Risk Management and Shareholders' Value in Banking From Risk Measurement Models to Capital Allocation Policies

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ISBN: 9780470029787 | 0470029781
Cover: Hardcover
Copyright: 5/21/2007

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This book presents an integrated framework for risk measurement, capital management and value creation in banks. Moving from the measurement of the risks facing a bank, it defines criteria and rules to support a corporate policy aimed at maximizing shareholders' value. Parts I - IV discuss different risk types (including interest rate, market, credit and operational risk) and how to assess the amount of capital they absorb by means of up-to-date, robust risk-measurement models. Part V surveys regulatory capital requirements: a special emphasis is given to the Basel II accord, discussing its economic foundations and managerial implications. Part VI presents models and techniques to calibrate the amount of economic capital at risk needed by the bank, to fine-tune its composition, to allocate it to risk-taking units, to estimate the "fair" return expected by shareholders, to monitor the value creation process. Risk Management and Shareholders' Value in Banking includes: * Value at Risk, Monte Carlo models, Creditrisk+, Creditmetrics and much more * formulae for risk-adjusted loan pricing and risk-adjusted performance measurement * extensive, hands-on Excel examples are provided on the companion website www.wiley.com/go/rmsv * a complete, up-to-date introduction to Basel II * focus on capital allocation, Raroc, EVA, cost of capital and other value-creation metrics

Foreword	p. xix
Motivation and Scope of this Book: A Quick Guided Tour	p. xxi
Interest Rate Risk	p. 1
	p. 3
The Repricing Gap Model	p. 9
Introduction	p. 9
The gap concept	p. 9
The maturity-adjusted gap	p. 12
Marginal and cumulative gaps	p. 15
The limitations of the repricing gap model	p. 19
Some possible solutions	p. 20
Non-uniform rate changes: the standardized gap	p. 20
Changes in rates of on-demand instruments	p. 23
Price and quantity interaction	p. 24
Effects on the value of assets and liabilities	p. 25
Selected Questions and Exercises	p. 25
The Term Structure of Interest Rates	p. 28
Forward Rates	p. 32
The Duration Gap Model	p. 35
Introduction	p. 35
Towards mark-to-market accounting	p. 35
The duration of financial instruments	p. 39
Duration as a weighted average of maturities	p. 39
Duration as an indicator of sensitivity to interest rates changes	p. 40
The properties of duration	p. 42
Estimating the duration gap	p. 42
Problems of the duration gap model	p. 45
Selected Questions and Exercises	p. 47
The Limits of Duration	p. 49
Models Based on Cash-Flow Mapping	p. 57
Introduction	p. 57
The objectives of cash-flow mapping and term structure	p. 57
Choosing the vertices of the term structure	p. 58
Techniques based on discrete intervals	p. 59
The duration intervals method	p. 59
The modified residual life method	p. 60
The Basel Committee Method	p. 61
Clumping	p. 64
Structure of the methodology	p. 64
An example	p. 65
Clumping on the basis of price volatility	p. 67
Concluding comments	p. 68
Selected Questions and Exercises	p. 69
Estimating the Zero-Coupon Curve	p. 71
Internal Transfer Rates	p. 77
Introduction	p. 77
Building an ITR system: a simplified example	p. 77
Single and multiple ITRs	p. 79
Setting internal interest transfer rates	p. 84
ITRs for fixed-rate transactions	p. 84
ITRs for floating-rate transactions	p. 85
ITRs for transactions indexed at "non-market" rates	p. 85
ITRs for transactions with embedded options	p. 88
Option to convert from fixed to floating rate	p. 88
Floating rate loan subject to a cap	p. 89
Floating rate loan subject to a floor	p. 90
Floating rate loan subject to both a floor and a cap	p. 91
