Financial Risk Management KPMG ADVISORY

A spate of high-profile business failures and the emergence of tougher regulations have put organizations under pressure to

manage financial risk more effectively. Financial organizations have to be aware of the need to identify, measure and manage

risk, e.g. credit, market, liquidity, and operational risk, as well as maintaining sufficient levels of regulatory and economic

capital to support the risks they face. Also, there is a need for adequate disclosure and presentation of information to

stakeholders and third parties.

Financial Instruments – Valuation / Accounting and Disclosure

Financial instrument valuations encompass valuations of a variety of simple, complex and

structured products. Examples of such products are credit derivatives (e.g. Credit Default

Swaps), interest rate and foreign exchange derivatives (e.g. Interest Rate Swaps, Cross

Currency Interest Rate Swaps, Interest and Foreign Exchange Rate Options, Swaptions,

etc.), Credit Link Notes and Total Return Swaps. Moreover, recent developments have

raised issues around the valuation of Asset Backed Securities (ABS), Collateralized Debt

Obligations (CDO) and related structures. Clients often raise questions such as: Do we

have a reliable market value? Do we use an appropriate valuation model? Is the outcome

of the model reasonable? We can assist in providing solutions in this area.

Our practice also provides support in the correct accounting of Financial Instruments,

in accordance with IFRS, US-GAAP or other accounting standards. An example would

be the review and implementation of Hedge Accounting where the appropriateness of

(Fair Value/Cash Flow) Hedge Accounting model and Hedge Accounting effectiveness

tests are evaluated . In addition, we have wide experience in the preparation of financial

reporting disclosures of financial instruments, risk management methods and models

(e.g. IFRS 7, Disclosure requirements acc. to Pillar 3 of Basel II).

Capital Adequacy, Regulatory Reporting & Compliance

Capital Adequacy for banks is calculated and

Regulatory Reporting is made according to

regulators’ rules and methodologies, defining

for each bank a minimum regulatory capital requirement and reporting. It comprises, but

is not limited to, the Basel II framework as,

e.g., transposed in Luxembourg with respect to

FinRep (Financial Reporting based on IFRS) and

CoRep (Common Reporting for the Solvency

Ratio based on IFRS) by the Commission de

Surveillance du Secteur Financier (“CSSF”).

Management of Financial Risks

The management of credit risk, market risk

(comprising interest rate risks, foreign exchange

risks, equity risk as well as commodity risks),

operational and reputational risk, insurance

risk as well as liquidity risk should be part

of every sound financial risk management

system within a company. The scope

depends on the relevance of each risk

category for a company. Most institutions

measure their risks based on Value-at-

Risk Models. Many of these risks are highly

relevant for most of the financial institutions

and are interrelated. As such, they need to

be measured and managed accordingly. Recent

developments have revealed significant weaknesses in the management of credit risk

and liquidity risk within many organizations. Sound credit risk management can mitigate

or avoid a significant financial impact of such events on an organization.

What We Do – And What You Get

Basel II Framework - 3 Principle Pillars

Minimum Regulatory

Capital Requirement

Supervisory Process

Market Discipline

Your potential benefits are :

An adequate and tailor-made •approach to any kind of financial instruments valuation.

Third party valuation where you •benefit from our valuation tools and knowledge.

Compliance with regulatory and •accounting frameworks.

Effective implementation of Hedge •Accounting and other valuation tools to mitigate volatility of accounting P&L.

Your potential benefits are :

Full compliance with regulatory •requirements in Luxembourg.

Sound capital requirement •calculations especially for IRB approach for credit risk and AMA approach for operational risk.

Integrated and comprehensive •methods to implement or refine existing processes to fulfill regulatory requirements.

Your potential benefits are :

Improved transparency and enhanced •understanding of risks the company is exposed to.

Identification of the different kinds of •relevant risks and their key drivers.

Development and implementation of •appropriate risk management models and procedures.

Setting up a sound risk management •practice for those risks.

Model Building and Model Validation

A model is a tool used to calculate or estimate

results based on a series of inputs often used

for analysis or quantification. Models are used

to make decisions easier and as such they

support the decision process. They do not

have an own purpose. Organizations use

a wide variety of models or spreadsheets,

which can be broadly categorized into

three areas: Decision Support, Financial

and Risk Management models.

