Market Risk Management
Risk may be defined as an exposure to uncertainty which may lead to a favorable or unfavorable outcome. Market risk refers to the risk of losses in the bank’s trading book due to movements in market prices. Risk taking forms an essential part of business. All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. Since financial institutions/banks form the pillar of any economy and are responsible for the efficient functioning of an economy, it is important for a bank to maintain a balance between the risk it can take and the expected returns it aims to achieve while maintaining the sound financial position of the bank. Risk management addresses the issue. It aims at mitigating the loss rather than eliminating it. So, it is essential to have a robust risk management system. The risk management system need to be commensurate with the complexity and size of a bank’s business operations and which ensures that bank’s risks are able to be managed according to the bank’s risk strategy. The risk management system is essentially a four step process of identifying, measuring, monitoring and controlling or mitigating material risks based on the guidance in “Core Principles for Effective Banking Supervision” issued by the Basel Committee in October 2006.
Types of Market Risks and Methods to estimate the Risk
The market risks are broadly categorized into types namely – interest rate risk, equity risk,currency risk and commodity risk.In order to manage market risk, banks used a number of statistical techniques and chief among these is value-at-risk (VAR) analysis, that over the past 15 years has established itself as the industry and regulatory standard in measuring market risk. In VAR analysis, the essential choices are the approach used to generate simulation scenarios (Monte Carlo versus historical simulation) and the valuation approach (full revaluation versus sensitivities).
The Monte Carlo method provides a more detailed picture of potential risks embedded in the tails of the normal distribution .It has consistency and synergies with other modeling approaches, such as the expected-potential-exposure (EPE) approach used for counterparty risk modeling. However, the model requires a large number of simulations per risk factor; it is complex in usage and longer reaction times that places a burden of complexity on the bank. On the other hand historical simulation is simple and transparent but relies on distribution of data from past occurrences that may be irrelevant when the future trend is different from past.
Full revaluation refers to the process in which the positions whose risk is being measured are fully revalued by using the front-office pricing models. On the other hand in case of sensitivities the positions are reduced to a few critical characteristics of their market behavior. Although both approaches produce similar results, most banks opt to use sensitivities for simple products and full revaluation for complex products that provides an accurate calculation of risk. However, there is inconsistency in data and the reporting hierarchies or book definitions cause major differences between VAR and P&L, leading to a burdensome reconciliation process.
Banks economic capital models are designed for more sensitive and extreme events. The model explains the maximum loss within a one-year time horizon and has a confidence interval in the range varying from 99.95 to 99.97 percent. This will yield events so rare that they might happen only 1 year in every 2,000; a confidence level of 99.97 will yield events that happen only 1 year in every 3,300. By comparison, VAR at 99.0 percent captures 1-day-in-100 events.
All these models would not have yielded the expected results had the IT architecture been not in place. IT is critical in supporting and enabling bank’s business goals .The banks recognized the importance of efficient data design and storage that radiates throughout the business system and empowers the critical task of risk aggregation. So they focused on the formation of a common data model that is used throughout the bank. This was aided by the improved data quality.
An improved level of governance also played a pivotal role in better risk aggregation .A simplified steering framework can only be achieved if they are properly embedded in the market-risk governance structure. In most cases, the risk group drives the process of setting the risk appetite that accurately reflect the risks for the trading operation and breaking it out into limits for individual desks. Also, Risk Limit systems needs to be integrated closely to investigate the root cause of limit breaches which may be only technical violations caused by data errors, or legitimate violations caused by excessive positions—and to enforce prompt and sensible corrections. Besides centralized Data management Effective Pricing models and their valuations, Simulations of models, risk aggregation, risk decomposition, risk reporting contribute significantly to managing market risk.
There are different methodologies that are available for estimation of the capital requirement to cover market risks and are categorized as follows:
1) The Standardized Measurement Method: This method used by the Reserve Bank, adopts an approach for equity instruments and interest-rate related which differentiate capital requirements for ‘specific risk’ from those of ‘ market risk’. This ‘specific risk charge’ is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. On the other hand, The ‘general market risk charge’ is designed to protect against the interest rate risk in the portfolio.
2) The Internal Models Approach (IMA): This method enables banks to use their proprietary in-house method which must meet the qualitative and quantitative criteria set out by the BCBS and is subject to the explicit approval of the supervisory authority.
Laws and Legal Provisions governing the marketrisk are:-
- SEBI Act, 1992-It establishes SEBI to protect investors and regulate securities in market.
- The securities contract Act, 1956 that regulates transaction in securities through control over stock exchanges.
- The depositories Act, 1996 that provides for electronic maintenance and transfer of ownership of securities.
