risk management.rtf

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Wharton

Financial Institutions Center

Commercial Bank Risk Management: an Analysis of the

Process

byAnthony M. Santomero

95-11-CThe Wharton School

University of Pennsylvania

THE WHARTON FINANCIAL INSTITUTIONS CENTER

The Wharton Financial Institutions Center provides a multidisciplinar! researchapproach to the pro"lems and opportunities #acin$ the #inancial services industr! in itssearch #or competitive e%cellence& The Center's research #ocuses on the issues related tomana$in$ ris( at the #irm level as )ell as )a!s to improve productivit! and per#ormance&

The Center #osters the development o# a communit! o# #acult!* visitin$ scholars and+h&,& candidates )hose research interests complement and support the mission o# theCenter& The Center )or(s closel! )ith industr! e%ecutives and practitioners to ensure thatits research is in#ormed "! the operatin$ realities and competitive demands #acin$industr! participants as the! pursue competitive e%cellence&

Copies o# the )or(in$ papers summari-ed here are availa"le #rom the Center& I# !ou)ould li(e to learn more a"out the Center or "ecome a mem"er o# our researchcommunit!* please let us (no) o# !our interest&


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Anthon! .&Santomero,irector

The Working Paper Series is made possible by a generous

grant from the Alfred P Sloan !oundation

Commercial /an( Ris( .ana$ement0 An Anal!sis o# the +rocess 1

This 2ersion0 Fe"ruar! 34* 1556

A"stract0 Throu$hout the past !ear* onsite visits to #inancial service #irms )ere conducted to revie) and

evaluate their #inancial ris( mana$ement s!stems& The commercial "an(in$ anal!sis covered a num"er o#

North American superre$ionals and 7uasimone! center institutions as )ell as several #irms outside the

U&S& The in#ormation o"tained covered "oth the philosoph! and practice o# #inancial ris( mana$ement& This

paper outlines the results o# this investi$ation& It reports the state o# ris( mana$ement techni7ues in the

industr!& It reports the standard o# practice and evaluates ho) and )h! it is conducted in the particular )a!

chosen& In addition* criti7ues are o##ered )here appropriate& We discuss the pro"lems )hich the industr!

#inds most di##icult to address* shortcomin$s o# the current methodolo$! used to anal!-e ris(* and the

elements that are missin$ in the current procedures o# ris( mana$ement&

8EL Classi#ication codes 0 93* 91* L3

:e! )ords 0 ris( mana$ement* #inancial ris(* "an(in$

1Anthon! .& Santomero is the Richard :& .ellon +ro#essor o# Finance at the Wharton School&


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This paper )as presented at the Wharton Financial Institutions Center Con#erence on Ris( .ana$ement in/an(in$* Octo"er 1;1or investment "an(in$ #irms& These results )ere then

presented to a much )ider arra! o# "an(in$ #irms #or reaction and veri#ication&

The purpose o# the present paper is to outline the #indin$s o# this investi$ation& It reports the

state o# ris( mana$ement techni7ues in the industr! 7uestions as(ed* 7uestions ans)ered and

7uestions le#t unaddressed "! respondents& 1 This report can not recite a litan! o# the approaches used

)ithin the industr!* nor can it o##er an evaluation o# each and ever! approach& Rather* it reports the

standard o# practice and evaluates ho) and )h! it is conducted in the particular )a! chosen& /ut* even

the "est practice emplo!ed )ithin the industr! is not $ood enou$h in some areas& Accordin$l!*

criti7ues also )ill "e o##ered )here appropriate& The paper concludes )ith a list o# 7uestions that are

currentl! unans)ered* or ans)ered imprecisel! in the current practice emplo!ed "! this $roup o#

relativel! sophisticated "an(s& Here* )e discuss the pro"lems )hich the industr! #inds most di##icult to

address* shortcomin$s o# the current methodolo$! used


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1A companion paper reports on ris( mana$ement practices #or insurance #irms& See /a""el and

Santomero ?1556@&1

to anal!-e ris( and the elements that are missin$ in the current procedures o# ris( mana$ement and

ris( control&

II& Ris( As a Central In$redient To the Industr!'s Franchise

A& What T!pe o# Ris( Is /ein$ Considered Commercial "an(s are in the ris( "usiness& In the process o# providin$ #inancial services* the!

assume various (inds o# #inancial ris(s& Over the last decade our understandin$ o# the place o#

commercial "an(s )ithin the #inancial sector has improved su"stantiall!& Over this time* much has

"een )ritten on the role o# commercial "an(s in the #inancial sector* "oth in the academic literature 3

and in the #inancial press ;& These ar$uments )ill "e neither revie)ed nor enumerated here& Su##ice it

to sa! that mar(et participants see( the services o# these #inancial institutions "ecause o# their a"ilit!

to provide mar(et (no)led$e* transaction e##icienc! and #undin$ capa"ilit!& In per#ormin$ these roles

the! $enerall! act as a principal in the transaction*& As such* the! use their o)n "alance sheet to

#acilitate the transaction and to a"sor" the ris(s associated )ith it&

To "e sure* there are activities per#ormed "! "an(in$ #irms )hich do not have direct "alance

sheet implications& These services include a$enc! and advisor! activities such as ?i@ trust and

investment mana$ement* ?ii@ private and pu"lic placements throu$h B"est e##ortsB or #acilitatin$

contracts* ?iii@ standard under)ritin$ throu$h Section 3 Su"sidiaries o# the holdin$ compan!* or ?iv@

the pac(a$in$* securiti-in$* distri"utin$ and servicin$ o# loans in the areas o# consumer and real estate

de"t primaril!& These items are a"sent #rom the traditional #inancial statement "ecause the latter rel!

on $enerall! accepted accountin$ procedures rather than a true economic "alance sheet& Nonetheless*

the over)helmin$ ma>orit! o# the ris(s #acin$ the "an(in$ #irm is in on"alancesheet "usinesses& It is

in this area that the discussion o# ris(

3There are ampl! revie)s o# the role o# "an(s )ithin the #inancial sector& See* #or e%ample*/hattachar!a and Tha(or ?155;@* Santomero ?154D@* or more recentl! Allen and Santomero


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?1556@&

;There are man! surve!s and articles here& See* #or e%ample* Economist ?155;@* Salomon/rothers and 9oldman Sachs E7uit! Research Reports on the "an(in$ sector&

3

mana$ement and the necessar! procedures #or ris( mana$ement and control has centered&

Accordin$l!* it is here that our revie) o# ris( mana$ement procedures )ill concentrate&

/& What :inds O# Ris(s Are /ein$ A"sor"ed The ris(s contained in the "an('s principal activities* i&e&* those involvin$ its o)n "alance

sheet and its "asic "usiness o# lendin$ and "orro)in$* are not all "orne "! the "an( itsel#& In man!

instances the institution )ill eliminate or miti$ate the #inancial ris( associated )ith a transaction "!

proper "usiness practices in others* it )ill shi#t the ris( to other parties throu$h a com"ination o#

pricin$ and product desi$n&

The "an(in$ industr! reco$ni-es that an institution need not en$a$e in "usiness in a manner

that unnecessaril! imposes ris( upon it nor should it a"sor" ris( that can "e e##icientl! trans#erred to

other participants& Rather* it should onl! mana$e ris(s at the #irm level that are more e##icientl!

mana$ed there than "! the mar(et itsel# or "! their o)ners in their o)n port#olios& In short* it should

accept onl! those ris(s that are uni7uel! a part o# the "an('s arra! o# services& Else)here* Old#ield and

Santomero ?1556@* it has "een ar$ued that ris(s #acin$ all #inancial institutions can "e se$mented into

three separa"le t!pes* #rom a mana$ement perspective& These are0

?i@ ris(s that can "e eliminated or avoided "! simple "usiness practices*

?ii@ ris(s that can "e trans#erred to other participants* and*

?iii@ ris(s that must "e activel! mana$ed at the #irm level&In the #irst o# these cases* the practice o# ris( avoidance involves actions to reduce the

chances o# idios!ncratic losses #rom standard "an(in$ activit! "! eliminatin$ ris(s that are

super#luous to the institution's "usiness purpose& Common ris( avoidance practices here include at

least three t!pes o# actions& The standardi-ation o# process* contracts and procedures to prevent

ine##icient or incorrect #inancial decisions is the #irst o# these& The construction o# port#olios that

"ene#it #rom diversi#ication across "orro)ers and that reduce the e##ects o# an! one loss e%perience is


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another& Finall!* the implementation o# incentivecompati"le contracts )ith the institution's

mana$ement to re7uire that emplo!ees "e held accounta"le is the third& In each

;

case the $oal is to rid the #irm o# ris(s that are not essential to the #inancial service provided* or to

a"sor" onl! an optimal 7uantit! o# a particular (ind o# ris(&

There are also some ris(s that can "e eliminated* or at least su"stantiall! reduced throu$h the

techni7ue o# ris( trans#er& .ar(ets e%ist #or man! o# the ris(s "orne "! the "an(in$ #irm& Interest rate

ris( can "e trans#erred "! interest rate products such as s)aps or other derivatives& /orro)in$ terms

can "e altered to e##ect a chan$e in their duration& Finall!* the "an( can "u! or sell #inancial claims to

diversi#! or concentrate the ris(s that result in #rom servicin$ its client "ase& To the e%tent that the

