Rd 2 Rickert-lambrigger

8/12/2019 Rd 2 Rickert-lambrigger

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Market Risk Management

a enges un er e

new Basel framework

Philipp Rickert

Partner

Dr. Dominik D. Lambrigger

Mana er

ETH Riskday, 9 September 2011


2/23

What makes a Traders life miserable?

Political challenges

Uncertainty in US and Europe

overe gn e cr s s

Global economy slow down

Market behavior

Increased participant mistrust

Increased competition (chasing the flow)

Cash is King

Low volumes, flight to quality, risk averse

egu a ory response

Risk taking becomes disproportionally capital intense and expensive

Qualitative requirements increase (IT, processes, people)

All that makes the Traders life miserable, because less volume and less risk combined

with higher volatility and higher production costs results in bad P&L and that means

1 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.

LOWER BONUS!


3/23

Basel III

NOT THIS BASEL THIS BASEL!



4/23

Why Basel III Regulators Views

Why the Financial Crisis

Excess of cheap money and procyclicality of globally important banks

Too little capital of insufficient quality (leverage between 1 to 33 and 1 to 100)

Inadequate liquidity buffers

Purpose

Improve the banking sector's ability to absorb shocks arising from financial and economic

stress, whatever the source Improve risk management and governance

Stren then banks' trans arenc and disclosures

Response

Coverage of risk focus on trading book exposures

Much higher levels of capital


Global liquidity standards


5/23

Capital under Basel Requirement vs Eligibility

Required Capital

.

Available

Capital

Op

Ris

Fixed assets

Tier 3

Abolished

CreditRisk

ankin

Boo

Secured Finance

Retail Loans

Tier 2

Restrictions Basel 2.5:

Tradin Book

Commercial Loans:Banks

CVA

Tier 2

Tier 1

isk

oo

k

CRM

Securitizations

Deductions Basel 3

Market

Tradin

Stressed VAR

IRC

VAR

Tier 1



6/23

socially honest

and adhere to the highest ethical principles,

especially in the face of temptationwhich will come!



7/23

Modeling market risk (Value-at-Risk)

Key elements

Market risk charge = C x VaR99%(V), C 3

10-day holding period

V is the value of the trading book portfolio

Risk Weighted Assets

CVAB III

V = 10-day change of V

ChallengesSecuritization

CRM

Complexity of the portfolio (and hence V ):need sophisticated front office pricing models

Comprehensive scope of risk factors

IRC

Stressed VaRB II.5

.

Responsiveness of VaR

Data quality

Com lexit of risk infrastructureCredit Risk

Op Risk

B II

Backtesting VaRMarket Risk



8/23

The Greeks

A Taylor expansion ofV reduces the problem to the calculation of:

The risk factor changes S and their volatilities(for simplicity assume that there is only 1 risk factor and no specific risk)

The sensitivities (Greeks)

1 22 VVV ...2

,...,2

SS

Delta Vega Gamma

Historical Risk Factor ChangesFront Office Pricing Models

and Cross-Gamma, Vanna, Volga, etc.

(stochastic)(deterministic)

Risk factor VolatilityValue Delta Vega

Delta Gamma Vanna

Vega Vanna Volga

Gamma Speed Zomma

Volga Ultima


For highly non-linear products Taylor might not be appropriate


9/23

Challenges in modelling market risk (1/4)

Banks tend to use full revaluation of the whole portfolio for VaR calculation and stress testing.

Greeks &Taylor

Expansion

Partial

revaluation

Full reval

C o m p l e x i t y

Most banks use historical simulationbased on a 1-5 year dataset

Some banks have the crisis in the VaR

Others have a strong desire to excludethe crisis from the dataset (due to theintroduction of stressed VaR and adouble-counting of the crisis)



10/23


How responsive should VaR be in a crisis?

Standard implementation of VaR is typically not very responsive to a crisis, especially if the

.

How can this problem be addressed?

Stressed VaRResponsive VaR

Dual approach

ase . see a er ca ng y mar e vo a y

Weighting of data



11/23


Backtesting:

Check erformance of VaR b com arin VaR a ainst PnL

But have 10-day VaR and 1-day PnL?!

Two options:

Scale 10-day VaR down to 1-day VaR: VaR1-day VaR10-day

Re-calculate 1-day VaR (costly)

10/


Source: Credit Suisse Annual Report 2005 -


12/23


How many backtesting exceptions per year are acceptable?

um er o excep ons ncrease n e mu p er

4 or less 0.00

5 0.40

6 0.507 0.65

k P(N=k) P(Nk)

N ~ Bin(n=250, p=0.01)

P(N > 4) = 10.8%

8 0.75

9 0.85

10 or more 1.00*

Source: FINMA Market Risk Circular 2008/20

0 0.081 0.081

1 0.205 0.286

2 0.257 0.543

3 0.215 0.758

4 0.134 0.892

5 0.067 0.959

* Any shortcomings must be eradicated without delay, since otherwise the conditions fordetermining capital adequacy requirements according to the model-based approach will

be deemed no longer to be fulfilled.

