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Risk Management in Banking
Course: B-505
Presented By : Md. Kamrul Hasan
ID-12036
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Topic :
Chapter 26,27,51 & 52
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ap er
Two main tools for integrating global riskmanagement
The Funds Transfer Pricing (FTP) system: allocate interestincome
The capital allocation system: allocate risks
Transfer prices serve as reference rates for calculating interestincome of transactions, product lines, market segments andbusiness units.
They transfer the liquidity and the interest rate risks
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Business SphereAssetLiability
Management (ALM)
FTP Systems
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Transferring funds between units.
Breaking down interest income by transaction or any
subportfolio.Setting target profitability for business units.
Transferring interest rate risk to ALM.
Pricing funds to business units.
Combining economic prices with commercialincentives.
4
The FTP System Specifications
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Allocate funds within the banks.Calculate the performance margins of a
transaction.
Define economic benchmarks for pricing andperformance measurement purposes.Define pricing policiesProvide incentives or penalties
Provide mispricing reports, making explicit thedifferences.Transfer liquidity and interest rate risk to the ALM
unit.
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THE GOALS OF THE TRANSFER PRICING SYSTEM
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The Funds Transfer Pricing system and itsapplications
6
Define economicbenchmarks
Measureperformance
Allocate funds
Pricing
FTP
system
Economictransferprices
Transfer risks to
ALM
Funds Transfer Pricing
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ALM, Treasury and Management Control
Internal Pools of Funds
NettingPricing all Outstanding Balances
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THE INTERNAL MANAGEMENT OF FUNDS AND NETTING
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Transfers of net balances only
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Market
Centralpooling of
netbalances
Business unit ADeficit of funds
Business unit BExcess of funds
Sale of resources
to A
Purchase ofnet excess of B
Netting
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The central pool of all assets and liabilities
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Market
Centralpooling of
net
balances
Business unit A Business unit B
Purchase of
all resourcesSale of all uses
of funds
Sale of all uses
of funds
Purchase of
all resources
Pricing all Outstanding Balances Transfer Pricing
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The commercial margin is the spread betweencustomer prices and internal prices.
The financial margin is that of ALM, which resultsfrom the volumes exchanged plus the spreads betweeninternal prices and the market prices used to borrower
invest.
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MEASURING PERFORMANCE
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For the bank : Sum all revenues and costs from lendingand borrowing
For the business units : Revenues result from customerprices minus the cost of any internal purchase ofresources by the central unit.
For the ALM unit: Revenues result from charging the
lending units the cost of their funds.
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MEASURING PERFORMANCE
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ALM Profitability and Risks
Setting Target Commercial Margins
Mbank = Mcommercial +MALM
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ALM AND BUSINESS UNIT PROFITABILITY GOALS
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Policies and profitability of ALM
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ALMP&L
Maintainrisk within
limits
Minimizefunding cost
Maximizeinvestment
return
Return
Risks
Setting Target Commercial Margins
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Interface between the commercial universeand the financial universe.
The transfer prices should be in line with
both commercial and financial constraints.Transfer prices should also be consistent with
market rates.
Mispricing is the difference between
economic prices and effective pricing.
Mispricing is not an error since it is business-driven.
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THE FINANCIAL AND COMMERCIAL RATIONALE
OF TRANSFER PRICES
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Chapter 27
Economic transfer prices refer to market prices.
Economic benchmark for transfer prices are all-in
cost of funds. the all-in cost of funds applies to lending activities
and represents the cost of obtaining these funds.
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Economic Transfer Prices Transfer Pricing
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Discrepancies of banks prices with marketprices lead to arbitrage by customer
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Transferprice
Commercialmargins
Rate for depositors
Maturity
Rate
Rate for borrowers
COMMERCIAL MARGIN AND MATURITY SPREAD
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Lending Activities
Transaction versus Client Revenues and Pricing
Target Risk-based Pricing Calculations
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PRICING SCHEMES
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Risk-based pricing is the benchmark, Itimplies two basic ingredients.
Commercial pricing refers to mark-ups andmark-downs over economic benchmarks
To drive the business policies throughincentives
Effective pricing refers to actual prices used
by banks.Mispricing is the difference between effective
prices and target prices.
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Lending Activities
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Risk-based pricing might not be competitiveat the individual transaction level simply
Because market spreads are not high enough
to price all costs to a large corporateBanks provide products and services and
obtain as compensation interest spreads andfees.
The overall client revenue is the relevantmeasure for calculating profitability
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Transaction versus Client Revenues and Pricing
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Components of transfer price Component%
Cost of debt 7.00
+Cost of liquidity 0.20
+Expected losses 0.50+Operating costs 0.50
=Transfer price 8.20
+Risk-based margin 0.72=Target risk-based price 8.92
+Commercial incentives 0
=Customer rate 8.9220
Target Risk-based Pricing Calculations
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The Cost of Existing Resources
The Notional Funding of Assets
The Cost of Funds
The Benefits of Notional Funding
Transfer Prices for Resources
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THE COST OF FUNDS FOR LOANS
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Two factors help to fully separate commercial andfinancial risks.
First, the commercial margins become independent ofthe market maturity spread of interest rates.
Second, referring to a debt replicating the assetremoves the liquidity and the market risks from the
commercial margin.
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TRANSFERRING LIQUIDITY AND INTEREST RATE RISK
TO ALM Transfer Pricing
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The bank considers global management of bothloan and investment portfolios.
Set up an investment policy independently of theloan portfolio
The transfer price for the portfolio becomesirrelevant
Segregation of assets in different sub portfolioscreates potential conflicts with the global ALM
view of the balance sheet.
