Page i Risk Management Michel Crouhy Dan Galai Robert Mark Page v Contents Foreword By Robert C. Merton xiii Introduction By John Hunkin xvii Preface xix Chapter 1 The Need for Risk Management Systems 1 1. Introduction 1 2. Historical Evolution 4 3. The Regulatory Environment 19 4. The Academic Background and Technological Changes 21 5. Accounting Systems versus Risk Management Systems 29 6. Lessons from Recent Financial Disasters 31 7. Typology of Risk Exposures 34 8. Extending Risk Management Systems to Nonfinancial Corporations 39 Notes 41 Chapter 2 The New Regulatory and Corporate Environment 45 1. Introduction 45 2. The Group of 30 (G-30) Policy Recommendations 48 3. The 1988 BIS Accord: The "Accord" 53 4. The "1996 Amendment" or "BIS 98" 62 5. The BIS 2000 + Accord 68 Notes 91 Chapter 3 Structuring and Managing the Risk Management Function in a Bank 97 1. Introduction 97 2. Organizing the Risk Management Function: Three-Pillar Framework 99 Page vi 3. Data and Technological Infrastructure 109 4. Risk Authorities and Risk Control 116 5. Establishing Risk Limits for Gap and Liquidity Management 126 6. Conclusion: Steps to Success 133 Notes 135 Chapter 4 The New BIS Capital Requirements for Financial Risks 137 1. Introduction 137 2. The Standardized Approach 138 3. The Internal Models Approach 150 4. Pros and Cons of the Standardized and Internal Models Approaches: A New Proposal—the "Precommitment Approach" 162 5. Comparisons of the Capital Charges for Various Portfolios According to the Standardized and the Internal Models Approaches 165 6. Conclusions 169 Notes 174 Chapter 5 Measuring Market Risk: The VaR Approach 177 1. Introduction 177 2. Measuring Risk: A Historical Perspective 179 3. Defining Value at Risk 187 4. Calculating Value at Risk 196 5. Conclusion: Pros and Cons of the Different Approaches 216 Appendix 1: Duration and Convexity of a Bond 218 Notes 225 Chapter 6 Measuring Market Risk: Extensions of the VaR Approach and Testing the Models 229 1. Introduction 229 2. Incremental-VaR (IVAR), DeltaVar (DVAR), and Most Significant Risks 230 3. Stress Testing and Scenario Analysis 232 Page vii 4. Dynamic-VaR 241 5. Measurement Errors and Back-Testing of VaR Models 243 6. Improved Variance-Covariance VaR Model 249 7. Limitations of VaR as a Risk Measure 252 Appendix: Proof of the Deltavar Property 255 Notes 257 Chapter 7 Credit Rating Systems 259 1. Introduction 259 2. Rating Agencies 261 3. Introduction to Internal Risk Rating 269 4. Debt Rating and Migration 275 5. Financial Assessment (Step 1) 282 6. First Group of Adjustment Factors for Obligor Credit Rating 290 7. Second Group of Adjustment Factors for Facility Rating 298 8. Conclusion 301 Appendix 1: Definitions of Key Ratios 302 Appendix 2: Key Financial Analysis Measures 303 Appendix 3A: Prototype Industry Assessment: Telecommunications in Canada 306 Appendix 3B: Prototype Industry Assessment: Footwear and Clothing in Canada 308 Appendix 4: Prototype Country Analysis Report (Condensed Version): Brazil 310 Notes 312 Chapter 8 Credit Migration Approach to Measuring Credit Risk 315 1. Introduction 315 2. CreditMetrics Framework 319 3. Credit VaR for a Bond (Building Block 1) 321 4. Credit VaR for a Loan or Bond Portfolio (Building Block 2) 329 5. Analysis of Credit Diversification (Building Block 2, Continuation) 338 6. Credit VaR and the Calculation of the Capital Charge 339 Page viii 7. CreditMetrics as a Loan/Bond Portfolio Management Tool: Marginal Risk Measures (Building Block 2, Continuation) 340 8. Estimation of Asset Correlations (Building Block 3) 342 9. Exposures (Building Block 4) 343 10. Conditional Transition Probabilities: CreditPortfolioView 344 11. Appendix 1: Elements of Merton's Model 347 Appendix 2: Default Prediction—The Econometric Model 350 Appendix 3: Transition Matrix over a Period of Less than One Year 352 Notes 352 Chapter 9 The Contingent Claim Approach to Measuring Credit Risk 357 1. Introduction 357 2. A Structural Model of Default Risk: Merton's (1974) Model 360 3. Probability of Default, Conditional Expected Recovery Value, and Default Spread 364 4. Estimating Credit Risk as a Function of Equity Value 366 5. KMV Approach 368 6. KMV's Valuation Model for Cash Flows Subject to Default Risk 381 7. Asset Return Correlation Model 384 Appendix 1: Integrating Yield Spread with Options Approach 389 Appendix 2: Risk-Neutral Valuation Using "Risk-Neutral" EDFs 392 Appendix 3: Limitations of the Merton Model and Some Extensions 395 Notes 399 Chapter 10 Other Approaches: The Actuarial and Reduced-Form Approaches to Measuring Credit Risk 403 1. Introduction 403 2. The Actuarial Approach: CreditRisk+ 404 3. The Reduced-Form Approach or Intensity-Based Models 411 Notes 422 Page ix Chapter 11 Comparison of Industry-Sponsored Credit Models and Associated Back-Testing Issues 425 1. Introduction 425 2. Comparison of Industry-Sponsored Credit Risk Models 427 3. Stress Testing and Scenario Analysis 430 4. Implementation and Validation Issues 436 Notes 438 Chapter 12 Hedging Credit Risk 441 1. Introduction 441 2. Credit Risk Enhancement 443 3. Derivative Product Companies 446 4. Credit Derivatives 448 5. Types of Credit Derivatives 452 6. Credit Risk Securitization for Loans and High Yield Bonds 461 7. Regulatory Issues 466 Notes 470 Chapter 13 Managing Operational Risk 475 1. Introduction 475 2. Typology of Operational Risks 478 3. Who Should Manage Operational Risk? 482 4. The Key to Implementing Bank-Wide Operational Risk Management 486 [...]