#inancial ris(s o# the assets created "! the #irm are understood "! the mar(et* these assets can "e sold

at their #air value& Unless the institution has a comparative advanta$e in mana$in$ the attendant ris(

andor a desire #or the em"edded ris( the! contain* there is no reason #or the "an( to a"sor" such ris(s*

rather than trans#er them&

Ho)ever* there are t)o classes o# assets or activities )here the ris( inherent in the activit!

must and should "e a"sor"ed at the "an( level& In these cases* $ood reasons e%ist #or usin$ #irm

resources to mana$e "an( level ris(& The #irst o# these includes #inancial assets or activities )here the

nature o# the em"edded ris( ma! "e comple% and di##icult to communicate to third parties& This is the

case )hen the "an( holds comple% and proprietar! assets that have thin* i# not none%istent* secondar!

mar(ets& Communication in such cases ma! "e more di##icult or e%pensive than hed$in$ the

underl!in$ ris(& D .oreover* revealin$ in#ormation a"out the customer ma! $ive competitors an undue

advanta$e& The second case included proprietar! positions that are accepted "ecause o# their ris(s* and

their e%pected return& Here* ris( positions that are central to the "an('s "usiness purpose are a"sor"ed

"ecause the! are the raison d'etre o# the #irm& Credit ris( inherent in the lendin$ activit! is a clear case

in point* as is mar(et ris( #or the tradin$ des( o# "an(s active in certain mar(ets& In all such

circumstances* ris( is a"sor"ed and needs to "e monitored and mana$ed e##icientl! "! the institution&

Onl! then )ill the #irm s!stematicall! achieve its #inancial per#ormance $oal&


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DThis point has "een made in a di##erent conte%t "! "oth Santomero and Trester ?1556@ and

/er$er and Udell ?155;@&D

C& Wh! ,o /an(s .ana$e These Ris(s At All It seems appropriate #or an! discussion o# ris( mana$ement procedures to "e$in )ith )h!

these #irms mana$e ris(& Accordin$ to standard economic theor!* mana$ers o# value ma%imi-in$ #irms

ou$ht to ma%imi-e e%pected pro#it )ithout re$ard to the varia"ilit! around its e%pected value&

Ho)ever* there is no) a $ro)in$ literature on the reasons #or active ris( mana$ement includin$ the

)or( o# Stul- ?154D@* Smith* Smithson and Wol#ord ?155@* and Froot* Shar#stein and Stein ?155;@ to

name "ut a #e) o# the more nota"le contri"utions& In #act* the recent revie) o# ris( mana$ement

reported in Santomero ?155


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ris( in a manner that is consistent )ith the #irm's $oals and o">ectives& To see ho) each o# these #our

parts o# "asic ris( mana$ement techni7ues achieves these ends* )e ela"orate on each part o# the

process "elo)& In Section I2 )e illustrate ho) these techni7ues are applied to mana$e each o# the

speci#ic ris(s #acin$ the "an(in$ communit!&

?i@ Standards and Reports

The #irst o# these ris( mana$ement techni7ues involves t)o di##erent conceptual

activities* i&e&* standard settin$ and #inancial reportin$& The! are listed to$ether "ecause the! are the

sine "ua non o# an! ris( s!stem& Under)ritin$ standards* ris( cate$ori-ations* and standards o# revie)

are all traditional tools o# ris( mana$ement and control& Consistent evaluation and ratin$ o# e%posures

o# various t!pes are essential to understand the ris(s in the port#olio* and the e%tent to )hich these

ris(s must "e miti$ated or a"sor"ed&

The standardi-ation o# #inancial reportin$ is the ne%t in$redient& O"viousl! outside audits*

re$ulator! reports* and ratin$ a$enc! evaluations are essential #or investors to $au$e asset 7ualit! and

#irm level ris(& These reports have lon$ "een standardi-ed* #or "etter or )orse& Ho)ever* the need here

$oes "e!ond pu"lic reports and audited statements to the need #or mana$ement in#ormation on asset

7ualit! and ris( posture& Such internal reports need similar standardi-ation and much more #re7uent

reportin$ intervals* )ith dail! or )ee(l! reports su"stitutin$ #or the 7uarterl! 9AA+ periodicit!&

?ii@ +osition Limits and Rules

A second techni7ue #or internal control o# active mana$ement is the use o# position

limits* andor minimum standards #or participation& In terms o# the latter* the domain o# ris( ta(in$ is

restricted to onl! those assets or counterparties that pass some prespeci#ied 7ualit! standard& Then*

even #or those investments that are eli$i"le* limits are imposed to cover e%posures to counterparties*

credits* and overall

=

position concentrations relative to various t!pes o# ris(s& While such limits are costl! to esta"lish and


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administer* their imposition restricts the ris( that can "e assumed "! an! one individual* and there#ore

"! the or$ani-ation as a )hole& In $eneral* each person )ho can commit capital )ill have a )ell

de#ined limit& This applies to traders* lenders* and port#olio mana$ers& Summar! reports sho) limits as

)ell as current e%posure "! "usiness unit on a periodic "asis& In lar$e or$ani-ations )ith thousands o#

positions maintained* accurate and timel! reportin$ is di##icult* "ut even more essential&

?iii@ Investment 9uidelines and Strate$iesInvestment $uidelines and recommended positions #or the immediate #uture are the

third techni7ue commonl! in use& Here* strate$ies are outlined in terms o# concentrations and

commitments to particular areas o# the mar(et* the e%tent o# desired assetlia"ilit! mismatchin$ or

e%posure* and the need to hed$e a$ainst s!stematic ris( o# a particular t!pe&

The limits descri"ed a"ove lead to passive ris( avoidance andor diversi#ication* "ecause

mana$ers $enerall! operate )ithin position limits and prescri"ed rules& /e!ond this* $uidelines o##er

#irm level advice as to the appropriate level o# active mana$ement* $iven the state o# the mar(et and

the )illin$ness o# senior mana$ement to a"sor" the ris(s implied "! the a$$re$ate port#olio& Such

$uidelines lead to #irm level hed$in$ and assetlia"ilit! matchin$& In addition* securiti-ation and even

derivative activit! are rapidl! $ro)in$ techni7ues o# position mana$ement open to participants

loo(in$ to reduce their e%posure to "e in line )ith mana$ement's $uidelines&

?iv@ Incentive SchemesTo the e%tent that mana$ement can enter incentive compati"le contracts )ith line

mana$ers and ma(e compensation related to the ris(s "orne "! these individuals* then the need #or

ela"orate and costl! controls is lessened& Ho)ever* such incentive contracts re7uire accurate position

valuation and proper internal control s!stems& < Such tools )hich include position postin$* ris(

anal!sis* the allocation o# costs* and settin$


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most #inancial de"acles can "e traced to the a"sence o# incentive compati"ilit!* as the cases o# the deposit

insurance and maveric( traders so clearl! illustrate&

III& Ris(s In +rovidin$ /an(in$ ServicesHo) are these techni7ues o# ris( mana$ement emplo!ed "! the commercial "an(in$ sector To

e%plain this* one must "e$in "! enumeratin$ the ris(s )hich the "an(in$ industr! has chosen to mana$e

and illustrate ho) the #ourstep procedure outlined is applied in each area& The ris(s associated )ith the

provision o# "an(in$ services di##er "! the t!pe o# service rendered& For the sector as a )hole* ho)ever the

ris(s can "e "ro(en into si% $eneric t!pes0 systematic or market risk# credit risk# counterparty risk# li"uidity

risk# operational risk# and legal risks Here* )e )ill discuss each o# the ris(s #acin$ the "an(in$ institution*

and in Section I2 )e )ill indicate ho) the! are mana$ed&

Systematic risk is the ris( o# asset value chan$e associated )ith s!stematic #actors& It is sometimes

re#erred to as market risk# )hich is in #act a some)hat imprecise term& /! its nature* this ris( can "e

hed$ed* "ut cannot "e diversi#ied completel! a)a!& In #act* s!stematic ris( can "e thou$ht o# as

undiversi#ia"le ris(& All investors assume this t!pe o# ris(* )henever assets o)ned or claims issued can

chan$e in value as a result o# "road economic #actors& As such* s!stematic ris( comes in man! di##erent

#orms& For the "an(in$ sector* ho)ever* t)o are o# $reatest concern* namel! variations in the $eneral level

o# interest rates and the relative value o# currencies&

/ecause o# the "an('s dependence on these s!stematic #actors* most tr! to estimate the impact o#

these particular s!stematic ris(s on per#ormance* attempt to hed$e a$ainst them and thus limit the

sensitivit! to variations in undiversi#ia"le #actors& Accordin$l!* most )ill trac( interest rate risk closel!&

The! measure

=See 8ensen and .ec(lin$ ?156=@* and Santomero ?154D@ #or discussions o# the shortcomin$s insimple linear ris( sharin$ incentive contracts #or assurin$ incentive compati"ilit! "et)een principals

and a$ents&4

and mana$e the #irm's vulnera"ilit! to interest rate variation* even thou$h the! can not do so per#ectl!&

At the same time* international "an(s )ith lar$e currenc! positions closel! monitor their foreign

e$change risk and tr! to mana$e* as )ell as limit* their e%posure to it&


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In a similar #ashion* some institutions )ith si$ni#icant investments in one commodit! such as

oil* throu$h their lendin$ activit! or $eo$raphical #ranchise* concern themselves )ith commodity price

risk Others )ith hi$h sin$leindustr! concentrations ma! monitor speci#ic industry concentration risk

as )ell as the #orces that a##ect the #ortunes o# the industr! involved&

Credit risk arises #rom nonper#ormance "! a "orro)er& It ma! arise #rom either an ina"ilit! or

an un)illin$ness to per#orm in the precommitted contracted manner& This can a##ect the lender

holdin$ the loan contract* as )ell as other lenders to the creditor& There#ore* the #inancial condition o#

the "orro)er as )ell as the current value o# an! underl!in$ collateral is o# considera"le interest to its

