Commercial Banking Risk Management

Commercial Banking

Risk Management

Regulation in the Wake of the Financial Crisis

Edited by

Weidong Tian

Commercial Banking Risk Management

Weidong Tian

Editor

Commercial Banking

Risk Management

Regulation in the Wake of the Financial Crisis

ISBN 978-1-137-59441-9 ISBN 978-1-137-59442-6 (eBook)

DOI 10.1057/978-1-137-59442-6

Library of Congress Control Number: 2016961076

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Editor

Weidong Tian

University of North Carolina at Charlotte

Charlotte, North Carolina, USA

v

One of the most important lessons from the financial crisis of 2007–2008

is that the regulatory supervision of financial institutions, in particular

commercial banks, needs a major overhaul. Many regulatory changes have

been implemented in the financial market all over the world. For instance,

the Dodd-Frank Act has been signed into federal law on July 2010; the

Basel Committee has moved to strengthen bank regulations with Basel

III from 2009; the Financial Stability Board created after the crisis has

imposed frameworks for the identification of systemic risk in the financial

sector across the world; and the Volcker Rule has been adopted formally by

financial regulators to curb risk-taking by US commercial banks. Financial

institutions have to manage all kinds of risk under stringent regulatory

pressure and have entered a virtually new era of risk management.

This book is designed to provide a comprehensive coverage of all impor￾tant modern commercial banking risk management topics under the new

regulatory requirements, including market risk, counterparty credit risk,

liquidity risk, operational risk, fair lending risk, model risk, stress tests,

and comprehensive capital analysis and review (CCAR) from a practical

perspective. It covers major components in enterprise risk management

and a modern capital requirement framework. Each chapter is written by

an authority on the relevant subject. All contributors have extensive indus￾try experience and are actively engaged in the largest commercial banks,

major consulting firms, auditing firms, regulatory agencies and universi￾ties; many of them also have PhDs and have written monographs and

articles on related topics.

Preface

vi PREFACE

The book falls into eight parts. In Part 1, two chapters discuss regu￾latory capital and market risk. Specifically, chapter “Regulatory Capital

Requirement in BASEL III” provides a comprehensive explanation of the

regulatory capital requirement in Basel III for commercial banks and global

systemically important banks. It also covers the current stage of Basel III

and the motivations. Chapter “Market Risk Modeling Framework Under

Basel” explains the market risk modeling framework under Basel 2.5 and

Basel III. The key ingredients are explained and advanced risk measures

on the market risk management are introduced in this chapter. The latest

capital requirement for the market risk is also briefly documented.

Part 2 focuses on credit risk management, in particular, counter￾party credit risk management. Chapter “IMM Approach for Managing

Counterparty Credit Risk” first describes the methodologies that have

been recognized as standard approaches to tackle counterparty credit

risk and, then uses case studies to show how the methodologies are cur￾rently used for measuring and mitigating counterparty risk at major com￾mercial banks. In the wake of the 2007–2008 financial crisis, one recent

challenge in practice is to implement a series of valuation adjustments in

the credit market. For this purpose, chapter “XVA in the Wake of the

Financial Crisis” presents major insights on several versions of valuation

adjustment of credit risks—XVAs, including credit valuation adjustment

(“CVA”), debt valuation adjustment (“DVA”), funding valuation adjust￾ment (“FVA”), capital valuation adjustment (“KVA”), and margin valua￾tion adjustment (“MVA”).

There are three chapters in Part 3. The three chapters each discuss three

highly significant areas of risk that are crucial components of the modern

regulatory risk management framework. Chapter “Liquidity Risk” docu￾ments in detail modern liquidity risk management. It introduces both

current approaches and presents some forward-looking perspectives on

liquidity risk. After the 2007-2008 financial crisis, the significant role of

operational risk has been recognized and operational risk management has

emerged as an essential factor in capital stress testing. A modern approach

to operational risk management is demonstrated in chapter “Operational

Risk Management”, in which both the methodology and several exam￾ples of modern operational risk management are discussed. Chapter “Fair

Lending Monitoring Models” addresses another key risk management

area in commercial banking: fair lending risk. This chapter underscores

some of the quantitative challenges in detecting and measuring fair lend￾ing risk and presents a modeling approach to it.

PREFACE vii

Part 4 covers model risk management. Built on two well-examined

case studies, chapter “Caveat Numerus: How Business Leaders Can Make

Quantitative Models More Useful” explains how significant model risk

could be, and it presents a robust framework that allows business lead￾ers and model developers to understand model risk and improve quan￾titative analytics. By contrast, chapter “Model Risk Management Under

the Current Environment” provides an extensive discussion about model

risk management. In this chapter, model risk management is fully doc￾umented, including the methodology, framework, and its management

organizational structure. The current challenges frequently encountered

in practice and some approaches to address these model risk issues are also

presented.

