Modern Banking

[ 168 ]

M O D E R N B A N K I N G

Chart 3.1 Credit Value at Risk.

Exposures Value-at-risk due to credit Correlations

Portfolio Value at Risk due to Credit

Source : JP Morgan (1997), CreditMetrics – Technical Document, New York: JP Morgan, p. 41.

from arising again, a more centralised structure has been put in place to oversee all credit decisions and assess risk across all asset classes. Based on their models, it might be expected that the bank would already be doing the latter. One interesting observation is that the bank announced it will use equity prices to assess credit risk, which is an approach developed by KMV Moody’s.53

3.6.8. Financial Innovation and Risk Management

The financial products discussed above are examples of recent financial innovations. Like the manufacturing sector, financial innovation can take the form of process innovation, whereby an existing product or service can be offered more cheaply because of a technological innovation. Product innovation involves the introduction of a new good or service. The new financial instruments discussed above are examples of where technological changes resulted in product innovations.

Silber (1975, 1983) argued that product innovation arises because of constraints placed on a bank – namely, regulation, competition and risk. Kane (1984) thought it important to observe the regulatory and technological factors behind any financial innovation. However, it is more useful to think of financial innovation, regulation and risk management as being interdependent. For example, regulations (such as exchange controls) can be a catalyst for financial innovation which allows bankers to bypass the rules. The eurocurrency markets developed in just this way – US interest rate restrictions and limits placed on foreign direct investment by US multinationals, together with UK exchange controls, created a demand for and supply of an offshore dollar market, the eurodollar market. As technology advanced,

53 Source of this information: Silverman (2003), The Financial Times.

[ 169 ]

M A N A G E M E N T O F R I S K S I N B A N K I N G

this became the eurocurrency market, allowing bankers to trade in all the key currencies outside any domestic regulations. Even though most of the offending regulations have since been relaxed, the market continues to thrive.

Risk management and financial innovation are also interdependent. Financial innovation has made it possible to unbundle the different types of risks which, in turn, has led to measurement of different types of risks. At the same time, financial innovation has forced banks to re-examine their risk management systems, because banks are increasingly exposed to new forms of risk, which are quite different in nature from the traditional credit risk. For example, Bankhaus Herstatt collapsed in 1974 because of inexperience in dealing with foreign exchange risk. However, to date, very few bank collapses can be said to have been caused by a failure to understand risk exposure associated with a new instrument.

3.7. Risk Management by Major Global Bank

Barclays Bank plc very kindly agreed to provide information on how a major global bank actually manages its risk.54 Barclays is a long-established British bank, headquartered in London but with major global operations. By tier 1 capital, it is the fourth largest UK bank, and ranks 14th in the world, according to the July 2003 edition of The Banker. Chart 3.2 shows the way Barclays organises its risk management. Essentially, risk is managed along two lines, by type of risk and by different business units. Four directors, each in charge of a certain type of risk (e.g. credit risk, market risk) report to a group risk director, as do three directors in charge of functional support, such as regulatory compliance. Seven ‘‘business risk’’ directors also report to the group risk director. One business unit is their investment banking arm, Barclays Capital, others include Barclaycard, Business Banking and Barclays Private Clients.

Barclays classifies risk into four categories: credit, market, non-financial and other risk. Credit Risk is defined as the risk that customers will not repay their obligations, and is

divided into retail and wholesale risk.

Market Risk is the risk of loss due to changes in the level or volatility of market rates or prices such as interest rates, foreign exchange rates, equity prices and commodity prices. It is incurred as a result of both trading and non-trading activities.

Non-financial Risk consists of operational risk, using the Basel definition (see p.110, Chapter 4) and business risk, defined as the potential to incur a loss because of an unexpected decline in revenue, which cannot be offset by a corresponding decrease in costs.

Other risk includes risks arising from all other sources, such as property, equipment, associates (e.g. risk linked to joint ventures), and so on. Given the diversity of risks in this category, there is no further discussion of it in this section.

Barclays divides market risk into trading risk and retail market risk. Trading risk is primarily incurred by Barclays Capital and Treasury operations – used to support customer services, such as the sale or purchase of foreign currencies. DVaR, or daily value at risk of the exposure, is the central measure used in Treasury operations and at Barclays Capital. Trading market risk is evaluated through a multiple of the DVaR (e.g. DVaR times some multiple). The same method is employed for Treasury operations but with a higher multiple.

