Risk management and capital adequacy

RISK MANAGEMENT

AND CAPITAL

ADEQUACY

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RISK MANAGEMENT

AND CAPITAL

ADEQUACY

RETO R. GALLATI

McGraw-Hill

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DOI: 10.1036/0071425586

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When I was young, people called me a gambler. As the

scale of my operations increased I became known as a

speculator. Now I am called a banker. But I have been

doing the same thing all the time.

—Sir Ernest Cassell

Banker to Edward VII

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To my parents with love and gratitude

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ACKNOWLEDGMENTS

The suggestion that I write a book about risk came from the late Fischer

Black, while I was working at Goldman Sachs. The vastness of the project

is daunting. The topic touches on the most profound depths of statistics,

mathematics, psychology, and economics. I would like to thank the editors

and reviewers and those who provided comments, especially M.R. Carey

and Jean Eske, who carefully read the entire manuscript and provided

valuable comments, corrections, and advice.

I end with a note of thanks to my family, my friends, and my faculty

colleagues at Sloan, who inspired much of the enthusiasm that went into

the creation of this book and endured me with patience.

RETO R. GALLATI

Cambridge, Massachusetts

February 2003

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CONTENTS

ACKNOWLEDGMENTS viii

INTRODUCTION xvii

Chapter 1

Risk Management: A Maturing Discipline 1

1.1 Background 1

1.2 Risks: A View of the Past Decades 5

1.3 Definition of Risk 7

1.4 Related Terms and Differentiation 8

1.5 Degree of Risk 10

1.6 Risk Management: A Multilayered Term 11

1.6.1 Background 11

1.6.2 History of Modern Risk Management 11

1.6.3Related Approaches 13

1.6.4 Approach and Risk Maps 22

1.7 Systemic Risk 22

1.7.1 Definition 22

1.7.2 Causes of Systemic Risk 26

1.7.3Factors That Support Systemic Risk 26

1.7.4 Regulatory Mechanisms for Risk Management 27

1.8 Summary 28

1.9 Notes 30

Chapter 2

Market Risk 33

2.1 Background 33

2.2 Definition of Market Risk 34

2.3 Conceptual Approaches for Modeling Market Risk 37

2.4 Modern Portfolio Theory 39

2.4.1 The Capital Asset Pricing Model 41

2.4.2 The Security Market Line 43

ix

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2.4.3Modified Form of CAPM by Black, Jensen, and Scholes 45

2.4.4 Arbitrage Pricing Theory 46

2.4.5 Approaches to Option Pricing 47

2.5 Regulatory Initiatives for Market Risks and Value at Risk 54

2.5.1 Development of an International Framework

for Risk Regulation 56

2.5.2 Framework of the 1988 BIS Capital Adequacy Calculation 56

2.5.3Criticisms of the 1988 Approach 58

2.5.4 Evolution of the 1996 Amendment on Market Risks 58

2.6 Amendment to the Capital Accord to Incorporate

Market Risks 60

2.6.1 Scope and Coverage of Capital Charges 60

2.6.2 Countable Capital Components 61

2.6.3The de Minimis Rule 62

2.7 The Standardized Measurement Method 62

2.7.1 General and Specific Risks for Equity- and

Interest-Rate-Sensitive Instruments 65

2.7.2 Interest-Rate Risks 66

2.7.3Equity Position Risk 79

2.7.4 Foreign-Exchange Risk 83

2.7.5 Commodities Risk 84

2.7.6 Treatment of Options 88

2.7.7 Criticisms of the Standard Approach 94

2.8 The Internal Model Approach 95

2.8.1 Conditions for and Process of Granting Approval 95

2.8.2 VaR-Based Components and Multiplication Factor 97

2.8.3Requirement for Specific Risks 98

2.8.4 Combination of Model-Based and Standard Approaches 98

2.8.5 Specification of Market Risk Factors to Be Captured 99

2.8.6 Minimum Quantitative Requirements 101

2.8.7 Minimum Qualitative Requirements 102

2.9 The Precommitment Model 107

2.10 Comparison of Approaches 108

2.11 Revision and Modification of the Basel Accord

on Market Risks 109

2.11.1 The E.U. Capital Adequacy Directive 109

2.11.2 New Capital Adequacy Framework to Replace

the 1988 Accord 110

x Contents

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2.12 Regulation of Nonbanks 110