Option for early repayment	p. 91
Summary: the ideal features of an ITR system	p. 93
Selected Questions and Exercises	p. 94
Derivative Contracts on Interest Rates	p. 96
Market Risks	p. 103
	p. 105
The Variance-Covariance Approach	p. 115
Introduction	p. 115
VaR derivation assuming normal return distribution	p. 115
A simplified example	p. 115
Confidence level selection	p. 121
Selection of the time horizon	p. 124
Sensitivity of portfolio positions to market factors	p. 126
A more general example	p. 126
Portfolio VaR	p. 128
Delta-normal and asset-normal approaches	p. 132
Mapping of risk positions	p. 133
Mapping of foreign currency bonds	p. 133
Mapping of forward currency positions	p. 135
Mapping of forward rate agreements	p. 139
Mapping of stock positions	p. 140
Mapping of bonds	p. 143
Summary of the variance-covariance approach and main limitations	p. 143
The normal distribution hypothesis	p. 144
Serial independence and stability of the variance-covariance matrix	p. 147
The linear payoff hypothesis and the delta/gamma approach	p. 148
Selected Questions and Exercises	p. 151
Stockmarket Betas	p. 154
Option Sensitivity Coefficients: "Greeks"	p. 157
Volatility Estimation Models	p. 163
Introduction	p. 163
Volatility estimation based upon historical data: simple moving averages	p. 163
Volatility estimation based upon historical data: exponential moving averages	p. 167
Volatility prediction: GARCH models	p. 172
Volatility prediction: implied volatility	p. 179
Covariance and correlation estimation	p. 181
Selected Questions and Exercises	p. 182
Simulation Models	p. 185
Introduction	p. 185
Historical simulations	p. 189
A first example: the VaR of a single position	p. 189
Estimation of a portfolio's VaR	p. 193
A comparison between historical simulations and the variance-covariance approach	p. 195
Merits and limitations of the historical simulation method	p. 196
The hybrid approach	p. 198
Bootstrapping and path generation	p. 201
Filtered historical simulations	p. 202
Monte Carlo simulations	p. 205
Estimating the VaR of a single position	p. 207
Estimating portfolio VaR	p. 209
Merits and limitations of Monte Carlo simulations	p. 214
Stress testing	p. 218
Selected Questions and Exercises	p. 221
Evaluating VaR Models	p. 225
Introduction	p. 225
An example of backtesting: a stock portfolio VaR	p. 225
Alternative VaR model backtesting techniques	p. 232
The unconditional coverage test	p. 233
The conditional coverage test	p. 238
The Lopez test based upon a loss function	p. 241
Tests based upon the entire distribution	p. 243
Selected Questions and Exercises	p. 244
VaR Model Backtesting According to the Basel Committee	p. 246
VaR Models: Summary, Applications and Limitations	p. 251
Introduction	p. 251
A summary overview of the different models	p. 251
Applications of VaR models	p. 253
Comparison among different risks	p. 253
Determination of risk taking limits	p. 257
The construction of risk-adjusted performance (RAP) measures	p. 258
Six "False Shortcomings" of VaR	p. 260
VaR models disregard exceptional events	p. 260
VaR models disregard customer relations	p. 261
VaR models are based upon unrealistic assumptions	p. 261
VaR models generate diverging results	p. 262
VaR models amplify market instability	p. 262
VaR measures "come too late, when damage has already been done"	p. 263
Two real problems of VaR models	p. 263
The Size of Losses	p. 263
Non-subadditivity	p. 265
An Alternative Risk Measure: Expected Shortfall (ES)	p. 268
Selected Questions and Exercises	p. 269
Extreme Value Theory	p. 272
Credit Risk	p. 275
	p. 277
Credit-Scoring Models	p. 287
Introduction	p. 287
Linear discriminant analysis	p. 287
The discriminant function	p. 287
Wilks' Lambda	p. 292
Altman's Z-score	p. 294
From the score to the probability of default	p. 295
The cost of errors	p. 296
The selection of discriminant variables	p. 297
