recognized that bank haddeveloped trustable risk management systems

if this approach lead to lower Capital Charge, Bankshave 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 quantitativelevels


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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 ofinterests

Back testing

Involvement senior

sufficient resources

Use of limits

Stress Testing Compliance (to a documented set of policies)

Independent Review


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Requirement on risk factors :

at least 6 factors for yield curve risk + separate risk factors tomodel spread risk

for equity, the model should at least consist of beta mappingon 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 forfor movements in the spot plus convenient yields

bank should also capture the non linear price characteristicsof options (gamma, vega , ...)

Correlation within broad risk categories are recognizedexplicitly

The Internal Model Approach (IMA) -Qualitative Requirements


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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 preventmodel misspecifications

a plus factor is added (depending on the performance of themodel)


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Stress Testing

Stress Testing can be described as a process to

identify and manage situations that could causeextraordinary losses

Tools

Scenarios Analysis

Stressing Models

Policy Response


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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 largehistorical 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


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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 moreobservations

On average, one would expect 1% of 250 or 2.5 instances ofexceptions over the last year

Too many exceptions indicate that

either the model is understating VAR

the Bank is unlucky

How to decide ?

Statistical inference


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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 couldcause extraordinary losses

Scenarios requiring no simulation

Scenarios requiring a simulation

Bank-Specific scenarios


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Basel Market Risk Charges

Back testing

A statistical testing framework that consists ofchecking whether actual trading losses are in linewith VAR forecasts

Exceptions

The Penalty Zones

Basic integrity of the model

Deficient model accuracy

Intraday trading Bad luck


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Internal Model Approach - VaR

Qualitative Requirements :

To use IMA, banks need to satisfy QualitativeRequirements

Robust risk measurement systems in place mustbe integrated into Management Decisions

Conduct Stress Tests regularly

Independent Risk Monitoring Framework

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