Risk Management: Rohit Garg

RISK MANAGEMENT
Presentation at FICCI Conference on Global Banking Paradigm Shift On Sept 14, 2003, Bangalore
ROHIT GARG
What is Risk?
Risk, in traditional terms, is viewed as a negative. Websters 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.
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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.
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Types of financial risk

Equity Risk Market Risk Interest Rate Risk Currency Risk Commodity Risk Trading Risk Gap Risk
Transaction Risk
Counterparty Risk Issuer Risk
Financial Risks
Credit Risk Liquidity Risk Operational Risk Regulatory Risk Human Factor Risk Portfolio Concentration Risk
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Understanding 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 rates, equity prices, credit spreads and/or commodity prices resulting in a loss to earnings and capital.
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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
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Best Practices in Market Risk Management

1. Rethinking the Market Risk process 2. Establish Top Management Oversight 3. Deploy Best practices framework 4. Adopt appropriate Organisation Structure 5. Invest in Good Technology 6. Use Hedging techniques Judiciously 7. Ensure Robust Marking to Market 8. Establish good operational processes 9. Measure, Monitor & Manage Value at Risk 10. Explore quantitative models for default prediction
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1. Rethinking the Market Risk process
Increased reliance on objective risk assessment Investment process differentiated on the basis of risk, not size Investment in workflow automation / back-end processes Align Risk strategy & Business Strategy Active Portfolio Management
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2. Establish Top Management Oversight
Board and senior Management Oversight

Delineate banks overall risk tolerance in relation to market risk Ensure that banks overall market risk exposure is maintained at prudent levels and consistent with the available capital Ensure that top management as well as individuals responsible for market risk management possess sound expertise and knowledge to accomplish the risk management function. Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of market risk. Ensure that adequate resources (technical as well as human) are devoted to market risk management.
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3. Deploy Best practices framework
Investment & Market Risk Policies should be comprehensive
Investment organisation - Independent set of people for front, mid & back offices Set exposure Limits On Different Parameters dealer wise, transaction, instruments, broker, & other counter parties Implement straight - through processing Operationalise stop-loss limits
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4. Adopt appropriate Organisation Structure
Organization Structure
The structure should conform to the overall strategy and risk policy set by the BOD Those who take risk (front office) must know the organizations risk profile, products that they are allowed to trade, and the approved limits. Apart from BOD responsibility to be assumed by forming following The risk management function should be independent, reporting directly to senior management or BOD. The Risk Management Committee The Asset-Liability Management Committee (ALCO) The Middle Office.
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5. Invest in Good Technology
Treasury Integration
Straight -through Processing

Back Office Integration Currency Risk Management Credit Liquidity Interest Rate Dealing Market Integration Payments
Business Process Management Accounting Cash Mgmt
Improved Control Enhanced Reporting
Improved Integration Enhanced Productivity

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6. Use Hedging techniques Judiciously
Interest Rate Swaps

Forward Rate Agreements Forward Contracts Currency Options
Equity Derivatives
Equity Options
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7. Ensure Robust Marking to Market
The need arises due to structured products and lack of liquidity results in
the absence of traded prices In case of non-traded securities, marking to market is critical for valuation & risk management CRISIL is the official provider of valuation services and appointed by SEBI / AMFI for the Mutual Fund industry segment In case of active investment management and for risk management, the periodicity of daily valuation is required
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8. Establish good operational processes
Align Business strategy and treasury process

front office Complete integration middle office
sound treasury control liquidity management position keeping limit management risk management settlement management treasury accounting
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back office
9. Measure, Monitor & Manage Value at Risk Value-at-Risk
Value at Risk
.022 .016 .011 .005 .000 1.5 2.9 4.3 5.6 Certainty is 95.00% from 2.6 to +Infinity 7.0 433 324.7 216.5 108.2 0
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
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Features of CRISIL VaR Model Yields Duration Multiple Portfolios Incremental VaR
VaR
Portfolio Optimization
VarianceVariancecovariance Matrix
Stop Loss Helpspicking up securities forin Riskyinvolatile securities Facility ofReturn Analysis which portfolios inofperiods For in aiding in cutting losses duringand setthe constraints For Identifying and isolating the given in single model For optimizing methods and gel well safe portfolio multiple portfolio aiding trade-off
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Managing Market Risk

Questions International practice % of Banks with + ve response 100%
1. Are all market risks centrally managed?
All Market Risks are centrally managed by Treasury / Global Markets 2. Do you measure Var of nonLarge International banks trading balance sheet? measure / Manage balance sheet Risks actively 3. Is Funds Transfer Pricing policy Incremental Cost of Funds based on marginal market rates? reflects in Incremental Transfer Pricing on Assets / Liabilities 4. Is board / senior management Board / Management Committee involved in managing Market overviews the management of risks? Market Risk 5. Is there a central unit for Basel II is being managed as a implementing Basle II guidelines? project with a central coordinator for the bank
0%
0%
85%
70%
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To Summarise.
Effective Management of Market Risk benefits the bank.. Efficient allocation of capital to exploit different risk / reward pattern across business Better Product Pricing Early warning signals on potential events impacting business Reduced earnings Volatility Increased Shareholder Value
No Risk
No Gain!
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for further details contact, . . .
Rohit garg PGDMPGDM-IB (IITTM) Email : [email protected] Ph.no: Ph.no: 5653 7531
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RISK MANAGEMENT

Types of financial risk

Counterparty Risk Issuer Risk

Understanding Market Risk

Why the focus on Market Risk Management ?

Best Practices in Market Risk Management

1. Rethinking the Market Risk process

2. Establish Top Management Oversight

Board and senior Management Oversight

3. Deploy Best practices framework

Investment & Market Risk Policies should be comprehensive

4. Adopt appropriate Organisation Structure

5. Invest in Good Technology

Straight -through Processing

Business Process Management Accounting Cash Mgmt

Improved Control Enhanced Reporting

Improved Integration Enhanced Productivity

6. Use Hedging techniques Judiciously

Interest Rate Swaps

7. Ensure Robust Marking to Market

8. Establish good operational processes

Align Business strategy and treasury process

9. Measure, Monitor & Manage Value at Risk Value-at-Risk

Managing Market Risk

1. Are all market risks centrally managed?

for further details contact, . . .

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