Course overview
In the current economic downturn, many financial institutions lost large amounts of money and had to be assisted by governments. Was this a failure of risk management, and if so, why? This course will discuss what happened, and how some institutions actually came out of the credit crisis with enhanced reputations.
The Euromoney Bank Risk Management School provides you firstly with a high-level overview of modern risk management, including a breakdown of the new Accord and a comparison with the old one. This is then followed by an in-depth examination of the techniques and management structures used to assess and to control risk, including a discussion on the implementation of Value-at-Risk (VaR), which is becoming the de facto standard for measuring risk.
Summary of course content
- A broad look across risk management
- The Basel Accord – what is it, and why do we have it?
- Did the Accord work in the current economic crisis?
- Basel II.5 and III – what are the impacts of the proposed changes
- Development of the ICAAP in preparation for your SReP
- Creation of a risk framework
- How risk management should be organized
- The assessment of market risk using both traditional and modern approaches
- Credit portfolio management – why is this the new paradigm?
- How operational risk is being assessed and managed
- Stress testing – what went wrong, and how this must be changed
- How can Risk Management add value?
Methodology
To reinforce the course, there are:
- A wide range of real-life case-studies discussing the lessons we should learn from these failed institutions - could the same events happen at your institute?
- Computer simulations of the latest techniques to model market, credit and operational risk, and discussions about commercially-available softwareWho should attend this training course?
Who should attend this training course?
- Heads of risk management
- Risk analysts
- Heads of project finance
- Financial analysts
- Portfolio managers
- Treasury managers
- Credit managers
- Rating agency analysts
Supporting publication
Day 1: Risk management
A brief historical background
- The evolution of banking risk
- Why the old Basel Accord was deemed necessary
- G30 report
Case study: Bankers Trust
- Why Basel II was necessary
- Expected and unexpected losses and the role of capital
- The evolution of bank risk management
- From a cost centre to a strategic competitive weapon
The Basel Accord II – a brief overview
It is assumed that all delegates will have heard of the Basel Accord. This section will summarise its implications for financial institutions, with particular attention to Pillars II and III.
- Objectives of the new Accord
- Application of the Accord - to whom does it apply?
- Legal standing of the Accord and national discretions
- Structure of the new Accord
- Pillar I: minimum capital requirement
- What constitutes bank capital?
- Changes to the definition of regulatory capital
- Changes to the regulatory mix of capital
- Likely implications
- Pillar II: supervisory review process
- Construction of an ICAAP - an overview with examples
- What risks should be covered?
- How should the risks be assessed?
- The structure of the ICAAP
- Principle-based supervision - what is meant by this?
- Pillar III: market disclosure - the requirements and some issues
- Changes as the result of Basel III
- Interaction with other regulatory requirements such as IFRS
- Procyclicality
- Introduction of a conservation capital buffer
- Introduction of a counter-cyclical capital buffer
Delegates will be encouraged to discuss the current and planned progress of their institution towards the new Accord.
Sound risk management practices
Whilst each class of risk has developed its own methodologies, there are some overarching practices required to support the overall risk management framework.
- What is a risk framework?
- The COSO framework - how applicable to banks?
- Developing an appropriate risk management environment
- Typical organisational structure
- Roles and responsibilities of each of the parties
- Defining the risk appetite of the institution
- Factors that may influence a risk appetite
- Quantitative and qualitative approaches
- Creation of risk management policies and procedures
- Risk identification framework
- Risk measurement methodologies
- Management and control of risks
- Reporting and monitoring of risks
- View of governance after the banking crisis
- Comments from the supervisors
- Introduction of bank-wide risk management
- What are the likely implications?
Group discussion: Discussion will be with reference to a leading international bank. Delegates will discuss the progress of their institution towards sound practices and highlight areas of priority.
Day 2: Market risk
Market risk has changed fundamentally over the past 20 years, with the introduction of Value-at-Risk (VaR).
These sessions first discuss the main approaches used to control traders at the “desk-top”, and then review in some detail the main approach banks use to calculate their regulatory VaR.
Due to the recent banking crisis, there have been a number of substantive regulatory changes. The regulatory methods will be reviewed with example calculations, and the implications of the changes discussed.
Introduction
- What are the main sources of market risk?
