Risk Management and Shareholders’ Value in Banking ppt

Risk management and shareholders’ value in banking : from risk measurement models to capital allocation policies / Andrea Sironi and Andrea Resti.. Contents xiii14.8.2 The assumption of

Risk Management and Shareholders’

Value in Banking

For other titles in the Wiley Finance Seriesplease see www.wiley.com/finance

Risk Management and Shareholders’

Value in Banking

From Risk Measurement Models

to Capital Allocation Policies

Andrea Resti and Andrea Sironi

Copyright  2007 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,

West Sussex PO19 8SQ, England Telephone ( +44) 1243 779777 Email (for orders and customer service enquiries): cs-books@wiley.co.uk

Visit our Home Page on www.wileyeurope.com or www.wiley.com

All Rights Reserved No part of this publication may be reproduced, stored in a retrieval system or

transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,

West Sussex PO19 8SQ, England, or emailed to permreq@wiley.co.uk, or faxed to ( +44) 1243 770620 Designations used by companies to distinguish their products are often claimed as trademarks All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners The Publisher is not associated with any product or vendor mentioned

in this book.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold on the understanding that the Publisher is not engaged in rendering professional services If professional advice or other expert assistance is required, the services of a competent professional should be sought.

Other Wiley Editorial Offices

John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA

Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA

Wiley-VCH Verlag GmbH, Boschstr 12, D-69469 Weinheim, Germany

John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia

John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 6045 Freemont Blvd, Mississauga, Ontario, L5R 4J3, Canada

Wiley also publishes its books in a variety of electronic formats Some content that appears

in print may not be available in electronic books.

Library of Congress Cataloging-in-Publication Data

Sironi, Andrea.

Risk management and shareholders’ value in banking : from risk measurement models to capital allocation policies / Andrea Sironi and Andrea Resti.

p cm.

Includes bibliographical references and index.

ISBN 978-0-470-02978-7 (cloth : alk paper)

1 Asset-liability management 2 Bank management 3 Banks and banking – Valuation.

4 Financial institutions – Valuation 5 Risk management I Resti, Andrea II Title.

HG1615.25.S57 2007

332.1068
1 – dc22

2006102019

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 978-0-0470-02978-7 (HB)

Typeset in 10/12pt Times by Laserwords Private Limited, Chennai, India

Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

This book is printed on acid-free paper responsibly manufactured from sustainable forestry

in which at least two trees are planted for each one used for paper production.

