Presentation on Financial Risk Management Market Risk Treasury Operations

1. Presentation onFinancial Risk Management Market Risk Treasury Operations

2. Highlights of the Presentation • What is Market Risk and Basel II Approaches • Financial Markets • Structure, Transactions and Functions of Treasury • Risks and their Controls for Treasury Activities

3. Managing Risk Effectively: Three Critical Challenges Management Challenges for the 21st Century GLOBALISM TECHNOLOGY CHANGE

4. What is Risk? • Risk, in traditional terms, is viewed as a ‘negative’. Webster’s • dictionary, for instance, defines risk as “exposing to danger or hazard”. • The Chinese give a much better description of risk • >The first is the symbol for “danger”, while • >the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

5. Risk Management Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.

6. Risk Assessment • Assess your risk bearing capacity • How much risk can you tolerate? • How much risk protection can you afford? • How much risk are you willing to accept

7. Risk Management • Risk management integrates production, marketing & financial decisions • Risk management is a planning process where you assemble and assess information • Every management decision carries risk management implications

8. Risk Management Requires • Understanding of Your financial situation • Understanding sources of risk and potential risk • Understanding of risk management tools

9. Risk Management Includes: • Evaluation of alternative plans & risk management strategies • Implementation of the plan • Monitoring the plan • Developing probabilities to formalize risk assessment

10. Steps in theRisk Management Process • Determine the corporation’s objectives • Identify the risk exposures • Quantify the exposures • Assess the impact • Examine alternative risk management tools • Select appropriate risk management approach • Implement and monitor program

11. The Bottom Line:It All Boils Down to Capital • “Capital” • Assets less liabilities; owners’ equity; net worth • Support for (riskiness of) operations • Thus, supports profitability and solvency of firm • “Capital Management” • Determine need for and adequacy of capital • Plans for increasing or releasing capital • Strategy for efficient use of capital

12. Why Do We Care About Managing Capital? • Leads to solvency and profitability • Benefits of solidity and profitability • Higher company value • Happy shareholders • Better ratings • Less unfavorable regulatory treatment • Ability to price products competitively • Customer loyalty • Potentially lower costs

13. What Does Capital Management require? Product Pricing Raising Capital Financial Risk Mgt. Setting Objectives Capital Management Strategic Planning Risk Management Liability Valuation Asset Allocation

14. Role of Capital in Financial Institution • Absorb large unexpected losses • Protect depositors and other claim holders • Provide enough confidence to external investors and rating agencies on the financial heath and viability of the institution.

15. Type of Capital • Economic Capital (EC) or Risk Capital. An estimate of the level of capital that a firm requires to operate its business. • Regulatory Capital (RC). The capital that a bank is required to hold by regulators in order to operate. • Bank Capital (BC) The actual physical capital held

16. Economic Capital • Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution.

17. Financial Risk and Basel

18. BASEL-I Capital Calculation Basel I Principles • Strengthen the stability of the international banking system • Create minimum risk-based capital adequacy requirements Basel I Benefits • Relatively simple framework • Widely adopted • Increased banks’ capital Capital Capital Adequacy Ratio = CreditRisk+ Market Risk RIWAC

19. Core Capital (Tier 1) • Stock issues • Disclosed reserves • Loan loss reserves to cushion future losses or for smoothing out income volatility • 50% of total capital Capital (Tiers 1, 2, 3) ≥ 8% Risk-Weighted Assets and Contingents Supplementary Capital (Tier 2) • Perpetual securities • Unrealised gains on investment securities • Hybrid capital instruments • Long-term subordinated debt with maturity > 5 years Market risk Capital (Tier 3) • Short-term subordinated debt Basel I Regulatory Capital Rules Types of capital Basel I capital calculation

20. RIWACCalculation On-Balance Sheet x Counterparty Weighting + = RIWAC Off-Balance Sheet Risk x Counterparty Weighting x Credit Conversion Factor

21. RIWAC Weightings

22. BASEL I- RIWAC Examples Corporate XYZ Bank Lends USD 100 M to UAE Corporate for 1 year Capital = USD 100 M X 100% (Risk Weight) X 8% (Capital Adequacy) = USD 8 M Banks XYZ Bank Lends USD 100 M to Barclays Bank for 2 years Capital = USD 100 M X 20% (Risk Weight) X 8% (Capital Adequacy) = USD 1.6 M Contingents XYZ confirms Sight L/C of USD 100 M issued by ABN AMRO Capital = USD 100 M X 20% (Risk Weight) X 20% (CCF) X 8% (Capital Adequacy) = USD 0.32 M