"an(&

The real ris( #rom credit is the deviation o# port#olio per#ormance #rom its e%pected value&

Accordin$l!* credit ris( is diversi#ia"le* "ut di##icult to eliminate completel!& This is "ecause a portion

o# the de#ault ris( ma!* in #act* result #rom the s!stematic ris( outlined a"ove& In addition* the

idios!ncratic nature o# some portion o# these losses remains a pro"lem #or creditors in spite o# the

"ene#icial e##ect o# diversi#ication on total uncertaint!& This is particularl! true #or "an(s that lend in

local mar(ets and ones that ta(e on hi$hl! illi7uid assets& In such cases* the credit ris( is not easil!

trans#erred* and accurate estimates o# loss are di##icult to o"tain&

Counterparty risk comes #rom nonper#ormance o# a tradin$ partner& The nonper#ormance

ma! arise #rom a counterpart!'s re#usal to per#orm due to an adverse price movement caused "!

s!stematic #actors* or #rom some other political or le$al constraint that )as not anticipated "! the

principals& ,iversi#ication is the ma>or tool #or controllin$ nons!stematic counterpart! ris(&

Counterpart! ris( is li(e credit ris(* "ut it is $enerall! vie)ed as a more transient #inancial

ris( associated )ith tradin$ than standard creditor de#ault ris(& In addition* a counterpart!'s #ailure to

settle a trade

5

can arise #rom other #actors "e!ond a credit pro"lem&%i"uidity risk can "est "e descri"ed as the ris( o# a #undin$ crisis& While some )ould include

the need to plan #or $ro)th and une%pected e%pansion o# credit* the ris( here is seen more correctl! as


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the potential #or a #undin$ crisis& Such a situation )ould inevita"l! "e associated )ith an une%pected

event* such as a lar$e char$e o##* loss o# con#idence* or a crisis o# national proportion such as a

currenc! crisis&

In an! case* ris( mana$ement here centers on li7uidit! #acilities and port#olio structure&

Reco$ni-in$ li7uidit! ris( leads the "an( to reco$ni-e li7uidit! itsel# as an asset* and port#olio desi$n

in the #ace o# illi7uidit! concerns as a challen$e&

&perational risk is associated )ith the pro"lems o# accuratel! processin$* settlin$* and ta(in$

or ma(in$ deliver! on trades in e%chan$e #or cash& It also arises in record (eepin$* processin$ s!stem

#ailures and compliance )ith various re$ulations& As such* individual operatin$ pro"lems are small

pro"a"ilit! events #or )ellrun or$ani-ations "ut the! e%pose a #irm to outcomes that ma! "e 7uite

costl!&

%egal risks are endemic in #inancial contractin$ and are separate #rom the le$al rami#ications

o# credit* counterpart!* and operational ris(s& Ne) statutes* ta% le$islation* court opinions and

re$ulations can put #ormerl! )ellesta"lished transactions into contention even )hen all parties have

previousl! per#ormed ade7uatel! and are #ull! a"le to per#orm in the #uture& For e%ample*

environmental re$ulations have radicall! a##ected real estate values #or older properties and imposed

serious ris(s to lendin$ institutions in this area& A second t!pe o# le$al ris( arises #rom the activities o#

an institution's mana$ement or emplo!ees& Fraud* violations o# re$ulations or la)s* and other actions

can lead to catastrophic loss* as recent e%amples in the thri#t industr! have demonstrated&

All #inancial institutions #ace all these ris(s to some e%tent& Nonprincipal* or a$enc! activit!

involves operational ris( primaril!& Since institutions in this case do not o)n the underl!in$ assets in

)hich the! trade* s!stematic* credit and counterpart! ris( accrues directl! to the asset holder& I# the

latter e%periences a #inancial loss* ho)ever* le$al recourse a$ainst an a$ent is o#ten attempted&

There#ore* institutions en$a$ed in

1

onl! a$enc! transactions "ear some le$al ris(* i# onl! indirectl!&Our main interest* ho)ever* centers around the "usinesses in )hich the "an( participates as a


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principal* i&e&* as an intermediar!& In these activities* principals must decide ho) much "usiness to

ori$inate* ho) much to #inance* ho) much to sell* and ho) much to contract to a$ents& In so doin$*

the! must )ei$h "oth the return and the ris( em"edded in the port#olio& +rincipals must measure the

e%pected pro#it and evaluate the prudence o# the various ris(s enumerated to "e sure that the result

achieves the stated $oal o# ma%imi-in$ shareholder value&

I2& /an( Ris( .ana$ement S!stemsThe "an(in$ industr! has lon$ vie)ed the pro"lem o# ris( mana$ement as the need to control

#our o# the a"ove ris(s )hich ma(e up most* i# not all* o# their ris( e%posure* vi-&* credit* interest rate*

#orei$n e%chan$e and li7uidit! ris(& While the! reco$ni-e counterpart! and le$al ris(s* the! vie) them

as less central to their concerns& 6 Where counterpart! ris( is si$ni#icant* it is evaluated usin$ standard

credit ris( procedures* and o#ten )ithin the credit department itsel#& Li(e)ise* most "an(ers )ould

vie) le$al ris(s as arisin$ #rom their credit decisions or* more li(el!* proper process not emplo!ed in

#inancial contractin$& Accordin$l!* the stud! o# "an( ris( mana$ement processes is essentiall! an

investi$ation o# ho) the! mana$e these #our ris(s& In each case* the procedure outlined a"ove is

adapted to the ris( considered so as to standardi-e* measure* constrain and mana$e each o# these ris(s&

To illustrate ho) this is achieved* this revie) o# #irmlevel ris( mana$ement "e$ins )ith a discussion

o# ris( mana$ement controls in each area& The more di##icult issue o# summin$ over these ris(s and

addin$ still other* more amorphous* ones such as le$al* re$ulator! or reputational ris(* )ill "e le#t to

the end&

A& Credit Ris( .ana$ement +rocedures

In presentin$ the approach emplo!ed to mana$e credit ris(* )e re#er to the #ourstep processoutlined

6

Some "an(in$ #irms )ould also list re$ulator! and reputational ris( in their set o# concerns&Nonetheless* all )ould reco$ni-e the #irst #our as (e!* and all )ould devote most o# their ris(mana$ement resources to constrainin$ these (e! areas o# e%posure&

11

in Section II , a"ove* dra)in$ di##erent pieces #rom di##erent or$ani-ations& The institutions are not

named* "ut are selected "ecause o# the representative nature o# their documentation o# the process&


14/44

We "e$in )ith standards and reports& As noted a"ove* each "an( must appl! a consistent

evaluation and ratin$ scheme to all its investment opportunities in order #or credit decisions to "e

made in a consistent manner and #or the resultant a$$re$ate reportin$ o# credit ris( e%posure to "e

meanin$#ul& To #acilitate this* a su"stantial de$ree o# standardi-ation o# process and documentation is

re7uired& This has lead to standardi-ed ratin$s across "orro)ers and a credit port#olio report that

presents meanin$#ul in#ormation on the overall 7ualit! o# the credit port#olio& In Ta"le 1* a credit

ratin$ procedure is presented that is t!pical o# those emplo!ed )ithin the commercial "an(in$

industr!&

The #orm reported here is a sin$le ratin$ s!stem )here a sin$le value is $iven to each loan*

)hich relates to the "orro)er's underl!in$ credit 7ualit!& At some institutions* a dual s!stem is in place

)here "oth the "orro)er and the credit #acilit! are rated& In the latter* attention centers on collateral

and covenants* )hile in the #ormer* the $eneral credit )orthiness o# the "orro)er is measured& Some

"an(s pre#er such a dual s!stem* )hile others ar$ue that it o"scures the issue o# recover! to separate

the #acilit! #rom the "orro)er in such a manner& In an! case* the reader )ill note that in the reported

s!stem all loans are rated usin$ a sin$le numerical scale ran$in$ "et)een 1 and 1& 4 For each

numerical cate$or!* a 7ualitative de#inition o# the "orro)er and the loan's 7ualit! is o##ered and an

anal!tic representation o# the underl!in$ #inancials o# the "orro)er is presented& Such an approach*

)hether it is a sin$le or a dual ratin$ s!stem allo)s the credit committee some com#ort in its

(no)led$e o# loan asset 7ualit! at an! moment o# time& It re7uires onl! that ne) loan o##icers "e

introduced to the s!stem o# loan ratin$s* throu$h trainin$ and apprenticeship to achieve a

standardi-ation o# ratin$s throu$hout the "an(&

9iven these standards* the "an( can report the 7ualit! o# its loan port#olio at an! time* alon$

the lines

4There is nothin$ uni7ue a"out 1 $rades& Some have 4* others have 13& The most importantthin$ here is that there are su##icient $radations to permit accurate characteri-ation o# theunderl!in$ ris( pro#ile o# a loan* or a port#olio o# loans&

13

o# the report presented in Ta"le 3& Notice that total receiva"les* includin$ loans* leases and


