Risk Management in the Derivatives Markets Derivatives and Risk Management in Mexico May 7, 2001 Dr Michel Crouhy Senior Vice President Risk Analytics and Capital Attribution Canadian Imperial Bank of Commerce Dr Robert Mark Senior Executive Vice President Chief Risk Officer Canadian Imperial Bank of Commerce Dr Michel Crouhy is Senior Vice President, Risk Analytics and Capital Attribution, Risk Management Division, at CIBC (Canadian Imperial Bank of Commerce) His responsibilities include the approval of all pricing models, the development and implementation of risk measurement methodologies for market, credit and operational risks, operational risk policy, and firm-wide capital attribution (RAROC) Prior to his current position at CIBC, Michel Crouhy was a Professor of Finance at the HEC School of Management in Paris, where he was also Director of the M.S HEC in International Finance He has been a visiting professor at the Wharton School and at UCLA Dr Crouhy holds a Ph.D from the Wharton School He is co-author of “Risk Management” (McGraw-Hill) and has published extensively in academic journals in the areas of banking, options and financial markets He is also an associate editor of the Journal of Derivatives, the Journal of Banking and Finance, and is on the editorial board of the Journal of Risk Dr Robert M Mark is a Senior Executive Vice President and Chief Risk Officer (CRO) at the Canadian Imperial Bank of Commerce (CIBC) Dr Mark reports directly to the Chairman and Chief Executive Officer of CIBC, and is a member of the Senior Executive Team (Management Committee) Dr Mark has global responsibility to cover all credit, market and operating risks for all of CIBC as well as for its subsidiaries He has been appointed to the Boards of the Fields Institute for Research in Mathematical Sciences, IBM’s Deep Computing Institute and the International Swaps and Derivative Association (ISDA) In 1998 he was awarded the Financial Risk Manager of the Year award by the Global Association of Risk Professionals (GARP) Prior to his current position at CIBC, he was the partner in charge of the Financial Risk Management Consulting practice at Coopers & Lybrand (C&L) The Risk Management Practice at C & L advised clients on market and credit risk management issues and was directed toward financial institutions and multi-national corporations This specialty area also coordinated the delivery of the firm’s accounting, tax, control, and litigation services to provide clients with integrated and comprehensive risk management solutions and opportunities Prior to his position at C&L, he was a managing director in the Asia, Europe, and Capital Markets Group (AECM) at Chemical Bank His responsibilities within AECM encompassed risk management, asset/liability management, research (quantitative analysis), strategic planning and analytic systems He served on the Senior Credit Committee of the Bank Before he joined Chemical Bank, he was a senior officer at Marine Midland Bank/Hong Kong Shanghai Bank Group (HKSB) where he headed the technical analysis trading group within the Capital Markets Sector He earned his Ph.D., with a dissertation in options pricing, from New York University’s Graduate School of Engineering and Science, graduating first in his class Subsequently, he received an Advanced Professional Certificate (APC) in accounting from NYU’s Stern Graduate School of Business, and is a graduate of the Harvard Business School Advanced Management Program He was also appointed chairperson of the National Asset/Liability Management Association (NALMA), and an Adjunct Professor at NYU’s Stern Graduate School of Business Agenda I Introduction II Best Practice Risk Management……… … 11 III Transforming Risk Into Value ……………… 34 IV New Capital Adequacy Framework ….….