RD 2 Rickert-Lambrigger

Market Risk Management
Ch ll d th Challenges under the

new Basel framework
Philipp Rickert
Partner
Dr. Dominik D. Lambrigger
Manager g
ETH Riskday, 9 September 2011
What makes a Traders life miserable?
Political challenges
Uncertainty in US and Europe
S i d bt i i Sovereign debt crisis
Global economy slow down
Market behavior
Increased participant mistrust
Increased competition (chasing the flow)
Client behavior Client behavior
Cash is King
Low volumes, flight to quality, risk averse
R l t Regulatory response
Risk taking becomes disproportionally capital intense and expensive
Qualitative requirements increase (IT, processes, people)
All that makes the Traders life miserable, because less volume and less risk combined
with higher volatility and higher production costs results in bad P&L and that means
LOWER BONUS!
1
2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMG
International Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG
International.
LOWER BONUS!
Basel III
NOT THIS BASEL THIS BASEL!
2
International.
Why Basel III Regulators Views
Why the Financial Crisis
Excess of cheap money and procyclicality of globally important banks
Excessive leverage in the global financial system Excessive leverage in the global financial system
Too little capital of insufficient quality (leverage between 1 to 33 and 1 to 100)
Inadequate liquidity buffers
Purpose
Improve the banking sector's ability to absorb shocks arising from financial and economic
stress, whatever the source
Improve risk management and governance
Strengthen banks' transparency and disclosures g p y
Response
Quality of capital tangible equity Quality of capital tangible equity
Coverage of risk focus on trading book exposures
Much higher levels of capital
3
International.
Global liquidity standards
Capital under Basel Requirement vs Eligibility
Required Capital
.

kOperational Risk
Available
Capital
Basel 2
O
p
.
R
i
s
kOperational Risk
k
Fixed assets
Derivatives
Tier 3
Abolished
Basel 2
C
r
e
d
i
t
R
i
s
k
B
a
n
k
i
n
g

B
o
o
kDerivatives
Secured Finance
Retail Loans
Tier 2
Restrictions
Basel 2.5:
Trading Book
B
Commercial Loans:
Banks
CVA
Tier 2
Tier 1
Trading Book
R
i
s
k
B
o
o
k
CRM
Securitizations
Deductions
Basel 3
M
a
r
k
e
t

R
T
r
a
d
i
n
g
B
Stressed VAR
IRC
VAR
Tier 1
4
International.
VAR
Paul Embrechts: Paul Embrechts:
Always be scientifically critical, Always be scientifically critical,
socially honest
and adhere to the highest ethical principles,
especially in the face of temptation
which will come!
5
International.
Modeling market risk (Value-at-Risk)
Key elements
Market risk charge = C x VaR
99%
(V), C 3
10-day holding period
V is the value of the trading book portfolio
Risk Weighted Assets
CVA
B III
V = 10-day change of V
Challenges
Securitization
CRM
Complexity of the portfolio (and hence V ):
need sophisticated front office pricing models
Comprehensive scope of risk factors
Historical simulation vs. Monte Carlo
IRC
Stressed VaR
B II.5
Historical simulation vs. Monte Carlo
Responsiveness of VaR
Data quality
Complexity of risk infrastructure
Credit Risk
Op Risk
B II
p y
Backtesting VaR
Market Risk
6
International.
The Greeks
A Taylor expansion of V reduces the problem to the calculation of:
The risk factor changes S and their volatilities
(for simplicity assume that there is only 1 risk factor and no specific risk)
The sensitivities (Greeks)
) (
1
) (
2
2

