Financial Risk Management KPMG ADVISORY
A spate of high-profile business failures and the emergence of tougher regulations have put organizations under pressure to
manage financial risk more effectively. Financial organizations have to be aware of the need to identify, measure and manage
risk, e.g. credit, market, liquidity, and operational risk, as well as maintaining sufficient levels of regulatory and economic
capital to support the risks they face. Also, there is a need for adequate disclosure and presentation of information to
stakeholders and third parties.
Financial Instruments – Valuation / Accounting and Disclosure
Financial instrument valuations encompass valuations of a variety of simple, complex and
structured products. Examples of such products are credit derivatives (e.g. Credit Default
Swaps), interest rate and foreign exchange derivatives (e.g. Interest Rate Swaps, Cross
Currency Interest Rate Swaps, Interest and Foreign Exchange Rate Options, Swaptions,
etc.), Credit Link Notes and Total Return Swaps. Moreover, recent developments have
raised issues around the valuation of Asset Backed Securities (ABS), Collateralized Debt
Obligations (CDO) and related structures. Clients often raise questions such as: Do we
have a reliable market value? Do we use an appropriate valuation model? Is the outcome
of the model reasonable? We can assist in providing solutions in this area.
Our practice also provides support in the correct accounting of Financial Instruments,
in accordance with IFRS, US-GAAP or other accounting standards. An example would
be the review and implementation of Hedge Accounting where the appropriateness of
(Fair Value/Cash Flow) Hedge Accounting model and Hedge Accounting effectiveness
tests are evaluated . In addition, we have wide experience in the preparation of financial
reporting disclosures of financial instruments, risk management methods and models
(e.g. IFRS 7, Disclosure requirements acc. to Pillar 3 of Basel II).
Capital Adequacy, Regulatory Reporting & Compliance
Capital Adequacy for banks is calculated and
Regulatory Reporting is made according to
regulators’ rules and methodologies, defining
for each bank a minimum regulatory capital requirement and reporting. It comprises, but
is not limited to, the Basel II framework as,
e.g., transposed in Luxembourg with respect to
FinRep (Financial Reporting based on IFRS) and
CoRep (Common Reporting for the Solvency
Ratio based on IFRS) by the Commission de
Surveillance du Secteur Financier (“CSSF”).
Management of Financial Risks
The management of credit risk, market risk
(comprising interest rate risks, foreign exchange
risks, equity risk as well as commodity risks),
operational and reputational risk, insurance
risk as well as liquidity risk should be part
of every sound financial risk management
system within a company. The scope
depends on the relevance of each risk
category for a company. Most institutions
measure their risks based on Value-at-
Risk Models. Many of these risks are highly
relevant for most of the financial institutions
and are interrelated. As such, they need to
be measured and managed accordingly. Recent
developments have revealed significant weaknesses in the management of credit risk
and liquidity risk within many organizations. Sound credit risk management can mitigate
or avoid a significant financial impact of such events on an organization.
What We Do – And What You Get
Basel II Framework - 3 Principle Pillars
Minimum Regulatory
Capital Requirement
Supervisory Process
Market Discipline
Your potential benefits are :
An adequate and tailor-made •approach to any kind of financial instruments valuation.
Third party valuation where you •benefit from our valuation tools and knowledge.
Compliance with regulatory and •accounting frameworks.
Effective implementation of Hedge •Accounting and other valuation tools to mitigate volatility of accounting P&L.
Your potential benefits are :
Full compliance with regulatory •requirements in Luxembourg.
Sound capital requirement •calculations especially for IRB approach for credit risk and AMA approach for operational risk.
Integrated and comprehensive •methods to implement or refine existing processes to fulfill regulatory requirements.
Your potential benefits are :
Improved transparency and enhanced •understanding of risks the company is exposed to.
Identification of the different kinds of •relevant risks and their key drivers.
Development and implementation of •appropriate risk management models and procedures.
Setting up a sound risk management •practice for those risks.
Model Building and Model Validation
A model is a tool used to calculate or estimate
results based on a series of inputs often used
for analysis or quantification. Models are used
to make decisions easier and as such they
support the decision process. They do not
have an own purpose. Organizations use
a wide variety of models or spreadsheets,
which can be broadly categorized into
three areas: Decision Support, Financial
and Risk Management models.