Some hypotheses underlying discriminant analysis	p. 299
Regression models	p. 299
The linear probabilistic model	p. 299
The logit and probit models	p. 301
Inductive models	p. 301
Neural networks	p. 301
Genetic algorithms	p. 304
Uses, limitations and problems of credit-scoring models	p. 307
Selected Questions and Exercises	p. 309
The Estimation of the Gamma Coefficients in Linear Discriminant Analysis	p. 311
Capital Market Models	p. 313
Introduction	p. 313
The approach based on corporate bond spreads	p. 313
Foreword: continuously compounded interest rates	p. 314
Estimating the one-year probability of default	p. 314
Probabilities of default beyond one year	p. 315
An alternative approach	p. 318
Benefits and limitations of the approach based on corporate bond spreads	p. 320
Structural models based on stock prices	p. 321
An introduction to structural models	p. 321
Merton's model: general structure	p. 322
Merton's model: the role of contingent claims analysis	p. 324
Merton's model: loan value and equilibrium spread	p. 326
Merton's model: probability of default	p. 328
The term structure of credit spreads and default probabilities	p. 328
Strengths and limitations of Merton's model	p. 330
The KMV model for calculating V[subscript 0] and [sigma subscript v]	p. 332
The KMV approach and the calculation of PD	p. 334
Benefits and limitations of the KMV model	p. 337
Selected Questions and Exercises	p. 340
Calculating the Fair Spread on a Loan	p. 342
Real and Risk-Neutral Probabilities of Default	p. 343
LGD and Recovery Risk	p. 345
Introduction	p. 345
What factors drive recovery rates?	p. 346
The estimation of recovery rates	p. 347
Market LGD and Default LGD	p. 347
Computing workout LGDs	p. 348
From past data to LGD estimates	p. 351
Results from selected empirical studies	p. 353
Recovery risk	p. 356
The link between default risk and recovery risk	p. 358
Selected Questions and Exercises	p. 362
The Relationship between PD and RR in the Merton model	p. 364
Rating Systems	p. 369
Introduction	p. 369
Rating assignment	p. 370
Internal ratings and agency ratings: how do they differ?	p. 370
The assignment of agency ratings	p. 372
Rating assessment in bank internal rating systems	p. 376
Rating quantification	p. 379
The possible approaches	p. 379
The actuarial approach: marginal, cumulative and annualized default rates	p. 380
The actuarial approach: migration rates	p. 386
Rating validation	p. 388
Some qualitative criteria	p. 388
Quantitative criteria for validating rating assignments	p. 389
The validation of the rating quantification step	p. 396
Selected Questions and Exercises	p. 398
Portfolio Models	p. 401
Introduction	p. 401
Selecting time horizon and confidence level	p. 402
The choice of the risk horizon	p. 402
The choice of the confidence level	p. 405
The migration approach: CreditMetrics	p. 406
Estimating risk on a single credit exposure	p. 407
Estimating the risk of a two-exposure portfolio	p. 412
Estimating asset correlation	p. 418
Application to a portfolio of N positions	p. 420
Merits and limitations of the CreditMetrics model	p. 422
The structural approach: PortfolioManager	p. 423
The macroeconomic approach: CreditPortfolioView	p. 426
Estimating conditional default probabilities	p. 426
Estimating the conditional transition matrix	p. 427
Merits and limitations of CreditPortfolioView	p. 428
The actuarial approach: CreditRisk+	p. 428
Estimating the probability distribution of defaults	p. 429
The probability distribution of losses	p. 430
The distribution of losses of the entire portfolio	p. 432
Uncertainty about the average default rate and correlations	p. 434
Merits and limitations of CreditRisk+	p. 438
A brief comparison of the main models	p. 439
Some limitations of the credit risk models	p. 442
The treatment of recovery risk	p. 443
The assumption of independence between exposure risk and default risk	p. 443