The two chapters in Part 5 concentrate on a major component of the

Dodd-Frank Act and Comprehensive Capital Analysis Review (CCAR)-

capital stress testing- for commercial banks. Chapter “Region and Sector

Effects in Stress Testing of Commercial Loan Portfolio” introduces a gen￾eral modeling approach to perform capital stress testing and CCAR in a

macroeconomic framework for a large portfolio. Chapter “Estimating the

Impact of Model Limitations in Capital Stress Testing” discusses model

limitation issues in capital stress testing and presents a “bottom-up”

approach to uncertainty modeling and computing the model limitation

buffer.

After a detailed discussion on each risk subject in corresponding chap￾ter, Part 6 next introduces modern risk management tools. Chapter

“Quantitative Risk Management Tools for Practitioners” presents a com￾prehensive introduction to quantitative risk management techniques

which are heavily employed at commercial banks to satisfy regulatory cap￾ital requirements and to internally manage risks. Chapter “Modern Risk

Management Tools and Applications” offers an alternative and comple￾mentary approach by selecting a set of risk management tools to demon￾strate the approaches, methodologies, and usages in several standard risk

management problems.

Part 7 addresses another recently emerging important risk manage￾ment issue: data and data technology in risk management. Commercial

banks and financial  firms have paid close attention to risk and regula￾tory challenges by improving the use of databases and reporting tech￾nology. A widely accepted recent technological solution, Governance,

Risk, and Compliance ("GRC"), is explained in greater depth in the two

chapters in Part 7. Chapter “GRC Technology Introduction” introduces

viii PREFACE

GRC technology–motivation, principle and framework; chapter “GRC

Technology Fundamentals” explains use cases in GRC technology and its

fundamentals. Both chapters “GRC Technology Introduction” and “GRC

Technology Fundamentals” together provide a comprehensive introduc￾tion on the data technology issues regarding many components of risk,

including operational risk, fair lending risk, model risk, and systemic risk.

Finally, in the last chapter, chapter “Quantitative Finance in the Post

Crisis Financial Environment” (Part 8), current challenges and directions

for future commercial banking risk management are outlined. It includes

many of the topics covered in previous chapters, for instance, XVAs, oper￾ational risk management, fair lending risk management, and model risk

management. It also includes topics such as risk of financial crimes, which

can be addressed using some of the risk management tools explained in

the previous chapters. The list of challenges and future directions is by

no means complete; nonetheless, the risk management methodology and

appropriate details are presented in this chapter to illustrate these vitally

important points and show how fruitful such commercial banking risk

management topics could be in the coming times.

Weidong Tian, PhD

Editor

ix

I would like to extend my deep appreciation to the contributors of this

book: Maia Berkane (Wells Fargo & Co), John Carpenter (Bank of

America), Roy E. DeMeo (Wells Fargo & Co), Douglas T. Gardner (Bank

of the West and BNP Paribas), Jeffrey R.  Gerlach (Federal Reserve of

Richmond), Larry Li (JP Morgan Chase), James B. Oldroyd (Brigham

Young University), Kevin D.  Oden (Wells Fargo & Co), Valeriu (Adi)

Omer (Bank of the West), Todd Pleune (Protiviti), Jeff Recor (Grant

Thornton), Brain A. Todd (Bank of the West), Hong Xu (AIG), Dong

(Tony) Yang (KPMG), Yimin Yang (Protiviti), Han Zhang (Wells Fargo

& Co), Deming Zhuang (Citigroup) and Steve Zhu (Bank of America).

Many authors have presented in the Mathematical Finance Seminar series

of University of North Carolina at Charlotte, and the origins of this book

were motivated by organizing these well-designed and insightful presen￾tations. Therefore, I would also like to thank the other seminar speak￾ers including Catherine Li (Bank of America), Ivan Marcotte (Bank of

America), Randy Miller (Bank of America), Mark J. Nowakowski (KPMG),

Brayan Porter (Bank of America), Lee Slonimsky (Ocean Partners LP)

and Mathew Verdouw (Market Analyst Software), and Stephen D. Young

(Wells Fargo & Co).

Many thanks are due to friends and my colleagues at the University of

North Carolina at Charlotte. I am particularly indebted to the following

individuals: Phelim Boyle, Richard Buttimer, Steven Clark, John Gandar,

Houben Huang, Tao-Hsien Dolly King, Christopher M. Kirby, David Li,

David Mauer, Steven Ott, C. William Sealey, Jiang Wang, Tan Wang and

Acknowledgments

x ACKNOWLEDGMENTS

Hong Yan. Special thanks go to Junya Jiang, Shuangshuang Ji, and Ivanov

Katerina for their excellent editorial support.

I owe a debt of gratitude to the staff at Palgrave Macmillan for edi￾torial support. Editor Sarah Lawrence and Editorial Assistant Allison

Neuburger deserve my sincerest thanks for their encouragement, sugges￾tions, patience, and other assistance, which have brought this project to

completion.