For example, structured products or Asset

Backed Securities are rarely priced on active

markets. Therefore, adequate financial models are

necessary to price those financial instruments. Furthermore, appropriate risk

management models adapted to the companies’ specific purpose and needs, such as

Value-at-Risk or Expected Shortfall, are needed to measure, manage and control the risk

thereof. The models underlying the Hedge Accounting effectiveness tests are another

example of models used in accounting.

ICAAP & Economic Capital Calculation

ICAAP (Internal Capital Adequacy Assessment Process), part of Pillar 2 within the Basel II

Framework, represents a financial institution’s own assessment of the capital needed to

run the business. This capital may differ from the minimum regulatory capital requirement

since, for instance, a financial institution may include risks that are not formally subject to

the minimum regulatory capital (e.g. liquidity risk, reputational risk or interest rate risk in

the banking book) or may use different parameters or methodologies (this is particularly

the case for operational risk).

Restrictions due

to Basel II, Pillar II

≤!

“EconomicCapital”

AvailableFinancial

Resources

Free FinancialResources

Restrictions due to Basel II, Pillar I

≤!

RegulatoryCapital

Pillar IOwn Funds

Capital Surplus

Your potential benefits are :

Development of effective models and •assistance in validating those models as well as assessment of the overall reliability of the model output.

Accurate pricing of financial •instruments based on efficient and precise models.

Leading risk management models for •sound financial risk management.

Your potential benefits are :

A risk management framework •consistent with financial risk strategy.

Efficient process in response to the •second pillar requirements of Basel II (ICAAP).

Full compliance with regulatory •requirements and in line with best practice.

Adequate economic capital models •and risk management processes and procedures consistent to the risk management framework resulting in a comprehensive and integrated financial risk management approach.

Understanding of the different types •of risks financial institutions are exposed to and how they impact the company, incorporating these into their business operations and monitoring.

Awareness of potential weaknesses •in the financial risk management strategy, frameworks and processes as well as in the risk mitigation methods and being able to prepare the management actions to be taken to avoid unexpected or surprising losses.

Financial strategies could be risk avoidance, reduction, limitation, transference or

acceptance. An integral part of financial strategies is the management of financial risks and

resources and comprises identification, measurement, assessment, controlling, monitoring,

reporting and stress testing of the several risks including risks essentially not integrated.

Risk Adjusted Performance Calculations

Risk-adjusted performance measures compare return with capital employed in a way

that incorporates an adjustment for risk. The most famous measures are RAROC

(risk-adjusted return on capital) and RORAC (return on risk-adjusted capital).

Risk-adjusted performance measures are based on either risk adjusted return or

economic capital.They can be used for comparing past performance or as a forward

looking measure to decide on the long-term viability of a business unit, whether

it should be expanded or scaled back.

Integrated Planning & Target Setting

Added Value (e.g., EVA)

Risk Cost

Cap. Cost

Value drivers/Operational Drivers/KPIs

Risk-Return Ratio (e.g., RORAC)

Revenue

Risk AggregationCost

1

Org

aniz

atio

nal

Un

it

Leg

al E

nti

ty

Pro

du

ct

Cu

sto

mer

2 3 4 5Market Risk Credit Risk Op. Risk Other Risks

Simulations & AnalysisReports/Cockpits

Expected Loss

Unexpected Loss

99.95% (AA)

EL

UL

0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35%

ECAP

PR

OB

AB

ILIT

Y

LOSS RATE (%)

EL = expected lossUL = unexpcted lossECAP = economic capitalAA = bank’s creditrating

Your potential benefits are :

Implementation of performance •measures or improvement of your current measures.

Risk-adjusted performance •calculations consistent and integrated into existing capital planning and risk management process.

New Product Process (NPP) for Asset Management

Current market trends show that innovations of products and instruments will become

more significant over the coming years because of a decrease in market growth and a gain

in margin of traditional products. Standardized products such as index funds have lately

become more and more attractive for investors and alternative products are becoming

increasingly mainstream for asset managers.

An efficient and high quality New Product Process (NPP) is necessary to keep up with the market demands and regulatory requirements for asset managers

Based on the increasing importance of new funding vehicles there is a need to accelerate

the time-to-market of new products while complying with applicable rules and regulations.