23. Step 1: RWA = On BS exposure X Risk Weight Step 2: Capital = 8% X RWA Step 1: Credit Equivalent Amount (CEA) = Notional amount X Credit Conversion Factor Step 2: RWA = CEA X Risk Weight Step 3: Capital = 8% X RWA Basel I regulatory capital rules – Credit risk (1) On-balance sheet risk weights and Basel I capital calculation Off-balance sheet risk weights and Basel I capital calculation for non-trading assets

24. Step 1: Current Exposure (CE) = Current marked-to-market value of asset Step 2: Potential Future Exposure (PFE) = Notional amount X Credit Conversion Factor Step 3: Credit Equivalent Amount (CEA) = CE + PFE Step 4: RWA = CEA X Risk Weight Step 5: Capital = 8% X RWA Basel I regulatory capital rules – Credit risk (2) Off-balance sheet risk weights and Basel I capital calculation for trading assets

25. Criticisms of Basel I Accord Consequences in the industry • Lack of risk sensitivity of capital requirements • One-size-fits-all’ approach to risk management • Limited attention to credit risk mitigation • Over emphasis on minimum capital requirements • Exclusive focus on financial risk • Sub-optimal lending behavior • Increased divergence between regulatory capital and economic capital • Regulatory capital arbitrage through product innovation BASEL I- Draw Backs

26. Objectives “Basel II” • The objective of the New Basel Capital accord (“Basel II) is: • To promote safety and soundness in the financial system • To continue to enhance completive equality • To constitute a more comprehensive approach to addressing risks • To render capital adequacy more risk-sensitive • To provide incentives for banks to enhance their risk measurement capabilities

27. Comparison

28. Economic Objectives • Efficiency: best use of capital across business lines, impetus for risk based pricing and operational cost savings • Stability: ensure capital protection consistent with shareholder value optimization

29. Economic Objectives • Growth sustainability: balanced Portfolio risk and return • Equity: level competitive playing field across(big and small) banks

30. Overview of Basel II Pillars The new Basel Accord is comprised of ‘three pillars’… Pillar I Pillar II Pillar III • Minimum Capital Requirements • Establishes minimum standards for management of capital on a more risk sensitive basis: • Credit Risk • Operational Risk • Market Risk • Supervisory Review Process • Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: • Evaluate Bank’s Capital Adequacy Strategies • Certify Internal Models • Level of capital charge • Proactive monitoring of capital levels and ensuring remedial action Market Discipline Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks. Expands the content and improves the transparency of financial disclosures to the market.

31. Minimum capital requirements Supervisory review process Market disclosure • How is capital adequacy measured particularly for Advanced approaches? • How will supervisory bodies assess, monitor and ensure capital adequacy? • What and how should banks disclose to external parties? Issue • Better align regulatory capital with economic risk • Evolutionary approach to assessing credit risk • Standardised (external factors) • Foundation Internal Ratings Based (IRB) • Advanced IRB • Evolutionary approach to operational risk • Basic indicator • Standardised • Adv. Measurement • Internal process for assessing capital in relation to risk profile • Supervisors to review and evaluate banks’ internal processes • Supervisors to require banks to hold capital in excess of minimum to cover other risks, e.g. strategic risk • Supervisors seek to intervene and ensure compliance • Effective disclosure of: • Banks’ risk profiles • Adequacy of capital positions • Specific qualitative and quantitative disclosures • Scope of application • Composition of capital • Risk exposure assessment • Capital adequacy Principle Development of a revised capital adequacy framework Components of Basel II Objectives The three pillars of Basel II and their principles • Continue to promote safety and soundness in the banking system • Ensure capital adequacy is sensitive to the level of risks borne by banks • Constitute a more comprehensive approach to addressing risks • Continue to enhance competitive equality Basel II Pillar 1 Pillar 2 Pillar 3

32. Overview of Basel II Approaches (Pillar I) Approaches that can be followed in determination of Regulatory Capital under Basel II Basic Indicator Approach Score Card Operational Risk Capital Standardized Approach Loss Distribution Advanced Measurement Approach (AMA) Internal Modeling Total Regulatory Capital Credit Risk Capital Standardized Approach Foundation Internal Ratings Based (IRB) Advanced Standard Model Market Risk Capital Internal Model

33. The Three Pillars • The First Pillar - Minimum Capital Requirements • The Second Pillar - Supervisory Review Process • The Third Pillar - Market Discipline

34. Pillar 1 • Calculation of the total minimum capital requirements for credit, market and operational risk. • The minimum capital requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets.