Most of all, I express the deepest gratitude to my wife, Maggie, and our

daughter, Michele, for their love and patience.

xi

Part I Regulatory Capital and Market Risk 1

Regulatory Capital Requirement in Basel III 3

Weidong Tian

Market Risk Modeling Framework Under Basel 35

Han Zhang

Part II Counterparty Credit Risk 53

IMM Approach for Managing Counterparty Credit Risk 55

Demin Zhuang

XVA in the Wake of the Financial Crisis 75

John Carpenter

Contents

xii CONTENTS

Part III Liquidity Risk, Operational Risk and Fair

Lending Risk 101

Liquidity Risk 103

Larry Li

Operational Risk Management 121

Todd Pleune

Fair Lending Monitoring Models 135

Maia Berkane

Part IV Model Risk Management 151

Caveat Numerus: How Business Leaders Can

Make Quantitative Models More Useful 153

Jeffrey R. Gerlach and James B. Oldroyd

Model Risk Management Under the Current Environment 169

Dong (Tony) Yang

Part V CCAR and Stress Testing 199

Region and Sector Effects in Stress Testing

of Commercial Loan Portfolio 201

Steven H. Zhu

Estimating the Impact of Model Limitations

in Capital Stress Testing 231

Brian A. Todd, Douglas T. Gardner, and Valeriu (Adi) Omer

CONTENTS xiii

Part VI Modern Risk Management Tools 251

Quantitative Risk Management Tools for Practitioners 253

Roy E. DeMeo

Modern Risk Management Tools and Applications 281

Yimin Yang

Part VII Risk Management and Technology 303

GRC Technology Introduction 305

Jeff Recor and Hong Xu

GRC Technology Fundamentals 333

Jeff Recor and Hong Xu

Part VIII Risk Management: Challenge

and Future Directions 393

Quantitative Finance in the Post Crisis Financial

Environment 395

Kevin D. Oden

Index 419

xv

Fig. 1 Capitals, capital ratios, and leverage ratios in Basel III 30

Fig. 1 Three components in counterparty risk management

framework 62

Fig. 2 Market factors for backtesting 68

Fig. 3 An example of backtesting 68

Fig. 4 Another example of backtesting 69

Fig. 5 Illustration of simulated interest rates in the future dates 70

Fig. 6 Prices of the portfolio under the similated scenarios 70

Fig. 7 Positive exposure of the portfolio under the simulated

scenarios 71

Fig. 8 The expected exposure profile over five years 72

Fig. 9 EPE and PFE of 97.7 percentile 72

Fig. 1 EPE profile for EUR-USD Cross-currency swap and USD

interest rate swap 81

Fig. 2 Funding flows for uncollateralized derivative assets 91

Fig. 3 Dealer 1’s received fixed trade flows at execution 97

Fig. 4 Dealer 1’s received fixed trade flows after

(mandatory) clearing 98

Fig. 1 Overlap in Firmwide Coverage 108

Fig. 2 Decision tree 112

Fig. 3 Operational balance 114

Fig. 4 Business needs break-up 115

Fig. 1 Aggregate loss distribution 129

Fig. 1 Histogram of Treatment Effect for Different

Matching Methods 146

List of Figures

xvi LIST OF FIGURES

Fig. 1 This figure shows the delinquency rate on single-family

mortgages and the 10-year Treasury constant maturity rate.

Note that the delinquency rate increased sharply during

the financial crisis of 2008 even as the Treasury rate continued

to decrease, a pattern not consistent with the assumptions

of the GRE model 162

Fig. 1 A typical MRM organizational structure 174

Fig. 2 MRM framework 181

Fig. 3 Model development, implementation and use 183

Fig. 4 Model validation structure 187

Fig. 1 Partitioning of rating transition matrix 206

Fig. 2 Quarterly iteration of estimating credit index Z from default

and transition matrix 208

Fig. 3 Historical default rate versus credit index 209

Fig. 4 Rho (ρ) and MLE curve as function of (ρ) for selected

industry sector 212

Fig. 5 Lead-Lag Relationship between credit index

and GDP growth 214

Fig. 6 2013 CCAR scenarios for USA and Europe GDP growth 215

Fig. 7 Credit index for North America (NA) under 2013

CCAR SAdv 217

Fig. 8 Stress PDs by region and sector across the rating grades 219

Fig. 9 Historical downturn PDs compare with CCAR

one year stress PDs 222

Fig. 10 Historical downturn PDs compare with CCAR

two year stress PDs 223

Fig. 11 Loan loss calculations for first year and second year 225

Fig. 12 2012 CCAR loan loss across 18 banks 226

Fig. 1 Illustrative example of model developed to forecast

quarterly revenue for a corporate bond brokerage

(a) Candidate independent variables are the spread

between the yields on the BBB corporate debt and the

10Y US Treasury (BBB; blue line) and the Market Volatility

Index (VIX; tan line) (b). Historical data are solid lines

and 2015 CCAR severely adverse scenario forecasts

are dashed lines. The VIX is chosen as the independent

variable in the Model and the BBB is used as the

independent variable in the Alt. model 234