15/44

commitments and derivatives* are reported in a sin$le #ormat& Assumin$ the adherence to standards*

the entiret! o# the #irm's credit 7ualit! is reported to senior mana$ement monthl! via this reportin$

mechanism& Chan$es in this report #rom one period to another occur #or t)o reasons* vi-&* loans have

entered or e%ited the s!stem* or the ratin$ o# individual loans has chan$ed over the intervenin$ time

interval& The #irst reason is associated )ith standard loan turnover& Loans are repaid and ne) loans are

made& The second cause #or a chan$e in the credit 7ualit! report is more su"stantive& 2ariations over

time indicate chan$es in loan 7ualit! and e%pected loan losses #rom the credit port#olio& In #act* credit

7ualit! reports should si$nal chan$es in e%pected loan losses* i# the ratin$ s!stem is meanin$#ul&

Studies "! .ood!'s on their ratin$ s!stem have illustrated the relationship "et)een credit ratin$ and

e% post de#ault rates& 5 A similar result should "e e%pected #rom internal "an(ratin$ schemes o# this

t!pe as )ell& Ho)ever* the lac( o# availa"le industr! data to do an appropriate a$$re$ate mi$ration

stud! does not permit the industr! the same de$ree o# con#idence in their e%pected loss calculations&

For this t!pe o# credit 7ualit! report to "e meanin$#ul* all credits must "e monitored* and

revie)ed periodicall!& It is* in #act* standard #or all credits a"ove some dollar volume to "e revie)ed

on a 7uarterl! or annual "asis to ensure the accurac! o# the ratin$ associated )ith the lendin$ #acilit!&

In addition* a material chan$e in the conditions associated either )ith the "orro)er or the #acilit!

itsel#* such as a chan$e in the value o# collateral* )ill tri$$er a reevaluation& This process* there#ore*

results in a periodic "ut timel! report card on the 7ualit! o# the credit port#olio and its chan$e #rom

month to month&

9enerall! accepted accountin$ principles re7uire this monitorin$& The credit port#olio is

su">ect to #air value accountin$ standards* )hich have recentl! "een ti$htened "! The Financial

Accountin$ Standards /oard ?FAS/@& Commercial "an(s are re7uired to have a loan loss reserve

account ? a contraasset@ )hich

5See .ood!'s ?155=@ and Santomero and /a""el ?1556@ #or evidence o# the relationship "et)eencredit ratin$ and de#ault rates&

1;

accuratel! represents the diminution in mar(et value #rom (no)n or estimated credit losses& As an industr!*


16/44

"an(s have $enerall! sou$ht estimates o# e%pected loss usin$ a t)ostep process* includin$ de#ault

pro"a"ilit!* and an estimate o# loss $iven de#ault& This approach parallels the )or( o# .ood!'s re#erred to

a"ove& 1 At least 7uarterl!* the level o# the reserve account is reassessed* $iven the evidence o# loss

e%posure driven directl! #rom the credit 7ualit! report* and internal studies o# loan mi$ration throu$h

various 7ualit! ratin$s&11

A"sent #rom the discussion thus #ar is an! anal!sis o# s!stematic ris( contained in the port#olio&

Traditionall! mutual #unds and merchant "an(s have concerned themselves )ith such ris( e%posure* "ut the

commercial "an(in$ sector has not& This appears to "e chan$in$ in li$ht o# the recent su"stantial losses in

real estate and similar losses in the nottoodistant past in petrochemicals& Accordin$l!* man! "an(s are

"e$innin$ to develop concentration reports* indicatin$ industr! composition o# the loan port#olio& This

process )as initiall! hampered "! the lac( o# a simple industr! inde%& SIC codes )ere emplo!ed at some

institutions* "ut most #ound them unsatis#actor!& Recentl!* ho)ever* .ood!'s has developed a s!stem o# ;D

industr! $roups that ma! "e used to report concentrations& Ta"le ; reports such an industr! $roupin$ to

illustrate the (ind o# concentration reports that are emer$in$ as standard in the "an(in$ industr!& Notice that

the report indicates the port#olio percenta$es "! sector* as )ell as commitments to various industries& For

the real estate port#olio* $eo$raph! is also reported* as Ta"le D su$$ests& While this ma! "e insu##icient to

capture total $eo$raphic concentration* it is a "e$innin$&

For the investment mana$ement communit!* concentrations are $enerall! "enchmar(ed a$ainst

some mar(et inde%es* and mutual #unds )ill $enerall! report not onl! the a"solute percenta$e o# their

industr!

1See Altman ?155;@ #or a discussion o# "oth the FAS/ standards and the methods emplo!ed toevaluate the level o# the reserve account&

11

Accuratel! estimatin$ loan losses #rom a loan 7ualit! report is* in #act* 7uite di##icult "ecause o#the limited in#ormation availa"le to the "an( on #uture loan losses and the chan$e in loan 7ualit! overtime& To see ho) the statistical properties o# the time series o# loan ratin$s can "e used to o"tain loanloss estimates* see :im and Santomero ?155;@&

1D

concentration* "ut also their positions relative to the "road mar(et inde%es& Un#ortunatel!* there is no

compara"le "enchmar( #or the loan port#olio& Accordin$l!* #irms must )ei$h the pros and cons o#


17/44

speciali-ation and concentration "! industr! $roup and esta"lish su">ective limits on their overall

e%posure& This is $enerall! done )ith "oth $uidelines and limits set "! senior mana$ement& Such a

report is not the result o# an! anal!tical e%ercise to evaluate the potential do)nside loss* "ut rather a

su">ective evaluation o# mana$ement's tolerance* "ased upon rather imprecise recollections o#

previous do)nturns& In addition* )e are seein$ the emer$ence o# a port#olio mana$er to )atch over the

loan port#olio's de$ree o# concentration and e%posure to "oth t!pes o# ris( concentration discussed

a"ove&

.ost or$ani-ations also )ill report concentration "! individual counterpart!& To "e

meanin$#ul* ho)ever* this e%posure must "e "an()ide and include all related a##iliates& /oth o# these

re7uirements are not easil! satis#ied& For lar$e institutions* a (e! relationship mana$er must "e

appointed to assure that overall "an( e%posure to a particular client is captured and monitored& This

level o# data accumulation is never eas!* particularl! across time -ones& Nonetheless* such a

relationship report is re7uired to capture the disparate activit! #rom man! parts o# the "an(&

Transaction )ith a##iliated #irms need to "e a$$re$ated and maintained in close to real time&

An e%ample o# this t!pe o# report is o##ered here as Ta"le


18/44

Investment "an(s $enerall! have vie)ed interest rate ris( as a classic part o# mar(et ris(* and

have developed ela"orate tradin$ ris( mana$ement s!stems to measure and monitor e%posure& For

lar$e commercial "an(s and Europeant!pe universal "an(s that have an active tradin$ "usiness* such

s!stems have "ecome a re7uired part o# the in#rastructure& /ut* in #act* these tradin$ ris( mana$ement

s!stems var! su"stantiall! #rom "an( to "an( and $enerall! are less real than ima$ined& In man! #irms*

#anc! valueatris( models* no) (no)n "! the acron!m 2aR* are up and runnin$& /ut* in man! more

cases* the! are still in the implementation phase& In the interim* simple ad hoc limits and close

monitorin$ su"stitute #or ela"orate realtime s!stems& While this ma! "e completel! satis#actor! #or

institutions that have little tradin$ activit! and )or( primaril! on "ehal# o# clients* the a"sence o#

ade7uate tradin$ s!stems else)here in the industr! is a "it distressin$&

For institutions that do have active tradin$ "usinesses* valueatris( has "ecome the standard

approach& This procedure has recentl! "een pu"licl! displa!ed )ith the release o# Ris(metrics "! 8& +&

.or$an* "ut similar s!stems are in place at other #irms& In that much e%ists in the pu"lic record a"out

these s!stems 13* there is little value to revie)in$ this techni7ue here& Su##ice it to sa! that the dail!*

)ee(l!* or monthl! volatilit! o# the mar(et value o# #i%edrate assets are incorporated into a measure

o# total port#olio ris( anal!sis alon$ )ith e7uit!'s mar(et ris(* and that o# #orei$ndenominated assets&

For "alance sheet e%posure to interest rate ris(* commercial "an(in$ #irms #ollo) a di##erent

drummer or is it accountant 9iven the $enerall! accepted accountin$ procedures ?9AA+@

esta"lished #or "an( assets* as )ell as the close correspondence o# asset and lia"ilit! structures*

commercial "an(s tend not to use mar(et value reports* $uidelines or limits& Rather* their approach

relies on cash #lo) and "oo( values* at the e%pense o# mar(et values& Asset cash #lo)s are reported in

various repricin$ schedules alon$ the line o# Ta"le =& This

13See* #or e%ample* the )or( o# * 8orion ?1556@* .arshall and Sie$el ?155=@* Fallon ?155=@* and +helan

?1556@&1=

s!stem has "een la"elled traditionall! a B$ap reportin$ s!stemB* as the as!mmetr! o# the repricin$ o#

assets and lia"ilities results in a $ap& This has classicall! "een measured in ratio or percenta$e


19/44

mismatch terms over a standardi-ed interval such as a ;da! or one!ear period&

This is sometimes supplemented )ith a duration anal!sis o# the port#olio* as seen in Ta"le 6&

Ho)ever* man! assumptions are necessar! to move #rom cash #lo)s to duration& Asset cate$ories that

do not have #i%ed maturities* such as prime rate loans* must "e assi$ned a duration measure "ased

upon actual repricin$ #le%i"ilit!& A similar pro"lem e%ists #or core lia"ilities* such as retail demand and

savin$s "alances& Nonetheless* the industr! attempts to measure these estimates accuratel!* and

include "oth on and o##"alance sheet e%posures in this t!pe o# reportin$ procedure& The result o# this

e%ercise is a rather crude appro%imation

o# the duration $ap&1;

