Risk Management and Shareholders’Value in Banking

PART I INTEREST RATE RISK 1
1 The Repricing Gap Model 9
1.1 Introduction 9
1.2 The gap concept 9
1.3 The maturity-adjusted gap 12
1.4 Marginal and cumulative gaps 15
1.5 The limitations of the repricing gap model 19
1.6 Some possible solutions 20
2 The Duration Gap Model 35
2.1 Introduction 35
2.2 Towards mark-to-market accounting 35
2.3 The duration of financial instruments 39
2.4 Estimating the duration gap 42
2.5 Problems of the duration gap model 45
3 Models Based on Cash-Flow Mapping 57
3.1 Introduction 57
3.2 The objectives of cash-flow mapping and term structure 57
3.3 Choosing the vertices of the term structure 58
3.4 Techniques based on discrete intervals 59
3.5 Clumping 64
3.6 Concluding comments 68
4 Internal Transfer Rates 77
4.1 Introduction 77
4.2 Building an ITR system: a simplified example 77
4.3 Single and multiple ITRs 79
4.4 Setting internal interest transfer rates 84
4.6 Summary: the ideal features of an ITR system 93
5 The Variance-Covariance Approach 115
5.1 Introduction 115
5.2 VaR derivation assuming normal return distribution 115
5.3 Sensitivity of portfolio positions to market factors 126
5.4 Mapping of risk positions 133
5.5 Summary of the variance-covariance approach and main limitations 143
6 Volatility Estimation Models 163
6.1 Introduction 163
6.2 Volatility estimation based upon historical data: simple moving averages 163
6.3 Volatility estimation based upon historical data: exponential moving averages 167
6.4 Volatility prediction: GARCH models 172
6.5 Volatility prediction: implied volatility 179
6.6 Covariance and correlation estimation 181
7 Simulation Models 185
7.1 Introduction 185
7.2 Historical simulations 189
7.3 Monte Carlo simulations 2057.4 Stress testing 218
8 Evaluating VaR Models 225
8.1 Introduction 225
8.2 An example of backtesting: a stock portfolio VaR 225
8.3 Alternative VaR model backtesting techniques 232
9 VaR Models: Summary, Applications and Limitations 251
9.1 Introduction 251
9.2 A summary overview of the different models 251
9.3 Applications of VaR models 253
9.4 Six “False Shortcomings” of VaR 260
9.5 Two real problems of VaR models 263
9.6 An Alternative Risk Measure: Expected Shortfall (ES) 268
10 Credit-Scoring Models 287
10.1 Introduction 287
10.2 Linear discriminant analysis 287
10.3 Regression models 299
10.4 Inductive models 301
10.5 Uses, limitations and problems of credit-scoring models 307
11 Capital Market Models 313
11.1 Introduction 313
11.2 The approach based on corporate bond spreads 313
11.3 Structural models based on stock prices 321
12 LGD and Recovery Risk 345
12.1 Introduction 345
12.2 What factors drive recovery rates? 346
12.3 The estimation of recovery rates 347
12.4 From past data to LGD estimates 351
12.5 Results from selected empirical studies 353
12.6 Recovery risk 356
12.7 The link between default risk and recovery risk 358
13 Rating Systems 369
13.1 Introduction 369
13.2 Rating assignment 370
13.3 Rating quantification 379
13.4 Rating validation 388
14 Portfolio Models 401
14.1 Introduction 401
14.2 Selecting time horizon and confidence level 402
14.4 The structural approach: PortfolioManagerTM 423
14.5 The macroeconomic approach: CreditPortfolioViewTM 426
14.6 The actuarial approach: CreditRisk+TM 428
14.7 A brief comparison of the main models 439
14.8 Some limitations of the credit risk models 442
15 Some Applications of Credit Risk Measurement Models 451
15.1 Introduction 451
15.2 Loan pricing 451
15.4 Setting limits on risk-taking units 459
15.5 Optimizing the composition of the loan portfolio 461
16 Counterparty Risk on OTC Derivatives 473
16.1 Introduction 473
16.2 Settlement and pre-settlement risk 474
16.3 Estimating pre-settlement risk 474
16.4 Risk-adjusted performance measurement 495
16.5 Risk-mitigation tools for pre-settlement risk 496
17 Operational Risk: Definition, Measurement and Management 511
17.1 Introduction 511
17.2 OR: How can we define it? 512
17.3 Measuring OR 517
17.4 Towards an OR management system 533
17.5 Final remarks 535
18 The 1988 Capital Accord 547
18.1 Introduction 547
18.2 The capital ratio 549
18.3 Shortcomings of the capital adequacy framework 555
18.4 Conclusions 559
19 The Capital Requirements for Market Risks 565
19.1 Introduction 565
19.2 Origins and characteristics of capital requirements 565
19.3 The capital requirement on debt securities 568
19.4 Positions in equity securities: specific and generic requirements 575
19.5 The requirement for positions in foreign currencies 576
19.6 The requirement for commodity positions 578
19.7 The use of internal models 578
20 The New Basel Accord 591
20.1 Introduction 591
20.2 Goals and Contents of the Reform 591
20.3 Pillar One: The Standard Approach to Credit Risk 593
20.4 The Internal Ratings-based Approach 597
20.5 Pillar Two: A New Role for Supervisory Authorities 612
20.6 Pillar Three: Market Discipline 614
20.7 Pros and Cons of Basel II 616
20.8 The Impact of Basel II 619
21 Capital Requirements on Operational Risk 633
21.1 Introduction 633
21.2 The capital requirement on operational risk 633
21.3 Weaknesses of the 2004 Accord 645
21.4 Final remarks 647
22 Capital Management 657
22.1 Introduction 657
22.2 Defining and measuring capital 658
22.3 Optimizing regulatory capital 675
22.4 Other instruments not included within regulatory capital 685
23 Capital Allocation 693
23.1 Introduction 693
23.2 Measuring capital for the individual business units 694
23.3 The relationship between allocated capital and total capital 702
23.4 Capital allocated and capital absorbed 712
23.5 Calculating risk-adjusted performance 715
23.6 Optimizing the allocation of capital 722
23.7 The organizational aspects of the capital allocation process 726
24 Cost of Capital and Value Creation 735
24.1 Introduction 735
24.2 The link between Risk Management and Capital Budgeting 735
24.3 Capital Budgeting in Banks and in Non-Financial Enterprises 736
24.4 Estimating the Cost of Capital 739
24.5 Some empirical Examples 745
24.6 Value Creation and RAROC 750
24.7 Value Creation and EVA 753
24.8 Conclusions 756