54 The author would like to thank Mick Green, Tim Thompson, and Saadia Mujeeb, of Barclays Bank plc for their assistance in supplying this information.

[ 171 ]

M A N A G E M E N T O F R I S K S I N B A N K I N G

Retail market risk arises from imperfect hedges against customer products, either due to the unexpected customer behaviour or losses arising from residual unhedged positions. It applies to all fixed rate, capped rate or index-linked products, across all business units, except for Barclays Capital. There are three categories. Prepayment risk – the risk that customer repayments or withdrawals are unexpected. Recruitment risk – the risk that the bank fails to sell the expected amount of a fixed rate product (e.g. bond), usually due to an adverse movement in market rates. In this event, the bank has to adjust the hedge, by buying/selling interest rate swaps. It can affect the expected cost of funds. Finally, residual unhedged risk – occurs if the actual hedge positions differ from the hedge positions determined by the hedge models that are used. Again, the risk is estimated based on a multiple of the DVaR of the exposure.

Wholesale Credit Risk is the risk of losses arising from default by a wholesale counterparty. Though Barclays uses both Creditmetrics and KMV Portfolio Manager. The KMV model, now based on five years of experience, is used to assess wholesale credit risk. The KMV model has been discussed at length. At Barclays, KMV Portfolio Manager is used to compute the capital which should be set aside for each individual exposure, then aggregated over the business unit to provide the overall capital allocation for that unit.

Retail Credit Risk employs two methodologies. For the ‘‘base level’’ methodology, it is assumed that the factors affecting the probability of borrower default are factors specific to a borrower (e.g. age, occupation) and the influence of the state of the macroeconomy on the retail sector. The correlation between the systematic and factor-specific variables is also taken into account. This framework was chosen because it is consistent with the KMV model (used to assess wholesale credit risk) and with the approaches recommended by Basel

2.It is also relatively easy to use because it is based on straightforward formulae.

The second methodology for retail credit risk is known as the advanced approach, and is

applied to Barclaycard. Here, Monte Carlo techniques are used to estimate a loss distribution. To reduce concentrations of retail credit risk, Barclays uses securitisation (transferring

assets off-balance sheet), credit derivatives and insurance.

Barclays manages operational risk beginning with the assumption that OR consists of two independent stochastic components, frequency of loss and severity of loss. Four variables are used to model operational risk: (1) the expected number of loss events over a one-year time horizon, assuming risk controls are in place; (2) the expected size of the loss once it occurs, assuming risk controls are in place; (3) loss mitigation or the use of effective controls to mitigate a percentage of the loss; (4) the degree to which the controls in (3) are effective. Using (1) through (4), Barclays employs a Monte Carlo model to simulate the frequency and severity of the loss events. It also monitors the effectiveness of risk controls over time, using the available data. Once the capital to be set aside is calculated, it can be reduced through a scorecard, which assesses how well the operating risks are being managed/controlled in a given unit.

3.8. Conclusion

This chapter reviewed the various aspects of bank risk management. It began by noting that banks differ from other firms in the range of financial risks they assume. The management of these risks will be a crucial determinant of their profitability and shareholder value-added.

[ 172 ]

M O D E R N B A N K I N G

The traditional function of an asset– liability management group in banks which involves the management of credit, interest rate and liquidity risks was reviewed, together with the use of gap analysis, duration and duration gap analysis for on-balance sheet items. Increasingly, however, banks act as intermediaries in risk management; a central objective of the modern bank is the management of a whole range of unbundled risks: credit/counterparty, market (including interest rate and currency risks), sovereign and operating risks. The latter two are discussed in Chapters 4 and 6, respectively. As credit insurance grows, some of the key global banks are acting as conduits of risk, shifting credit risk to non-bank financial institutions, an issue to be discussed in the next chapter.