.ost "an(s* ho)ever* have attempted to move "e!ond this $ap methodolo$!& The! reco$ni-e that

the $ap and duration reports are static* and do not #it )ell )ith the d!namic nature o# the "an(in$

mar(et*

)here assets and lia"ilities chan$e over time and spreads #luctuate& In #act* the varia"ilit! o# spreads is

lar$el!

responsi"le #or the hi$hl! pro#ita"le per#ormance o# the industr! over the last t)o !ears& Accordin$l!*

the

industr! has added the ne%t level o# anal!sis to their "alance sheet interest rate ris( mana$ement

procedures&

Currentl!* man! "an(s are usin$ "alance sheet simulation models to investi$ate the e##ect o# interest

rate variation on reported earnin$s over one* three and #ive!ear hori-ons& These simulations* o#

course*

are a "it o# science and a "it o# art& The! re7uire relativel! in#ormed repricin$ schedules* as )ell as

estimates

o# prepa!ments and cash #lo)s& In terms o# the #irst issue* such an anal!sis re7uires an assumed

response

#unction on the part o# the "an( to rate movement* in )hich "an( pricin$ decisions in "oth their local

and


20/44

national #ranchises are simulated #or each rate environment& In terms o# the second area* the

simulations

re7uire precise prepa!ment models #or proprietar! products* such as middle mar(et loans* as )ell as

standard

1;See Saunders ?155=@ or Hempel* Simonson and Coleman ?155D@ #or a discussion o#duration $ap* its construction and its use#ulness&

16

products such as residential mort$a$es or traditional consumer de"t& In addition* these simulations

re7uire !ield curve simulation over a presumed relevant ran$e o# rate movements and !ield curve

shi#ts&

Once completed* the simulation reports the resultant deviations in earnin$s associated )ith

the rate scenarios considered& Whether or not this is accepta"le depends upon the limits imposed "!

mana$ement* )hich are usuall! couched in terms o# deviations o# earnin$s #rom the e%pected or most

li(el! outcome& This notion o# Earnin$s At Ris(* EaR* is emer$in$ as a common "enchmar( #or

interest rate ris(& Ho)ever* it is o# limited value as it presumes that the ran$e o# rates considered is

correct* andor the "an('s response mechanism contained in the simulation is accurate and #easi"le&

Nonetheless* the results are vie)ed as indicative o# the e##ect o# underl!in$ interest rate mismatch

contained in the "alance sheet& Reports o# these simulations* such as contained in Ta"le 4* are no)

commonplace in the industr!&

/ecause o# concerns over the potential earnin$s outcomes o# the simulations* treasur!

o##icials o#ten ma(e use o# the cash* #utures and s)ap mar(ets to reduce the implied earnin$s ris(

contained in the "an('s em"edded rate e%posure& Ho)ever* as has "ecome increasin$l! evident* such

mar(ets contain their o)n set o# ris(s& Accordin$l!* ever! institution has an investment polic! in place

)hich de#ines the set o# allo)a"le assets and limits to the "an('s participation in an! one area see* #or

e%ample* Ta"le 5& All institutions restrict the activit! o# the treasur! to some e%tent "! de#inin$ the set

o# activities it can emplo! to chan$e the "an('s interest rate position in "oth the cash and #or)ard

mar(ets& Some are )illin$ to accept derivative activit!* "ut all restrict their positions in the s)ap caps


21/44

and #loors mar(et to some de$ree to prevent un#ortunate surprises& As reported losses "! some

institutions mount in this area* ho)ever* investment $uidelines are "ecomin$ increasin$l! circumspect

concernin$ allo)a"le investment and hed$in$ alternatives& C& Forei$n E%chan$e Ris( .anana$ement

+rocedures

In this area there is considera"le di##erence in current practice& This can "e e%plained "! the

di##erent #ranchises that coe%ist in the "an(in$ industr!& .ost "an(in$ institutions vie) activit! in the

#orei$n e%chan$e mar(et "e!ond their #ranchise* )hile others are active participants& The #ormer )ill

ta(e virtuall! no principal

14

ris(* no #or)ard open positions* and have no e%pectations o# tradin$ volume& Within the latter $roup*

there is a clear distinction "et)een those that restrict themselves to actin$ as a$ents #or corporate

andor retail clients and those that have active tradin$ positions&

The most active "an(s in this area have lar$e tradin$ accounts and multiple tradin$ locations&

And* #or these* reportin$ is rather strai$ht#or)ard& Currencies are (ept in real time* )ith spot and

#or)ard positions mar(edtomar(et& As is )ell (no)n* ho)ever* reportin$ positions is easier than

measurin$ and limitin$ ris(& Here* the latter is more common than the #ormer& Limits are set "! des(

and "! individual trader* )ith monitorin$ occurrin$ in real time "! some "an(s* and dail! closin$ at

other institutions& As a $eneral characteri-ation* those "an(s )ith more active tradin$ positions tend to

have invested in the realtime 2aR s!stems discussed a"ove* "ut there are e%ceptions&

Limits are the (e! elements o# the ris( mana$ement s!stems in #orei$n e%chan$e tradin$ as

the! are #or all tradin$ "usinesses& As Ta"le 1 illustrates "! e%ample* it is #airl! standard #or limits to

"e set "! currenc! #or "oth the spot and #or)ard positions in the set o# tradin$ currencies& At man!

institutions* the derivation o# e%posure limits has tended to "e an imprecise and ine%act science& For

these institutions* ris( limits are set currenc!"!currenc! "! su">ective variance tolerance& Others*

ho)ever* do attempt to derive the limits usin$ a method that is anal!ticall! similar to the approach

used in the area o# interest rate ris(&

Even #or "an(s )ithout a 2aR s!stem in place* stress tests are done to evaluate the potential


22/44

loss associated )ith chan$es in the e%chan$e rate& This is done #or small deviations in e%chan$e rates

as sho)n in Ta"le 1* "ut it also ma! "e investi$ated #or historical ma%imum movements& The latter is

investi$ated in t)o )a!s& Either historical events are captured* and )orsecase scenario simulated* or

the historical events are used to estimate a distri"ution #rom )hich the distur"ances are dra)n& In the

latter case* a one or t)o standard deviation chan$e in the e%chan$e rate is considered& While some use

these methods to estimate volatilit!* until recentl! most did not use covaria"ilit! in settin$ individual

currenc! limits* or in the a$$re$atin$ e%posure across multiple correlated currencies&

15

Incentive s!stems #or #orei$n e%chan$e traders are another area o# si$ni#icant di##erences

"et)een the avera$e commercial "an( and its investment "an(in$ counterpart& While* in the

investment "an(in$ communit! trader per#ormance is directl! lin(ed to compensation* this is less true

in the "an(in$ industr!& While some admit to si$ni#icant correlation "et)een trader income and

tradin$ pro#its* man! ar$ue that there is a"solutel! none& This latter $roup tends to see such lin(a$es

leadin$ to e%cess ris( ta(in$ "! traders )ho $ain #rom successes "ut do not su##er #rom losses&

Accordin$l!* to their )a! o# thin(in$* ris( is reduced "! separatin$ #orei$n e%chan$e pro#ita"ilit! and

trader compensation&

,& Li7uidit! Ris( .ana$ement +roceduresT)o di##erent notions o# li7uidit! ris( have evolved in the "an(in$ sector& Each has some

validit!& The #irst* and the easiest in most re$ards* is a notion o# li7uidit! ris( as a need #or continued

#undin$& The counterpart o# standard cash mana$ement* this li7uidit! need is #orecasta"le and easil!

anal!-ed& Get* the result is not )orth much& In toda!'s capital mar(et "an(s o# the sort considered here

have ample resources #or $ro)th and recourse to additional lia"ilities #or une%pectedl! hi$h asset

$ro)th& Accordin$l!* attempts to anal!-e li7uidit! ris( as a need #or resources to #acilitate $ro)th* or

honor outstandin$ credit lines are o# little relevance to the ris( mana$ement a$enda pursued here&

The li7uidit! ris( that does present a real challen$e is the need #or #undin$ )hen and i# a

sudden crisis arises& In this case* the issues are ver! di##erent #rom those addressed a"ove& Standard

reports on li7uid assets and open lines o# credit* )hich are $ermane to the #irst t!pe o# li7uidit! need*


23/44

are su"stantiall! less relevant to the second& Rather* )hat is re7uired is an anal!sis o# #undin$

demands under a series o# B)orst caseB scenarios& These include the li7uidit! needs associated )ith a

"an(speci#ic shoc(* such as a severe loss* and a crisis that is s!stem)ide& In each case* the "an(

e%amines the e%tent to )hich it can "e sel#supportin$ in the event o# a crisis* and tries to estimate the

speed )ith )hich the shoc( )ill result in a #undin$ crisis& Reports center on "oth #eatures o# the crisis

)ith Ta"le 11 illustratin$ one "an('s attempt to estimate the immediate #undin$ short#all associated

)ith a do)n$rade& Other institutions attempt to measure the speed )ith

3

)hich assets can "e li7uidated to respond to the situation usin$ a report that indicates the speed )ith

)hich the "an( can ac7uire needed li7uidit! in a crisis& Response strate$ies considered include the

e%tent to )hich the "an( can accomplish su"stantial "alance sheet shrin(a$e and estimates are made

o# the sources o# #unds that )ill remain availa"le to the institution in a time o# crisis& Results o# such

simulated crises are usuall! e%pressed in da!s o# e%posure* or da!s to #undin$ crisis&