… 57 V BIS 98 …………………………………………… 59 VI BIS 2000+ …………………………………… 66 VII Credit Risk Mitigation ……………………… 97 VIII Counterparty Risk …………………………… 114 IX Operational Risk …………………………… 121 X Appendix……………………………………… 155 I Introduction Why Financial Institutions try to Manage Risk ? Introduction Global trends are leading to … ■ The rising importance of risk management In financial institutions ■ More complex markets – Global markets – Greater product Complexity – New businesses (e-banking, merchant banking,…) – Increasing competition – New players – Regulatory imbalances Increased Risk I Introduction ■ In the Distant Past – Institutions disaggregated their risks, and – treated each one separately ■ However, today this approach is limited due to increasing – Linkages between markets – Importance of calculating portfolio effects, e.g issuer and counterparty risks, credit spread equity risks, etc Introduction ■ In the future The leading institutions will be distinguished by their intelligent management of risk Introduction ■ Risk is multidimensional Market Risk Credit Risk Financial Risks Operational Risk Reputational Risk Business and strategic risks Introduction ■ One can “slice and dice” these multiple dimensions of risk* Equity Risk Market Risk Credit Risk “Specific Risk” Trading Risk Interest Rate Risk Currency Risk Gap Risk General Market Risk Commodity Risk Financial Risks Operational Risk Reputational Risk Business and strategic risks Counterparty Risk Transaction Risk Issuer Risk Portfolio Concentration Risk Issue Risk * For more details, see Chapter-1, “Risk Management” by Crouhy, Galai and Mark 10 OpVar Process - Shor t Ter m Adjust for changes in activity Exposure Bases Adjust for changes in risk Loss History * Historic Internal * PE, LGE, γ Industry Loss History Historic Internal + External Current PE, LGE, γ Key Risk Drivers Internal + External Scenario Analysis PE, LGE, γ * adjust rates where sufficient internal data is available OpVar 152 OpVar Process - Longer ter m Adjust for changes in activity Exposure Bases Adjust for changes in risk Loss History Industry Loss History Historic Internal PE, LGE, γ Historic Internal + External Current OpVar PE, LGE, γ Key Risk Drivers Internal + External Scenario Analysis PE, LGE, γ 153 X Appendix 154 Risk Weight for Corporate Exposure Operational Risk Related: Operational Risk’s Loss Types Exposure Base, PE, LGE Eligibility Criteria for IMA Operational Risk Disclosures: Pillar Book announcement: Risk Management by M Crouhy, D Galai and R Mark 155 Appendix Risk Weight for Cor p orate Exposure RWC = ( LGD / 50) * BRWC ( PD) *[1 + b( PD) * ( M − 3)] or (12.5 * LGD ) whichever is smaller BRWC ( PD) = Corporate benchmark risk weight: 976.5 * N (1.118 * G ( PD) + 1.288) * (1 + 0470 * (1 − PD) / PD 0.44 )10 PD = probability of default M = maturity 0.235 * (1 − PD) b( PD) = PD 0.44 + 0470 * (1 − PD) N(x) G(z) 1 = cumulative normal distribution = inverse cumulative normal distribution PD is expressed as a decimal (e.g., 0.01 for percent) 156 ■ N(1.118xG(PD)+1.288) = sum of expected and unexpected losses associated with a hypothetical, infinitelygranular portfolio of one-year loan having an LGD of 100%, using a so-called Merton-style credit risk model in which there is a single systematic risk factor and the values of borrowers’ assets are assumed lognormally distributed, a confidence level of 99.5% and an average correlation of 20% ■ The term (1+.0470x(1-PD)/PD 0.44 ) is an adjustment to reflect that the IRB benchmark risk weights are calibrated to a 3-year average maturity; and the scaling factor 976.5, which is calibrated so that the IRB benchmark risk weight equals 100% for values of PD and LGD equal to 0.7% and 50% respectively 157 Maturity Adjustments to The Risk Weights, Derived From MTM-models Maturity Adjustments PD(%) Year Years Years Years 0.03 0.4 1.0 1.6 2.3 0.05 0.4 1.0 1.6 2.1 0.10 0.5 1.0 1.5 2.0 0.20 0.6 1.0 1.4 1.8 0.50 0.7 1.0 1.3 1.6 1.00 0.7 1.0 1.3 1.5 1.40 0.8 1.0 1.2 1.5 3.30 0.8 1.0 1.2 1.3 6.60 0.9 1.0 1.1 1.3 15.0 0.9 1.0 1.1 1.2 158 Appendix CIBC Operational Risk Loss Types Legal Liability Employee* Wrongful termination Discrimination Workplace safety Privacy violation Client Restitution * Goodwill payments Payments to make client whole Theft, Fraud, Unauthorized Activities Theft/ Fraud * Defalcation Forged Cheques Worthless deposits Counterfeit cheques Account takeover Robbery Kiting Misappropriations of assets Credit card fraud Client * Fiduciary breaches/guidelines Suitability/ disclosure Account