S
V V
S
V
S V ... ) (
2
,...) , (
2

S
S
S
S
S V
Delta Vega Gamma

Historical Risk Factor Changes Front Office Pricing Models
and Cross-Gamma, Vanna, Volga, etc.
g
(stochastic)
g
(deterministic)
Risk factor Volatility
Value Delta Vega g
Delta Gamma Vanna
Vega Vanna Volga
Gamma Speed Zomma
Volga Ultima
7
International.
For highly non-linear products Taylor might not be appropriate
Challenges in modelling market risk (1/4)
Banks tend to use full revaluation of the whole portfolio for VaR calculation and stress testing.
Greeks &
Taylor
Expansion
Partial
revaluation
Full reval
C o m p l e x i t y
Most banks use historical simulation
based on a 1-5 year dataset
Looking at the past instead of the future Looking at the past instead of the future
Some banks have the crisis in the VaR
Others have a strong desire to exclude
the crisis from the dataset (due to the
introduction of stressed VaR and a
double-counting of the crisis)
8
International.
How responsive should VaR be in a crisis?
Standard implementation of VaR is typically not very responsive to a crisis, especially if the
underlying data is unweighted and is based on several years underlying data is unweighted and is based on several years.
How can this problem be addressed?
Stressed VaR
B l 2 5 ( l t )
Responsive VaR
S li b k t l tilit
Dual approach
Basel 2.5 (see later) Scaling by market volatility
Weighting of data
9
International.
Backtesting:
Check performance of VaR by comparing VaR against PnL Check performance of VaR by comparing VaR against PnL
But have 10-day VaR and 1-day PnL?!
Two options:
Scale 10-day VaR down to 1-day VaR: VaR
1-day
VaR
10-day
Re-calculate 1-day VaR (costly)
10
/
Daily adjusted PnL 1 Day VaR (99%)
10
International.
Source: Credit Suisse Annual Report 2005
Daily adjusted PnL 1-Day VaR (99%)
How many backtesting exceptions per year are acceptable?
N b f ti I i th lti li Number of exceptions Increase in the multiplier
4 or less 0.00
5 0.40
6 0.50
7 0.65
k P(N=k) P(Nk)
N ~ Bin(n=250, p=0.01)
P(N > 4) = 10.8%
7 0.65
8 0.75
9 0.85
10 or more 1.00*
Source: FINMA Market Risk Circular 2008/20
0 0.081 0.081
1 0.205 0.286
2 0.257 0.543
3 0.215 0.758
4 0.134 0.892
5 0.067 0.959
* Any shortcomings must be eradicated without delay, since otherwise the conditions for
determining capital adequacy requirements according to the model-based approach will
be deemed no longer to be fulfilled.
6 0.027 0.986
7 0.010 0.996
8 0.003 0.9989
9 0 0008 0 9997
Credit Suisse Annual Report 2008:
Annual Report 10
- CS:
9 0.0008 0.9997
10 0.0002 0.99995
UBS Annual Report 2008:
0 exceptions
- UBS:
1 exception
11
International.
Alternative backtesting approach:
2
... ) (
2
1
,...) , (
2
2
2