To our parents

Motivation and Scope of this Book: A Quick Guided Tour xxi

2.3.2 Duration as an indicator of sensitivity to interest rates

viii Contents

3 Models Based on Cash-Flow Mapping 57

Contents ix

5.5 Summary of the variance-covariance approach and main limitations 143

5.5.2 Serial independence and stability of the

5.5.3 The linear payoff hypothesis and the delta/gamma

6 Volatility Estimation Models 163

7.2.3 A comparison between historical simulations and the

7.2.4 Merits and limitations of the historical simulation method 196

x Contents

Appendix 8A VaR Model Backtesting According to the Basel

9 VaR Models: Summary, Applications and Limitations 251

9.3.3 The construction of risk-adjusted performance (RAP)

9.4.6 VaR measures “come too late, when damage has already

Contents xi

Appendix 10A The Estimation of the Gamma Coefficients in Linear

11.2.5 Benefits and limitations of the approach based on corporate

11.3.3 Merton’s model: the role of contingent claims analysis 324

11.3.6 The term structure of credit spreads and default probabilities 328

xii Contents

Appendix 12A The Relationship between PD and RR in the Merton

13.2.1 Internal ratings and agency ratings: how do they differ? 370

13.3.2 The actuarial approach: marginal, cumulative and annualized

13.4.2 Quantitative criteria for validating rating assignments 389

14.3.5 Merits and limitations of the CreditMetricsTM model 422

14.6.1 Estimating the probability distribution of defaults 429

14.6.4 Uncertainty about the average default rate and correlations 434

Contents xiii

14.8.2 The assumption of independence between exposure risk and

14.8.3 The assumption of independence between credit risk and

15 Some Applications of Credit Risk Measurement Models 451

15.2.2 The cost of economic capital absorbed by unexpected losses 453

16 Counterparty Risk on OTC Derivatives 473

16.3.1 Two approaches suggested by the Basel Committee (1988) 475

16.3.3 Estimating the loan equivalent exposure of an interest rate

16.3.5 Peak exposure (PE) and average expected exposure (AEE) 489

16.3.7 Loan equivalent and Value at Risk: analogies and differences 494

17 Operational Risk: Definition, Measurement and Management 511

17.3.2 Mapping business units and estimating risk exposure 518

PART V REGULATORY CAPITAL REQUIREMENTS 543

18.3.3 Limited recognition of the link between maturity and credit

19 The Capital Requirements for Market Risks 565

Contents xv

19.4 Positions in equity securities: specific and generic requirements 575

19.7.4 Advantages and limitations of the internal model approach 582

Appendix 19A Capital Requirements Related to Settlement,

20.4.2 Minimum Requirements of the Internal Ratings System 60020.4.3 From the Rating System to the Minimum Capital

21 Capital Requirements on Operational Risk 633

21.2.3 The requirements for adopting the standardized approach 638

xvi Contents

PART VI CAPITAL MANAGEMENT AND VALUE CREATION 651

22.2.2 The relationship between economic capital and available

22.2.4 The relationship between economic capital and regulatory

22.2.5 The constraints imposed by regulatory capital: implications

22.3.1 Technical features of the different regulatory capital

23.3 The relationship between allocated capital and total capital 702

23.3.3 Calculating the correlations used in determining diversified

Contents xvii

23.7 The organizational aspects of the capital allocation process 726

24 Cost of Capital and Value Creation 735

24.3 Capital Budgeting in Banks and in Non-Financial Enterprises 736

24.4.3 The method based on the Capital Asset Pricing Model

Risk Management and Shareholders’ Value in Banking is quite simply the best written

and most comprehensive modern book that combines all of the major risk areas that impactbank performance The authors, Andrea Resti and Andrea Sironi of Bocconi University

in Milan are well known internationally for their commitment to and knowledge of riskmanagement and its application to financial institutions Personally, I have observed theirmaturation into world class researchers, teachers and consultants since I first met Sironi in

1992 (when he was a visiting scholar at the NYU Salomon Center) and Resti (when, a fewyears later, he was on the same program as I at the Italian Financial Institution DepositInsurance Organization (FITD)) This book is both rigorous and easily understandableand will be attractive to scholars and practitioners alike

It is interesting to note that the authors’ knowledge of risk management paralleled thetransformation of the Italian Banking System from a relatively parochial and unsophis-ticated system, based on relationship banking and cultural norms, to one that rivals themost sophisticated in the world today based on modern value at risk (VaR) principles In

a sense, the authors and their surroundings grew-up together

Perhaps the major motivations to the modern treatment of risk management in bankingwere the regulatory efforts of the BIS in the mid-to-late 1990’s – first with respect tomarket risk in 1995 and then dealing with credit risk, and to a lesser extent operationalrisk, in 1999 with the presentation of the initial version of Basel II These three elements

of risk management in banking form the core of the book’s focus But, perhaps the greatestcontribution of the book is the discussion of the interactions of these elements and howthey should impact capital allocation decisions of financial institutions As such, the bookattempts to fit its subject matter into a modern corporation finance framework – namelythe maximization of shareholder wealth

Not surprisingly, my favorite part of the book is the treatment of credit risk and myfavorite chapter is the one on “Portfolio Models” within the discussion of “Credit Risk”(Chapter 14 in Part III of the book) As an introduction to these sophisticated, yet con-troversial models, the authors distinguish between expected and unexpected loss – both

in their relationships to estimation procedures and to their relevance to equity valuation,i.e., the concept of economic capital in the case of unexpected loss While there are manystructures discussed to tackle the portfolio problem, it is ironic that despite its impor-tance, the Basel Committee, in its Basel II guidelines, does not permit banks to adjusttheir regulatory capital based on this seemingly intuitively logical concept Perhaps themajor conceptual reason is that the metric for measuring correlations between credit risks

xx Foreword

of different assets in the portfolio is still approached by different theories and measures

Is it the co-movement of firm’s equity values which presumably subsumes both macroand industry factors as well as individual factors, or is it the default risk correlation asmeasured by the bimodal or continuous credit migration result at the appropriate horizon

Or, is it simply the result of a simulation of all of these factors

While the use of market equity values is simply impossible in many countries andfor the vast majority of non-publicly traded companies worldwide, perhaps the majorimpediment is the difficulty in back-testing these models (as the authors point out) andthe fact that banks simply do not make decisions on individual investments based onportfolio guidelines (except in the most general way and by exception, e.g., industry orgeographical limits) In any event, the portfolio management of the banks’ credit policiesremains a fertile area for research

It is understandable, yet still a bit frustrating, that the operations risk area only receivesminor treatment in this book (two chapters) The paradox is that we simply do not know

a great deal about this area, at least not in a modern, measurable and modelable way, yetoperational problems, particularly human decisions or failures, are probably the leadingcauses of bank failure crises, and will continue to be

In summary, I really enjoyed this book and I believe it is the most comprehensive andinstructive risk management book available today

Edward I Altman Max L Heine Professor of Finance NYU Stern School of Business

Motivation and Scope of this Book:

A Quick Guided Tour

Banks operating in the main developed countries have been exposed, since the Seventies,

to four significant drivers of change, mutually interconnected and mutually reinforcing.The first one is a stronger integration among national financial markets (such as stockmarkets and markets for interest rates and FX rates) which made it easier, for economicshocks, to spread across national boundaries Such an increased integration has made somefinancial institutions more prone to crises, sometimes even to default, as their managementproved unable to improve their response times by implementing adequate systems for riskmeasurement and control

