Risk Management in the Polish Financial System This page intentionally left blank Risk Management in the Polish Financial System A Systemic Approach Konrad Raczkowski Marian Noga and Jarosław Klepacki © Konrad Raczkowski, Marian Noga and Jarosław Klepacki 2015 Softcover reprint of the hardcover 1st edition 2015 978-1-137-54901-3 All rights reserved No reproduction, copy or transmission of this publication may be made without written permission No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988 First published 2015 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-349-57154-3 DOI 10.1057/9781137549020 ISBN 978-1-137-54902-0 (eBook) This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Raczkowski, Konrad Risk management in the Polish financial system : a systemic approach/ Konrad Raczkowski, Marian Noga, Jarosław Klepacki pages cm Finance – Poland Financial institutions – Poland Risk management – Poland I Noga, Marian II Klepacki, Jarosław III Title HG186.P7R33 2015 332.09438—dc23 2015018871 Contents List of Figures viii List of Tables x Preface xii National Systemic Risk Management Introduction 1.1 Managerial grounds for risk and making strategic decisions 1.2 Economic risk versus state risk 1.2.1 State systemic risks 1.2.2 Economic risk 1.2.3 Tax risk from the perspective of the state and the economy Conclusions Stability of the Polish Financial System and the Risk Involved Introduction 2.1 Macroprudential policy 2.1.1 The operation of a financial system and the influence it exerts on economic growth 2.1.2 Interaction between financial institutions 2.1.3 Protection of financial stability – macroprudential policy goals and tools 2.2 Microprudential policy 2.2.1 Prevention of individual bankruptcy Individual hazard analysis 2.2.2 Depositor protection 2.3 Comprehensive assessment of the financial situation in Poland Conclusions v 1 8 20 24 39 40 40 47 47 59 61 73 73 91 94 99 vi Contents Management of Financial Stability Risk Introduction 3.1 The structure and function of the financial safety system 3.2 Systemic risk institutions in the network of international capital ties 3.3 The principles of effective supervision of the financial market 3.4 Transfer of banking risk into the financial system 3.5 Reorganization of legal risk management processes Conclusions 100 100 The Risk of Investing in Financial Instruments Introduction 4.1 Types of financial instruments 4.1.1 Money market instruments 4.1.2 Debt instruments 4.1.3 Equity instruments 4.1.4 Derivative instruments (derivatives) 4.2 Investment risk involved in equity financial instruments 4.2.1 Market risk 4.2.2 Issuer risk 4.2.3 Liquidity risk 4.2.4 Risk of total value loss 4.3 The risk of investing in debt instruments 4.3.1 Inflation risk 4.3.2 Currency risk 4.3.3 Risk of price change and risk related to a given company 4.3.4 Default risk 4.3.5 Risk of early amortization Conclusions 138 138 138 146 148 155 160 Strategic Risks of Investing in Stock Exchange Introduction 5.1 Stock exchange investment style 5.2 Risk of investment strategies 5.2.1 Speculation 5.2.2 Short selling 101 107 121 124 131 136 167 170 173 175 176 177 178 180 181 182 184 184 186 186 186 191 195 197 Contents 5.3 Risk of other strategies 5.3.1 Opportunistic strategy 5.3.2 Buy and hold strategy 5.3.3 Market timing strategy 5.3.4 Behavioral strategy 5.3.5 Dollar cost averaging strategy 5.3.6 Current yield strategy 5.3.7 Ratio investment strategy 5.3.8 Capital preservation strategy 5.3.9 The Benjamin Graham strategy 5.3.10 Fixed structure strategy 5.3.11 Constant proportion strategy 5.3.12 The black swan strategy Conclusions Final remarks vii 201 202 204 206 207 209 214 216 218 219 222 225 227 232 234 Notes 235 References 239 Index 255 List of Figures 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 2.1 2.2 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 5.1 5.2 5.3 5.4 5.5 5.6 5.7 The influence of the socioeconomic system on individual risk management Profitability of ten-year government bonds in Poland The population of Poland by functional age groups in the years 2015 and 2050 Overall risk involved in the financial system Economic risk Overall and primary balances of national and local government institutions in Poland The total tax burdens in EU Member States in 2014 The VAT gap in Poland A functional model