Such studies are* "! their nature* imprecise "ut essential to e##icient operation in the event o#

a su"stantial chan$e in the #inancial conditions o# the #irm& As a result* re$ulator! authorities have

increasin$l! mandated that a li7uidit! ris( plan "e developed "! mem"ers o# the industr!& Get* there is

a clear distinction amon$ institutions* as to the value o# this t!pe o# e%ercise& Some attempt to develop

care#ul #undin$ plans and estimate their vulnera"ilit! to the crisis )ith considera"le precision& The!

contend that* either #rom prior e%perience or attempts at veri#ication* the! could and )ould use the

proposed plan in a time o# crisis& Others vie) this plannin$ document as little more than a re$ulator!

hurdle& While some actuall! invest in "ac(up lines )ithout Bmaterial adverse conditionsB clauses*

others have little #aith in their a"ilit! to access them in a time o# need&

31

E& Other Ris(s Considered /ut Not .odeled/e!ond the "asic #our #inancial ris(s* vi-&* credit* interest rate* #orei$n e%chan$e and li7uidit!

ris(* "an(s have a host o# other concerns as )as indicated a"ove& Some o# these* li(e operatin$ ris(*

andor s!stem #ailure* are a natural out$ro)th o# their "usiness and "an(s emplo! standard ris(


24/44

avoidance techni7ues to miti$ate them& Standard "usiness >ud$ment is used in this area to measure the

costs and "ene#its o# "oth ris( reduction e%penditures and s!stem desi$n* as )ell as operational

redundanc!& While $enerall! re#erred to as ris( mana$ement* this activit! is su"stantiall! di##erent

#rom the mana$ement o# #inancial ris( addressed here&

Get* there are still other ris(s* some)hat more amorphous* "ut no less important& In this latter

cate$or! are le$al* re$ulator!* suita"ilit!* reputational and environmental ris(& In each o# these ris(

areas* su"stantial time and resources are devoted to protectin$ the #irm's #ranchise value #rom erosion&

As these ris(s are less #inanciall! measura"le* the! are $enerall! not addressed in an! #ormal*

structured )a!& Get* the! are not i$nored at the senior mana$ement level o# the "an(&

2I& Ris( A$$re$ation and the :no)led$e o# Total E%posureThus #ar* the techni7ues used to measure* report* limit* and mana$e the ris(s o# various t!pes

have "een presented& In each o# these cases* a process has "een developed* or at least has evolved* to

measure the ris( considered* and techni7ues have "een deplo!ed to control each o# them& The e%tent o#

the di##erences across ris(s o# di##erent t!pes is 7uite stri(in$& The credit ris( process is a 7ualitative

revie) o# the per#ormance potential o# di##erent "orro)ers& It results in a ratin$* periodic reevaluation

at reasona"le intervals throu$h time* and on$oin$ monitorin$ o# various t!pes or measures o#

e%posure& Interest rate ris( is measured* usuall! )ee(l!* usin$ on and o##"alance sheet e%posure& The

position is reported in repricin$ terms* usin$ $ap* as )ell as e##ective duration* "ut the real anal!sis is

conducted )ith the "ene#it o# simulation techni7ues& Limits are esta"lished and s!nthetic hed$es are

ta(en on the "asis o# these cash #lo) earnin$s #orecasts& Forei$n e%chan$e or $eneral tradin$ ris( is

monitored in real time )ith strict limits and

33

accounta"ilit!& Here a$ain* the e##ects o# adverse rate movements are anal!-ed "! simulation usin$ ad

hoc e%chan$e rate variations* andor distri"utions constructed #rom historical outcomes& Li7uidit! ris(*

on the other hand* more o#ten than not* is dealt )ith as a plannin$ e%ercise* althou$h some reasona"le

)or( is done to anal!-e the #undin$ e##ect o# adverse ne)s&


25/44

The anal!tical approaches that are su"sumed in each o# these anal!ses are comple%* di##icult

and not easil! communicated to nonspecialists in the ris( considered& The "an(* ho)ever* must select

appropriate levels #or each ris( and select or* at least articulate* an appropriate level o# ris( #or the

or$ani-ation as a )hole& Ho) is this "ein$ done

The simple ans)er is Bnot ver! )ell&B Senior mana$ement o#ten is presented )ith a m!riad o#

reports on individual e%posures* such as speci#ic credits* and comple% summaries o# the individual

ris(s* as outlined a"ove& The ris(s are not dimensioned in similar )a!s* and mana$ement's technical

e%pertise to appreciate the true nature o# "oth the ris(s themselves and the anal!ses conducted to

illustrate the "an('s e%posure is limited& Accordin$l!* over time* the mana$ers o# speci#ic ris(s have

$ained increased authorit! and autonom!& In li$ht o# recent losses* ho)ever* thin$s are "e$innin$ to

chan$e&

As the or$ani-ational level* overall ris( mana$ement is "ein$ centrali-ed into a Ris(

.ana$ement Committee* headed "! someone desi$nated as the Senior Ris( .ana$er& The purpose o#

this institutional response is to empo)er one individual or $roup )ith the responsi"ilit! to evaluate

overall #irmlevel ris(* and determine the "est interest o# the "an( as a )hole& At the same time* this

$roup is holdin$ line o##icers more accounta"le #or the ris(s under their control* and the per#ormance

o# the institution in that ris( area& Activit! and sales incentives are "ein$ replaced "! per#ormance

compensation* )hich is "ased not on "usiness volume* "ut on overall pro#ita"ilit!&

At the anal!tical level* a$$re$ate ris( e%posure is receivin$ increased scrutin!& To do so*

ho)ever* re7uires the summation o# the di##erent t!pes o# ris(s outlined a"ove& This is accomplished

in t)o distinct*

3;

"ut related )a!s& The #irst o# these* pioneered "! /an(ers Trust* is the RAROC s!stem o# ris(

anal!sis&1D In this approach* ris( is measured in terms o# varia"ilit! o# outcome& Where possi"le* a

#re7uenc! distri"ution o# returns is estimated* #rom historical data* and the standard deviation o# this

distri"ution is estimated& Capital is allocated to activities as a #unction o# this ris( or volatilit!

measure& Then* the ris(! position is re7uired to carr! an e%pected rate o# return on allocated capital


26/44

)hich compensates the #irm #or the associated incremental ris(& /! dimensionin$ all ris( in terms o#

loss distri"utions* and allocatin$ capital "! the volatilit! o# the proposed activit!* ris( is a$$re$ated

and priced in one and the same e%ercise&

A second approach is similar to the RAROC* "ut depends less on a capital allocation scheme

and more on cash #lo) or earnin$s e##ects o# the implied ris(! position& This )as re#erred to as the

Earnin$s At Ris( methodolo$! a"ove* )hen emplo!ed to anal!-e interest rate ris(& When mar(et

values are used* the approach "ecomes identical to the 2aR methodolo$! emplo!ed #or tradin$

e%posure& This method can "e used to anal!-e total #irmlevel ris( in a similar manner to the RAROC

s!stem& A$ain* a #re7uenc! distri"ution o# returns #or an! one t!pe o# ris( can "e estimated #rom

historical data& E%treme outcomes can then "e estimated #rom the tail o# the distri"ution& Either a

)orstcase historical e%ample is used #or this purpose* or a one or t)o standard deviation outcome is

considered& 9iven the do)nside outcome associated )ith an! ris( position* the #irm restricts its

e%posure so that* in the )orstcase scenario* the "an( does not lose more than a certain percenta$e o#

current income or mar(et value& There#ore* rather than movin$ #rom volatilit! o# value throu$h

capital* this approach $oes directl! to the current earnin$s implications #rom a ris(! position& The

approach* ho)ever* has t)o ver! o"vious shortcomin$s& I# EaR is used* it is cash #lo) "ased* rather

than mar(et value driven& And* in an! case* it does not directl! measure the total varia"ilit! o#

potential outcomes throu$h an a priori distri"ution speci#ication& Rather it depends upon a su">ectivel!

prespeci#ied ran$e o# the ris(! environments to drive the )orstcase scenario&

1DSee Salomon /rothers ?155;@ and Wee and Lee ?155


27/44

addition& As a result* much is lost in the a$$re$ation& +erhaps over time this issue )ill "e addressed&

2I& Areas Where Further Wor( Will Improve the .ethodolo$!