A second trend of change is “disintermediation”, which saw savers moving from bankdeposits to more profitable investment opportunities, and non-financial companies turningdirectly to the capital markets to raise new debt and equity capital This caused banks

to shift their focus from the traditional business of deposits and loans to new forms offinancial intermediation, where new risks had to be faced and understood Such a shift,

as well as a number of changes in the regulatory framework, has undoubtedly blurredthe traditional boundaries between banks and other classes of financial institutions As aresult, different types of financial intermediaries may now be investing in similar assets,exposing themselves to similar risk sources

A third, significant trend is the supervisors’ growing interest in capital adequacyschemes, that is, in supervisory practices that aim at verifying that each bank’s cap-ital be enough to absorb risks, in order to ensure the stability of the whole financialsystem Capital-adequacy schemes have by now almost totally replaced traditional super-visory approaches based on direct controls on markets and intermediaries (e.g., limitingthe banks’ geographic and functional scope of operation) and require banks to develop athorough and comprehensive understanding of the risks they are facing

Finally, the liberalisation of international capital flows has led to sharper competitionamong institutions based in different countries to attract business and investments, as well

as to an increase in the average cost of equity capital, as the latter has become a key factor

in bank management This increasing shareholders’ awareness has been accompanied andfavoured, at least in continental Europe, by a wave of bank privatisations which, whilebeing sometimes dictated by public budget constraints, have brought in a new class ofshareholders, more aware about the returns on their investments, and thereby increasedmanagerial efficiency This has made the banking business more similar to other forms of

xxii Risk Management and Shareholders’ Value in Banking

entrepreneurship, where a key management goal is the creation of adequate shareholders’returns Old, protected national markets, where bank management could pursue size targetsand other “private” objectives, has given way to a more competitive, international marketarena, where equity capital must be suitably rewarded, that is, where shareholders’ valuemust be created

The four above-mentioned drivers look closely interwoven, both in their causes andconsequences Higher financial integration, disintermediation and the convergence amongdifferent financial intermediation models, capital adequacy-based regulatory schemes and

an increased mobility/awareness in bank equity investors: all these facts have stronglyemphasised the relevance of risk and the ability of bank managers to create value fortheir shareholders

Accordingly, the top management of banks – just like the management of any othercompany – needs to increase profitability in order to meet the expectations of their share-holders, which are now much more skilled and careful in measuring their investment’sperformance

Bank management may therefore get caught in a sort of “targets’ dilemma”: increasingcapital profitability requires to rise profits, which in turn calls for new businesses and newrisks to be embraced However such an expansion, due to both economic and regulatoryreasons, needs to be supported by more capital, which in turn calls for higher profitability

In the short term, such a dilemma may be solved by increasing per-dollar profits throughslashing operating expenses and raising operational efficiency In the long term, however,

it requires that the risk-adjusted profitability of the bank’s different businesses be carefullyassessed and optimised

Such a strategy hinges on three key tools

The first one is an effective risk measurement and management system: the bank must

be able to identify, measure, control and above all price all the risks taken aboard, more

or less consciously, in and off its balance sheet This is crucial not only to the bank’sprofitability, but also to its solvency and future survival, as bank crises always arise from

an inappropriate identification, measurement, pricing or control of risks

The second key tool is an effective capital allocation process, through which holders’ capital is allotted to the different risk-taking units within the bank, according

share-to the amount of risks that each of them is allowed share-to generate, and consequently mustreward Note that, according to this approach, bank capital plays a pivotal role not just inthe supervisors’ eyes (as a cushion protecting creditors and ensuring systemic stability),but also from the managers’ perspective: indeed capital, being a scarce and expensiveresource, needs to be optimally allocated across all the bank’s business units to maximiseits rate of return Ideally, this should be achieved by developing, inside the bank, a sort

of “internal capital market” where business units compete for capital (to increase theirrisk-taking capacity), by committing themselves to higher return targets

The third key tool, directly linked to the other two, is organisation: a set of processes,measures, mechanisms that help the different units of the bank to share the same value-creation framework This means that the rules for risk measurement, management andcapital allocation must be clear, transparent, as well as totally shared and understood

by the bank’s managers, as well as by its board of directors An efficient tion is indeed a necessary condition for the whole value creation strategy to deliver theexpected results

organisa-This book presents an integrated scheme for risk measurement, capital managementand value creation that is consistent with the strategy outlined above, as well as with

