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Banking and Trading Book Integrated Risk Management

Banking and Trading Book Integrated Risk Management. David Brathwaite, CFA Bill Collette. Objectives. To provide an Asset Liability Management View of Integrated Risk Management To Provide a Theoretical View of Integrated Risk Management

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Banking and Trading Book Integrated Risk Management

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  1. Banking and Trading Book Integrated Risk Management David Brathwaite, CFA Bill Collette

  2. Objectives • To provide an Asset Liability Management View of Integrated Risk Management • To Provide a Theoretical View of Integrated Risk Management • To Present a Proven Solution Set which Achieves Integrated Risk Management

  3. Agenda • Background • Best Practise Techniques • Risk Profile • Integrated Risk Management • SunGard’s Integrated Solution • Questions and Answers David Brathwaite Bill Collette

  4. Agenda • Background • Best Practise Techniques • Risk Profile • Integrated Risk Management • SunGard’s Integrated Solution • Questions and Answers

  5. Why Asset/Liability Management? • Increased regulatory requirements • Better understanding of risks inherent in the Balance Sheet • Capacity to advance beyond Gap Analysis and Net Interest Income Simulation • Find opportunities and avoid pitfalls

  6. Introduction- ALM & Risk Management • 1960/70’s - Treasury Management • Treasury/Dealer Responsibility - No Centralised Risk Management • Little or No Competition for Financial Institutions • 6:3:3 Risk Management Process, GAP & Stable Deposit Base • 1980/90’s Asset/Liability Management • Globalisation & Bank Centralisation/Focus of Risk Management • Income Simulation, Economic Value of Equity, VaR/Total Return • Increasing Competition for Financial Institutions

  7. Introduction- ALM & Risk Management • The Next Millennium - 2000’s A/L Management • ALM Risk Focus on Behaviour Risk Analysis Not Client/Product Contractual Dates - Optionality Accounting • Integrated - Enterprise-wide Risk Management • Total Return FAS 133 Risk Accounting/Measurement • Total Competition in the Financial Markets • Financial Institutions, As We Know Them, Disappear

  8. ALM: In the Beginning • Development of ALM • Stable Rates and Generous Margins • Regulatory Requirements Focus • Cost Center Then Business Unit Ethos • Centralised & Isolated Process From Business Units

  9. ALM: Today’s Priority High Impact Managerial Process • Measurement and Management of Potential Loss • Value at Risk • Limits: Positions and Potential Losses • Stoploss • Capital At Risk Management • Pro-active ALCO • Integrated Risk Management • Credit • Operations • Legal • Liquidity • Interest Rate • Exchange Rate

  10. Risk Silos or Firm Wide Risk Management • Market Risks • Liquidity Risk • Interest Rate Risk • Currency/Commodity Risk • Correlation Risk • Price/Position Risk & Trading Book VaR • Equity Risk • Business/Strategic Risk • The Interface with Planning, Budgeting & Strategy • Credit Portfolio & Portfolio Concentration Risk • Operational Risk

  11. Risk/Reward - The Process • Therefore There Is a Simple Process: • Establish the Strategic Aims of the Institution • Risk Identification - Via Risk Profiling Exercises • Segment Market, Operational & Business Risk Groups - Via Transfer Pricing and Re-engineering/re-organisation of the Institution • Measure - Using Traditional and More Modern ALM Techniques • Monitor - a General Technique of Traditional and Modern Management Methods • Calculate Capital at Risk - Via Risk Adjusted Performance Measures (RAPM’s) • Measure Risk/reward Performance - Return on Equity, Risk Adjusted Return on Capital Etc. • Operationally, Do the Business/provide the Institution’s Services • Provide Benefits to Shareholders, Clients & Employees - Via Incentive Schemes

  12. Balance Steering Oversight Brakes Reverse Positions Within the Cone? Management Board Decision Concurrence Compliance Cashflow Support Substance Size Being Information Management & Processing Business Unit Business Unit Business Unit Business Unit Business Unit Business Unit Business Unit Business Unit