The assumption of independence between credit risk and market risk	p. 444
The impossibility of backtesting	p. 444
Selected Questions and Exercises	p. 446
Asset correlation versus default correlation	p. 449
Some Applications of Credit Risk Measurement Models	p. 451
Introduction	p. 451
Loan pricing	p. 451
The cost of the expected loss	p. 452
The cost of economic capital absorbed by unexpected losses	p. 453
Risk-adjusted performance measurement	p. 457
Setting limits on risk-taking units	p. 459
Optimizing the composition of the loan portfolio	p. 461
Selected Questions and Exercises	p. 462
Credit Risk Transfer Tools	p. 464
Counterparty Risk on OTC Derivatives	p. 473
Introduction	p. 473
Settlement and pre-settlement risk	p. 474
Estimating pre-settlement risk	p. 474
Two approaches suggested by the Basel Committee (1988)	p. 475
A more sophisticated approach	p. 477
Estimating the loan equivalent exposure of an interest rate swap	p. 479
Amortization and diffusion effect	p. 484
Peak exposure (PE) and average expected exposure (AEE)	p. 489
Further approaches to LEE computation	p. 493
Loan equivalent and Value at Risk: analogies and differences	p. 494
Risk-adjusted performance measurement	p. 495
Risk-mitigation tools for pre-settlement risk	p. 496
Bilateral netting agreements	p. 496
Safety margins	p. 500
Recouponing and guarantees	p. 501
Credit triggers and early redemption options	p. 501
Selected Questions and Exercises	p. 504
Operational Risk	p. 505
	p. 507
Operational Risk: Definition, Measurement and Management	p. 511
Introduction	p. 511
OR: How can we define it?	p. 512
OR risk factors	p. 512
Some peculiarities of OR	p. 514
Measuring OR	p. 517
Identifying the risk factors	p. 518
Mapping business units and estimating risk exposure	p. 518
Estimating the probability of the risky events	p. 519
Estimating the losses	p. 522
Estimating expected loss	p. 524
Estimating unexpected loss	p. 527
Estimating Capital at Risk against OR	p. 529
Towards an OR management system	p. 533
Final remarks	p. 535
Selected Questions and Exercises	p. 537
OR measurement and EVT	p. 539
Regulatory Capital Requirements	p. 543
	p. 545
The 1988 Capital Accord	p. 547
Introduction	p. 547
The capital ratio	p. 549
Regulatory capital (RC)	p. 549
Tier 1 capital	p. 549
Supplementary capital (Tier 2 and Tier 3)	p. 552
Risk weights (w[subscript i])	p. 554
Assets included in the capital ratio (A[subscript i])	p. 555
Shortcomings of the capital adequacy framework	p. 555
Focus on credit risk only	p. 556
Poor differentiation of risk	p. 556
Limited recognition of the link between maturity and credit risk	p. 556
Disregard for portfolio diversification	p. 556
Limited recognition of risk mitigation tools	p. 559
"Regulatory arbitrage"	p. 559
Conclusions	p. 559
Selected Questions and Exercises	p. 559
The Basel Committee	p. 563
The Capital Requirements for Market Risks	p. 565
Introduction	p. 565
Origins and characteristics of capital requirements	p. 565
Origins of the requirements	p. 565
Logic and scope of application	p. 566
The "building blocks" approach	p. 567
Tier 3 Capital	p. 568
The capital requirement on debt securities	p. 568
The requirement for specific risk	p. 568
The requirement for generic risk	p. 569
Positions in equity securities: specific and generic requirements	p. 575
The requirement for positions in foreign currencies	p. 576
The requirement for commodity positions	p. 578
The use of internal models	p. 578
Criticism of the Basel Committee proposals	p. 578
The 1995 revised draft	p. 579
The final amendment of January 1996	p. 581
Advantages and limitations of the internal model approach	p. 582
The pre-commitment approach	p. 583
Selected Questions and Exercises	p. 585
Capital Requirements Related to Settlement, Counterparty and Concentration Risks	p. 588
The New Basel Accord	p. 591