of the transformation of a financial crisis into a crisis of the real economy Model of the system of interactions among financial institutions in Poland Comparison between systematic and systemic risk The dynamics of the GDP of Poland and Germany New European architecture of financial supervision Types of bank risk in the area of finance Model of credit risk transfer Financial risk according to the Bank for International Settlements Classical investment areas and the scales of accompanying investment risk Juxtaposition of changes to the reference rate in Poland between 1991 and 2014 Changes to WIG over the last 30 years Changes to WIG20 over the last 30 years Short selling diagram Prices of shares of Volkswagen AG between January 2008 and March 2010 KGHM stock prices Changes to WIG at the beginning of its functioning Changes to the American S&P 500 Index at the beginning of its functioning viii 15 17 19 22 27 31 38 55 59 110 111 119 126 129 132 169 179 193 193 198 200 203 205 206 List of Figures 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15 5.16 KGHM share price, the purchase price averaging strategy, diversification in time KGHM share price, the purchase price averaging strategy, diversification in the price in an uptrend KGHM share price, the purchase price averaging strategy, diversification in the price in a downward trend Changes to stock prices Changes to the WIG index and profitability of Polish ten-year government bonds Behavior of the WIG20 index and the profitability of ten-year government bonds between 2006 and 2014 Behavior of the S&P 500 Index and the profitability of ten-year German government bonds between 2005 and 2014 Behavior of the American S&P 500 Index Juxtaposition of percentage changes in valuation of the units of the Eurogeddon Fund ix 210 211 212 215 219 223 225 229 230 References 247 McBride, J (2001) Instrumenty pochodne Przewodnik menedżera [Derivatives: a manager’s guide], translated by J Sobkowiak, Warsaw: WIG-Press, p 58 McDonald, L.G and Robinson, P (2009) A Colossal Failure of Common Sense The Inside Story of the Collapse of Lehman Brothers, New York: Crown Business, p 164 McDougal, A (2001) Swapy Techniki zawierania transakcji i zarządzanie ryzykiem [Swaps Techniques of making transaction and risk management], Kraków: Dom Wydawniczy ABC, p 24 Median and 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10/30/2014 http://www.gpw.pl/biblioteka-gpw-pobierz?gpwl_id=40&gpwlf_id=42, accessed 10/15/2014 http://www.akcjegrahama.pl, accessed 10/20/2014 http://www.parkiet.com/artykul/982293.html, accessed 10/21/2014 http://www.parkiet.com/artykul/374556.html, accessed 10/29/2014 http://10-procent-rocznie.blogspot.com/2014/02/ryzyko-w-systemie-inwestycyjnym-o.html, accessed 10/29/2014 http://polishtax.com/wp-content/uploads/2012/01/Polish-Accounting-Act.pdf, accessed 03/17/2015 http://www.gpw.pl/liquidity_support_programme, accessed 03/22/2015 http://europa.eu/rapid/press-release_ECA-14-30_en.htm, accessed 03/31/2015 https://www.knf.gov.pl/en/Images/ustawa_o_obrocie_aktualizacja_2011_tcm8126532.pdf, accessed on 03/17/2015 https://www.knf.gov.pl/en/Images/ustawa_fi_ang_tcm81-4131.pdf, accessed 03/19/ 2015 Index Altman model, bankruptcy warning, 74–5, 78 banking risk components of, 125 definition, 124–5 factors, 127 transfer into financial system, 124–31 types of, in finance, 126 banking sector balance sheet items in Polish, 83 elements of, 105 impact on financial system, 110–11 Polish, 98 rating agencies, 11–12 stress tests, 85–6 systemic risk analysis, 80 banking union, 133 bankruptcy early warning, 79–80 microprudential policy for preventing, 73–91 Basal Committee on Banking Supervision, 72, 86, 94, 118–21, 132, 235n4, 236n5–6 Basel III (Basel Committee on Banking Supervision), 72, 86, 89–90, 94, 97 behavioral strategy, investment, 207–9 Benjamin Graham strategy, investment, 219–21, 238n3 BFG (Bank Guarantee Fund), 91, 113, 116 deposit amount under protection, 92–3 disbursements of funds, 93–4 BGLN (Bank Governance Leadership Network), 125 BIS (Bank for International Settlements), 63, 67, 120–1, 132, 135, 160, 170, 235n4, 236n5–6, 236n8, 237n5 black swan strategy Eurogeddon Fund, 230 globalization, 228 Idea Premium fund, 230 investment, 227–32 Long-Term Capital Management (LTCM), 228–9 turbulence of capital