... Notes 577 Chapter 15 Model Risk 579 1 Introduction 579 2 Valuation Models and Sources of Model Risk 581 3 Typology of Model Risks 585 4 What Can Go Wrong? 594 5 What Can Market Risk Management Do to Mitigate Model Risk? 606 6 Conclusions 610 Notes 611 Chapter 16 Risk Management in Nonbank Corporations 615 1 Introduction 615 2 Why Manage Risks? 617 Page xi 3 Procedure for Risk Management 622 4 Accounting... field of risk management We try to cover both institutional aspects and organizational issues, while not forgetting that risk management is based on statistical and financial models The book is a comprehensive treatment of all aspects of risk management It starts by discussing the new regulatory framework that is shaping best practice risk management in the banking industry worldwide The risk management. .. consistent with our own risk management strategy and experience Our risk management strategy is designed to ensure that our senior management operates together in partnership to control risk while ensuring the independence of the risk management function Improvements in analytic models and systems technology have Page xviii greatly facilitated our ability to measure and manage risk However, the new millennium... bear its credit risk, even for a price The book presents the major competing models for measuring and valuing credit risk and evaluates them, both theoretically and empirically In addition to market and credit risk exposures, a comprehensive approach to risk measurement and risk management must also include operational risks, which is the subject of Chapter 13 Furthermore, no risk management system... for Operational Risk 489 6 Capital Attribution for Operational Risks 505 7 Self-Assessment versus Risk Management Assessment 509 8 Integrated Operational Risk 511 9 Conclusion 513 Appendix 1: Group of Thirty Recommendations: Derivatives and Operational Risk 514 Appendix 2: Types of Operational Risk Losses 518 Page x Appendix 3: Severity versus Likelihood 519 Appendix 4: Training and Risk Education 519... institution's ability to manage risk, then its share price will be penalized Risk is a cost of doing business for a financial institution and consequently best practice risk management is a benefit to our shareholders To manage the risks facing an institution we must have a clearly defined set of risk policies and the ability to measure risk But what do we measure? And how do we measure such risks? We must also... The book is arranged according to the major subjects of modern risk management Chapter 1 discusses the need for risk management systems Chapter 2 presents the new regulatory framework that is shaping modern risk management in financial institutions and nonbank corporations Chapter 3 provides an integrated framework for best-practice risk management We explain how financial institutions should establish... the risk that it has assumed The change in emphasis from simplistic "profit-oriented" management to risk/ return management can also be seen in non-bank corporations Many major corporations are now engaged in active risk management Of course, "risk" was always a major consideration in deciding whether to take advantage of investment opportunities However, rejecting projects because they seem to be risky... cons of modern risk management techniques as applied to nonbank corporations The relevant question is not whether corporations should engage in risk management but, rather, how they can manage risk in a rational way We also discuss some new accounting standards that have been introduced to deal with the derivative and hedging activities of corporations Chapter 17 presents our views on risk management in... financial risks and the techniques and instruments being adopted to control these risks The book provides a consistent and comprehensive coverage of all aspects of risk management organizational structure, methodologies, policies, and infrastructure—for both financial and nonfinancial institutions It offers an up-to-date exposition of risk measurement techniques for market, credit risk, and operational risk . and credit risk exposures, a comprehensive approach to risk measurement and risk management must also include operational risks, which is the subject of Chapter 13. Furthermore, no risk management. Mitigate Model Risk? 606 6. Conclusions 610 Notes 611 Chapter 16 Risk Management in Nonbank Corporations 615 1. Introduction 615 2. Why Manage Risks? 617 Page xi 3. Procedure for Risk Management. consistent with our own risk management strategy and experience. Our risk management strategy is designed to ensure that our senior management operates together in partnership to control risk while ensuring