Risk Management in Emerging Markets

1. Risk Management in Emerging Markets BSCH Experience in Latin America Trinidad, February 2000

2. Risk Management in Emerging Markets • AGENDA • BSCH - Firmwide Risk Management • Risk Factors in Emerging Markets • Implemementing Market Risk Management in Emerging Markets • Summary

3. Risk Management in Emerging Markets • BSCH - Firmwide Risk Management • BSCH Mission • Risk Management Philosophy • Detailed Functions • Business and Risk Management Organization • Market Risk Management Group

4. Firmwide Risk Management BSCH Risk Management Mission ... The primary objective is to protect the capital of the firm, maximizing the return on the capital invested. Senior Management has assigned the Market Risk Function the responsibility to gather, analyze control and report the information regarding the market risk´s held by the firm in order to allow the risk takers, managers and other personnel to understand and make informed decisions regarding the management and control of risks taken.

5. Firmwide Risk Management BSCH Risk Management Philosophy ... • Independence from the Business Units • Support for Informed Business Decision-making • Local Expertise in Each Products • Flexible Policies Adaptable to Local Risks and Structures • Key Characteristics: • Countries • Global Products • Business Objectives • Maximized Return on Risk Adjusted Capital (RORAC); Reduced Risk Firm´s Directive : No surprises in unexpected losses

6. Firmwide Risk Management BSCH Risk Management Function ... • Ensure that business within the Firm do not expose the organization to unexpected losses that could threaten the financial stability. • Identify, analyze, measure and assess risk, with no surprises. • Establish risk management policies and procedures. • Monitor and Control Risk parameters and Management P&L. • Set new product development guidelines and inclusion of new exposures within the current framework. • Propose capital allocation and portfolio management methodologies.

7. Firmwide Risk Management BSCH Business Organization ... SECURITIES TRADING GROUP FUND MANAGMNT GROUP CORPORATE FINANCE GROUP EUROPE OFFICES OFFICES OFFICES AMERICAS OFFICES OFFICES OFFICES FUNCTIONAL MANAGEMENT ASIA PACIFIC OFFICES OFFICES OFFICES REGIONAL MANAGEMENT

8. Firmwide Risk Management Risk Management Mirrors the Business Sr Management By Country Risk Aooetite By Risk Taker Trading/ALM PROPOSAL GLOBAL: RISK COMMITTEE APPROVAL GLOBAL MARKET RISK MINIMUM REQUIRED CAPITAL Sens MVE Sens NIM Gap Concentration LOCAL: ALCOCOMMITTEE Risk Apetite by Local Sr. Management Global Limits Distribution Sublimits by Business Lines LOCAL MARKET RISK BALANCE VarD Loss Trigger Stop Loss Greeks Vol Eq,... NEGOCIACIÓN

9. Firmwide Risk Management Risk Management Organization Global Head of Risk Management Global Market Risk Corp./Cpty Risk Credit RORAC Commercial Banking CRMG Regional Coordinator Market Risk Control Methodology and Infrastructure Capital Markets/ Structured Products RORAC … the ultimate responsible for Risk Management is the Chairman of the Firm

10. Firmwide Risk Management The Risk Management Landscape: Trading Book Banking Book Global Structural Products • Price Risk • Liquidity Risk • Credit Risk • Settlement Risk • Operational Risk • Legal Risk Loss in market value of a position Inability to unwind a position/meet payment obligations Loss due to inability of counterparty to perform legal commintment Risk of no receiving funds/instruments at the expected time Loss due to execution error Risk that contracts are not legally enforceable or documented correctly

11. Global Market Risk Group. Underlying Principles Global Market Risk Principles... • Independence from the Business Areas • Mirror the business structure in the organization of the market risk function. • Help to Managedein a global view the Price and Liquidity Risks for the different portfolios like Trading, Investment, ALM ... • Identify and measure the Risk effect in the economic value of the Balance Sheet  Assign the economic capital in a homogeneous and consistent way. • Measure the risk from an economic perspectiveindependent from accounting effects  The accounting effect is another variable that affects the economic capital.