36. RISK BASED SUPERVISION

37. BASEL II : CAPITAL CHARGE

38. Credit Risk • The standardized approach • The Internal Ratings-Based Approach • Foundation • Advanced

39. Ops Risk • The Basic Indicator Approach • The Standardised Approach • Advanced Measurement Approach

40. Market Risk Market • Potential loss in value from market risk factors • Primarily through trading, off balance sheet and on balance sheet items

41. Equity Risk Trading Risk Market Risk Interest Rate Risk Gap Risk Currency Risk Commodity Risk Transaction Risk Counterparty Risk Credit Risk Financial Risks Portfolio Concentration Risk Issuer Risk Liquidity Risk Operational Risk Regulatory Risk Human Factor Risk Types of financial risk

42. Market Risk under Basel II • Standardized Approach Building Block Approach: Capital charge captured separately for each risk and then summed. Trading book used for general and specific risk in interest and equities markets. Both trading and banking books are used for general risk in currency and commodities markets. • Internal Model VAR modeling:On daily basis and 99th percentile one-tailed confidence interval is to be used, 10days holding period.

43. Why the focus on Market Risk Management ? • Convergence of Economies • Easy and faster flow of information • Skill Enhancement • Increasing Market activity Leading to • Increased Volatility • Need for measuring and managing Market Risks • Regulatory focus • Profiting from Risk

44. Measure, Monitor & Manage – Value at Risk Value-at-Risk Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence VaR is denominated in units of a currency or as a percentage of portfolio holdings For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a daily value at risk of Rs. 5000- at a 99% confidence level, which means there is a 1/100 chance of the loss exceeding Rs. 5000/- considering no great paradigm shifts in the underlying factors. It is a probability of occurrence and hence is a statistical measure of risk exposure

45. Features of RMD VaR Model Yields Duration Incremental VaR Multiple Portfolios VaR Portfolio Optimization Variance- covariance Matrix Stop Loss Facility of multiple methods and portfolios in single model Return Analysis for aiding in trade-off For Identifying and isolating Risky and safe securities For picking up securities which gel well in the portfolio For aiding in cutting losses during volatile periods Helps in optimizing portfolio in the given set of constraints

46. Approaches to Market Risk Capital Calculation Choices • Standardized Approach Capital requirement is the sum of capital calculated for • Interest Rate Risk • Equity Price Risk • Foreign Exchange Risk • Commodity Price Risk • Internal Model Approach • Based on bank’s internal VaR models to quantify capital charge required

47. Financial Markets? • Money Market • Trade in funds denominated in local currency and operate under local regulations. • Commercial Banks, Central Banks, Large Corporations, Institutions and the Public at large (every checking A/c holder is a participant). • Money or near money is bought and sold • Purposes: Legal Requirement, Trading, Investment, and Customers Needs. • Statutory Liquidity Requirement (SLR) un-encumbered approved securities, which shall not be less then 19% of DL at the end of any business day. • Statutory Cash Reserve Requirement (CRR) 4% - 5% DL • Statutory Cash Reserve Requirement (CRR) 0% - 0% TL

48. Money Market • Transactions and Main Instruments; • Reverse Repo/ Repo and Call. • Treasury Bills • Federal Investment Bonds (FIBs) • Pakistan Investment Bonds (PIBs) • Certificates of Investment / Deposits (COIs or CODs) • Term Finance Certificates (TFCs)

49. Foreign Money Market • Foreign Inter-bank Placements • Commerz Bank AG Germany • Deutsche Bank AG Germany • Fortis Bank, Belgium • Placements with our overseas treasuries

50. Foreign Exchange Market • Two different currencies are exchanged for each other at certain mutually agreed rate. • Or paper denominated in a given currency is traded against paper denominated in another currency.