Risk Management Future Challenges

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Risk Management

Future Challenges

Computational Finance & Financial Engineering for

R/Rmetrics User and Developer Workshop

July 8

July 8 ––12,12, ThuneThune, Switzerland, Switzerland

Mahendra Mehta

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Some common quotes on risk

“

The greatest risk you can take in life is to risk nothing

”

“

If your life is free of failures, you are not taking

enough risks

”

“

All of life is the management of risk, not its

elimination.

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What does the bankers do all day along?

• What is their raw material?

• What is the semi-finished good?

• What is the final output?

• What do they produce?

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Define Solutions with a Difference

The main business?

Selling and Buying

Risk

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Broad Categories of Risk in Banks &

financial Services

• Credit Risk

• Market Risk

• Operational Risk

• Other Risks

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Credit Risk

• Issuer Risk (Obligor Risk)

• Cross Border Risk (Country Risk)

• Settlement Risk

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Market Risk

• Price Risk

• Liquidity Risk

• Basis Risk

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Operational Risk

• Fraud Risk (Internal & External) • Documentation Risk

• Communication Risk • System Risk

• Model Risk • Regulatory Risk • External Event Risk • Legal Risk

• Competence Risk (People Risk) • Careless Error Risk

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Other Risks

• Reputation Risk

• Strategic Risk

• Business Complexity Risk

• Acquisition Risk

• Competitive Risk

• Business P & L Risk

• Infrastructure Risk

• Compliance Risk

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Life cycle of various risks in Financial Markets

Adoption Maturity Relatively Slower _Advancement

Operational Risk

Credit Risk

Price Risk

Liquidity Risk Asset/Liability Management

Level of

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Risk Management

Seeking security in an increasingly volatile

world

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Developed Financial World

Increased financial risks

PRODUCTION AND SALES OF HEDGING INSTRUMENTS

BANKS

INSURANCE COMPANIES OF FINANCIAL RISKS

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Financial Derivatives & other Complex

Products

RISK

BETTER INTERNAL CONTROL BETTER EXTERNAL SUPERVISION

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Magnitude of some major losses in

derivatives business in nineties

Date

Date OrganizationOrganization EventEvent

1986

1986--8888 HammersmithHammersmith Loss of US $ 900 million in Loss of US $ 900 million in interest rate swap

interest rate swap

March 1991

March 1991 Allied LyonsAllied Lyons Loss of US $ 265 million in Loss of US $ 265 million in FX options

FX options

February 1993

February 1993 Showa ShellShowa Shell Write off of US$ 1.4 billion in Write off of US$ 1.4 billion in FX forward contracts

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Magnitude of some major losses in

derivatives business in nineties

Date

December 1993

December 1993 MetallgesellshaftMetallgesellshaft Loss of US$ 1.3 billion in Loss of US$ 1.3 billion in oil futures trading

oil futures trading

January 1994

January 1994 CodelcoCodelco Loss of US$ 207 million in Loss of US$ 207 million in Copper futures deal

Copper futures deal

April 1994

April 1994 Kashima OilKashima Oil Loss of US$ 1.5 billion in Loss of US$ 1.5 billion in currency forwards

currency forwards

April 1994

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Magnitude of some major losses in

derivatives business in nineties

Date

May 1994

May 1994 Air Products and ChemicalsAir Products and Chemicals Loss of US$ 60 million inLoss of US$ 60 million in interest rate derivatives

interest rate derivatives

May 1994

May 1994 SandozSandoz Lost US$ 78.5 million inLost US$ 78.5 million in derivatives Transactions (BT)

derivatives Transactions (BT)

1st Half of 1994

1st Half of 1994 Gibson GreetingsGibson Greetings Lost US$ 19.7 million inLost US$ 19.7 million in interest rate derivatives

interest rate derivatives - -Sued BT for 23 million.

Sued BT for 23 million.

Settled out of court.