S
S
V V
S
S
V
S V
Delta Vega Gamma

Historical Risk Factor Changes
(stochastic)
Front Office Pricing Models
(deterministic)
Use realized risk factor changes to calculate V Model-based PnL (risk-based PnL)
Backtest model-based PnL against realized PnL
Pros: Model deficiencies detected on a daily basis (dont have to wait for a VaR backtesting
exception)
Cons: Non-market risk factors have to be modelled or need good clean PnL data
12
International.
Invest in human capital
and their quantitative (high quality) education!
13
International.
and their quantitative (high-quality) education!
Basel 2.5
Incremental Risk Charge (IRC)
Key elements
Default and credit rating migration of trading book positions
99.9% VaR, 1-year holding period
Fixed Income products (mainly plain vanilla bonds and
credit default swaps)
CVA
B III
credit default swaps)
Key inputs are ratings/PDs, LGDs, EADs, credit spreads,
migration matrix and liquidity horizon
Securitization
CRM
Challenges
Migration risk modelling
Constant level of risk (and liquidity horizon):
d f lt d/ i t d iti h t b b l d
IRC
Stressed VaR
B II.5
defaulted/migrated positions have to be re-balanced
Completeness of positions
Risk data capturing and enrichment
Model risk (imposed by the regulators?)
Credit Risk
Op Risk
B II
Model risk (imposed by the regulators?)
Structured credits, credit derivatives
Market Risk
15
International.
Stressed VaR
Key elements
What-if-the-crisis-comes-in-again-VaR
Standard VaR model with todays portfolio
But risk factors based on 1-year stressed period (e.g. 2008)
CVA
B III
99% VaR, 10-day holding period
Challenges
Securitization
CRM
Choice of stressed period
Methodology and implementation framework
Model integration within existing market risk framework
Ch t f k f th t d V R i k
IRC
Stressed VaR
B II.5
Change management framework for the stressed VaR risk
parameters
Credit Risk
Op Risk
B II
Market Risk
16
International.
Securitizations and Re-securitizations
Key elements
Capital charge for (re)-securitization positions in trading
book
Product scope: CDO, CDO^2, RMBS, CMBS, NTD, etc.
Standardized charge: very costly
CVA
B III
Standardized charge: very costly
Corporate CDOs and NTDs can be modelled by CRM (see
next slide)
Specific risks only, general risk through VaR
Securitization
CRM
Challenges
Robustness of methodology
IRC
Stressed VaR
B II.5
gy
Completeness of scope
Completeness of data feeds
Data quality
Credit Risk
Op Risk
B II
Market Risk
17
International.
Comprehensive Risk Measure (CRM)
Key elements
CVA
B III
Capital charge for correlation trading
Product scope: synthetic CDOs (index tranche and bespoke
tranche), nth-to-default and corresponding hedges (e.g.
CDS, index CDS and bonds)
Securitization
CRM
, )
All price risk model: default, rating migration, basis risk
(index basis, i.e. basis between index and single names,
correlation basis, e.g. basis between index tranches and
bespoke tranches), FX (?) and interest rate risk (?)
IRC
Stressed VaR
B II.5
bespo e t a c es), ( ) a d te est ate s ( )
Challenges
Credit Risk
Op Risk
B II
Very sophisticated models
Large model risk
Scope definition
C l t f d t f d
Market Risk
Completeness of data feeds
18
International.
And beyond market risk?
Dont forget Operational Risk
Advanced Measurement Approach (AMA):
Does having a large Op Risk capital add-on help
to reduce the risk or is it just a regulatory capital
add-on?
After the crisis people stopped talking about Op
CVA
B III
After the crisis, people stopped talking about Op
Risk (since 2010, regulators start to care about
Op Risk again).
The new challenges are the old challenges: data
quality data quality data quality
Securitization
CRM
quality, data quality, data quality.
How to combine external, internal data with
expert judgment and scenario analysis? How to
estimate correlation between business lines
(d it k )?
IRC
Stressed VaR
B II.5
(does it make sense)?
Does a 99.9% quantile make sense (dont want
to speak about 99.97% economic risk capital)?
C dit Ri k
Credit Risk
Op Risk
B II
Credit Risk
A-IRB
and Liquidity Risk
Market Risk
19
International.
Basel 3
Credit Valuation Adjustments (CVA)
Key elements
CVA
B III
CVA is the Market Value of Counterparty credit risk (CCR)
Not only default of counterparty, but also change in credit
worthiness of counterparty has to be addressed
CVA is also a lesson learned from Lehmans default as a
Securitization
CRM
CVA is also a lesson learned from Lehman s default as a
major counterparty for OTC derivatives
If Bank has an internal VaR model: Advanced CVA
All other Banks: Standardized CVA
IRC
Stressed VaR
B II.5
Need to dynamically price CCR
Very costly (infrastructure, resources and capital)
Credit Risk
Op Risk
B II
Challenges
Potentially large capital impact
Methodology and implementation framework not straight-
f d
Market Risk
forward
Securitizing CVA?
21
International.
Thank you! Thank you!
Philipp Rickert
Partner
Dr. Dominik D. Lambrigger
Manager Manager
Audit Financial Services
KPMG AG
Badenerstrasse 172
CH-8026 Zrich CH 8026 Zrich
prickert@kpmg.com
dlambrigger@kpmg.com

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Market Risk Management

Ch ll d th Challenges under the

Delta Vega Gamma

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