12. Global Market Risk Group. Process Global Market Risk Process... Business Capital Allocation NO Take Risk? Risk Identification Risk Estimated Analysis of Portfolios P&L Measurement SI Risk Measurement Information and Control Policies Aprovals Measures Committees Methodologies Valuation Measurement Limits Global Local Reports Daily Weekly Monthly Eficiency Measures Numerical: RORAC Cualitative: ALCO Committee

13. Global Market Risk Group. Process Breaking down the risks... • … Along different dimensions: • Risk type - Interest Rate, FX, Equity, Commodity, Other (Basis, Vol, ...) • … to identify: • Risk Concentrations - whether large risks are due to size/nature of the position • Diversification Benefits - Risk is not additive - Total risk is less that the sum of the parts • Opportunities • … and apply synergies from different business units: • Analysis (Valuation, Risk Measurement) • Information Technology (Intratet, Databases, Development) • Management Information Systems Flexible risk analysis and reporting us essential !!!

14. Global Market Risk Group. Process Market Risk Methodologies Static measures (FX, Equity exposure), IR sensitivity, Gap analysis, Greeks. VaR (Correlation) Scenarios from a Normalize market environment VaR (Monte Carlo) Scenarios from historical returns VaR (Historical Simulation), Ad-hoc scenarios, MaxVaR, Marginal VaR Scenarios set in a complete social, political and economic context • PARAMETRIC: • MONTECARLO SIMULATION: • HISTORICAL SIMULATION: • STRESS TEST/ SCENARIO ANAL: • EVENT RISK ANALYSIS

15. Global Market Risk Group. Process The Risk Management Group Should do more than just control... • Evaluate Risk/Return • Explore the exposures in a flexible way to identify Key Risk Sources / Concentrations • Report your risk flexibly to deliver the right amount of detail • Experiment with alternative strategies THE RISK MANAGEMENT GROUP SHOULD PLAY AN ACTIVE DECISION-MAKING ROLE

16. Local Market Risk Committee Global Delegated Risk Committee Global Market Risk Committee Local ALCO Local Market Risk Function Global / Local Market Risk Interaction • Local Market Risk Unit provides local control and local product expertise • Global Market Risk Areas (e.g., Technology, Quantitative Analysis) provide specific support services • Global Market Risk Unit is fully informed of all local Market Risk decisions • Requests for limits are coordinated by local Market Risk Function and forwarded to the Global Team for review and approval Global Proposals Approvals Local

17. Local Market Risk Function Key Elements: Local Presence • Determine and Apply the Methodologies of: • Portfolio Valuation • Risk Measurement • Identify, Measure and Analyze all Market Risks • Management (MTM) P&L: • Define the valuation criteria • Implement Global models • Propose and Control of all Market Risks Limits • Fulfil the Market Risk Policies • Adapt the Recommendations of: • Local Regulators • Central Banks Look for Efficiency: Act where the Risk arises OBJETIVE: • REINFORCE THE LOCAL UNIT ROLE • CREATE A GLOBAL RISK CULTURE

18. Risk Management in Emerging Markets • Risk Factors in Emerging Markets • Fixed Income Products • Local and International Equities • Foreign Exchange

19. Fixed Income Products • Local & External Debt: Brady, Eurobond, Govt • There is no homogeneous Country Yield curve • There is almost no country with the same structure of local FI markets • There are almost no mechanisms to arbitrage/hedge the local curves • Different measures quote bonds that create inefficiencies: • Sobretasa (Mex), Nominal-Real curve (Chile,Mex,Col) • Amortising/Capitalising Debt (Argentina), 15 day - 20 year 5 quote YC (Chile) • Business-days daycount (Brazil), Survey YC quotes (Peru) • Stripped Yield, Blended Yield, IR Duration, Stripped Duration • The products are driven by exogenous factors (liquidity, investors, …) • Limited repo market, almost no short sales (except synthetic products)

20. Local and International Equities • Equities: Betas? Correlation? Liquidity? • The Liquidity in the market is far below the Developed markets (see table) • The Market Valuations are not comparable with Developed Markets (see table) • Volatility needs to be measured in local and US dollar returns • Correlation has limited effect and may be volatile • The CAPM model needs to be adjusted … but how? • Proxy assignment?? How? • There is still a chance … the ADR and GDR market

21. Foreign Exchange Markets • FX: Is the history reliable? • Most EM countries have experienced FX control regimes (bands, fixed rate) • The last five years has witnessed the change in those controls, with important adjustments in the FX rate. • Volatility changes considering the historical period. • Correlation has limited effect between currencies and may be volatile • Macroeconomic models are not reliable to measure the timing of a FX crisis