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BENCHMARKS FOR EXCESS RESOURCES
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Chapter 51
The risk contribution
the risk retained by a facility, or a sub portfolio,post-diversification.
the foundation of the capital allocation systemand of the risk-adjusted performancemeasurement system.
Risk contributions absolute risk contributions or
marginal risk contributions.
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Capital Allocation and RiskContributions
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Definitions
The standalone riskThe marginal risk contributionThe absolute risk contribution
Notation
The portfolio loss is the summation of individualobligor losses. The exposures are Xi , i = 1 to N. Li , i = 1 to N. To make random losses distinct from certain
exposures, we use Li for losses and Xi for exposures. The loss volatility is the standard deviation of a loss. The unit exposure loss volatility of a single facility The correlation coefficients between individual losses
Li are ij = ji Superscript P is used .
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DEFINITIONS AND NOTATION
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Risk Contribution Definitions
Basic Properties of Risk Contributions
Undiversifiable Risk
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ABSOLUTE AND MARGINAL RISK CONTRIBUTIONS TO
PORTFOLIO LOSS VOLATILITY AND CAPITAL
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Portfolio Loss Volatility
The Absolute Risk Contributions to Portfolio LossVolatility
From Absolute Risk Contributions to Capital
Allocation
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2P = Cov(LP,LP)
2P= Cov (Li, Lj)=Cov (Li,LP)
For all combinations of i and j, of the ijijterms:
2
P =ij ijThe correlation coefficient between the losses of i and
j is:
ij = Cov(Li , Lj)/ij
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Definition of Absolute Risk Contributions toVolatility :
2P = Cov (LP,L
P) = Cov (L
i, L
P)
= Cov (Li ,LP)
The loss volatility is
P=Cov(Li, LP)/ P
ARCP i = Cov(Li,LP)/P
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The Absolute Risk Contributions to Portfolio Loss Volatility Transfer Pricing
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Simplified Formulas for Risk Contributions:
To find a simple formula,we first write Cov(Li , LP)
= iP i P .Dividing both terms by P , we find the first simplerelation: ARCPi= iP iTo find an alternative simple relation, we use the
definition of the coefficient i :
i = im i/m and i i= im iP as the reference portfolio instead of the market
portfolio:ARCPi= iP i= i P
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Risk Contributions Capture Correlation Effects:
The absolute risk contributions sum to the lossvolatility of the portfolio, a key property that becomesobvious given the definition of ARCPi :
ARCPi=Cov(Li, LP)/P= 2P/P = P
ARCPi = P
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The ratio of portfolio capital to loss volatility
K() = m() LVP =m()ARCi
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Absolute RC
to PortfolioLoss Volatility
Multiple
m= K(a) / LVP
Absolute RC to
PortfolioCapital
i
=
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Marginal risk contributions
the changes in risk with and without an additionalunit of exposure, a facility or a subportfolio of facilities.
serve essentially for risk-based pricing with an ex anteview of risk decisions.
pricing based on marginal risk contributions charges
to customers a mark-up equal to the risk contributiontimes the target return on capital.
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Chapter 52Marginal Risk Contributions Transfer Pricing
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Marginal Contributions to Loss Volatility
The Marginal Risk Contributions to Capital
General Properties of Marginal Risk Contributions
Implications
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The marginal contribution of B to the portfolioloss volatility is the latter minus the loss.
The marginal risk contribution of A is determinedin the same way.
The sum of these marginal risk contributions is21.05, significantly less than the portfolio loss
volatility.We observe that:
MRC(LVP) < ARC(LVP) < standalone risk
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Pricing
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Capital derives from the loss distributions and theloss percentiles at various confidence levels.Capital is the loss percentile in excess of expected
loss totaling 9.5, or 100 9.5 = 90.5.At a 1% confidence level, leading to a loss
percentile of 100 for the portfolio A + B and acapital of 100 9.5 = 90.5.
At a 0.5% confidence level would result in amaximum portfolio loss of 150 and a capital of 150 9.5 = 140.5.
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The marginal risk contributions to the portfolio lossvolatility are lower than the absolute riskcontributions.
Marginal risk contributions to portfolio capital can behigher or lower than absolute risk contributions to
capital.
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Transfer Pricing
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Relation between the Marginal and Absolute RiskContributions
MRCf
= P+f P
P+f= ARCP+fP + ARCP+f
Marginal versus Absolute Risk Contribution for a
New FacilityMRCf < ARCP+ff< fThe difference between MRCfand ARC
P+ff is (ARC
P+fP
P )
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When the additional facility is small compared tothe portfolio, chances are that the gap betweenthe marginal and the absolute risk contributionto loss volatility gets small.
Capital allocation and risk-based performance
using absolute risk contributions cannot beequivalent to using marginal risk contributions.
When we add a facility to an existing portfolio,we have two effects. The absolute risk
contribution of the new facility is positive, whichincreases the portfolio loss volatility.Simultaneously, the second term, or [ARCP
P+fP ], is negative, which contributes to decreasethe portfolio loss volatility.
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Implications
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Risk-based Pricing Requires Marginal Risk
Contribution
General Formulation
The Pricing Paradox with Risk Contributions
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Ex Ante versus Ex Post Views of Risk and Return
Capital Allocation
Risk-adjusted Performance versus Risk-based Pricing
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Absolute risk contributions serve to allocatecapital.
Marginal contributions serve for pricing.
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Ex Ante Ex Post
MarginalRisk Contributions
AbsoluteRisk Contributions
Risk-based Pricing
Pricing Consistent withTarget Return
Capital Allocation
Risk-adjustedPerformance
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THANKS TO ALL
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