MARKET & LIQUIDITY RISK

MANAGEMENT
Overview
What is Risk?
What is Risk Management?
Why Risk Management?
Different Types of Risk
Market Risk
Liquidity Risk
BASEL II Accord
Tools to manage risk
Career prospects in Risk Management
What is risk?
It is the potential that events expected or unexpected,
may have an adverse effect on a financial institution’s
capital or earnings.

Risk is the possibility that an uncertain outcome

/event might have undesirable consequence

Risk is the exposure to a potential loss or reduction in

income
What is risk?
Risk is inherent in all business and financial activities.

The greater the RISK associated with an activity the

greater potential to generate a high return.

Banks do take RISKS – The biggest RISK is Not

Taking A RISK.
Characteristics of Risk
Risk must be:
 Known
 Understood
 Quantifiable
 Controllable / Acceptable /Bankable
 Characteristics of Risk
Risk cannot be eliminated
Risk can be minimized
High risk high return!!!
Low risk low return!!!
How to manage risks?
There are four ways of dealing with, or managing,
each risk that you have identified.
 You can: Accept it; Transfer it; Reduce it;
Eliminate it.
You may decide to accept a risk because the cost of
eliminating it completely is too high.
You might decide to transfer the risk, which is
typically done with insurance.
Or you may be able to reduce the risk by introducing
new safety measures
Or eliminate it completely by changing the way you
produce your product
What is Risk Management?
Henry Ford once said.

“Keep all your eggs in one basket?”

RIGHT OR WRONG?
What is Risk Management?
“DIVERSIFICATION”

Risk Management is the process of measuring or

quantifying risk and then developing strategies to
eliminate or reduce losses.
What is Risk Management?
Risk Management is the process of identifying,

measuring, monitoring and controlling risks

It is comprehensive process adopted by an organization

that seeks to minimize the adverse effects it is exposed

to due to various factors -- economic, political or
environmental… some of them inherent to the
business, others unforeseen and unexpected.
What is Risk Management?
Familiarisation of Management with Risks
Implementation of Internal Controls
Sound Internal Audit System
Efficient MIS in Place
Competent Group of Risk Managers
Prompt Action & Monitoring
Why risk management?
Crisis of financial industry in 1990’s, e.g., LTCM,
Barings bank
Learning from Past Experiences
How should Financial industry behave?
Looking back into the Past:
Long Term Capital Management (LTCM)
Barings Bank
Society Gen
Long Term Capital Management
The Team : John Meriwether, Myron Scholes and
Robert Merton (Nobel-prize winning economists), David
Mullen (a former vice-chairman of the Federal Reserve)
Minimum Investment: $ 10 Million.
Clients: The Who’s who of international financial sector.
The Financials: Equity of $4 billion, borrowings $ 125
billion, Exposure $ 1.25 Trillion
The Strategy: Convergence Trades in sovereigns
The Cause: Russian Sovereign Default and Flight to
liquidity
LTCM -Lessons
 Systemic Risk:
 Market values matter
 Liquidity risk is itself a factor
 Models must be stress-tested and combined
with judgment
 Financial institutions must aggregate exposures
to common risk factors
Barings Bank
A Bank with 223 year old history.
The Culprit: Nick Leeson (General Manager of Barings
Futures subsidiary in Singapore)
The Strategy: Straddling, High risk options
Trading at SIMEX, NIKKEI 225 Index.
The Loss: $ 1 Billion
The Cause: Fraud, Lack of internal controls.
The After math: Bank defaulted and sold of.
Can u guess the price?
BARINGS BANK: LESSONS
Lack of internal checks and balances
Even when segregation of duties was suggested by
internal audit, the concentration of power in the
Leeson's hands was scarcely diluted.
Lack of understanding of the business
Lack of a clear reporting line
Society Generale
France's Société Générale, one of Europe's biggest
banks and a global superstar in the booming
derivatives-trading business
A staggering $7.1 billion loss from rogue
trading by a single employee, Jerome Kerviel, the
Culprit
The trader "had taken massive fraudulent directional
positions"—bets on future movements of European
stock indexes—without his supervisors' knowledge
Society Generale
he had previously worked in the trading unit's back
office, he had "in-depth knowledge of the control
procedures" and evaded them by creating fictitious
transactions to conceal his activity.
His intention was not to drown the bank in to that
great loss. He wanted to make profit for the bank and
to cover up the loss, he took different positions in the
DAX (German Stock Market Index), but those
positions results in a huge loss of 7.1 Bio for the
bank.
Societe Generale – LESSONS:
Lack of IT Controls
Poor supervision/monitoring of higher management
A person with strong back office knowledge, even
who knows the flaws, should not be allowed to make
front office deals
Dealer should not cross its assigned limit.
Banking and Risk

Banking is an art of striking a balance

between Risk and Revenue.”