- Interest rate, foreign exchange, equity and commodity risks
- Definition of “Trading”
- Introducing model risk
Case study: NatWest Bank
Traditional desk-top risk measurement
- Adopting a portfolio approach, interest rate risk will be discussed:
- Construction of classic gridpoint sensitivity reports for a significant portfolio
- Extension to incorporate curvature
Modern risk measures: Valueat- Risk (VaR)
- Introduction through a simple 1-factor example
- Using historic simulation
- Extension to a 2-factor example
- Demonstration of more realistic examples
- What do banks do in practice?
- Practical difficulties of implementation: volatility and correlation, holding period
Regulatory requirements of the Basel Accord
- The standardised approach
- How to estimate the IR capital requirement using maturity bands
- How to estimate the IR capital requirement using duration bands
- How to estimate the FX, equity and commodity capital requirements
- How to incorporate options
- Specific risk: inclusion of credit risk from the trading book
- Internal models - using VaR
- Qualitative approval process
- Normal and stressed VaR
- Calculation of the regulatory capital for market
- Back testing: what is it and how to apply it?
- Other changes to the market risk framework
- Valuation of illiquid positions
- Introduction of the incremental risk charge - what are its implications?
- Likely further developments
Measurement of interest rate and liquidity risk
The Basel Accord makes a distinction between traded and non-traded market risk. The latter includes funding liquidity risk, namely the risk that the bank simply cannot renew its funding. Many instances of this were seen in 2007-9.
Banks apply different approaches to try to assess non-traded and liquidity risk, and this section briefly discusses them.
- IRR exposure: earnings and economic value approaches
- Traditional technique: banding and gap analysis
- Funding liquidity risk - how is this being assessed now
- Development of an Internal Liquidity Adequacy Standards document
- Introduction of liquidity constraints
- Liquidity coverage ratio - how will this work?
- Net stable funding ratio - how do we think this will work
- Likely implications
- Simulating the balance sheet
- What does the Accord require?
- Example of a standardised framework for estimating capital
Delegates will be encouraged to discuss the organisation of the market risk function within their institution and the main management reports used.
Day 3: Credit risk
Banks are traditional credit risktaking institutions. Hence, through experience, they have developed wellfounded mechanisms for managing credit risk. If this is the case, why have the international banks fundamentally changed the way in which they view credit risk over the past 10 years? Does the Basel Accord support or hinder this new paradigm?
Overview – the traditional view of Credit Risk Management (CRM)
- Banks as credit taking institutions
- The typical credit control process
- Traditional credit risk mitigation
- The effectiveness of the process: does it work?
- Level I CRM
Case studies: Bankgesellschaft Belin, Continental Illinois and redit Lyonnais.
Modern credit risk mnagement
- Portfolio credit risk management
- why is it the new paradigm?
- What are the fundamental concepts?
- Basic data requirements
- Exposure at default (EAD)
- Probabilities of defaults (PDs)
- Loss given defaults (LGDs)
- Correlations
- How to estimate EADs and EPEs
- Traditional loan exposures
- Provision of guarantees such as standby Letters of Credit or trade finance
- Settlement, pre-settlement and derivative risks
- The concept of credit conversion factors
- The concept of expected positive exposure
- How to estimate PDs
- Using historic internal data
- Supplementing with external data
- Incorporating the economic cycle
- Factor-based statistical modelling such as scoring
- Examples of factor models
- Why are factor models better than naive historic models
- How to assess PDs from statistical models
- Traditional credit analysis - can this be used as well?
- What are the main components of a traditional rating methodology
- Credit analysis vs. statistical modelling?
- Market-based approaches
- The credit market
- The debt market
- The equity market and Merton’s model
- Hybrid models
Each approach will be briefly and yet ritically discussed
- How to estimate LGDs:
- Is estimating LGDs difficult?
- Discussion of some estimation projects
- Seven levels of credit risk management
- Where is your institution?
- Active credit portfolio management
Delegates will be encouraged to discuss the organisation of the credit risk unction within their institution and the main management reports used
Estimation of regulatory capital for credit risk
- The standardised approach
- The “who” and the “what” of the Accord
- The role of external rating agencies
- International or domestic?