6 0.027 0.986

7 0.010 0.996

8 0.003 0.9989

Credit Suisse Annual Report 2008: Annual Report 10

- CS:. .

10 0.0002 0.99995

UBS Annual Report 2008:

0 exceptions

- UBS:

1 exception



13/23


Alternative backtesting approach:

...)(2

1,...),( 2

2

S

S

VVS

S

VSV

Delta Vega Gamma

Historical Risk Factor Changes(stochastic)

Front Office Pricing Models(deterministic)

Use realized risk factor changes to calculate V Model-based PnL (risk-based PnL)

Backtest model-based PnL against realized PnL

Pros: Model deficiencies detected on a daily basis (dont have to wait for a VaR backtestingexception)

Cons: Non-market risk factors have to be modelled or need good clean PnL data



14/23


Invest in human capital


-


15/23

Basel 2.5


16/23

Incremental Risk Charge (IRC)

Key elements

Default and credit rating migration of trading book positions

99.9% VaR, 1-year holding period

Fixed Income products (mainly plain vanilla bonds and


CVAB III

Key inputs are ratings/PDs, LGDs, EADs, credit spreads,migration matrix and liquidity horizonSecuritization

CRM

Challenges

Migration risk modelling

Constant level of risk (and liquidity horizon):IRC

Stressed VaRB II.5

e au e m gra e pos ons ave o e re- a ance

Completeness of positions

Risk data capturing and enrichmentCredit Risk

Op Risk

B II

Structured credits, credit derivativesMarket Risk



17/23


18/23

Securitizations and Re-securitizations

Key elements

Capital charge for (re)-securitization positions in tradingbook

Product scope: CDO, CDO^2, RMBS, CMBS, NTD, etc.


CVAB III

Corporate CDOs and NTDs can be modelled by CRM (seenext slide)

Specific risks only, general risk through VaRSecuritization

CRM

Challenges

Robustness of methodolo

IRC

Stressed VaRB II.5

Completeness of scope

Completeness of data feeds

Data qualityCredit Risk

Op Risk

B II

Market Risk



19/23

Comprehensive Risk Measure (CRM)

Key elements


CVAB III

Capital charge for correlation trading

Product scope: synthetic CDOs (index tranche and bespoke

tranche), nth-to-default and corresponding hedges (e.g.CDS index CDS and bonds

Securitization

CRM All price risk model: default, rating migration, basis risk

(index basis, i.e. basis between index and single names,

correlation basis, e.g. basis between index tranches and

bes oke tranches FX ? and interest rate risk ?

IRC

Stressed VaRB II.5

Challenges

Credit Risk

Op Risk

B II

Very sophisticated models

Large model risk

Scope definition

Market Risk omp e eness o a a ee s



20/23

And beyond market risk?

Dont forget Operational Risk

Advanced Measurement Approach (AMA):

Does having a large Op Risk capital add-on helpto reduce the risk or is it just a regulatory capitaladd-on?


CVAB III

,Risk (since 2010, regulators start to care aboutOp Risk again).

The new challenges are the old challenges: dataSecuritization

CRM

, , .

How to combine external, internal data withexpert judgment and scenario analysis? How toestimate correlation between business lines

IRC

Stressed VaRB II.5

oes ma e sense

Does a 99.9% quantile make sense (dont wantto speak about 99.97% economic risk capital)?Credit Risk

Op Risk

B II

re s

A-IRB

and Liquidity Risk

Market Risk



21/23

Basel 3


22/23

Credit Valuation Adjustments (CVA)

Key elements


CVAB III

CVA is the Market Value of Counterparty credit risk (CCR)

Not only default of counterparty, but also change in credit

worthiness of counterparty has to be addressed

Securitization

CRM

major counterparty for OTC derivatives

If Bank has an internal VaR model: Advanced CVA

All other Banks: Standardized CVA

IRC

Stressed VaRB II.5 Need to dynamically price CCR

Very costly (infrastructure, resources and capital)

Credit Risk

Op Risk

B II

Challenges

Potentially large capital impact

Methodology and implementation framework not straight-Market Risk

orwar

Securitizing CVA?



23/23

Philipp RickertPartner

Dr. Dominik D. Lambrigger

Audit Financial ServicesKPMG AGBadenerstrasse 172CH-8026 Zrich

[email protected]@kpmg.com

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