- The companies Act, 1956 lays the code of conduct for the corporate with respect to issue, allotment and transfer of securities and disclosures to be made in public issues.
Market Risk Management in the Indian Banking context
If we see the Indian scenario, Risk management is a newer practice. But it is showing a gradual trend in increasing the efficiency of the banks. The financial sector in countries like India is facing tough competition in the banking area from foreign banks and thus has caused Indian Banks to include the concept of Risk management. Besides increasing de-regulation, introduction of innovative products and delivery channels have put risk management to the fore. The ability to tackle and mitigate risks will be an important factor for success. Globalization, Liberalization and Privatization have opened up new methods of transaction thus causing the level of risk to be very high. Risk Management in the Indian banking context has the following functions –
- Risk Identification
- Risk quantification
- Risk control
- Risk Monitoring and Reviewing
Risk Identification: As mentioned above regarding the various kinds of risk this step comprises of tasks understanding the various kinds of risks and circumstances
Risk Quantification: Here the banks need to measure with the help of risk rating models the degree to which risk is attached to an activity .The exact measurement is not possible, but with good practices and proper rating models the banks strive to achieve accuracy.
Risk Control, Monitoring and Reviewing: In the step of Risk control banks use certain tools to control the risk, such as diversification of business, Insurance and hedging, fixation of exposure ceiling, transferring the risk to another party at the appropriate time, securitization and reconstruction.
Risk Monitoring: is the regular check-up wherein bankers have to fix up the parameters on which the transaction is to be tested.
Banks of International Settlement(BIS) have set up a committee called Basel Committee on banking supervision in 1988.This committee issues guidelines for maintain risk management in banks . These measures have brought many standardization initiatives thus improving the risk management sector among the banking fraternity. In addition it also seeks to protect the interests of the depositors/shareholders of the bank. One of such measures includes maintaining the Capital Adequacy Ratio at least 8%. The capital Adequacy ratio is the measure of bank’s capital, ratio of capital to risk weighted assets. It is an indicator of the safety limit for the banks.
Challenges in Market Risk Management in the Indian Context
With an intention to improve the safety and soundness of the Indian financial system an increased emphasis is needed to be put on the bank’s own internal control and the processes and models of risk management. The banks alsoneed to look into the supervisory review process and the market disciplinary process. In order to enable the calculations of capital requirements the banks need to build a comprehensive risk management framework. But doing so will have significant effects on the banks information technology,processes, people and business. Every bank has to invest a lot of time, energy and manpower in the implementation of the Basel committee which enforces various measures to regulate Risk management. It does help and enable the banks to do better business but the processes and methods used for the banks especially in a developing country like India pose considerable implementable challenges.
International Practices followed in Market Risk Management
Certain practices followed by the international standards to follow Risk Management include International Certificate in Banking Risk and Regulation (ICBRR)which delivers a deep and qualitative understanding of risk management methodologies. It focuses on governance structures for the management of risk in banks. Besides it also includes the regulatory principles outlined by the Basel Committee on Banking Supervision. The primary objective is to provide better measures to handle Risk Management.
There are a number of basic risk management tools that international firms in all sectors generally use to manage risks. These generally include the development of corporate policies and processes, use of mathematical and statistical methods to measure risk , pricing products and services according to the risks calculated , establishment of risk limiters ,risk diversification and hedging techniques and building of back-up cushions both reserves , capital and provisions to absorb losses.
Another important practice followed by international firms is the role of financial analysts and rating agencies. These agencies through their assessments of institutions provide information which is used by the banks for the risk management reviews and thus analyze on the risk factor.The need for market participants to compare firms across the industries is emerging among financial conglomerates. These firms seek to diversify their activities in response to changes in the market place. In assessing financial firms, both rating agencies and market analysts focus largely on the earnings and forecasts of future earnings.
Different Perspectives on the topic
PWC came up in 2012 with its take on Market Risk Management for new market realities Risk in review 2012: Based on the article – Rethinking risk management for new market realities
With global trade, financial markets and supply chains inextricably linked in a landscape of complexity and uncertainty, risks come quite swiftly and unexpectedly – with significant impact on the operations, reputations and even survival of a company. In response, forward-looking companies are continuing to shift their risk management focus in fundamental strategic ways, incorporating and integrating a culture which is risk-aware and top-down across departments and functions. Other key findings include beliefs that risks are increasing, with macroeconomic and financial volatility and thus including the potential for severe disruption from the Eurozone debt crisis—high on the risk agenda. Risk leaders are shifting their risk perspectives from the operational to the strategic—from focusing on internal risks to devising internal responses to external events like macroeconomic shocks and regulatory change.