[Swiss Banking Corporation’s Credit Manual]

Banking and Risk
Banking is all about taking risk.
Banks take one person’s (depositor) money and lend
to someone else (borrower) to earn profit for itself
and the depositors.
All functions in banks are there to take risk.
Major Risks
Market Risk
 Operational Risk
 Credit Risk
Market Risk
“It is the risk that the value of on and off-balance
sheet positions of a financial institution will be
adversely affected by movements in market rates or
prices such as interest rates, foreign exchange, equity
prices, credit spreads and/or commodity prices
resulting in a loss of earnings and capital.”
Market Risk
Types of Market Risk

 Interest Rate Risk

 Foreign Exchange Risk
 Equity Price Risk
 Liquidity Risk
Market Risk
Interest Rate Risk

“ Interest Rate Risk arises when there is a mismatch

between positions, which are subject to interest
rate adjustment within a specified period.”

The bank’s lending, funding and investment

activities give rise to interest rate risk.
Market Risk
Interest Rate Risk…..Continued

Accepting this risk is the ‘bread and butter’ of

banking and is an important source of profitability
and shareholder’s value if managed properly.
Uncalculated and imprudently managed interest
rate risk can erode bank’s earning and capital base.
Market Risk
Sources of Interest Rate Risk
Re-pricing Risk
Arises out of timing difference in the maturity (for fixed RSAs
& RSLs) and re-pricing (for floating RSAs & RSLs) of bank’s
assets, liabilities and off-balance sheet items.
Basis Risk
Imperfect correlation in the adjustment of the rates earned
and paid on different instruments with otherwise similar re-
pricing characteristics.
Market Risk
Sources of Interest Rate Risk
Yield Curve / yield curve twist risk
Changes in the slope and shape of yield curve.
Disproportionate change in the interest rates of different
tenors. (weighted av. duration of a portfolio)
Option Risk
Option to prepay or other embedded options in the assets or
liability based products or OBS portfolio.
Market Risk
Effects of Interest Rate Risk
Changes in interest rate can have adverse effect both on
a bank’s earnings and its economic value

Earning Perspective
 Focus is on the ‘accounting’ or reported earning.
 Advantages: affect on ‘earning’ which is well understood and
objective.
 Disadvantages: focuses only on the near term effects of
changes in the interest rate
Market Risk
Effects of Interest Rate Risk
Economic Value Perspective
 Variation in market interest rates can also affect the economic
value of bank’s assets and liabilities.
 Represents assessment of PV of its expected net cash flows.

 Provides a more comprehensive view of the potential long term

effects of changes in IR.

 Reflects sensitivity across full spectrum of maturity but relies

on a number of subjective assessment factors.

Foreign Exchange Risk
It is the risk arising from the fluctuation in the
denomination of local currency to foreign currencies.
Equity Price Risk
Equity Price Risk is the risk to earnings or capital that
results from adverse changes in the value of equity
related portfolios of NBP.
Price risk associated with equities could be systematic
or unsystematic. The former refers to sensitivity of
portfolio’s value to changes in overall level of equity
prices, while the later is associated with price volatility
that is determined by firm specific characteristics.”
Liquidity Risk
Risk of being unable to meet claims/financial
obligations ‘without financial impairment
Basel-II Defines as:
“Potential for loss to an institution arising from either
its inability to meet its obligation or to fund increase
in assets as they fall due without incurring
unacceptable cost or losses”
BASED ON MARKET CONDITIONS &
PERCEPTIONS
Liquidity Risk
Defining the liquidity
Maturity Profile Versus Cash flow statement
Assumption regarding behavior of deposits and
advances.
Risk of assumptions going wrong
Liquidity Risk
Managing Liquidity Risk