Motivation and Scope of this Book: A Quick Guided Tour xxiiithe four drivers surveyed at the outset of this preface Moving from the definition ofthe measurement criteria for the main risk types to which a bank is exposed, we aim atdefining the criteria for an effective capital allocation process and the management rulesthat should support a corporate policy aimed at maximizing shareholders’ value creation.This will be based on three logical steps: in the first step (Parts I–IV), individual risksare defined and measured This makes it possible to assess the amount of capital absorbed

by the risks generated by the different business units within a bank Also, this enablesthe bank to price its products correctly (where it is free to set their price), or at least

to estimate their risk-adjusted profitability (where the price is fixed by the market) Notethat, while risk can be defined, in very general terms, as an unexpected change in thevalue of the bank or of its profits, different classes of risk exist which refer to differentuncertainty sources (“risk factors”); therefore, different models and approaches will beneeded, in order to get a comprehensive picture of the risks to which the bank is exposed

In the second step (Part V), external regulatory constraints, in the form of minimumcapital requirements, must be analyzed, in order to take into account their implicationsfor the overall risk and capital management process

The third step (Part VI) requires: (i) setting the total amount of capital that the bankneeds to hold, based on the risks it is facing; (ii) fine-tuning its composition taking profit

of hybrid instruments such as subordinated debt; (iii) estimating the “fair” return thatshareholders are likely to expect on equity capital; (iv) finally, comparing actual profits

to the “fair” cost of capital in order to assess the value creation capacity of the bank.More specifically, the six parts of this book will cover the following topics (see alsoFigure 1)

check regulatory constraints to the risk measurement

process and to capital quantification

measure and

manage

interest rate risk

measure and manage operational risk

measure and manage market risk

measure and manage credit risk

Figure 1 Plan of the book

xxiv Risk Management and Shareholders’ Value in Banking

Parts I–IV will deal with the main classes of risks that affect a bank’s profitability andsolvency The first one is interest rate risk (Part I, Chapters 1–4), arising from the differentmaturity structure of the banks’ traditional assets and liabilities (the so-called “bankingbook”) The models and approaches developed by academics and practitioners to tacklethis type of risk have evolved significantly and can now be used to gain an accurate andcomprehensive assessment of the effects that unexpected changes in the level of marketinterest rates produce on the net value of the bank, as well as on its profits

The second category of risks (Part II, Chapters 5–9) revolves around market risk, that

is, the risk of a decrease in the value of the bank’s net investments, due to unexpectedchanges in market prices (such as FX rates, stock and commodities prices) Unlike themodels for interest rate risk discussed in Part I, which are applied across the wholespectrum of the bank’s assets and liabilities, the measurement and management of marketrisk usually focuses on a limited portion of the bank’s balance sheet, that is, the set ofinvestments (including short positions and derivatives) aimed at producing trading profits

in the short-term, and therefore called “trading book” Note that the factors creating marketrisk also include the price of traded bills and bonds, which in turn depends on the level

of interest rates; therefore, interest rate risk, when producing changes in the value of thebank’s trading book, can also be considered part of market risk Similarly, if a secondarymarket for corporate bonds exists, where credit spreads are priced, reflecting the issuer’screditworthiness, then the risk of an increase in market spreads, although it pertains tocredit risk and therefore, which is addressed specifically in Part III, can also be seen as

a specific type of market risk

The third risk class faced by a bank (Part III, Chapters 10–16), and probably the mostsignificant one, is credit risk, that is, the risk of changes in the fair value of the bank’sassets (including off-balance sheet items), due to unexpected changes in the creditwor-thiness of its counterparties This includes default risk, migration risk, recovery risk,country risk, settlement and pre-settlement risks Credit risk affects not only traditionalbank loans, but also investments in debt securities (bonds), as well as any other contract(such as OTC–over the counter–derivatives) in which the inability/unwillingness to pay

of the counterparty may cause losses to the bank

The fourth category of risk is operational risk This is more difficult to define thanthe previous ones, as it encompasses many different types of risk: the risk of damagescaused by the human and technological resources used by the bank (e.g., due to infidelity

or IT crashes); the risk of losses caused by errors (e.g human errors as well as softwaremalfunctions); the risk of fraud and electronic theft; the risk of adverse natural events

or robberies; all risks due to the inadequacy of the procedures, control systems andorganizational procedures of the bank Such a risk class, although quite wide-ranging, hasbeen somewhat overlooked in the past and started receiving attention only in the last tenyears Issues concerning the definition, measurement, management of operational risk aredealt with in Part IV (Chapter 17)

After this comprehensive discussion of the main risk types facing a bank, Part V(Chapters 18–21) surveys the exogenous constraints arising from the risk-measurementschemes and the minimum capital requirements imposed by the regulation and the super-visory authorities Special emphasis is given to the Basel Capital Accord approved in

1988 and revised subsequently in 1996 and 2004 The logic and implications of the 2004update of the Accord will be discussed carefully in Chapters 20 and 21, showing howthe new rules, while imposing a regulatory constraint on banks, also provide them with

Motivation and Scope of this Book: A Quick Guided Tour xxv

a robust conceptual scheme through which their risks (especially credit and operationalrisk) can be understood, measured and managed