  13. The ALM Solution ALCO Management, Regulatory Reporting, Cost Allocation and Pro-forma FTP Advanced Risk Management and Analytics Asset/Liability Management Financial Planning and Forecasting Data Transformation and Management Existing Internal Source Systems

  14. Where Are You on the Risk Reporting Continuum? OAV (Total Return Analysis) RAROC Historical/Future FTP Monte Carlo Simulation VaR Multiple Income Simulation Balance Sheet & Derivatives Support Multiple Simulation Budget & Forecasting Basic Income Simulation - Single/Multi Currency Duration Gap Reporting Regulatory Returns Complex Regulatory Minimum? Medium Benefit Minimal

  15. Agenda • Background • Best Practise Techniques • Risk Profile • Integrated Risk Management • SunGard’s Integrated Solution • Questions and Answers

  16. ALM Techniques & Methods • GAP Analysis • Maturity Structure, Repricing & Fx Positions • Duration Analysis • Price Sensitivity, Immunisation • Scenario Analysis / Simulation • Net Margin, Effect of New Business • Market Valuation & Trade Analytics - • Economic Value of Equity • Embedded Options, US Market, Mainly MBS’s • Option Adjusted Value at Risk • Integrated All Above, Including Behaviour Optionality • Total Return Analysis - Institution Wide

  17. Sources of Risk Direct: Reprice Term Mismatch Indirect: Optionality Prepayments Deposits Risk Measurement Standard Net Interest Income Market Value  Capital Interest Rate Sensitivity Potential and Sustainable Losses Interest Rate Risk

  18. Measurement Methods Static Analysis Gap Duration Dynamic Analysis Simulation Interest Rate Risk: Measurement

  19. Gap Analysis: • Maturity Structure, Repricing Gap, Liquidity Gap • Starting Point • Based on the first reprice moment • Time Bands • Gap(t) = Asset(t) - Liability(t) • NII analysis tool

  20. Gap • The Simplest But Least Accurate Tool • Short Term, One Point in Time, Static, No Reflection of Future Changes • Records Balances (Par Values) Not Cashflows • Principle Balances Unaffected by Interest Rate Changes • Arbitrary Repricing Buckets/intervals • Indicates a Nominal Risk Amount Rather Than Income or Capital at Risk • Misleading Results With Amortising & Leases • Rate Shock Calculations Are Parallel & Totally Misleading • Totally Ignores Basis Risk & Optionality of A/l’s

  21. Duration Analysis to DVBP/PVBPPrice Sensitivity, Immunisation • Ideal for Bond Type Instruments With Fixed Cashflows • The Majority of a Financial Institution's A/L’s Are Not Bond Type in Nature • Difficulties Coping With Embedded Optionality • Rate Shocks Suffer From Convexity Errors • An Important Calculation But Not The End Measurement Method

  22. Simulation/Scenario Analysis to MVPE/EVENet Margin, Run-off & Effect of New Business • Dynamic • Models Future Balance Sheet • Models Optionality Characteristics • Prepayments • Deposits • Term Structure of Interest Rates • Asset/liability Mix • Hedge Strategies • Simulates Gaps and Durations Under Different Scenarios

  23. Monte Carlo Simulation • A Statistical Technique to Generate a Large Number of Random Variables Such As Interest Rate Paths • Eliminates Single Point Estimates and Allows Real “What-if?” Capabilities • Define a Stochastic Process for Any Assumption Be It an Interest Rate Scenario, Prepayment, or Future Business Assumptions • User-defined Number Of Trials. • User-defined Volatility • Correlation Of Assumptions • Sensitivity Analysis Ranks Assumptions According To Importance • Real Time Graphics • Full Range Of Graphics And Statistics

  24. Agenda • Background • Best Practise Techniques • Risk Profile • Integrated Risk Management • SunGard’s Integrated Solution • Questions and Answers

  25. Risk Management Profile V@R Market Interest Rate Liquidity Income Retail Banking Fund Management Credit Behavior Corporate Banking Wholesale Bank Operational Banking Book Trading Book