2.12.1 Pension Funds 111

2.12.2 Insurance Companies 111

2.12.3Securities Firms 112

2.12.4 The Trend Toward Risk-Based Disclosures 113

2.12.5 Disclosure Requirements 113

2.12.6 Encouraged Disclosures 114

2.13 Market Instruments and Credit Risks 114

2.14 Summary 116

2.15 Notes 117

Chapter 3

Credit Risk 129

3.1 Background 129

3.2 Definition 130

3.3 Current Credit Risk Regulations 130

3.4 Deficiencies of the Current Regulations 131

3.5 Deficiencies of the Current Conceptual Approaches

for Modeling Credit Risk 133

3.6 Conceptual Approaches for Modeling Credit Risk 135

3.6.1 Transaction and Portfolio Management 136

3.6.2 Measuring Transaction Risk–Adjusted Profitability 140

3.7 Measuring Credit Risk for Credit Portfolios 140

3.7.1 Economic Capital Allocation 141

3.7.2 Choice of Time Horizon 146

3.7.3 Credit Loss Measurement Definition 146

3.7.4 Risk Aggregation 149

3.8 Development of New Approaches to Credit

Risk Management 150

3.8.1 Background 151

3.8.2 BIS Risk-Based Capital Requirement Framework 152

3.8.3 Traditional Credit Risk Management Approaches 154

3.8.4 Option Theory, Credit Risk, and the KMV Model 159

3.8.5 J. P. Morgan’s CreditMetrics and Other VaR

Approaches 167

3.8.6 The McKinsey Model and Other

Macrosimulation Models 178

Contents xi

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3.8.7 KPMG’s Loan Analysis System and Other Risk-Neutral