Part VI of the book relates to capital management and value creation Chapter 22 willshow how the optimal amount of capital for a bank can be quantified, taking into accountboth economic capital (that is, the capital required to cover risks discussed in Parts I–IV)and regulatory capital (that is, the minimal capital imposed by the Basel rules) Chapter 23will discuss techniques for allocating capital to the different business units inside the bank(such as the credit department, the asset management unit, the treasury and so on), takinginto account the benefits of diversification, and how risk-adjusted performance measurescan be computed, to assess the true level of profitability of the different units Finally,Chapter 24, after showing how to estimate the “fair” level of profits that the bank’sshareholders can reasonably expect, will focus on tools (such as Raroc and Eva) thatenable the top management to estimate the value margins created (or destroyed) by thebank, both in the short run and in a medium-term perspective

Although some of the models and algorithms described in Parts I–IV (as well as theregulatory schemes presented in Part V) may sometimes look rather technical in nature, thereader should keep in mind that a proper understanding of these techniques is required, inorder to fully assess the correctness and reliability of the value-creation metrics discussed

in the last Part of the book In a word, risk management and regulation are too serious

to be left totally to .risk managers and regulators A full and critical awareness of

these instruments, as well as a constant and sharp commitment to their enterprise-wideimplementation, is required directly from the bank’s top management, in order for thevalue-creation paradigm to be deployed safely and consistently

In order to help the reader understand the more technical concepts presented in thebook, many numerical examples and exercises are included in each chapter Most of them

WWW.

(indicated by a symbol like the one on the right) are replicated and solved in the excelfiles found on the book’s website (www.wiley.com/go/rmsv/) Answers to end-of-chapterquestions, errata and other materials may also be found on this companion site

Finally, we would like to thank our wives for their patience and kind support duringthe months spent on this book We will also be grateful to all readers that will provide uswith comments and advice on this first edition

Part I

Interest Rate Risk

Interest Rate Risk 3

INTRODUCTION TO PART I

One of the primary functions of the financial system is to transform maturities: in mostcases, banks finance their investments in loans or bonds by issuing liabilities whoseaverage maturity is shorter than that of those same investments The resulting imbalancebetween maturities of assets and liabilities implies interest rate risk-taking

To see why, let’s take a 10-year fixed rate mortgage of 100,000 euros at 6 % Tofinance this investment the bank issues a 1-year certificate of deposit of the same amountwith a 2 % fixed rate The net interest income (NII) of this operation is 4 % of the totalamount: 4,000 euros

Assume that during the year market interest rates (both on assets and liabilities) rise byone percentage point When the certificate of deposit matures, the bank will be obliged torefinance the mortgage by issuing a new CD at a higher rate (3 %), though it’s still getting

a 6 % return on its investment So, the NII would shrink from 4,000 to 3,000 euros (that

is, from 4 % to 3 % of the investment)

When the maturity on an asset is longer than that of a liability, the bank is exposed to

refinancing risk (namely, the risk that the cost associated with financing an interest-earning

position rises, resulting in a lower interest margin)

The opposite is true if the maturity of an asset is shorter than that of a liability Forexample, think of a 1-year loan to an industrial firm at a fixed rate of 5 %, financed byissuing 10-year bonds at a 4 % fixed rate If market interest rates fell, the bank wouldhave to reinvest the funds from the bonds in assets with a lower yield once the loan hadmatured As a result, we would see a reduction in the interest margin When there are

assets with a shorter maturity than liabilities, the bank is exposed to reinvestment risk.

Therefore, interest rate risk in its broadest sense can be defined as the risk that changes

in market interest rates impact the profitability and economic value of a bank Note thatthis risk does not derive solely from the circumstances described above (i.e possiblechanges in flows of interest income and expenses, and in the market value of assets andliabilities brought about by an imbalance between their maturities) An indirect effect canalso occur, which is linked to the impact that rate changes can have on volumes negotiated

by a bank

So, for example, a rise in interest rates not only triggers an upsurge in interest earnedand paid by the bank, along with a slump in the market value of fixed-rate assets andliabilities.1 Usually such a change also causes a decline in demand liabilities and callloans In effect, when market rates go up, account holders usually find it more convenient

to transfer their funds to more profitable types of investment At the same time, the bank’sdebtors (be they firms or individuals) tend to cut down on the use of credit lines due to thehigher cost of these services This last phenomenon does not depend on the imbalancebetween the average maturities of assets and liabilities, but rather on the elasticity ofdemand for deposits and loans to rate changes This problem does not affect only on-demand items, but also term loans with options for early repayment, or conversion fromfixed to floating (which allow customers to act at their own discretion, making interestrate risk estimation even more complex)

To estimate this risk in the most comprehensive possible way, we need to take intoaccount all the factors described above In the upcoming three chapters, we’ll discuss

1 The relationship between market rates and market value of fixed-rate assets and liabilities is detailed in Chapter 3.

4 Risk Management and Shareholders’ Value in Banking

risk-measurement methods developed by banks Though they have been considerablyfine-tuned in the past 20 years, these methods often focus on just a few of these factors,namely on those deriving from the maturity structure of assets and liabilities