  26. Risk Management Profile V@R Market Interest Rate Liquidity Income Retail Banking Fund Management Credit Behavior Corporate Banking Wealth Management Operational

  27. Cashflow Catalysts Cash Attrition FX deals Credit Cards/cheques Funds Drawdowns/ Rollovers New business Settlements

  28. Risk Management Profile Report Report Report Report V@R V@R V@R Market Market Market V@R Market V@R Market Report Interest Rate Interest Rate Liquidity Liquidity Liquidity Liquidity Income Income Income Report Interest Rate Liquidity Report Report Report Income Private Banking Private Banking Fund Management Credit Credit Credit Credit Report Report Behavior Report Behavior Corporate Banking Asset Management Wealth Management Wealth Management Operational Operational Operational Report Report Operational Report Report Report

  29. What’s driving the Banking Book/Trading Book? Large/Small Transaction Volumes Simple/Complex Instruments Any Bank Small/Large Cashflow Implications Long/Short Term Re-Pricing

  30. Consider • Is Integrated Risk Management • a technology issue • a software issue • a risk management methodology issue • a strategic Board level issue • or a combination of the above?? • Integrated Risk Management should not be a “source system” issue but a unification process which recognises that source systems and their environments can, and will, change over time

  31. Consider • Risk Management procedures vary vastly from institution to institution as well as the available data and environments • This implies Integrated Risk Management will be both expensive and time consuming • Therefore, Integrated Risk Management MUST be custom made according to the institution’s requirements

  32. Agenda • Background • Best Practise Techniques • Risk Profile • Integrated Risk Management • SunGard’s Integrated Solution • Questions and Answers

  33. Where does ERM fit it? Interest Rate Credit 1 Long/Short Term Re-Pricing Market Operational Enterprise Risk Management

  34. ABC Bank Finance Environment: Online Applications Financial Analysis & Reporting Before ERM Liquidity DDA’S CDs M.I.S. & E.I.S. IRAs Planning & Forecasting C/L Transactions Interest Rate Risk Analysis All Loans Corporate Profitability Measurement Bank Card Trades V@R Bonds/ Equities

  35. ABC Bank Finance Environment: Online Applications Financial Analysis & Reporting After ERM Liquidity DDA’S • ERM • Common Rate Assumptions/Yield Curves • Shared Current Position • PLUS • F.T.P. • Datawarehouse CDs M.I.S. & E.I.S. IRAs E-W Market Risk Measurement C/L Transactions Credit Limit Measurement All Loans Corporate Profitability Planning Bank Card Trades Enterprise-wide V@R Bonds/ Equities

  36. Techniques Applied • TRADING BOOK • Instruments • Bonds & Equities • Equity Derivatives • Forwards • Futures • Options • IR Derivatives (FRA, swaps, futures, swaptions) • Currency Derivatives (FRA, futures, swaps, options) • Precious Metals derivatives (forward, future, options) • Guarantees • BANKING BOOK : • Instruments • Loans • Mortgages • Checking Accounts • Savings Off and On Balance Sheet BEHAVIOR : Data Coupon Spread Seasoning Seasonality Burnout Complex mathematical equations and algorithms

  37. Problems BANKING BOOK Long term Simple instruments Higher volume Smaller cash flows Rate Assumption “B” Risk Methodology “2” No Common Business Volume Plan TRADING BOOK Short term Complex instruments Smaller volume Large cash flows Rate Assumption “A” Risk Methodology “1”

  38. Solution Overview Market Risk A/LM Balance Sheet Market Data Trading Portfolio Data Repository • Shared Current Position • Common Rate Assumptions Cash Flows for EW V@R, HS V@R Analysis

  39. Strategy • The global financial institution needs to achieve the same process that has evolved in the trading arena - e.g. STP combination of front, middle and back offices • Equalise the Micro risk management of the trading book with the Macro risk management of the retail banking book • Equalise the use of financial engineering and behaviour analysis across the trading and banking books