For example, structured products or Asset
Backed Securities are rarely priced on active
markets. Therefore, adequate financial models are
necessary to price those financial instruments. Furthermore, appropriate risk
management models adapted to the companies’ specific purpose and needs, such as
Value-at-Risk or Expected Shortfall, are needed to measure, manage and control the risk
thereof. The models underlying the Hedge Accounting effectiveness tests are another
example of models used in accounting.
ICAAP & Economic Capital Calculation
ICAAP (Internal Capital Adequacy Assessment Process), part of Pillar 2 within the Basel II
Framework, represents a financial institution’s own assessment of the capital needed to
run the business. This capital may differ from the minimum regulatory capital requirement
since, for instance, a financial institution may include risks that are not formally subject to
the minimum regulatory capital (e.g. liquidity risk, reputational risk or interest rate risk in
the banking book) or may use different parameters or methodologies (this is particularly
the case for operational risk).
Restrictions due
to Basel II, Pillar II
≤!
“EconomicCapital”
AvailableFinancial
Resources
Free FinancialResources
Restrictions due to Basel II, Pillar I
≤!
RegulatoryCapital
Pillar IOwn Funds
Capital Surplus
Your potential benefits are :
Development of effective models and •assistance in validating those models as well as assessment of the overall reliability of the model output.
Accurate pricing of financial •instruments based on efficient and precise models.
Leading risk management models for •sound financial risk management.
Your potential benefits are :
A risk management framework •consistent with financial risk strategy.
Efficient process in response to the •second pillar requirements of Basel II (ICAAP).
Full compliance with regulatory •requirements and in line with best practice.
Adequate economic capital models •and risk management processes and procedures consistent to the risk management framework resulting in a comprehensive and integrated financial risk management approach.
Understanding of the different types •of risks financial institutions are exposed to and how they impact the company, incorporating these into their business operations and monitoring.
Awareness of potential weaknesses •in the financial risk management strategy, frameworks and processes as well as in the risk mitigation methods and being able to prepare the management actions to be taken to avoid unexpected or surprising losses.
Financial strategies could be risk avoidance, reduction, limitation, transference or
acceptance. An integral part of financial strategies is the management of financial risks and
resources and comprises identification, measurement, assessment, controlling, monitoring,
reporting and stress testing of the several risks including risks essentially not integrated.
Risk Adjusted Performance Calculations
Risk-adjusted performance measures compare return with capital employed in a way
that incorporates an adjustment for risk. The most famous measures are RAROC
(risk-adjusted return on capital) and RORAC (return on risk-adjusted capital).
Risk-adjusted performance measures are based on either risk adjusted return or
economic capital.They can be used for comparing past performance or as a forward
looking measure to decide on the long-term viability of a business unit, whether
it should be expanded or scaled back.
Integrated Planning & Target Setting
Added Value (e.g., EVA)
Risk Cost
Cap. Cost
Value drivers/Operational Drivers/KPIs
Risk-Return Ratio (e.g., RORAC)
Revenue
Risk AggregationCost
1
Org
aniz
atio
nal
Un
it
Leg
al E
nti
ty
Pro
du
ct
Cu
sto
mer
2 3 4 5Market Risk Credit Risk Op. Risk Other Risks
Simulations & AnalysisReports/Cockpits
Expected Loss
Unexpected Loss
99.95% (AA)
EL
UL
0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35%
ECAP
PR
OB
AB
ILIT
Y
LOSS RATE (%)
EL = expected lossUL = unexpcted lossECAP = economic capitalAA = bank’s creditrating
Your potential benefits are :
Implementation of performance •measures or improvement of your current measures.
Risk-adjusted performance •calculations consistent and integrated into existing capital planning and risk management process.
New Product Process (NPP) for Asset Management
Current market trends show that innovations of products and instruments will become
more significant over the coming years because of a decrease in market growth and a gain
in margin of traditional products. Standardized products such as index funds have lately
become more and more attractive for investors and alternative products are becoming
increasingly mainstream for asset managers.
An efficient and high quality New Product Process (NPP) is necessary to keep up with the market demands and regulatory requirements for asset managers
Based on the increasing importance of new funding vehicles there is a need to accelerate
the time-to-market of new products while complying with applicable rules and regulations.