Sometimes interest rate risk is only measured on the trading book, i.e the overall set of

securities and financial contracts that the bank buys for trading on the secondary marketwith the aim of making capital gains.2

Nonetheless, interest rate risk pertains to all positions in the bank’s assets and ities portfolio (namely, the banking book ) To measure this risk we have to consider all

liabil-interest-earning and interest-bearing financial instruments and contracts on both sides ofthe balance sheet, as well as any derivatives whose value depends on market interest rates.Guidelines on how to go about estimating interest rate risk on the banking book weredrawn up by the Basel Committee (an advisory body whose members are representatives

of banking supervisory authorities from major industrialized countries) in January 1997.These 12 fundamental principles3are intended as a tool for facilitating the work of author-ities for banking supervision from individual nations who are responsible for evaluatingthe adequacy and effectiveness of interest rate risk management systems developed bybanks under their supervision The 12 principles address the role of boards of directorsand senior management; policies and procedures for managing interest rate risk; sys-tems for measuring and monitoring risk, and for internal controls; and information to

be provided to supervisory bodies on a periodic basis These standards, therefore, arenot simply methodological instructions, but go further to provide recommendations onorganizational issues This approach reflects the authorities’ desire to leave risk mea-surement to a bank’s managers and focus simply on providing suggestions (based on a

“moral-suasion” approach), so that risk measurement is complemented by an effectiveand well-organized system of risk management

These principles, which have served as an important standard for banks the world over,were reviewed and increased to 15 in July 2004.4 The addition of three new principleswas closely linked to the finalization of a new accord on capital adequacy requirements forbanks, which is known as Basel II.5 This agreement (approved by the Basel Committee

in June 2004) does not call for a specific capital requirement for interest rate risk arisingfrom the banking book Rather, it focuses on transparency, and gives supervisory bodies

in member countries the right to request extra capital from banks exposed to high interestrate risks Consequently, Principle 14, introduced in 2004, requires that banks reportresults from their internal measurement systems to national supervisory bodies.6

The 15 principles laid down in 2004 are listed in the box on page 11 Briefly, the mostcrucial and ground-breaking points are the following:

First of all, a significant emphasis is given to the involvement of senior management(Principle 2) Although this might appear obvious, it still represents a critical issue formany banks, where risk measurement systems were introduced independently by the

2 In this case, interest rate risk represents a specific kind of market risk, i.e the risk that a financial portfolio is hit by unexpected losses due to trends in one or more market variables (such as share prices, exchange rates,

or interest rates) Part II addresses market risk.

3 See Basel Committee on Banking Supervision (1997).

4 Basel Committee on Banking Supervision (2004b)

5 See Chapter 20 for further information.

6 More specifically, banks have to estimate their potential decrease in their value, if a “standard shock” were

to occur to interest rates This standard shock might be, for example, a parallel shift in the rate curve of 200 basis points (or else, a change that is consistent with shocks witnessed in the five previous years).

Interest Rate Risk 5budget and control department, the finance department or the research department, withoutany direct involvement by senior management According to the Basel Committee, instead,top managers should participate in the definition of objectives, criteria, and procedures ofthe risk management system.

A second crucial point (Principle 3) is that risk management is to be assigned to anindependent unit (separated, e.g., from the Finance or Treasury department) Such a riskmanagement unit must support senior management from a technical point of view andits duties and responsibilities must include the definition of criteria for measuring risk,the validation of risk measures provided by individual business units in the bank, and theupdating of parameter estimates needed to feed the system The risk management unithas to be independent, in order to be perceived as authoritative and credible

Third, Principle 4 highlights the importance of measuring and managing interest raterisk at a consolidated level By doing so, the Basel Committee acknowledges that interestrate risk can be adequately appraised and managed only by taking into account the bank

as a whole, instead of focusing on individual areas

Lastly, the risk measurement system should be integrated into the day-to-day ment of the bank Accordingly, any criteria developed for measuring interest rate riskhave to be used in practice, as a means to steer corporate policy, and must not simply beseen as a purely theoretical tool used only by risk managers

manage-Interest rate risk on the banking book: Principles of the Basel Committee

Board and senior management oversight of interest rate risk

1: In order to carry out its responsibilities, the board of directors in a bank shouldapprove strategies and policies with respect to interest rate risk management and ensurethat senior management takes the steps necessary to monitor and control these risksconsistent with the approved strategies and policies The board of directors should beinformed regularly of the interest rate risk exposure of the bank in order to assess themonitoring and controlling of such risk against the board’s guidance on the levels ofrisk that are acceptable to the bank

2: Senior management must ensure that the structure of the bank’s business and thelevel of interest rate risk it assumes are effectively managed, that appropriate policiesand procedures are established to control and limit these risks, and that resources areavailable for evaluating and controlling interest rate risk