Holding excess liquidity – needs to be contrasted

against the profits from asset transformation.
Diversifying the deposit base: leads to improved
predictability.
Retail Vs. Corporate deposits!!
Importance of Money market instruments and
developed money market.
Contingency funding line and cost
Risk Management and Basel II
 Revised Basel Framework in June 2004 (B2:
Three Pillars Approach)
 To bring harmony in banking system
 Covers all the factors of risks inherent in
banking industry
 Investors/depositors will know the banks
credibility
 Deadlines set forth by State Bank Of Pakistan
Basel II
Emphasis on focused risk management
Encouragement towards improving Bank’s risk
assessment capabilities.
Capital Requirement for Market Risk remains the
same as envisaged under Basel-I in 1996
Basel II
The Framework
Pillar 1: Minimum Capital Requirement.
Same for Market Risk as in Basel-I
Standard Approach and Internal Model Approach
Calculated for Interest Rate Risk in Trading Book
Specific Risk, General Market Risk, Equity Risk,
FX Risk, Options Risk
Defining Trading and Banking Book
Trading Book
For the purposes of capital adequacy, that part of a
bank's business which broadly involves its trading
department(FX, MM, Equity)

The portfolio of financial instruments held by a brokerage or

bank. The financial instruments in the trading book are
purchased or sold to facilitate trading for their customers, to
profit from spreads between the bid/ask spread, or to hedge
against various types of risk.
Defining Trading and Banking Book
Banking Book
For the purposes of capital adequacy, that part of a
bank's business which broadly involves its lending
department and long-term investments.

An accounting book that includes all securities that are

not actively traded by the institution, that are meant to
be held until they mature. These securities are
accounted for in a different way than those in the
trading book, which are traded on the market and
valued by the performance of the market.
Basel II
The Framework
Pillar 2: Supervisory Review.
Also covers risk which are not covered under pillar 1. i.e.
Liquidity Risk, Concentration Risk, Interest Rate Risk in
Banking Book
Pillar 3: Market Disclosure.
Tools to manage risk
Organizational restructuring
Designing and implementation of policies and
procedures
Setting and monitoring of limits
Establishing Risk Rating Criteria
Conducting Sectoral Analysis
Stress Testing
Calculating VaR
Compliance to regulatory requirement
Tools to manage risk
Interest Rate Sensitivity Analysis
Gap Analysis
Duration Analysis
Hedging Techniques:
Derivatives such as:
 Futures & Forwards
 Options & swaps
Tools to manage risk
Organizational restructuring
Independent Risk Management Unit
BoD and Senior Management’s oversight and active
involvement
Risk Management Committees
Effective and Efficient Internal Auditing
Independent Middle Office
Assignment of duties and responsibilities
Delegation of authority
Tools to manage risk
Policies and Procedures designing
Designing Bank wide Risk Policy
Defining Bank’s Risk Tolerance Level
Designing Fund Management and Investment Policies
Defining and Designing Bank’s Contingency Funding
Plans
Designing Dynamic Business Strategies and Policies
Tools to manage risk
Setting and Monitoring Limits