- Impact of the Dodd-Frank Act of 2010
- Credit conversion factors
- Permitted risk mitigation
- Overview of the internal rating-based approaches
- Foundation and advanced approaches
- What you supply, what the Accord supplies, and what the national supervisor supplies
- Future changes
- How to apply to different client sectors
- Example calculations
- The regulatory credit model
- The underlying theoretical assumptions
- Minimum organisational and technical requirements to implement these approaches
- Permitted risk mitigation
- Revisions made in 2005:
- Redefinition between banking and trading
- Double defaults
- Minimum maturity
- Hedging banking exposures with trading derivatives
- CCFs for derivatives
- Revisions made in 2010
- Introduction of a leverage constraint
- Changes to traded counterparty credit risk
- Introduction of the credit valuation adjustment
A brief outline of portfolio credit modelling
- Analytically modelling portfolio default assuming independence
- Simulating portfolio default
- Introducing correlations
- Estimation of correlations
- Modelling a realistic portfolio
- Construction of a loss distribution
- Calculating credit VaR
- Implementing such a model in practice
- Extension of the default model to a migration model - as required by IRC
If there is time, the events and strategies underlying the credit crisis will be discussed - with case studies on the US Investment Banks and Sachsen LB.
Day 4: Operational risk
The Basel Accord has introduced a capital requirement for operational risk for the first time. But can operational risk be realistically measured as the Accord requires? Or is the whole topic the triumph of optimism over reality? These are some of the basic questions to be debated in the section, along with
a detailed coverage of the approaches banks are employing.
Overview
- What is operational risk?
- Alternative definitions
- What is the regulatory charge supposed to cover?
- The Basel categories and definitions
- The results of the latest loss data collection exercise
- Why has operational risk been included in the Accord?
Case study: Royal Bank of Canada
Developing an operational risk methodology
- Developing suitable objectives and policies
- Role and responsibility of senior management
- Typical operational risk organisational structures
- Relationship with other functions, especially internal audit
- Top down or bottom up
- Creating a risk framework
- Risk identification
- Causal and event frameworks
- Recording of loss events and other data
- What should be stored - with a real example
- Definition of loss - direct or indirect?
- Build or buy an operational risk database
- Risk assessment
- Process analysis will be briefly discussed:
- Which are the key processes?
- Process mapping - what are the major risks in any given process?
- Indicator approaches - what are the key assumptions
- Key risk indicators - what can be used as a risk metric?
- The KRI project
- Regulatory indicator approaches - what is permitted?
- Business efficiency and internal control factors
- Bottom-up risk measurement models
- Loss distribution analysis: statistical modelling using historic data
- Using external data - good or bad?
- Fitting severity and frequency distributions
- Modelling LD, and estimating the 99.9% VaR
- Improving such a model
Computer-based demonstration using real data
- Control self assessment: Score-card or self-assessment approaches
- Examples of assessment questionnaires
- Training of people to conduct selfassessment
- Examples of professional software used to support this methodology
- Results from a CSA
- Estimation of VaR using simulation and other approache
Computer-based demonstration
- Exceptional and unexceptional events
- Will the normal modelling capture exceptional events?
- If not, what can be done?
Case studies: Barings, Société Générale and Allied Irish Bank
- Where is current best practice, and what are the leading institutions doing?
- Results of QIS3 (2004) and QIS5 (June 2006)
- Will they work?
Delegates will be encouraged to discuss the organisation of the operational risk function within their institution and the main management reports used.
Day 5: Stress testing
Stress testing has always been seen as a necessary compliment to “normal” risk management. Yet, it has often been perceived by senior management as an irrelevance!! This session discusses the attitude towards stress testing before the global financial crisis, what represents good stress testing, and how attitudes
have changed more recently.
- Definition of stress testing
- How were pre-2007 stress tests conducted and what lessons can be learnt?
Case study: LTCM
- How stress tests should be conducted
- What is current best practice after the banking crisis?
How does risk management add value?
The objective of this session is to explore how modern risk management may contribute to the overall strategic development of the institution. In particular, what is the acceptable tradeoff between the return on a transaction, and the risk it incurs for the bank? A number of different aspects will be reviewed, and current global “best practice” will be discussed.
- RAROC: risk-adjusted return on riskadjusted capital
- What is RAROC? How is it defined? Variants such as EVA
- Determining the cost of capital using the capital asset pricing model
- The use of RAROC:
- Ex ante: allocating economic capital to business units
- Ex post: performance measurement
- Implementing RAROC: what are the practical problems?
- Final words
- How can risk management add value to the organisation?
- Risk management of the future
Course summary