3: Banks should clearly define the individuals and/or committees responsible for aging interest rate risk and should ensure that there is adequate separation of duties inkey elements of the risk management process to avoid potential conflicts of interest.Banks should have risk measurement, monitoring, and control functions with clearlydefined duties that are sufficiently independent from position-taking functions of thebank and which report risk exposures directly to senior management and the board ofdirectors Larger or more complex banks should have a designated independent unitresponsible for the design and administration of the bank’s interest rate risk measure-ment, monitoring, and control functions

man-6 Risk Management and Shareholders’ Value in Banking

Adequate risk management policies and procedures

4: It is essential that banks’ interest rate risk policies and procedures are clearly definedand consistent with the nature and complexity of their activities These policies should

be applied on a consolidated basis and, as appropriate, at the level of individual iates, especially when recognising legal distinctions and possible obstacles to cashmovements among affiliates

affil-5: It is important that banks identify the risks inherent in new products and activities andensure these are subject to adequate procedures and controls before being introduced

or undertaken Major hedging or risk management initiatives should be approved inadvance by the board or its appropriate delegated committee

Risk measurement, monitoring, and control functions

6: It is essential that banks have interest rate risk measurement systems that capture allmaterial sources of interest rate risk and that assess the effect of interest rate changes inways that are consistent with the scope of their activities The assumptions underlyingthe system should be clearly understood by risk managers and bank management.7: Banks must establish and enforce operating limits and other practices that maintainexposures within levels consistent with their internal policies

8: Banks should measure their vulnerability to loss under stressful market conditions including the breakdown of key assumptions – and consider those results when estab-lishing and reviewing their policies and limits for interest rate risk

-9: Banks must have adequate information systems for measuring, monitoring, ling, and reporting interest rate exposures Reports must be provided on a timely basis

control-to the bank’s board of direccontrol-tors, senior management and, where appropriate, individualbusiness line managers

Internal controls

10: Banks must have an adequate system of internal controls over their interest raterisk management process A fundamental component of the internal control systeminvolves regular independent reviews and evaluations of the effectiveness of the systemand, where necessary, ensuring that appropriate revisions or enhancements to internalcontrols are made The results of such reviews should be available to the relevantsupervisory authorities

Information for supervisory authorities

11: Supervisory authorities should obtain from banks sufficient and timely informationwith which to evaluate their level of interest rate risk This information should takeappropriate account of the range of maturities and currencies in each bank’s portfo-lio, including off-balance sheet items, as well as other relevant factors, such as thedistinction between trading and non-trading activities

Capital adequacy

12: Banks must hold capital commensurate with the level of interest rate risk theyundertake

Interest Rate Risk 7

Disclosure of interest rate risk

13: Banks should release to the public information on the level of interest rate riskand their policies for its management

Supervisory treatment of interest rate risk in the banking book

14: Supervisory authorities must assess whether the internal measurement systems ofbanks adequately capture the interest rate risk in their banking book If a bank’s internalmeasurement system does not adequately capture the interest rate risk, the bank mustbring the system to the required standard To facilitate supervisors’ monitoring ofinterest rate risk exposures across institutions, banks must provide the results of theirinternal measurement systems, expressed in terms of the threat to economic value,using a standardised interest rate shock

15: If supervisors determine that a bank is not holding capital commensurate with thelevel of interest rate risk in the banking book, they should consider remedial action,requiring the bank either to reduce its risk or hold a specific additional amount ofcapital, or a combination of both

These guidelines set by the Basel Committee have prompted a significant evolution insystems used by banks for managing interest rate risk, which have gradually become moreaccurate and comprehensive

How can interest rate risk

s?

be meas red on real life portfolios?

ank

How can interest rate risk across the bank

?

be monitored and managed on an integrated basis?

Figure I.1 Key questions answered by Part I of this Book

8 Risk Management and Shareholders’ Value in Banking

The aim of Part I (see Figure I.1) is to illustrate this evolution by means of severalexamples Specifically, the next chapter reviews the characteristics, strengths and weak-

nesses of one of the most popular approaches: the repricing gap model We’ll see how

this model centres on the effect of changes in market rates on a bank’s net interest income(that is, on its profit and loss account) Also, the limitations of this model will be dis-cussed, that prevent it from providing a really complete picture of a bank’s exposure tounexpected changes in interest rates

In an attempt to overcome these limitations, duration gap models were developed,

which are discussed in Chapter 2 This type of techniques shifts the focus from a bank’scurrent earnings to its net worth, thus including medium-to-long term effects that repricinggap would basically overlook However, they are usually based on the assumption thatinterest rates are subject to uniform changes across maturities, that is, to parallel shifts inthe yield curve

To overcome such an unrealistic hypothesis, interest risk measurement evolved towardscash-flow mapping techniques, which aim to measure and manage the effects of differentchanges in rates, associated with different maturities These models, among which cash-

flow clumping is one of the most widely known, are examined in Chapter 3.