FX Limits
MM Limits
Overseas Limits
Equity Limits
FX Limits
Internal as well as regulatory
Protects against adverse change in exchange rates
Helps in managing risk/exposure against counter
parties
Helps in FX Deals/Trading
FX Limits
FX Contract Limit
Internal Limit
Contract Limit is the maximum value of outstanding
contracts on overall basis that can be entered with a
single counterparty.
Consists of different types of deals like Swap, Ready,
Tomorrow, Forward etc
Monitored on daily basis
Action taken in case of Breach
FX Limits
FX Settlement Limit
Internal Limit
Settlement Limit is the maximum value of
outstanding contracts maturing on any single
trading day with a particular counterparty
Consists of different types of deals like Swap, Ready,
Tomorrow, Forward etc
Monitored on daily basis
Action taken in case of Breach
FX Limits
FX Reval Limit
Internal Limit
Reval Limit is 10% of Contract Limit for FX.
The overall net position of the contracts with a
counterparty are revalued daily to see the changes
due to exchange rate movements in the value of the
contracts.
Monitored on daily basis
Action taken in case of Breach
FX Limits
FX MTM Limit
Internal Limit
It reflects the market value of forward FX contracts
day to day basis
Any resulting gain or loss is accounted for as FX
trading profit or loss.
In case of excess loss action is taken
Monitored on daily basis
FX Limits
FX Transaction wise Reval Limits
Internal Limit
Same as FX MTM but it is for individual transactions
Individual transactions are Revalued and then
compared to assigned limits
In case of excess loss action is taken
Monitored on daily basis
FX Limits
FEEL
Regulatory requirement of SBP
State Bank of Pakistan assigns FEEL
FEEL is the overall LONG or SHORT position
expressed in PKR for all foreign currencies.
The maximum position either long or short is taken
as FEEL
Monitored on daily basis
FX Limits
FC Gap
Internal Limit
Gap is calculated by multiplying the position for
every maturity bucket of the concerned currency with
a factor.
The factors presently used are approved by TMG and
validated by TMO.
The gap limits are proposed by TMG, reviewed and
validated by TMO and approved by ALCO.
FX Limits
FC Exposure
Internal Limit
The risk of loss stemming from exposure to adverse
foreign exchange rate movements
A foreign currency exposure arises when entering into an
open position i.e. un-hedged position in trading any
foreign currency
Exposure is the sum of all the positions in a particular
foreign currency’s within each defined maturity buckets.
The exposure limits are proposed by Treasury
Management Group (TMG), reviewed and validated by
TMO and approved by ALCO.
FX Limits
NOSTRO Balances Monitoring
Monitoring NOSTRO accounts for any Debit
balances, on daily basis
In case there is any debit balance, TMO must verify it
with FE Reconciliation Department and notify TFO to
replenish funds in that account to avoid interest/
overdraft charges.
Identifying unconciled NOSTRO balances in order to
reduce them
MM Limits
Internal as well as regulatory
Protect against adverse change in interest rates
Helps in managing risk/exposure
Helps in Liquidity management and efficient MM
Trading
MM Limits
MM Reverse Repo Limit
Internal Limit
This limit is assigned for lending against Securities
Approved by FID
Monitored daily basis
Action is taken in case of breach
MM Limits
MM Call Limit
Internal Limit
This limit is assigned for clean lending
More risk involved
Approved by FID
Monitored daily basis
Action is taken in case of breach
MM Limits
MM Reval Limit
Internal Limit
This limit basically protects against negative price
movements in security used in Repo transaction.
This limit covers rate risk and is usually set at 5% of
Repo Contract Limit
Monitored daily basis
Action is taken in case of breach
MM Limits
SLR/CRR Limit
Regulatory Requirement
 To monitor and ensure banks cash reserves with SBP
as per requirement.
Also ensures SLR requirements of SBP by monitoring
banks fixed income securities investments
Monitored daily / weekly basis depending on
availability of DTL
Penalty is levied/Imposed by SBP in case of breach
Overseas Limits
Overseas FEEL
SBP’s Regulatory requirement
FEEL assigns by SBP
Data is to be taken from 17 Overseas branches on daily
basis
FEEL is the overall LONG or SHORT position
expressed in PKR for all foreign currencies.
Overall FEEL comprises of ‘Domestic Exposure’,
Overseas Exposure’ and ‘Overseas Off-Balance Sheet
Exposure’
Overseas FEEL (contd)
The maximum position either long or short is taken
as FEEL
Total exposure is also used to calculate the ‘FX CCY
Risk Exposure to Capital Ratio’
It also shows the ‘% of FEEL utilized’ and ‘Overall FX
Risk Exposure to Capital Ratio’
Monitored on daily basis and reported on Weekly
basis
Currency Wise Exposure of Overseas
Branches
FEEL statement sent by the overseas branches at the
end of the week are used to monitor the exposure of
the branches taken in all currencies they trade.
Data is also used to calculate the NOP of the overseas
branches.
Monitoring on daily basis and reported on weekly
basis
Overseas Off-Balance Sheet FX Risk
Exposure
Regulatory requirement of SBP
It is the exposure taken on contingent liabilities and
Forward positions bank takes to hedge their positions
Overseas branches sent their fwd positions if any, and
MLRW make analysis to observe the net fwd position
(Fwd Purchse-Fwd Sales)
It is also used to calculate the “Off-Balance Sheet FX
Risk Exposure to Capital Ratio”
Monitoring on Weekly basis.
Placement Positions of Overseas
branches
Internal Limits
Overseas branches sent the data at every week end
interval
Analysis report to be made showing the Net Income as
at maturity and at report date on the placement to be
with other overseas banks, NBP overseas banks, Head
Office and with SBP
It also shows the limit breach (if any), assigned to the
overseas branches for their placement with other
overseas banks
Monitoring on Weekly basis
Investment Position of Overseas
Branches
Internal Limits
Overseas branches sent the data at every week end
interval
Analysis report to be made showing the Mark-to-
Market Profit/Loss on the Investment and the Net
Income as at maturity and at report date on the
Investment made in other Instruments
Monitoring on Weekly basis
Borrowing Position of Overseas
Branches
Internal Limits
Overseas branches sent the data at every week end
interval
Analysis report to be made showing the Net Expense
as at maturity and at report date on the borrowing to
be done with other overseas banks, NBP overseas
banks, Head Office and with SBP
Monitoring on Weekly basis
Equity Limits
Regulatory (SBP) as well as Internal Limits
Protect against adverse changes in the equity related
portfolio due to price movements
Helps in managing risk/movements against price
volatility
Categories of Securities
Held for Trading (HFT)