Section 3.5 on market risk introduced many of the new techniques developed to manage market risk. Risk adjusted return on capital (RAROC) can be used both for risk management and to compare relative performance, using a hurdle rate. Value at Risk was originally developed to manage market risk, though it has been modified to measure credit risk exposures. Though VaR offers a new quantitative approach to measuring market risk, a critique of its use followed, illustrated by the quotes from Jorion and Taleb (see p. 153–4). Given the problems with VaR, stress tests under different scenarios are essential, though they have their limitations too. Techniques for managing retail, corporate and aggregate credit risk were also discussed.

Derivatives, introduced briefly in Chapter 2, were reviewed in more detail, together with a discussion of the ways banks use them as tools for risk management. The growth of exchange traded and customised OTC derivatives has meant banks can broaden the type of intermediation they undertake. Banks can use derivatives for proprietary trading and speculation, to hedge, or as part of fee-based risk management services offered to customers. It was argued that banks and customers alike must understand the purpose for which a given instrument is being used. There have been many cases where large corporations have lost enormous sums and have claimed, in some cases correctly, that they were ill-advised by their banks.

Section 3.7 looked at how a major commercial bank organises its risk management function. If the objective is to maximise profits and shareholder value-added, then the way risk management is organised in a bank is as important as the development of risk management tools and techniques. This point assumes even greater importance now that the Basel Committee is proposing to allow banks, subject to the approval of national supervisors, to determine their capital requirements for market and other risks, using their own internal models.

In this chapter, it has been stressed that bank risk management has undergone a profound change since the 1980s, and will continue to evolve in the 21st century. In the next two chapters, the focus shifts to the role of the regulatory bodies, which are trying to introduce systems to encourage the operation of an efficient but stable domestic and global financial system. These chapters should help managers understand how and why governments tend to single out banks for special attention, how the regulations impact on bank structure, and identify the major regulatory challenges of the 21st century.

[ 174 ]

M O D E R N B A N K I N G

amount of output produced by the monopolist is lower and the price charged is higher compared to firms operating in a perfectly competitive market. Governments react either by introducing measures to encourage greater competition and/or monitoring the price set by these firms, and if necessary, intervening to force the firms to reduce prices.

3.To protect the public from criminal activity.

4.To deal with the effects of externalities: the effects of the actions of one agent in the economy on others, which is not reflected through the price mechanism. There are positive and negative externalities. If a neighbour’s property is kept in good order, other neighbours benefit not just from enhanced property values but because it is pleasant to look at neighbourhood houses and gardens. A classic example of a negative externality is pollution. Industrial output in the USA can pollute the rivers, lakes and air in Canada. Governments intervene to minimise the effects of negative externalities. For example, the Canadian government might try to reach an agreement with the USA to reduce emissions.

In financial markets, these principles apply to the following.

1.Protecting the investor: the quality of many financial products is not easily observed, which makes it important for the investor to be kept fully informed about the risks he or she incurs when purchasing a financial product. Investors are expected to assume some of this responsibility, but often, government directives are needed to ensure financial firms provide adequate information.

2.The concentration of financial firms in the market place: the financial sector is made up of many different markets, from retail banking markets to global bond markets. The competitive structure of each of these markets varies considerably. Global markets tend to be more competitive if firms from all over the world are active in them. Some domestic markets have only a few firms offering banking services. Recall from Chapter 1 the concern expressed by Cruickshank over the apparent lack of competition in the UK payments system because it was controlled by only a few firms. In 2001, the UK’s Competition Commission ruled against the proposed merger of Lloyds TSB and Abbey National on the grounds that it would leave the retail banking market too concentrated. In 1998, the federal government of Canada refused the proposed mergers of the Toronto Dominion Bank with the Canadian Imperial Bank of Commerce and the Royal Bank of Canada with the Bank of Montreal on the grounds that the Canadian system would be too concentrated.1

3.Illegal activities: agents who engage in financial fraud, money laundering and tax evasion.

4.Externalities: the problem is actions by agents which undermine the stability of the financial system. In the financial markets, contagion often results in negative externalities. For example, in 1998, when it became apparent that a hedge fund, Long Term Capital Markets (LTCM), was about to collapse, concern that its failure might threaten

1 Concern was also expressed that if one of the newly merged banks got into difficulty and was closed, it would increase monopoly power, and/or the risk of systemic crises should another failure occur. The possible takeover of a major bank (should it get into financial difficulty) by a foreign concern is also considered undesirable, unlike other countries, such as Mexico and New Zealand.