The techniques presented in Chapters 1–3 can only be applied if the bank managesthe maturity structure of its assets and liabilities on an integrated basis This means thatdifferent financial contracts (e.g., loans, bonds and deposits) originated by each branchmust be combined into a bank-wide, up-to-date picture This can be done through asystem of internal transfer rates (ITRs), which enable banks to aggregate interest raterisks originated by various business units and make it possible for bank managers tomanage interest rate risk effectively: ITRs are covered in Chapter 4

1 The Repricing Gap Model

Among the models for measuring and managing interest rate risk, the repricing gap

is certainly the best known and most widely used It is based on a relatively simpleand intuitive consideration: a bank’s exposure to interest rate risk derives from the factthat interest-earning assets and interest-bearing liabilities show differing sensitivities tochanges in market rates

The repricing gap model can be considered an income-based model, in the sense that thetarget variable used to calculate the effect of possible changes in market rates is, in fact,

an income variable: the net interest income (NII – the difference between interest incomeand interest expenses) For this reason this model falls into the category of “earningsapproaches” to measuring interest rate risk Income-based models contrast with equity-

based methods, the most common of which is the duration gap model (discussed in the

following chapter) These latter models adopt the market value of the bank’s equity asthe target variable of possible immunization policies against interest rate risk

After analyzing the concept of gap, this chapter introduces maturity-adjusted gaps, and

explores the distinction between marginal and cumulative gaps, highlighting the difference

in meaning and various applications of the two risk measurements The discussion thenturns to the main limitations of the repricing gap model along with some possible solutions.Particular attention is given to the standardized gap concept and its applications

The gap is a concise measure of interest risk that links changes in market interest rates

to changes in NII Interest rate risk is identified by possible unexpected changes in this

variable The gap (G) over a given time period t (gapping period ) is defined as the difference between the amount of rate-sensitive assets (SA) and rate-sensitive liabilities (SL):

The term “sensitive” in this case indicates assets and liabilities that mature (or are subject

to repricing) during periodt So, for example, to calculate the 6-month gap, one must take

into account all fixed-rate assets and liabilities that mature in the next 6 months, as well asthe variable-rate assets and liabilities to be repriced in the next 6 months The gap, then,

is a quantity expressed in monetary terms Figure 1.1 provides a graphic representation

of this concept

By examining its link to the NII, we can fully grasp the usefulness of the gap concept.

To do so, consider that NII is the difference between interest income (II ) and interest expenses (IE ) These, in turn, can be computed as the product of total financial assets (FA)

and the average interest rate on assets (rA) and total financial liabilities (FL) and average

interest rate on liabilities (rL) respectively Using NSA and NSL as financial assets and

10 Risk Management and Shareholders’ Value in Banking

Sensitive Liabilities (SL t )

Not Sensitive Liabilities (NSLt)

Sensitive Assets (SAt)

Not Sensitive Assets (NSAt)

Gap t (>0)

Figure 1 The repricing gap concept

liabilities which are not sensitive to interest rate fluctuations, and omitting t (which is considered given) for brevity’s sake, we can represent the NII as follows:

NII = II − IE = r A · FA − r L · FL = r A · (SA + NSA) − r L · (SL + NSL) (1.2)

from which:

Equation (1.3) is based on the simple consideration that changes in market interest ratesaffect only rate-sensitive assets and liabilities If, lastly, we assume that the change inrates is the same both for interest income and for interest expenses



Equation (1.5) shows that the change in NII is a function of the gap and interest ratechange In other words, the gap represents the variable that links changes in NII tochanges in market interest rates More specifically, (1.5) shows that a rise in interest

rates triggers an increase in the NII if the gap is positive This is due to the fact that

the quantity of rate-sensitive assets which will be renegotiated, resulting in an increase

in interest income, exceeds rate-sensitive liabilities Consequently, interest income grows

The Repricing Gap Model 11

faster than interest expenses, resulting in an increase of NII Vice versa, if the gap is negative, a rise in interest rates leads to a lower NII.

Table 1.1 reports the possible combinations of the effects of interest rate changes on a

bank’s NII, depending on whether the gap is positive or negative and the direction of the

interest rate change

Table 1.1 Gaps, rate changes, and effects on NII

∆r

positive net reinvestment

positive net refinancing

of 50 basis points (0.5 %),1 the expected change in the NII would then be:

E(NII ) = G · E(r) = (−20, 000, 000) · (+0.5 %) = −100, 000 (1.6)

In a similar situation, the bank would be well-advised to cut back on its rate-sensitiveassets, or as an alternative, add to its rate-sensitive liabilities On the other hand, wherethere are no expectations about the future evolution of market rates, an immunizationpolicy for safeguarding NII should be based on zero gap

Some very common indicators in interest rate risk management can be derived fromthe gap concept The first is obtained by comparing the gap to the bank’s net worth Thisallows one to ascertain the impact that a change in market interest rates would have on

1 Expectations on the evolution of interest rates must be mapped out by bank management, which has various tools at its disposal in order to do so The simplest one is the forward yield curve presented in Appendix 1B.