The "an(in$ industr! is clearl! evolvin$ to a hi$her level o# ris( mana$ement techni7ues and

approaches than had "een in place in the past& Get* as this revie) indicates* there is si$ni#icant room

#or improvement& /e#ore the areas o# potential value added are enumerated* ho)ever* it is )orth)hile

to reiterate an earlier point& The ris( mana$ement techni7ues revie)ed here are not the avera$e* "ut

the techni7ues used "! #irms at the hi$her end o# the mar(et& The ris( mana$ement approaches at

smaller institutions* as )ell as lar$er "ut relativel! less sophisticated ones* are less precise and

si$ni#icantl! less anal!tic& In some cases the! )ould need su"stantial up$radin$ to reach the level o#

those reported here& Accordin$l!* our revie) should "e vie)ed as a $limpse at "est practice* not

avera$e practices&

Nonetheless* the techni7ues emplo!ed "! those that de#ine the industr! standard could use

some improvement& /! cate$or!* recommended areas )here additional anal!tic )or( )ould "e

desira"le are listed "elo)&

A& CRE,IT RIS:

The evaluation o# credit ratin$ continues to "e an imprecise process& Over time* this approachneeds to "e standardi-ed across institutions and across "orro)ers& In addition* its ratin$

procedures need to "e made compati"le )ith ratin$ s!stems else)here in the capital mar(et&

Credit losses* currentl! va$uel! related to credit ratin$* need to "e closel! trac(ed& As in the"ond mar(et* credit pricin$* credit ratin$ and e%pected loss ou$ht to "e demonstra"l! closer&Ho)ever* the industr! currentl! does not have a su##icientl! "road data "ase on )hich to

per#orm the mi$ration anal!sis that has "een studied in the "ond mar(et&3ected cash #lo)s ?includin$anticipated credit e%tensions@ )ill continue a stron$ trend* and provide continued )idemar$ins o# protection* li7uidit! and de"t service covera$e& E%cellent asset 7ualit! andmana$ement& T!picall! lar$e national corporations&

;& M"#est Risk/orro)ers in the lo)er end o# the hi$h 7ualit! ran$e& 2er! $ood asset 7ualit! andli7uidit! stron$ de"t capacit! and covera$e ver! $ood mana$ement& The credite%tension is considered de#initel! sound ho)ever* elements ma! "e present )hich


31/44

su$$est the "orro)er ma! not "e #ree #rom temporar! impairments sometime in the#uture& T!picall! lar$er re$ional or national corporations&

D& Bel"$ A%era&e RiskThe hi$h end o# the medium ran$e "et)een the de#initel! sound and those situations)here ris( characteristics "e$in to appear& The mar$ins o# protection are satis#actor!* "ut

suscepti"le to more rapid deterioration than class ; names& Some elements o# reducedstren$th are present in such areas as li7uidit!* sta"ilit! o# mar$ins and cash #lo)s*concentration o# assets* dependence upon one t!pe o# "usiness* c!clical trends* etc&*)hich ma! adversel! a##ect the "orro)er& T!picall! $ood re$ional or e%cellent localcompanies&


32/44

A "orro)er )ith )ell de#ined )ea(ness?es@ that >eopardi-e the orderl! li7uidation o# thede"t& /orro)ers that have "een or )ould normall! "e classi#ied Su"standardM "!re$ulator! authorities& A su"standard loan is inade7uatel! protected "! the current sound)orth and pa!in$ capacit! o# the o"li$or& Normal repa!ment #rom this "orro)er is in>eopard!* althou$h no loss o# principal is envisioned& There is a distinct possi"ilit! that apartial loss o# interest andor principal )ill occur i# the de#iciencies are not corrected&

5& P"tential L"ssA "orro)er classi#ied here has all )ea(nesses inherent in the one classi#ied a"ove )iththe added provision that the )ea(nesses ma(e collection o# de"t in #ull* on the "asis o#currentl! e%istin$ #acts* conditions* and values* hi$hl! 7uestiona"le and impro"a"le&Serious pro"lems e%ist to the point )here a partial loss o# principal is li(el!& Thepossi"ilit! o# loss is e%tremel! hi$h* "ut "ecause o# certain important* reasona"l! speci#icpendin$ #actors* )hich ma! )or( to the advanta$e and stren$thenin$ o# the assets* itsclassi#ication as an estimated loss is de#erred until its more e%act status ma! "edetermined& +endin$ #actors include proposed mer$er* ac7uisition* or li7uidation* capitalin>ection* per#ectin$ liens on additional collateral* and re#inancin$ plans&

1& L"ss/orro)ers deemed incapa"le o# repa!ment o# unsecured de"t& Loans to such "orro)ersare considered uncollecti"le and o# such little value that their continuance as active assetso# the "an( is not )arranted& This classi#ication does not mean that the loan hasa"solutel! no recover! or salva$e value* "ut rather it is not practical or desira"le to de#er)ritin$ o## this "asicall! )orthless asset even thou$h partial recover! ma! "e e##ected inthe #uture&

TABLE 2BANK LEVEL LOAN CREDIT QUALITY REPORT

RISKRATING

RATING 0 1 2 3 4 5 6 7

TYPE RESERVABLES

1a. COMMERCIA OA!S A!" EASES 2 4 201 252 511 2#000 3#374 937 1

1b. CO!S$MER OA!S 0 5#139 0 0 1#629 521 65 15

1%. O&'ER OA!S A!" EASES 481

TOTAL LOANS AND LEASES 2 5#143 201 252 2#140 2#521 3#920 952 1LOANS

AND 1(. ESS) *ROSS COMMERCIA OA! C+O

LEASES ES&IMA&E

1e. ESS) *ROSS COMMERCIA OA! C+O

ES&IMA&E

TOTAL LOAN AND LEASE CHARGEOFFS 0 0 0 0 0 0 0 0

LOANS AND LEASE RESERVABLES 2 5#143 201 252 2#140 2#521 3#920 952 1

2a. OREO


33/44

OREO 2b. ESS) OREO C'AR*E-O,, ES&IMA&E

OREO RESERVABLES 0 0 0 0 0 0 0 0

3a. $!$SE" COMMI&ME!&S 1#959 1#959 980 980

50 0 0 0 980 980 490 490 0

3b. COMMERCIA E&&ERS O, CRE"I& 0 1 1 3 19 51 83 5

18 1 27 44 76 141 183 78

CONTINGENT 18 1 27 44 76 141 183 78

E!POS"RE 3(.S/AS

0 0 0 0 0 0 0

100 O, CRE"I& E$IAE!& 0 0 0 0 0 0 0EOS$RE

3e. A!ERS ACCE&A!CES 0 0 0 13 1 47 80 6

100 0 0 0 13 1 47 80 6

CONTINGENT E!POS"RE RESERVABLES 18 1 27 1#037 1#060 688 770 85

RESERVABLES #TOTAL RESERVABLES 20 5#144 288 1#288 3#200 3#209 4#690 1#037

1a 1b 1%

1(

1e

2a 2b

3a

3b

3%

3(

3e

All items in millions of dollars

TABLE *

CREDIT E+P,S-RE BY ;D .INOR IN,USTRG SECTORS

$OODY%S GRO"P

Outstan&in's "n(un&e& Co))it)ents

Co))it)ents

*

To

Ter

)

Ris+

Rat

o(

Tot

Ter

)

Ris+

Rat

o(

Tot

Ter

)

Ris+

Rat

R

Aeroa%e an( "eene 0.5 2.8 4.8 0.9 2.7 3.6 0.7 2.7 4.1 42

A:tomob; 0.6 2.7 4.7 0.6 2.5 4.3 0.6 2.6 4.5 5

";=er;;e(+Con>r;%:


34/44

5.1 3.3 4.6 5.2 1.9 3.6 5.2 2.7 4.2 57

'ome+O;%e ,:rn;h;n># 'o:e?are# 2.2 2.1 4.6 2 1.4 3.7 2.1 1.8 4.3 6

":rab


35/44

&ota< 594 194 130 85 49

All items in millions of dollars

TABLE .

E+P,S-RE S-MMARY ,R ,NE SPECIIC E+ISTING ACILITY

PROD"CT3P"RPOSE RISKRATING

APPROVEDA$O"NT

FACILITIESIN "SE

LOAN

STR"CT"RE3RATE

A A(=;e( ;ne o Cre(;t

,;nan%e A+R an( In=entory

6 5#000

;m;t) oan Re=o

,;nan%e A%%o:nt Re%e;=ab


36/44

Rea< etate 1-4 am;a>e

Other rea< etate mort>a>e 2#572 2#171 591 537 1#478 359 578 8#286

Rea< etate %ontr:%t;on 732 112 1 12 18 - 235 1#110

Con:mer 729 4#071 226 303 628 93 2#053 8#103

eae ;nan%;n> - 85 94 175 850 8 - 1#212

,ore;>n) - 18 - - - - - 18

&ota< oan @2 8#163 9#769 3#162 2#065 5#715 1#550 3#386 33#099

Ot.er earnin' assets6 52 52

&ota< earn;n> aet 8#163 11#990 3#162 5#150 13#06 2#865 3#478 47#877

Noninterestearnin' assets6 4#636 4#636

&ota< aet 8#163 11#990 3#162 5#150 13#06 2#865 8#114 52#513

All units in millions of US dollars (Table continued on

next page)

TABLE 6 continued

r;me G3- G6-12 !on

o:r%e 0-3 month month month G1-5 year G5 year maret &otan o;%e)

&ota< ;nteret bear;n> (eo;t

Fe&eral (un&s -urc.ase& an& securities sol& un&er re-urc.ase a'ree)ents

Co))ercial -a-er an& ot.er s.ortter) orro1in's

Senior &et

Suor&inate& &et

&ota<


37/44

A(F:te( cu)ulati>e 'a-

- 4#789 4#789

- - - - - - 2#544 2#544

8#163 5#905 1#005 2#011 - - - 17#084

65 13 31 191 13 2 315

- 38 - - - - - 38

8#163 8#163 2#375 3#111 2#628 163 7#349 31#925

- 1#079 - - - - - 1#079

- 188 - - - - - 188

- 1#527 26 318 343 42 - 2#256

- 1#895 - - - - 70 1

8#163 12#825 2#401 3#429 2#971 205 7#419 37#41

- - - - - - 10#785 10#785

- - - - - - 4 315 4

8 163 12#82 2 401 3 429 2 971 205 22#51 52#5

- -835.00

761 1#721 10#098 2#660 -14#405 -

- 193 214 245

- @1#48 954 1#93 10#3 2#66 14#4

- @1#48 533 1#40 11#7 14#4

10#464

-7333 - - - - 7#33

- @8#82 @7#8 @5#9 4#41 7#07 10#4

@1 &he nonmaret %o


38/44

On Balance S.eet O(( Balance S.eet Co)ine

On O((

E((ecti A&/uste

As o( Dece)er 9; ;@@= Durati Notional Net A&/u E((ecti>

#)illions5 Balance Rate Years A)ount# S-rea Rate Duratio

Assets6ar;ab


39/44

#5 23 De-osit rates re(lectin'=8 asis -oint ti'.tenin' inunc.an'e&

1#551.00 1#560.50

Total earnin' assets 32#892 32#912

Net rate 4.72@ 4.74@

Change in net interest income 9.50 -10.20 J+-78.90

% Net interest income 0.6@ -0.6@ J+-

Port(olio Euit06

$aret &alue 5#727.00 5#241.00

Change in maret &alue -486 J+-

% Shareholder's euit 111(%) *+-"!!(%)