market, 227–8 Black Swan: The Impact of Highly Improbable, The (Taleb), 227 bonds convertible, 152–3 covered, 153–4 debt instrument, 148–53 indexed, 151–2 long-term certificates of deposit, 154–5 long-term corporate, 151 municipal, 150–1 treasury, 149–50 Buffett, Warren, 189–90, 237–8n1 buy and hold strategy, investment, 204–6 call option, 165 capital buffers, 95–6 capital preservation strategy, investment, 218, 219 certificates of close-end investment funds, equity, 158 certificates of deposit, money market, 147 commercial banks characteristics of, 80–1, 84–6 debt-to-income (DTI), 88 instruments of microprudential policy, 89 lender of last resort, 90–1 leverage ratio (LR), 89 loan-to-value (LTV), 88 regulatory capital, 89 simulations, 84–5 stress tests, 85–6 Tier and solvency, 90 255 256 Index commercial papers, money market, 148 Common Equity Tier 1, 89, 90, 96 compound derivative instruments, 145 constant proportion strategy, investment, 225–7 contrarian investment strategy, 208–9 convertible bonds, 152–3 Corporate Income Tax (CIT), 32–4 covered bonds, 153–4 CRD (Capital Requirement Directive IV), 0, 69, 72, 89–90, 94–5 credit easing, United States, 52–3, 56 credit losses, simulations, 84–5 credit ratings, Polish banks, 82 credit risk, 128–30 CRR (Capital Requirement Regulation), 69, 72, 89–90, 94–5 currency crisis, 44 currency risk, 164, 180–1 current yield strategy, investment, 214–16 Czech Republic, assets of financial system, 48 death spiral, 212 debt instruments bonds, 148–53 convertible bonds, 152–3 covered bonds, 153–4 currency risk, 180–1 default risk, 182–4 indexed bonds, 151–2 inflation risk, 178–80 interest rate risk, 179 investment risks, 177–84 long-term certificates of deposit, 154–5 long-term corporate bonds, 151 municipal bonds, 150–1 risk of change in price, 181–2 risk of early amortization, 184 risk related to given company, 181–2 treasury bonds, 149–50 see also financial instruments debt-to-income (DTI), 88 default risk, debt, 182–4 depositor protection, Bank Guarantee Fund, 91–4 derivatives, 143–5, 160–7 financial instruments, 160–7 fundamental groups of, 163–7 futures and forward contracts, 163 literature, 161 nonstandardized, 144, 161 options, 164–6 standardized, 144, 161 swap contracts, 163–4 warrants, 166–7 weight of risk, 162 discriminant models, bankruptcy warning, 79–80 dollar cost averaging strategy, 209–14 Dreman, David, 209 DSGE (dynamic stochastic general equilibrium), 64–5 EBA (European Banking Authority), 116, 117, 119, 134 ECA (European Court of Auditors), 134–5 ECB (European Central Bank), 53, 112, 115–17, 134 economic risk, 20–4 currency, 180 definition, 22–4 productivity shocks, 23 tax risk, 24–5, 26 EIOPA (European Insurance and Occupational Pensions Authority), 116, 117, 118 electronic trade, 156, 168 equity instruments, 139 certificates of close-end investment funds, 158 investment risk involved in, 167–77 issuer risk, 173–5 liquidity risk, 175–6 market risk, 170–3 participation units in open-ended investment funds, 157 preemptive right, 160 risk of total value loss, 176–7 shares, 155–6 subscription rights, 159 see also financial instruments ESA (European Supervision Authorities), 117, 119, 236n10 Index ESFS (European System of Financial Supervisors), 117, 118, 119 ESMA (European Securities and Markets Authority), 11, 116–18, 134 ESRB (European Systemic Risk Board), 60, 112, 114, 116–18, 136 EU (European Union), profitability of ten-year bonds, 14–15 Euro Area assets of financial system, 48 GDP between 2001 and 2014, 54 European Union Member States GDP between 2001 and 2014, 54 ratings, 13 tax burdens, 31 everyday life risk, 4, 19, 233 excessive debt procedure, 25 expected utility principle, Federal Reserve System, 45, 102 financial assets, 139, 237n1 financial crisis causes of, 46 events of, 45 functional model of, 55 GDP in countries between 2001 and 2014, 53, 54 global, 43–7 mortgage, 44–5 Polish financial system during, 98 public debt crisis, 44, 45–6, 53 second phase, 45–6 three crises in, 44 US economy, 52 financial instruments compound derivative instruments, 145 debt instruments, 148–55 definitions of, 139–41 derivative financial instruments, 143–5 diversity of, 142 equity instruments, 155–60 investment risk, 169, 184–5 legal provisions, 141–2 money market instruments, 146–8 original instruments, 143 