Introduction	p. 591
Goals and Contents of the Reform	p. 591
Pillar One: The Standard Approach to Credit Risk	p. 593
Risk Weighting	p. 593
Collateral and Guarantees	p. 596
The Internal Ratings-based Approach	p. 597
Risk Factors	p. 597
Minimum Requirements of the Internal Ratings System	p. 600
From the Rating System to the Minimum Capital Requirements	p. 603
Pillar Two: A New Role for Supervisory Authorities	p. 612
Pillar Three: Market Discipline	p. 614
The Rationale Underlying Market Discipline	p. 614
The Reporting Obligations	p. 614
Other Necessary Conditions for Market Discipline	p. 615
Pros and Cons of Basel II	p. 616
The Impact of Basel II	p. 619
The Impact on First Implementation	p. 619
The Dynamic Impact: Procyclicality	p. 623
Selected Questions and Exercises	p. 630
Capital Requirements on Operational Risk	p. 633
Introduction	p. 633
The capital requirement on operational risk	p. 633
The Basic Indicator Approach	p. 634
The Standardized Approach	p. 635
The requirements for adopting the standardized approach	p. 638
Advanced measurement approaches	p. 638
The requirements for adopting advanced approaches	p. 639
The role of the second and third pillars	p. 644
The role of insurance coverage	p. 644
Weaknesses of the 2004 Accord	p. 645
Final remarks	p. 647
Selected Questions and Exercises	p. 647
Capital Management and Value Creation	p. 651
	p. 653
Capital Management	p. 657
Introduction	p. 657
Defining and measuring capital	p. 658
The definition of capital	p. 658
The relationship between economic capital and available capital	p. 661
Calculating a bank's economic capital	p. 663
The relationship between economic capital and regulatory capital	p. 667
The constraints imposed by regulatory capital: implications on pricing and performance measurement	p. 671
The determinants of capitalization	p. 674
Optimizing regulatory capital	p. 675
Technical features of the different regulatory capital instruments	p. 676
The actual use of the various instruments included within regulatory capital	p. 680
Other instruments not included within regulatory capital	p. 685
Insurance capital	p. 685
Contingent capital	p. 687
Selected Questions and Exercises	p. 691
Capital Allocation	p. 693
Introduction	p. 693
Measuring capital for the individual business units	p. 694
The "benchmark capital" approach	p. 695
The model-based approach	p. 695
The Earnings-at-Risk (EaR) approach	p. 697
The relationship between allocated capital and total capital	p. 702
The concept of diversified capital	p. 702
Calculating diversified capital	p. 703
Calculating the correlations used in determining diversified capital	p. 710
Capital allocated and capital absorbed	p. 712
Calculating risk-adjusted performance	p. 715
Optimizing the allocation of capital	p. 722
A model for optimal capital allocation	p. 722
A more realistic model	p. 724
The organizational aspects of the capital allocation process	p. 726
Selected Questions and Exercises	p. 728
The Correlation Approach	p. 730
The Virtual Nature of Capital Allocation	p. 731
Cost of Capital and Value Creation	p. 735
Introduction	p. 735
The link between Risk Management and Capital Budgeting	p. 735
Capital Budgeting in Banks and in Non-Financial Enterprises	p. 736
Estimating the Cost of Capital	p. 739
The method based on the dividend discount model	p. 739
The method based on the price/earnings ratio	p. 741
The method based on the Capital Asset Pricing Model (CAPM)	p. 742
Caveats	p. 744
Some empirical Examples	p. 745
Value Creation and RAROC	p. 750
Value Creation and EVA	p. 753
Conclusions	p. 756
Selected Questions and Exercises	p. 757
Bibliography	p. 759
Index	p. 771
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Risk Management and Shareholders' Value in Banking From Risk Measurement Models to Capital Allocation Policies

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