Risk Management and Capital Adequacy by Reto R. Gallati

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ACKNOWLEDGMENTS viii
INTRODUCTION xvii

Chapter 1 Risk Management: A Maturing Discipline 1
1.1 Background 1
1.2 Risks: A View of the Past Decades 5
1.3 Definition of Risk 7
1.4 Related Terms and Dif ferentiation 8
1.5 Degree of Risk 10
1.6 Risk Management: A Multilayered Term 11
1.6.1 Background 11
1.6.2 History of Modern Risk Management 11
1.6.3Related Approaches 13
1.6.4 Approach and Risk Maps 22
1.7 Systemic Risk 22
1.7.1 Definition 22
1.7.2 Causes of Systemic Risk 26
1.7.3Factors That Support Systemic 2R6isk
1.7.4 Regulatory Mechanisms for Risk Management 27
1.8 Summary 28
1.9 Notes 30

Chapter 2 Market Risk 33
2.1 Background 33
2.2 Definition of Market Risk 34
2.3 Conceptual Approaches for Modeling Market Risk 37
2.4 Modern Portfolio Theory 39
2.4.1 The Capital Asset Pricing Model 41
2.4.2 The Security Market Line 43
2.4.3Modified Form of CAPM by Black, Jensen, 4a5nd Scholes
2.4.4 Arbitrage Pricing Theory 46
2.4.5 Approaches to Option Pricing 47
2.5 Regulatory Initiatives for Market Risks and Value at Risk 54
2.5.1 Development of an International Framework for Risk Regulation 56
2.5.2 Framework of the 1988 BIS Capital Adequacy Calculation 56
2.5.3Criticisms of the 1988 oacAhppr58
2.5.4 Evolution of the 1996 Amendment on Market Risks 58
2.6 Amendment to the Capital Accord to Incorporate Market Risks 60
2.6.1 Scope and Coverage of Capital Charges 60
2.6.2 Countable Capital Components 61
2.6.3The de Minimis Ru6l2e
2.7 The Standardized Measurement Method 62
2.7.1 General and Specific Risks for Equity- and Interest-Rate-Sensitive Instruments 65
2.7.2 Interest-Rate Risks 66
2.7.3Equity Position Risk79
2.7.4 Foreign-Exchange Risk 83
2.7.5 Commodities Risk 84
2.7.6 Treatment of Options 88
2.7.7 Criticisms of the Standard Approach 94
2.8 The Internal Model Approach 95
2.8.1 Conditions for and Process of Granting Approval 95
2.8.2 VaR-Based Components and Multiplication Factor 97
2.8.3Requir ement for Specific R98isks
2.8.4 Combination of Model-Based and Standard Approaches 98
2.8.5 Specification of Market Risk Factors to Be Captured 99
2.8.6 Minimum Quantitative Requirements 101
2.8.7 Minimum Qualitative Requirements 102
2.9 The Precommitment Model 107
2.10 Comparison of Approaches 108
2.11 Revision and Modification of the Basel Accord on Market Risks 109
2.11.1 The E.U. Capital Adequacy Directive 109
2.11.2 New Capital Adequacy Framework to Replace the 1988 Accord 110
2.12 Regulation of Nonbanks 110
2.12.1 Pension Funds 111
2.12.2 Insurance Companies 111
2.12.3Securities Firms 112
2.12.4 The Trend Toward Risk-Based Disclosures 113
2.12.5 Disclosure Requirements 113
2.12.6 Encouraged Disclosures 114
2.13 Market Instruments and Credit Risks 114
2.14 Summary 116
2.15 Notes 117

Chapter 3 Credit Risk 129
3.1 Background 129
3.2 Definition 130
3.3 Current Credit Risk Regulations 130
3.4 Deficiencies of the Current Regulations 131
3.5 Deficiencies of the Current Conceptual Approaches for Modeling Credit Risk 133
3.6 Conceptual Approaches for Modeling Credit Risk 135
3.6.1 Transaction and Portfolio Management 136
3.6.2 Measuring Transaction Risk–Adjusted Profitability 140
3.7 Measuring Credit Risk for Credit Portfolios 140
3.7.1 Economic Capital Allocation 141
3.7.2 Choice of Time Horizon 146
3.7.3 Credit Loss Measurement Definition 146
3.7.4 Risk Aggregation 149
3.8 Development of New Approaches to Credit Risk Management 150
3.8.1 Background 151
3.8.2 BIS Risk-Based Capital Requirement Framework 152
3.8.3 Traditional Credit Risk Management Approaches 154
3.8.4 Option Theory, Credit Risk, and the KMV Model 159
3.8.5 J. P. Morgan’s CreditMetrics and Other VaR Approaches 167
3.8.6 The McKinsey Model and Other Macrosimulation Models 178
3.8.7 KPMG’s Loan Analysis System and Other Risk-Neutral Valuation Approaches 183
3.8.8 The CSFB CreditRisk+ Model 190
3.8.9 CSFB’s CreditRisk+ Approach 193
3.8.10 Summary and Comparison of New Internal Model Approaches 197
3.9 Modern Portfolio Theory and Its Application to Loan Portfolios 205
3.9.1 Background 205
3.9.2 Application to Nontraded Bonds and Credits 208
3.9.3 Nonnormal Returns 209
3.9.4 Unobservable Returns 209
3.9.5 Unobservable Correlations 209
3.9.6 Modeling Risk–Return Trade-off of Loans and Loan Portfolios 209
3.9.7 Differences in Credit Versus Market Risk Models 225
3.10 Backtesting and Str ess Testing Credit Risk Models 226
3.10.1 Background 226
3.10.2 Credit Risk Models and Backtesting 227
3.10.3 Stress Testing Based on Time-Series Versus Cross-Sectional Approaches 228
3.11 Products with Inherent Credit Risks 229
3.11.1 Credit Lines 229
3.11.2 Secured Loans 231
3.11.3 Money Market Instruments 233
3.11.4 Futures Contracts 237
3.11.5 Options 240
3.11.6 Forward Rate Agreements 243
3.11.7 Asset-Backed Securities 245
3.11.8 Interest-Rate Swaps 247
3.12 Proposal for a Modern Capital Accord for Credit Risk 250
3.12.1 Institute of International Finance 251
3.12.2 International Swaps and Derivatives Association 252
3.12.3 Basel Committee on Banking Supervision and the New Capital Accord 253
3.13 Summary 263
3.14 Notes 265