22. Risk Management in Emerging Markets • Implementing Market Risk Management • in Emerging Markets • Risk Management tools for Latin America • IADB - BSCH Project

23. Risk Management tools for Latin America Risk Management in Latin America • Markets are illiquid, with an absence of financial benchmarks for valuation and risk measurement. • Some countries trade with a fixed or captive FX market. • There are serious limitations with time series, being unable to compute reliable volatilties and correlations. • Some local products have unique characteristics. • There is a limited investment in IT systems and valuation tools. • Difficult to find qualified professionals in Risk Management, which stresses the need to increase training in the Risk Management arena.

24. Risk Management tools for Latin America In Emerging Markets the numerical measures are just the begining ... • Markets without memory • Very Illiquid • Risk Factors not measurable • Mix of Price/Liquidity & Credit Risk • The Models are unable to reflect the extreme cases Additional Qualitative Measures • QUALITATIVE • CONTINGENCY PLANS • NON MEASURABLE FACTORS • DETAILLED KNOWLEDGE OF POSITIONS AND • MARKETS • CONTINUOUS COMMUNICATION BUSINESS/RISKS • CUANTITATIVE • BACKTESTING • STRESS TEST • ESCENARIOS NUMERICAL RESULTS MARKET RISK MANAGEMENT DISCUSSION ARENA: ALCO COMMITTEE

25. BSCH Market Risk Profile in Latin America TOTAL PORTFOLIO Management P&L vs Value at Risk (VaR)

26. IADB - BSCH Project Starting point: BS Chile - BS PerúMarket Risk Model Proposal • Common Issues • Both are companies within BSCH, with a common culture in Risk Management and Control • Have a previous Risk Management and Control model • Control has Independence from the Business group • Past Culture in IR Gaps • Employ Market Risk methodologies, although not • Absence of an integrated system solution • Problems with the MIS system, procedures and training

27. IADB - BSCH Project Differences and Strategies BS Chile BS Perú Differences Low Liquidity Market Medium Liquidity 8.000 MM USD (2º) 1.000 MM USD (7º) Total Assets 15 years 3 years In BSCH for Strategy Creation of the Market Risk group Organizational Structure Minor changes in functions & committees Market Variables Market data captured daily Data estimation Information Systems GlobalRisk Implementarion Customized application

28. IADB - BSCH Project Market Risk model proposed: Determine the criteria to take risk Limit Structure Implementation Organization Policies Procedures Methodologies Systems Controls Training Decision Making Process Risk Management Análisis y Evaluación de los Riesgos Existentes Risk Analysis Control del perfil de Riesgo Risk Control M.I.S. P&L Behaviour vs Risk Taken Performance Measurement

29. Risk Management in Emerging Markets Summary

30. IADB - BSCH Project Risk Management Project - Key Factors for Success • Country Analysis • Clear determination of Goals • Compromise from Local Senior Management • Total commitment from the key departments • Personalized solutions for each market/financial institution • Training and Mentoring the local personnel

31. IADB - BSCH Project … But always be careful with ... • Liquidity and Market environment • Discontinuities in prices • Market Depth and characteristics • Model Risk • Training and Human Resources conflicts • Regulatory Issues

32. Summary - Risk Management in Emerging Markets The Management Tool goes Beyond VaR Market Risk goes Beyond Risk Measurement OBJETIVES: Short Term - No surprises to unexpected losses Long Term Achieve an Efficient Managemnt of the Firm´s Capital Policies and Procedures Limit Structure Methodology CAPITAL Control and Reporting Measurement and Valuation Tools Infraestructure and Systems

33. Risk Management in Emerging Markets • Annex - Graphs for • External Interest Rate Risk • Internal/Local Interest Rate Risk • Equity Risk • Foreign Exchange Risk

34. Fixed Income Products

35. Fixed Income Products

36. Fixed Income Products • Long Term Interest Rates Behaviour

37. Fixed Income Products • Long Term Interest Rates Behaviour

38. Fixed Income Products

39. Local and International Equities

40. Local and International Equities Indices expresados en base $USD. Punto referencia 1 Enero 97.

41. Local and International Equities Indices expresados en base $USD. Punto referencia 1 Enero 97.

42. Foreign Exchange Markets

43. Foreign Exchange Markets