Valuation Approaches 183

3.8.8 The CSFB CreditRisk+ Model 190

3.8.9 CSFB’s CreditRisk+ Approach 193

3.8.10 Summary and Comparison of New Internal

Model Approaches 197

3.9 Modern Portfolio Theory and Its Application

to Loan Portfolios 205

3.9.1 Background 205

3.9.2 Application to Nontraded Bonds and Credits 208

3.9.3 Nonnormal Returns 209

3.9.4 Unobservable Returns 209

3.9.5 Unobservable Correlations 209

3.9.6 Modeling Risk–Return Trade-off of Loans

and Loan Portfolios 209

3.9.7 Differences in Credit Versus Market Risk Models 225

3.10 Backtesting and Stress Testing Credit Risk Models 226

3.10.1 Background 226

3.10.2 Credit Risk Models and Backtesting 227

3.10.3 Stress Testing Based on Time-Series Versus

Cross-Sectional Approaches 228

3.11 Products with Inherent Credit Risks 229

3.11.1 Credit Lines 229

3.11.2 Secured Loans 231

3.11.3 Money Market Instruments 233

3.11.4 Futures Contracts 237

3.11.5 Options 240

3.11.6 Forward Rate Agreements 243

3.11.7 Asset-Backed Securities 245

3.11.8 Interest-Rate Swaps 247

3.12 Proposal for a Modern Capital Accord

for Credit Risk 250

3.12.1 Institute of International Finance 251

3.12.2 International Swaps and Derivatives Association 252

3.12.3 Basel Committee on Banking Supervision

and the New Capital Accord 253

3.13 Summary 263

3.14 Notes 265

xii Contents

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Chapter 4

Operational Risk 283

4.1 Background 283

4.2 Increasing Focus on Operational Risk 285

4.2.1 Drivers of Operational Risk Management 286

4.2.2 Operational Risk and Shareholder Value 288

4.3 Definition of Operational Risk 289

4.4 Regulatory Understanding of Operational Risk Definition 293

4.5 Enforcement of Operational Risk Management 296

4.6 Evolution of Operational Risk Initiatives 299

4.7 Measurement of Operational Risk 302

4.8 Core Elements of an Operational Risk Management Process 303

4.9 Alternative Operational Risk Management Approaches 304

4.9.1 Top-Down Approaches 305

4.9.2 Bottom-Up Approaches 314

4.9.3Top-Down vs. Bottom-Up Approaches 319

4.9.4 The Emerging Operational Risk Discussion 321

4.10 Capital Issues from the Regulatory Perspective 321

4.11 Capital Adequacy Issues from an Industry Perspective 324

4.11.1 Measurement Techniques and Progress

in the Industry Today 327

4.11.2 Regulatory Framework for Operational Risk Overview

Under the New Capital Accord 330

4.11.3 Operational Risk Standards 335

4.11.4 Possible Role of Bank Supervisors 336

4.12 Summary and Conclusion 337

4.13 Notes 338

Chapter 5

Building Blocks for Integration of Risk Categories 341

5.1 Background 341

5.2 The New Basel Capital Accord 342

5.2.1 Background 342

5.2.2 Existing Framework 343

5.2.3Impact of the 1988 Accord 345

5.2.4 The June 1999 Proposal 346

5.2.5 Potential Modifications to the Committee’s Proposals 348

Contents xiii

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5.3 Structure of the New Accord and Impact

on Risk Management 352

5.3.1 Pillar I: Minimum Capital Requirement 352

5.3.2 Pillar II: Supervisory Review Process 353

5.3.3 Pillar III: Market Discipline and General

Disclosure Requirements 354

5.4 Value at Risk and Regulatory Capital Requirement 356

5.4.1 Background 356

5.4.2 Historical Development of VaR 357

5.4.3VaR and Modern Financial Management 359

5.4.4 Definition of VaR 364

5.5 Conceptual Overview of Risk Methodologies 366

5.6 Limitations of VaR 368

5.6.1 Parameters for VaR Analysis 368

5.6.2 Different Approaches to Measuring VaR 373

5.6.3Historical Simulation Method 380

5.6.4 Stress Testing 382

5.6.5 Summary of Stress Tests 389

5.7 Portfolio Risk 389

5.7.1 Portfolio VaR 390

5.7.2 Incremental VaR 393

5.7.3Alternative Covariance Matrix Approaches 395

5.8 Pitfalls in the Application and Interpretation of VaR 404

5.8.1 Event and Stability Risks 405

5.8.2 Transition Risk 406

5.8.3Changing Holdings 406

5.8.4 Problem Positions 406

5.8.5 Model Risks 407

5.8.6 Strategic Risks 409

5.8.7 Time Aggregation 409

5.8.8 Predicting Volatility and Correlations 414

5.8.9 Modeling Time-Varying Risk 415

5.8.10 The RiskMetrics Approach 423

5.8.11 Modeling Correlations 427

5.9 Liquidity Risk 431

5.10 Summary 436

5.11 Notes 437

xiv Contents

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Chapter 6

Case Studies 441

6.1 Structure of Studies 441

6.2 Overview of Cases 441

6.3 Metallgesellschaft 445

6.3.1 Background 445

6.3.2 Cause 448

6.3.3 Risk Areas Affected 457

6.4 Sumitomo 461

6.4.1 Background 461

6.4.2 Cause 461

6.4.3Effect 464

6.4.4 Risk Areas Affected 464

6.5 LTCM 466

6.5.1 Background 466

6.5.2 Cause 468

6.5.3Effect 472

6.5.4 Risk Areas Affected 473

6.6 Barings 479

6.6.1 Background 479

6.6.2 Cause 480

6.6.3Effect 485

6.6.4 Risk Areas Affected 486

6.7 Notes 490

GLOSSARY 495

BIBLIOGRAPHY 519

INDEX 539

Contents xv

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