  40. Strategy • REPORTING • Enterprise-Wide V@R • HS V@R • Liquidity • Regulatory • Market Value of Equity • Effective Duration/Delta • Income Simulation • Option Adjust Spread Analysis

  41. Agenda • Background • Best Practise Techniques • Risk Profile • Integrated Risk Management • SunGard’s Integrated Solution • Questions and Answers

  42. SunGard • Listed on the New York Stock Exchange (symbol:SDS) • 16th Largest Information Services Firm • Market Cap US $ 4,8B and 1999 Revenues US $ 1.3B • Portfolio of focused products for financial institutions including the • Over 7000 employees • Handles 70% of Nasdaq trades - Mangage over $7trillion in investment funds • SunGard Trading and Risk Systems • Product Group for Risk Management • BancWare: Asset and Liability Management, Financial Forecasting & Planning, and Funds Transfer Pricing • Infinity & Panorama: Real Time Portfolio Management, Market, Credit Risk, Straight Through Processing & BackOffice • Collateral: Credit Risk Mitigation • Credient: Credit Limit Monitoring

  43. Agenda 1 Enterprise Risk Management Which Risks? Enterprise Risk Management Integrating the Trading and Banking Books - Yes or No? 2 Asset Liability Management What capabilities should be provided? 3 Trading and Risk Management What capabilities should be provided? 4 Integration of Risk Achieving Enterprise Risk - Sample Integration 5 Discussion Questions and comments 6

  44. Enterprise Risk Management Risk Analysis Risk Dimension Currency Risk Interest Rate Risk Product Coverage Market Risk Counterparty Risk Credit Operational Risk Product Dimension Trading Balance Sheet Bonds, Equities, Swaps, Options, FRA’s Mortgages, Demand Deposits, CD’s, Loans etc.

  45. Integrated Risk Management Financial Balance Sheet Trading Book Liability IR-, Position-, FX-Risk Investment Book Capital Currency Risk Interest Rate Risk • Both the Trading Books and Banking Book have Interest Rate and FX Risk • The trading book and the banking book need a different approach and different systems

  46. Why have ALM and Trading Risk Systems? The trading book and the banking book need a different approach and different systems • BANKING BOOK • Frequency: weeks or months • Instruments:deposits, loans, ... • Goal: long term stability • Strategic Management • Buy and Hold Portfolio • Earnings at Risk • Profitability Analysis • TRADING BOOK • Frequency: hours or days • Instruments: equities, bonds, … • Goal: short term gains • P&L focused • Trading Strategies and Desk level Risk • Limits on Trading and Exposures Accurate methodology & systems Accurate methodology & systems …so we need to put two different systems together for an overall overview

  47. Techniques Applied Convergence of both risk systems for an overall risk view • BANKING BOOK : • ALM & FTP • Repricing Balance Sheet • Market Values • Sensitivities, EaR, VaR • Modelling of non maturing accounts • Funds Transfer Pricing • Budgeting & Forecasting • GAP Analysis • Behavior Modeling • ... • TRADING BOOK • Market & Credit Risk • Market Valuation • Trading, STP • Sensitivities, Hedging • Market and Credit VaR • Exposure & Limits Management • P & L Analysis • Return on Capital • Stress Testing • …. Interest Rates, FX Rates Managing Risk

  48. Solution Overview ALM Market Balance Sheet Market Data Trading Portfolio Current Position Data • Long Holding Period • Impact of New Business • Income Simulation • Transfer Pricing • Balance Sheet Valuation • Total Return Analysis • Short Holding Period • Valuation and VAR • Exposure • Benchmarking • Shared Current Position • Common Rate Assumptions Cash Flows for VAR Analysis • Essential Outputs • Asset Liability Management • Comprehensive Planning • Profitability Measurement • Essential Outputs • Enterprise Wide Market Risk Management • Credit Limit Management

  49. ALM Analysis Overview • Focus on Risk In Banking Business • Mark to Market Less Relevant • Net Interest Income Exposure • Repricing • Customer Options • Market Value Sensitivity - Used as Indicator of Earnings Exposure

  50. ALM - Gap Analysis • Interpretation

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