financialization, Polish economy, 49, 108, 234 257 financial liability, 139, 237n2 financial market, supervision of, 121–3 financial safety system banking system, 104–5 definition of, 103–4 effectiveness of net, 101, 103 effective supervision of market, 121–3 organization of net, 102, 233–4 reorganization of legal risk management, 131–6 role of government in shaping, 105–6 role of insurance companies, 106–7 structure and function of, 101–7 systemic risk institutions, 107–21 Financial Stability Committee, 113, 115, 235n2 financial stability risk, 100–101, 131–7 financial system, 19 assets of, 48–9 assets of Polish financial institutions, 49, 50 behavioral economics, 43 comprehensive assessment of Poland’s, 94–8 cross-generational transfer of incomes and economic growth, 17–18 direct or indirect influence of risks, 18–19 impact of banking system on, 110–11 influence on economic growth, 47–59 interaction between financial institutions, 59–61 legal basis defining, 60 mainstream economics, 42–3 operation of, 47–59 overall risk, 19 Polish, 40–1, 234 primary balance, 27–8 process of penetration of bank risk, 127–8 public debt, 28–9 transfer of banking risk into, 124–31 258 Index Fitch Ratings, 12, 13, 82, 149, 177 fixed structure strategy, investment, 222–4 forward contracts, derivatives, 163 FSB (Financial Stability Board), 60, 63–4 functional model, financial crisis, 55 futures, derivatives, 163 GDP (gross domestic product) countries between 2001 and 2014, 53, 54 dynamics of, of Poland and Germany, 111 estimating potential, 57–9 global economic crisis, see financial crisis global risk, taxonomy of, 18 Graham, Benjamin, 219–21, 222, 238n3 Greece, public debt crisis, 56, 62 Hadasik model, microprudential policy, 75, 76, 77, 78 Hungary, assets of financial system, 48 IMF (International Monetary Fund), 63, 67, 114, 236n8 indexed bonds, 151–2 individual risk management, inflation risk, debt, 178–80 INF (Polish Financial Supervision Authority), recommendations, 86–8 interest rate risk, debt, 179 interest rate swaps, 164 internal business risk, 20 International Accounting Standards, 140 International Banking Research Network, 130, 236n8 investment regime, stock exchange, 188 investment risk debt instruments, 177–84 equity instruments, 167–77 financial instruments, 169 investment strategies advantages and disadvantages, 200–201 behavioral strategy, 207–9 Benjamin Graham strategy, 219–21 black swan strategy, 227–32 buy and hold strategy, 204–6 capital preservation strategy, 218, 219 constant proportion strategy, 225–7 contrarian investment strategy, 208–9 current yield strategy, 214–16 dollar cost averaging strategy, 209–14 fixed structure strategy, 222–4 market timing strategy, 206–7 materialization of risk of, 194 naked short selling, 201 one-time event, 3, 196–7 opportunistic strategy, 202–3 pillars of, 192 ratio investment strategy, 216–17 risk of, 191–202 risks of stock exchange investment, 232–3 settlement risk, 199 short selling, 197–201 short squeeze risk, 199 speculation, 195–7 stock exchange, 187–8 Warsaw Stock Exchange, 192, 193 investment style stock exchange, 186–90 variables, 189 Warren Buffett, 189–90 Ireland, banking system, 46–7 issuer risk, equity instruments, 173–5 KGHM stock prices, 203, 210, 211, 212 KNF (Polish Financial Supervision Authority), 86–7, 93–4, 113–16, 122, 134, 161, 170 KTB (Kooperativna Tyrgovska Banka), 90–1, 99 legal basis, financial system, 60 legal risk management categorization in banking activity, 132–3 definition, 132 foundation of rules, 133–4 reorganization, 131–6 Index 259 Lehman Brothers, 45, 52, 100, 101, 111, 131 lender of last resort, 90–1 leverage ratio, 89 liquidity risk, 130–1, 175–6 Liquidity Support Program, 175, 237n7 loan portfolio risk, 128 loan-to-value (LTV), 88 long-term certificates of deposit, 154–5 long-term corporate bonds, 151 long-term refinancing operations (LTRO), 53, 56 Luxembourg, tax havens, 29, 30 money market instruments certificates of deposit, 147 commercial papers (CP), 148 money bills, 147 short-term commercial papers, 147–8 treasury bills, 146–7 see also financial instruments Moody’s rating, 12, 13, 82, 149, 177 mortgage crisis, 44–5 municipal bonds, 150–1 macroeconomic growth, taxonomy of threats and risks, 5–7 macroeconomic policy, mistakes of, 61–2 macroprudential policies, 60, 120 goals