Risk Management and Capital Adequacy / Edition 1

by Reto Gallati

Overview

Under the new Basle Guidelines, all financial institutions subject to local banking laws will soon be required to operate under dramatically different risk exposure rules. Risk Management and Capital Adequacy provides details on the key risk approaches under these new guidelines and is the first book to analyze if and how they can be integrated. From conceptual frameworks to analyses of models and approaches, it provides a solid reference source for the information that everyone in risk management will soon need to know.

Product Details

ISBN-13:	9780071407632
Publisher:	McGraw Hill LLC
Publication date:	03/21/2003
Pages:	550
Product dimensions:	6.30(w) x 9.10(h) x 1.73(d)

About the Author

Reto Gallati, Ph.D., is deputy chief risk officer at Putnam Investments. A visiting professor at MIT's Sloan School of Management, Dr. Gallati has also worked in risk management at KPMG, Goldman Sachs, and Crédit Suisse and has been an instructor at Boston University, Harvard, and the University of Zurich.

Table of Contents

	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 Differentiation	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
1.6.3	Related 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
1.7.3	Factors That Support Systemic Risk	26
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
2.4.3	Modified Form of CAPM by Black, Jensen, and Scholes	45
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
2.5.3	Criticisms of the 1988 Approach	58
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
2.6.3	The de Minimis Rule	62
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
2.7.3	Equity Position Risk	79
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
2.8.3	Requirement for Specific Risks	98
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
2.12.3	Securities 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[superscript +] Model	190
3.8.9	CSFB's CreditRisk[superscript +] 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 Stress 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
4.9.3	Top-Down vs. Bottom-Up Approaches	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 Accord	345
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
5.4.3	VaR and Modern Financial Management	359
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
5.6.3	Historical Simulation Method	380
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
5.7.3	Alternative Covariance Matrix Approaches	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
5.8.3	Changing 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
6.4.3	Effect	464
6.4.4	Risk Areas Affected	464
6.5	LTCM	466
6.5.1	Background	466
6.5.2	Cause	468
6.5.3	Effect	472
6.5.4	Risk Areas Affected	473
6.6	Barings	479
6.6.1	Background	479
6.6.2	Cause	480
6.6.3	Effect	485
6.6.4	Risk Areas Affected	486
6.7	Notes	490
	Glossary	495
	Bibliography	519
	Index	539