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Magnitude of some major losses in

derivatives business in nineties

Date

July 1994

July 1994 GlaxoGlaxo Provision of US$ 205 millionProvision of US$ 205 million for asset backed bond and

for asset backed bond and

derivatives

Dec 1994

Dec 1994 Orange CountyOrange County Lost US$ 1.7 billion inLost US$ 1.7 billion in leveraged interest rate

leveraged interest rate

transactions

Feb 1995

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Magnitude of some major losses in

derivatives business in nineties

Date

June 1996

June 1996 SumitomoSumitomo Lost US$ 1.8 billion over 10Lost US$ 1.8 billion over 10 years unauthorized trades

years unauthorized trades

in copper derivatives

Feb 1997

Feb 1997 National WestminsterNational Westminster Loss of US$ 136 millionLoss of US$ 136 million mis

mis--pricing in interest ratepricing in interest rate derivatives

derivatives

Mar 1999

Mar 1999 Long Term Capital Long Term Capital More than US$ 2.3 billionMore than US$ 2.3 billion Management (LTCM)

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Magnitude of some major losses in

derivatives business in nineties

Date

February 2002 Allied Irish Bank Loss of US$ 691 million in Foreign Exchange trading

August 2006 Amaranda Loss of over USD 3 Billion in energy related large bets

Note

Note --There are many more which are not listed here, such as BankThere are many more which are not listed here, such as BankNegaraNegara- -Malaysia,

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The need for understanding market risk

Thus we saw, world

Thus we saw, world’’s giant entities lost billions of dollars in s giant entities lost billions of dollars in financial markets.

financial markets.

Question:

Question: How and why?How and why?

Answer:

Answer: On closer analysis of most of these cases, the On closer analysis of most of these cases, the conclusion is that

conclusion is that

Senior management poorly monitored the corporations

Senior management poorly monitored the corporations’’

exposure to market risks.

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Market risk

Market risk -

-

good advice

“

“We must all guard against a situation in which the designers We must all guard against a situation in which the designers of financial strategies (traders) lack the experience to

of financial strategies (traders) lack the experience to

evaluate the attendant risks, and their experienced senior

managers are too embarrassed to admit that they do not

understand the new strategies.

understand the new strategies.””

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What

’s at stake for banks who cannot

’

s at stake for banks who cannot

balance the risk/reward relationship?

Their own survival! -

Illustrative Example % bp

1. Net Interest Revenues 3.00 2. Plus: Other Income (Fee/FX) 1.00 3. Net Customer Revenues (1+2) 4.00

4. Less: Direct + Allocated Costs -2.50 5. Net Margin Before Credit Costs 1.50 6. Less: Expected Credit Costs -1.25*

Net Income (5-6) 0.25

1. Required Return on Risk Adjusted Assets 1.60** 2. Premium Shareholder Income/Loss -1.35

(* Based on assumed portfolio quality) (** Assumes 8% Risk Adjusted Capital allocation and required RORAC of 20%)

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Market Risk

-

Challenges

• Increasing complexity of financial instruments

• Increasing correlation between various markets worldwide • Strange behavior of volatility of various market factors

• Increased violation of assumptions in distributional properties of market factors (thick tail effects)

• Over reliance of poorly constructed or configured models? • Passive control of risk in many banks?

• Risk management in many places merely a regulatory exercise • Inadequate risk systems

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Market Risk

-

Challenges

• Increasing centralized risk taking?

• Difficulty in isolating credit and market risks in many derivative instruments – complex & risky bets

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Credit Risk

-

Challenges

• Rapid shift from qualitative measurement of risk to quantitative measurement – (PD) – Basel – 2 these – Obligor default model building challenges?

• Single obligor credit risk to Portfolio credit risk? – Challenges in estimating correlation of PDs.

• Increasing use of credit derivatives for management of credit risks – Increasing complexity of risk and thus measurement and control

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Operational Risk

• Definition – It is defined as inadequate of failed internal

process, people, system and external events. Legal risk is a part of operational risk.

• Modeling & measuring heterogeneous types of risk – real challenges • Data issues – Actual loss data do not reveal much?

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Basel

–

2

2 –

–

Key issues

• Basel -2 related issues

– Pillar – 1 – Minimum capital requirement

– Pillar – 2 – Supervisory Review Process

– Pillar - 3 – Market Discipline

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Conclusions

• Complex instruments - continuous innovation in progress

• Risk Management, system development and implementation lags the market innovation process – need to keep pace?

• Modeling challenges – Various types of risks (academic challenge)

• Data challenges – Operational & credit risks, e.g. extreme events (External) • Model building, testing and acceptance?

• Pillar – 2 in Basel - 2

• Reputation risk, Strategic risk etc.

• Hedge fund Risk Management – Large exposure of banks

• Largely - various markets is increasing being controlled by hedge fund players

• Failures of certain big hedge funds can cause serious economic problems – Risk Management – regulatory issues?

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