churning Aggressive sales Violation of confidentiality Lender liability Third Party * Copyright/patent /license infringement Supplier lawsuits Unauthorized Activity * lending/trading above limits intentional mismarking of positions unlicensed activity hiding trades/ loans unapproved account access Regulatory, Compliance and Taxation Penalties * Failure to comply with regulations Money laundering Tax non compliance Market manipulation Insider trading Bribes Transaction Processing Risk * Loss or Damage to Assets * Damage to buildings equipment physical certificates physical commodities holdings (eg gold) records * indicates the level at which Op VaR is calculated for each business line Data entry errors Delivery failure Collateral management failure Incomplete legal documents Reporting errors Calculation errors Wrong delivery Wrong payment amount Cash shortages Missing or disputed cheques 159 Appendix CIBC Operational Risk EI, PE, LGE LR = PE x LGE EI (Base) PE LGE Legal Liability: Client No of clients * Av Bal Per client No of lawsuits/no of clients Av loss/Av bal Per client Employee No of employee * Av Comp No of lawsuits/no of employees Av loss/Av Comp No of penalties1/no of accounts Av penalty1/Av balance per acc’t No of damages/no of phy assets Av loss/Av value of phy assets No of restitutions/no of accounts Av restitution/Av bal per account No of accounts * Av bal per account No of frauds/no of accounts Av loss/Av balance per account No of transaction & Av value per trans No of frauds/no of transactions Av loss/Av value per transaction No of errors/No of transaction Av loss/Av value per transaction Regulatory, Compliance and Taxation Penalties: No of physical assets * Av value Loss of, or Damage to Assets: No physical assets * Av value Client Restitution No of accounts * Av bal Per account Theft, Fraud and Unauthorized Activities Or Transaction Processing Risk No of transaction * Av value per transaction includes cost to comply 160 Appendix Eligibility Criteria: for IMA IMA • Active involvement of board and senior management • Independent operational risk management and control process covering design, implementation and review of measurement methodology Effective • Internal Audit Groups conduct regular reviews of management process and measurement methodology Risk Management and Control • Documentation of risk management systems • Bank must use data for risk reporting, management reporting, capital allocation, risk analysis, etc 161 Eligibility Criteria: for IMA IMA • Appropriate risk reporting systems to generate aggregate data used in capital calculation • Construct management reporting based on results • Systematically tract relevant operational risk data Measurement and Validation • Sound internal loss and event reporting practices supported by loss database systems • Regular validation of loss rates, risk indicators and size estimations, supplemented with external data • Regular scenario analysis and stress testing • Supervisors must examine the data collection, measurement, validation process and assess the appropriateness of the operational risk control environment 162 Appendix Operational Risk Disclosure: Pillar 1) The approach a bank qualifies for (i.e IMA) 2) Key elements of operational risk management framework including information about the following: a) risk policies b) organizational structure c) risk reporting system d) documentation of risk management procedures e) effective use of an information system f) organization (reporting framework) and responsibilities of an independent risk control unit g) independent reviews of the risk management systems at least annually h) involvement of board and senior management in taking responsibility for operational risk; and i) any operational risk mitigation techniques used 3) Operational risk exposure by business line (a proxy for the risk exposure is the capital charge) 163 ANNOUNCING Risk Management Michel Crouhy, Dan Galai, and Robert Mark The All-in-One Banker's and Financial Manager's Guide for Implementing  and Using  an Effective Risk Management Program In today’s world of multibillion-dollar credit losses and bailouts, it