,uration (ears) 4.20 4.30

TABLE /

IN0ESTMENT P,LICY

A& Intr"#ucti"n

The purpose o# this polic! is to provide the "asis #or the "an( to responsi"l! mana$e theinvestments in accordance )ith the philosoph! and o">ectives stated "elo)& Unless statedother)ise* the terms investmentM and investment port#olioM )ill re#er to "oth cashmana$ement activities and lon$erterm investment securities& The term capital )illre#er to the sum o# Undivided Earnin$s* +aid in Capital* Re$ular Reserve* and theAllo)ance #or Loan Losses&

B In%est!ent P2il"s"32y

The "an( reco$ni-es a #iduciar! responsi"ilit! to customers to invest all #unds prudentl!

and in accordance )ith ethical and prevailin$ le$al standards& It reco$ni-es that theinvestment port#olio must complement the loan port#olio and to$ether the! must "ematched )ith lia"ilities& In addition* the polic! )ill support the overall "usiness andassetlia"ilit! strate$ies o# the institution&

Certain $eneral tenets appl! to the investment port#olio& Sa#et! o# assets is o# primar!concern& In all cases* onl! hi$h 7ualit! investments )ill "e purchased& The investmentport#olio should provide ade7uate* "ut not e%cessive li7uidit! in meetin$ mem"er demand#or #unds& Reasona"le port#olio diversi#ication should "e pursued to ensure that the "an(does not have e%cessive concentration o# individual securities* securit! t!pes or securit!characteristics& The investment port#olio )ill "e mana$ed on a "u! and holdM "asis&Ho)ever* periodic sales o# investment securities are permissi"le to meet operational cash

needs or to restructure the port#olio mi% in accordance )ith chan$es in investmentstrate$!& In all cases* investments must meet all criteria stated in the Federal La)* theRules and Re$ulations o# the Re$ulators* and all re7uirements o# our "ondin$ compan!&Investment per#ormance in all classi#ications )ill "e monitored on a #re7uent and re$ular"asis to ensure that o">ectives are attained and $uidelines adhered to&

C In%est!ent Aut2"rity

Authorit! #or investments is the responsi"ilit! o# the /oard ,irectors& The /oard shall


40/44

desi$nate the Chie# E%ecutive O##icer and the Chie# Financial O##icer to act on its "ehal#and in accordance )ith this polic!& The Chie# Financial O##icer* in con>unction )ith)ither the Controller or the Financial Anal!sis .ana$er* shall oversee the da!toda!operations o# the investment port#olio and have speci#ic investment and transactione%ecution authorit!&

Kuarterl!* the activit! #or sa#et! and sound the Chie# E%ecutive O##icer* Chie# FinancialO##icer and the Financial Consultants )ill revie) the past 7uarters investment activit!#or sa#et! and soundness&

D In%est!ent ,b4ecti%es an# Gui#elines

Firm investments shall "e mana$ed at t)o levels0 cash mana$ement needs and lon$erterminvestment activities& In all cases* sa#et! o# #unds shall ta(e precedence over !ield and itsattendant ris(s* and the onl! #inancial instruments )hich ma! "e purchased are those )hich in theopinion o# the Chie# Financial O##icer pose no si$ni#icant credit ris(& All investment activit! is to"e $uided "! the criteria speci#ied in this polic!&

1& The #unds o# the "an( can "e invested in the #ollo)in$ t!pes o# instruments )ith7uali#ications as provided0

a& United States Treasur! o"li$ations )ill have a ma%imum maturit! o# three !ears&

"& United States A$enc! Securities ?e%cludin$ ./S@ shall "e limited to a ma%imummaturit! o# three !ears&

c& .ort$a$e /ac(ed Securities issues "! or #ull! $uaranteed as to principal and interest"! the Federal National .ort$a$e Association* 9overnment National .ort$a$eAssociation* or the Federal Home Loan .ort$a$e Corporation& Theseinvestments )ill primaril! "e one !ear AR.s and #ive !ear "alloons* "ut three

!ear AR.s and seven !ear "alloons ma! "e purchased& Individual issues shallnot e%ceed


41/44

Certi#icates o# ,eposit issued onl! "! approved "an(s )ith a ma%imum maturities not to e%ceedone ?1@ !ear& Total certi#icates deposited in a sin$le institution shall not e%ceed


42/44

upon lendin$ trends and )ithdra)al e%perience* and other e%ternal #actorsdeemed appropriate&

c& The Chie# Financial O##icer* Financial Anal!sis .an$er* or Controller* orAccountin$ Supervisor shall e%ecute these cash mana$ement activities and the Chie# Financial

O##icer shall revie) these transactions&

;&

Investment +ort#olio

The mana$ement o">ective o# the #irms Investment +ort#olio is to provide ma%imum return)ithin the "ounds o# sa#et! o# principal and interest* li7uidit!* and asset lia"ilit!mana$ement demand& Each speci#ic investment decision )ill "e evaluated )ith respect tosuch issues as e%pected return* credit ris(* li7uidit!* e##ect on the investment port#olio*impact on assetlia"ilit! needs* and proper sa#e(eepin$& The Chie# Financial O##icer*

Controller* or Financial Anal!sis mana$er )ill e%ecute investment port#olio transactions&

D& +rohi"ited Activities

The #ollo)in$ activities are prohi"ited0

a& Cash #or)ard a$reements to "u! )hen the deliver! date is in e%cess o#ninet! ?5@ da!s #rom the trade date&

"& Stand"! commitments to purchase or sell a securit! at a #uture date )here"!the "u!er is re7uired to accept deliver! o# the securit! at the option o# theseller&

c& Ad>usted to tradin$* meanin$ an! method or transaction used to de#er a loss)here"! the "an( sells a securit! to a vendor at a price a"ove its currentmar(et price and simultaneousl! purchases or commits to purchase #romthat vendor another securit! a"ove its current mar(et price&

d& Short sales o# securities not o)ned "! the

"an(& e&Futures tradin$&

E Maturity Structure

The maturit! structure o# the investment port#olio )ill "e mana$ed in accordance )ithasset lia"ilit! mana$ement needs* mar(et conditions* and the o">ectives o# this +olic!Statement&

It is the responsi"ilit! o# the Chie# Financial O##icer to constantl! monitor the maturit!structure o# the investment port#olio and implement modi#ications in the avera$e maturit!and ma(eup o# the port#olio& These modi#ications )ill "e "ased on AssetLia"ilit!


43/44

.ana$ement concerns ?i&e&* price ris(* li7uidit! ris(* reinvestment ris(@ and chan$in$mar(et conditions&

F& ASB 11. C"!3liance

In order to compl! )ith the FAS/ 11


44/44

AA!ESE KE! K 210.00 420.00 14#600 6#000

,R, 90.00 10.00 180.00 8#300 5#500

E*IA! ,RA!C E, 65.00 10.00 130.00 3#000 2#160

E$ 65.00 130.00 7#150 6#670

$!I& @EC$MI!OR C$RRE!CIES

160.00 60.00

AR*E!&I!IA! A$S&RA AR 5.00 10.00

A$S&RIA! SC'II!* A&S 30.00 10.00 60.00 750 510

A'AMIA! "OAR S" 2.00 4.00

A'RAI! "I!AR '" 2.00 4.00

ARA"OS "OAR " 2.00 4.00

RC 5.00 10.00

CAY$AN DOLLAR K" 2.00 4.00

C'I!ESE RE!MI!I C!K 9.00 18.00 120

"A!IS' RO!E " 45.00 5.00 90.00 1#000 640

E.CARIEA! "OAR C" 2.00 4.00

,II "OAR ," 8.00 16.00 72

,I!!IS' MARA ,IM 30.00 14.00 60.00 250 130

*REE "RAC'MA *R" 10.00 8.00 20.00

&AE 11O!E "AK ,AO$& ,$!"I!* SCE!ARIO

CATEORY! OVERNI"T #UNDS AVAILABLE

R$tin% Mo&e'ent Do(n($)d to! Tot$* C+$n%e Pct, C+$n%e

Thomson Bankwatch B $16,229

Thomson Bankwatch B/C $13,365 ($2,864) (17.65%)

CATEORY! TERM #UNDS AVAILABLE

R$tin% Mo&e'ent Do(n($)d Tot$* C+$n%e Pct, C+$n%e

Thomson Bankwatch B $19,299

Thomson Bankwatch B/C $17,020 ($2,209) (11.49%)

Thomson Bankwatch C $12,458 ($6,771) (35.21%)

risk management.rtf

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