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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.

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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

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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