has become increasingly imperative for corporate and banking leaders to monitor and manage riskon all fronts Risk Management introduces and explores the latest financial and hedging techniques in use around the world, and provides the foundation for creating an integrated, consistent, and effective risk management strategy Risk Management presents a straightforward, nononsense examination of the modern risk management function — and is today’s best risk management resource for bankers and financial managers Its tested and comprehensive analyses and insights will give you all the information you need for: Risk Management Overview — From the history of risk management to the new regulatory and trading environment, a look at risk management past and present • 700 pages ISBN: 0-07-135731-9 $70.00 To Order Call: 1-800-2-MCGRAW Fax Orders to: 1-614-755-5645 Risk Management Program Design — Techniques to organize the risk management function, and design a system to cover your organization’s many risk exposures • Risk Management Implementation — How to use the myriad systems and productsvalue at risk (VaR), stress-testing, derivatives, and morefor measuring and hedging risk in today’s marketplace • In the financial world, the need for a dedicated risk management framework is a relatively recent phenomenon But as the recent crises attest, lack of up-todate knowledge concerning its many components can be devastating For financial managers in both the banking and business environments, Risk Management will introduce and illustrate the many aspects of modern risk managementand strengthen every financial risk management program 164 CONTENTS ABOUT THE AUTHORS Chapter 1: The Need for Risk Management Systems Michel Crouhy, Ph.D., is senior vice president, Global Chapter 2: The New Regulatory and Corporate Environment Analytics, Risk Management Division at Canadian Imperial Bank of Commerce (CIBC), where he is in charge of market and credit risk analytics He has published extensively in academic journals, is currently associate editor of both Journal of Derivatives and Journal of Banking and Finance, and is on the editorial board of Journal of Risk Chapter 3: Structuring and Managing the Risk Management Function Chapter 4: The New BIS Capital Requirements for Financial Risks Chapter 5: Measuring Market Risk: The VaR Approach Chapter 6: Measuring Market Risk: Extensions of the VaR Approach and Testing the Models Chapter 7: Credit Rating Systems Chapter 8: Credit Migration Approach to Measuring Credit Risk Chapter 9: The Contingent Claim Approach to Measuring Credit Risk Chapter 10: Other Approaches: The Actuarial and Reduced-form Approaches to Measuring Credit Risk Chapter 11: Comparison of Industry-sponsored Credit Models and Associated Back-Testing Issues Chapter 12: Hedging Credit Risk Dan Galai, Ph.D., is the Abe Gray Professor of Finance and Business Administration at Hebrew University and a principal of Sigma P.C.M Dr Galai has consulted for the Chicago Board Options Exchange and the American Stock Exchange and published numerous articles in leading journals He was the winner of the First Annual Pomeranze Prize for excellence in options research presented by the CBOE Robert Mark, Ph.D., is senior executive vice president at the Canadian Imperial Bank of Commerce Dr Mark is the chief risk officer at CIBC He is a member of the senior executive team of the bank and reports directly to the chairman In 1998, Dr Mark was named Financial Risk Manager of the Year by the Global Association of Risk Professionals (GARP) Chapter 13: Managing Operational Risk Chapter 14: Capital Allocation and Performance Measurement Chapter 15: Model Risk Chapter 16: Risk Management in Nonbank Corporations Chapter 17: Risk Management in the Future The McGraw-Hill Companies Order Services Dept., P.O Box 545, Blacklick, OH 43004-0545 Call: 1-800-2MCGRAW • Fax: 1-614-755-5645 • Email: customer.service@mcgraw-hill.com Order online at: www.books.mcgraw-hill.com  Yes, please send me copies of Crouhy / Risk Management (0-07-135731-9) for the price of $70.00 each (Price subject to change.) 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