By launching new products asset managers are faced with a variety of challenges, e.g.

regulatory, economic, process-related and technical challenges. An efficient new product

process takes all essential departments and functions of the value chain into account.

Our project management approach for the multidisciplinary NPP – A cube-based Illustration

Particular business functions are involved in one or more phases of the NPP.

Cross-sectional issues come up for several business functions during various phases.

Our project management approach recognizes this variety and interconnection among

the various functions.

- Callable Yield Notes - Callable Path Dependant Floaters - Certificates, Discount, Bonus, Express etc. - Basket Structures - Snowballs - Target Range Accrual Notes - Exotic Options – Equity, Commodity etc. - Triggerable Reverse Floater - Inflation products, e. g. Zero Inflation Swaps, Inflation Swaps - CPPI - Variance Swap - […]

- Compliance with international regulatory guidelines and local requirements (e.g. IFRS, InvG, SolvV, MiFID, AnlV, Derivative regulation)- Coverage of permanently increasing requirements (Reporting, Corporate and Governance and Risk Management) in regard to regulatory law, accounting- and taxation law

- New products and instruments need to match with the market expectations - Product profitability

- Liquidity and risk performance- Adequate mapping within the system and correct treatment in the day-to-day business activities have to be assured- Utilization of synergies

Modification / mix of existing products

Real innovations

New products

Reg

ula

tory

Eco

no

mic

ch

alle

ng

es

Pro

cess

-rel

ated

te

chn

ical

ch

alle

ng

es

Fund managementMarket research

LegalTax

Internal auditEconomic analysis

TradingCompliance

Order controlPricing & valuation

Risk analysisPerform. analysisFund accounting

Reporting

Initiation &Analysis Design Implementation Testing

Appproval &Going Live

BusinessFunctions

21

Cross-sectional Issues

NPP Phases

3Coordination

CommunicationIT architecture

InterfacesData

Execution (by default)

Your potential benefits are :

Ability to introduce new products •adequately and smoothly, minimizing the time span from the initiation to going live and keeping track of the expenses for related structures, processes and IT.

Assurance of appropriate prices •and risk figures with regard to new products accommodating both true innovations and modifications efficiently.

Financial Risk Management

Why ? Risk management is highly complex, with risks often interrelated, which require sophisticated tools and techniques. Sarbanes-Oxley, Basel II, Solvency II and the cost of capital require organizations to improve their risk management practices. This ultimately helps management to view risk as a major part of corporate strategy. Financial risks are more and more interrelated to financial accounting and reporting (e. g. IAS 39 and IFRS 7) as well as to the calculation of the solvency ratio (e. g. calculation of the regulatory own funds based on IFRS). These require integrated and comprehensive management frameworks to optimize Financial Risk Management, Asset-Liability Management and overall product processes.

How can we help ? Based on an integrated approach, we can help design and implement frameworks to manage and/or reduce risk. We can provide assistance in creating an overall framework that helps to identify, measure, monitor and report risks leading, ultimately, to better strategic decision making and efficient processes.

Our quality ? In striving to provide high quality services, we participate in a global accreditation program, we work closely with professionals from other KPMG member firms, liaise regularly with our global KPMG Financial Risk Management group and share experiences on a variety of different national and international projects. We also cooperate with universities to be able to provide the most up to date methodologies to our clients.

Your benefit ? KPMG Financial Risk Management is committed to ensure that we are always available to help identify opportunities, solve problems and as a result add value firm wide based on a multidisciplinary approach. You can benefit from our cross-border knowledge and experience – in Luxembourg and abroad. Whatever problem you might have regarding Financial Risk Management, we can provide you with a tailored approach.

Your Needs – Our Approach

B

anks

Investment Funds

Insurances Com

panies

Corporates

Valuation of Financial Instruments

Capital Adequacy /RegulatoryReporting

ICAAP&Economic Capital

Calculation

Integrated andComprehensive

Risk Management

Model Building &Validation

Risk-adjustedPerformanceCalculations

NewProductProcess

Accounting &Disclosure of

Financial Instruments

Financial Risk Management

(FRM)

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