Available for Sale (AFS)

Held to Maturity (HTM)

Regulatory Limits
Investment in the Shares of a company should not
exceed 5% of NBP’s Equity.

Total Investment in shares by a bank shall not exceed

20% of its equity.
Internal Limits
Sector wise limit (Cap)
Investment in any one sector, as per classification of
stock exchange, shall not exceed 25% (Twenty Five
percent) of the market value of portfolio at any point in
time
AFS Limit (At least 80% of Total Investment)
80% (eighty percent) of total investment listed equity
securities based on the market value will be held in the
“Available for Sale” portfolio
Internal Limits (contd.)
HFT Limit (Upto 20% of Total Investment)
Upto 20% (twenty percent) of the total investment in
listed equity securities based on market value will be in
“Trading” portfolio.
Trading Portfolio Limit of Rs. 800 million
Trading Portfolio of investment in shares shall not
exceed Rs. 800 million
Tools to manage risk
Regulatory Requirements
Prudential Regulations
Time to Time Instruction/Circulars by SBP
SLR/CRR
Basel-II Requirements
Tools to manage risk
ALM Analysis
Maturity wise Assets and Liabilities Break up
NII Analysis
Difference Between Interest Income and Interest
Expenses
Gap Analysis
Gap b/w Assets and Liabilities in various maturity
Buckets
Tools to manage risk
Duration Analysis
Duration is measure of the sensitivity of present value
or price of a financial instrument in interest rates

It is average time to receipt of cash flow weighted by

present value of each of cash flows in series

It estimates an impact if interest rate changes on

present value of cash flows generated
Tools to manage risk
Designing VaR and VaR based Limits
Statistical measures, at a certain confidence level, the
amount of value that the financial institution may
stand to lose within a specified time.
VaR approach measures total portfolio at risk and
identified the like hood of loss across the different
products to produce a single VaR number.
It is useful because –it converts measures of potential
losses arising from different market variables into a
common measure.
VaR Calculation
 Trading Portfolio of 45,000 Shares of PSO
Relative volatility from 1st Jan 2007 to 3oth June 2008
is 1.9% . Calculated by Standard Deviation
Confidence Interval 99% (Factor 2.3263)
Price on 28th June 2008 417.24
VaR 4.43%
(Relative Volatility*Risk Factor*SQRT(Time
Horizon)
VaR in absolute terms Rs. 831,255
Tools to manage risk
Parameters of VaR
Confidence Interval
Holding Period
Sample Period
Tools to manage risk
VaR must be supplemented by:
 Stress testing
 Prudent checks and balance
 Policies and procedures
 Controls and limits
Random audits.
Tools to manage risk
Three Approaches to VaR
Historical Simulation
Variance Covariance
Monte-Carlo Simulation
Tools to manage risk
Hedging Techniques:
Derivatives
Future
Forward
Options
Swaps
IRS
CCY Swap
Structured Products
Career prospects
 Growing awareness about Risk Management and its
benefits across Financial industry
Growth in Risk Management
Lack of experienced people in financial industry
Lucrative salary structure
Going to stay until financial institutions exist
Good job prospects globally
Thank you for
Listening

Any questions?