Chapter 4 Operational Risk 283
4.1 Background 283
4.2 Increasing Focus on Operational Risk 285
4.2.1 Drivers of Operational Risk Management 286
4.2.2 Operational Risk and Shareholder Value 288
4.3 Definition of Operational Risk 289
4.4 Regulatory Understanding of Operational Risk Definition 293
4.5 Enforcement of Operational Risk Management 296
4.6 Evolution of Operational Risk Initiatives 299
4.7 Measurement of Operational Risk 302
4.8 Core Elements of an Operational Risk Management Process 303
4.9 Alternative Operational Risk Management Approaches 304
4.9.1 Top-Down Approaches 305
4.9.2 Bottom-Up Approaches 314
4.9.3T op-Down vs. Bottom-Up oacAhpepsr 319
4.9.4 The Emerging Operational Risk Discussion 321
4.10 Capital Issues from the Regulatory Perspective 321
4.11 Capital Adequacy Issues from an Industry Perspective 324
4.11.1 Measurement Techniques and Progress in the Industry Today 327
4.11.2 Regulatory Framework for Operational Risk Overview Under the New Capital Accord 330
4.11.3 Operational Risk Standards 335
4.11.4 Possible Role of Bank Supervisors 336
4.12 Summary and Conclusion 337
4.13 Notes 338

Chapter 5 Building Blocks for Integration of Risk Categories 341
5.1 Background 341
5.2 The New Basel Capital Accord 342
5.2.1 Background 342
5.2.2 Existing Framework 343
5.2.3 Impact of the 1988 Ac3c4o5rd
5.2.4 The June 1999 Proposal 346
5.2.5 Potential Modifications to the Committee’s Proposals 348
5.3 Structure of the New Accord and Impact on Risk Management 352
5.3.1 Pillar I: Minimum Capital Requirement 352
5.3.2 Pillar II: Supervisory Review Process 353
5.3.3 Pillar III: Market Discipline and General Disclosure Requirements 354
5.4 Value at Risk and Regulatory Capital Requirement 356
5.4.1 Background 356
5.4.2 Historical Development of VaR 357
5.4.3V aR and Modern Financial Mana3g5em9 ent
5.4.4 Definition of VaR 364
5.5 Conceptual Overview of Risk Methodologies 366
5.6 Limitations of VaR 368
5.6.1 Parameters for VaR Analysis 368
5.6.2 Different Approaches to Measuring VaR 373
5.6.3Historical Simulation Method380
5.6.4 Stress Testing 382
5.6.5 Summary of Stress Tests 389
5.7 Portfolio Risk 389
5.7.1 Portfolio VaR 390
5.7.2 Incremental VaR 393
5.7.3Alternative Covariance Matrix Aoapcphres 395
5.8 Pitfalls in the Application and Interpretation of VaR 404
5.8.1 Event and Stability Risks 405
5.8.2 Transition Risk 406
5.8.3Changing Holdings 406
5.8.4 Problem Positions 406
5.8.5 Model Risks 407
5.8.6 Strategic Risks 409
5.8.7 Time Aggregation 409
5.8.8 Predicting Volatility and Correlations 414
5.8.9 Modeling Time-Varying Risk 415
5.8.10 The RiskMetrics Approach 423
5.8.11 Modeling Correlations 427
5.9 Liquidity Risk 431
5.10 Summary 436
5.11 Notes 437

Chapter 6 Case Studies 441
6.1 Structure of Studies 441
6.2 Overview of Cases 441
6.3 Metallgesellschaft 445
6.3.1 Background 445
6.3.2 Cause 448
6.3.3 Risk Areas Affected 457
6.4 Sumitomo 461
6.4.1 Background 461
6.4.2 Cause 461
6.4.3Effect 464
6.4.4 Risk Areas Affected 464
6.5 LTCM 466
6.5.1 Background 466
6.5.2 Cause 468
6.5.3Effect 472
6.5.4 Risk Areas Affected 473
6.6 Barings 479
6.6.1 Background 479
6.6.2 Cause 480
6.6.3Effect 485
6.6.4 Risk Areas Affected 486
6.7 Notes 490

GLOSSARY 495
BIBLIOGRAPHY 519
INDEX 539