By launching new products asset managers are faced with a variety of challenges, e.g.
regulatory, economic, process-related and technical challenges. An efficient new product
process takes all essential departments and functions of the value chain into account.
Our project management approach for the multidisciplinary NPP – A cube-based Illustration
Particular business functions are involved in one or more phases of the NPP.
Cross-sectional issues come up for several business functions during various phases.
Our project management approach recognizes this variety and interconnection among
the various functions.
- Callable Yield Notes - Callable Path Dependant Floaters - Certificates, Discount, Bonus, Express etc. - Basket Structures - Snowballs - Target Range Accrual Notes - Exotic Options – Equity, Commodity etc. - Triggerable Reverse Floater - Inflation products, e. g. Zero Inflation Swaps, Inflation Swaps - CPPI - Variance Swap - […]
- Compliance with international regulatory guidelines and local requirements (e.g. IFRS, InvG, SolvV, MiFID, AnlV, Derivative regulation)- Coverage of permanently increasing requirements (Reporting, Corporate and Governance and Risk Management) in regard to regulatory law, accounting- and taxation law
- New products and instruments need to match with the market expectations - Product profitability
- Liquidity and risk performance- Adequate mapping within the system and correct treatment in the day-to-day business activities have to be assured- Utilization of synergies
Modification / mix of existing products
Real innovations
New products
Reg
ula
tory
Eco
no
mic
ch
alle
ng
es
Pro
cess
-rel
ated
te
chn
ical
ch
alle
ng
es
Fund managementMarket research
LegalTax
Internal auditEconomic analysis
TradingCompliance
Order controlPricing & valuation
Risk analysisPerform. analysisFund accounting
Reporting
Initiation &Analysis Design Implementation Testing
Appproval &Going Live
BusinessFunctions
21
Cross-sectional Issues
NPP Phases
3Coordination
CommunicationIT architecture
InterfacesData
Execution (by default)
Your potential benefits are :
Ability to introduce new products •adequately and smoothly, minimizing the time span from the initiation to going live and keeping track of the expenses for related structures, processes and IT.
Assurance of appropriate prices •and risk figures with regard to new products accommodating both true innovations and modifications efficiently.
Financial Risk Management
Why ? Risk management is highly complex, with risks often interrelated, which require sophisticated tools and techniques. Sarbanes-Oxley, Basel II, Solvency II and the cost of capital require organizations to improve their risk management practices. This ultimately helps management to view risk as a major part of corporate strategy. Financial risks are more and more interrelated to financial accounting and reporting (e. g. IAS 39 and IFRS 7) as well as to the calculation of the solvency ratio (e. g. calculation of the regulatory own funds based on IFRS). These require integrated and comprehensive management frameworks to optimize Financial Risk Management, Asset-Liability Management and overall product processes.
How can we help ? Based on an integrated approach, we can help design and implement frameworks to manage and/or reduce risk. We can provide assistance in creating an overall framework that helps to identify, measure, monitor and report risks leading, ultimately, to better strategic decision making and efficient processes.
Our quality ? In striving to provide high quality services, we participate in a global accreditation program, we work closely with professionals from other KPMG member firms, liaise regularly with our global KPMG Financial Risk Management group and share experiences on a variety of different national and international projects. We also cooperate with universities to be able to provide the most up to date methodologies to our clients.
Your benefit ? KPMG Financial Risk Management is committed to ensure that we are always available to help identify opportunities, solve problems and as a result add value firm wide based on a multidisciplinary approach. You can benefit from our cross-border knowledge and experience – in Luxembourg and abroad. Whatever problem you might have regarding Financial Risk Management, we can provide you with a tailored approach.
Your Needs – Our Approach
B
anks
Investment Funds
Insurances Com
panies
Corporates
Valuation of Financial Instruments
Capital Adequacy /RegulatoryReporting
ICAAP&Economic Capital
Calculation
Integrated andComprehensive
Risk Management
Model Building &Validation
Risk-adjustedPerformanceCalculations
NewProductProcess
Accounting &Disclosure of
Financial Instruments
Financial Risk Management
(FRM)
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