of, 63–4 indexes, 95–7 instruments and features, 70–1 literature, 62–3 models of organization of, 112–13 monetary policy, 68–9 objective of, 61, 62 operation of financial system, 47–59 protection of financial stability, 61–72 recommendations for organization, 67 supervisory activity, 112, 116 market risk, 110, 170–3 market timing strategy, investment, 206–7 martingale strategy, 212–13 microprudential policies, 60 Altman model, 74–5, 78 bankruptcy prevention, 73–91 depositor protection, 91–4 Hadasik model, 75, 76, 77, 78 instruments of, 89 Poznań model, 75, 76, 78 supervisory activity, 112 world crisis, 42 Z-score model by Maczyńska, 75 money bills, 147 OECD (Organization for Economic Co-operation and Development), 9, 10, 15, 23 Official Journal of the European Union (journal), 69, 94, 112 one-time event, 3, 196–7 open-ended investment funds, 157 operational risk, 126, 132 opportunistic strategy, investment, 202–3 opportunity funds, 202 options, derivatives, 164–6 naked short selling, 201 National Bank of Poland, 16, 40–1, 46, 60, 113–14, 147, 151, 231, 235n2 Poland affiliation of companies conducting business in, 30 assets of, 48, 49, 50 components of risk assessment, comprehensive assessment of financial system, 94–8 Corporate Income Tax (CIT), 32–4 demographic risks, 16 dynamics of GDP, 111 financialization of economy, 49, 108, 234 financial system structure in, 40–1 GDP between 2001 and 2014, 53, 54 interaction between financial institutions, 59–61 interest rate market, 179 network of institutions, 113 number of financial institutions in, 49, 51 260 Index Poland – continued population by age group, 16, 17 primary balance, 27–8 profitability of ten-year bonds, 14–15 revenue, expenditure, and debt in public finance, 28 Systemic Risk Board draft bill, 65–8 tax burdens, 33 VAT gap, 37, 38 Polish banks balance sheet items, 83 characteristics of operation, 88–91 ratings, 82 Polish Financial Supervision Authority (KNF), 86–8, 93–4, 113–16, 122, 134, 161, 170 Poznań Model, microprudential policy, 75, 76, 78 preemptive right, equity, 160 productivity shocks, economic risk, 23 public debt countries, 28–9 Greece, 56, 62 public debt crisis, 44, 45–6, 53 public finances, risk management, 25, 27 QE (quantitative easing), United States, 52–3, 56 rating agencies, risk measurement, 11–12, 13 ratio investment strategy, 216–17 regulatory capital, 89 risk, 1–2 categorization, economic, 20–4 financial system, 19 macroeconomic growth, 5–7 managerial grounds for, 2–7 state systemic, 8–20 taxonomy of global, 18 risk assessment, 9, 11–12 risk buffer, 95–6 risk management, 2, 4, 10 dimensions of, 3–4, 21, 233 efficiency of, 111–12 reorganization of legal processes, 131–6 risk measurement, 13–14 risk of change in price, debt, 181–2 risk of early amortization, debt, 184 risk of total value loss, equity, 176–7 risk related to given company, debt, 181–2 RRS (Systemic Risk Board), 114, 116 S&P 500 Index, 206, 209, 224, 225, 229 shares, equity, 155–6 short selling diagram, 198 investment strategy, 197–201 naked, 201 uptick rule, 238n2 short-term commercial papers, 147–8 simulations, absorption of credit losses, 84–5 speculation, investment, 195–7 Standard & Poor’s, 12, 13, 82, 149, 177 state risk, 8–20 stock exchange American S&P 500 Index, 206, 209, 224, 225, 229 changes to stock prices, 215 Eurogeddon Fund, 230 Idea Premium fund, 230 investment style, 186–90 KGHM stock prices, 203, 210, 211, 212 risk of total value loss, 176–7 Warsaw Stock Exchange, 156, 163, 166–7, 175, 177, 192, 193, 203, 205, 215, 223 strategic risk, 20 stress tests, banks, 85–6 subprime loan, 236n7 subscription rights, equity, 159 swap contracts, derivatives, 163–4 systemic risk, 65, 108 banking sector, 80 comparing systematic and, 110 exit of capital, 109–10 Index systemic risk – continued incremental effect, 109 institutions in network, 107–21 spillover effect, 109 Systemic Risk Board, 65–9, 114, 116 systemic risk buffer (SRB), 95 Taleb, Nassim Nicholas, 227–8 tax burdens, EU Member States, 31–2 tax havens, 29, 30 tax risk aggressive tax policy, 233 categories of, 24–5 foundations for management, 26 state and economy, 24–39 value-added tax (VAT), 34–8 ten-year government bonds, Poland, 14–15 Tier 1, Common Equity, 89, 90, 96 too-big-to-fail (TBTF) concept, 52, 108, 131 transaction risk, currency, 180 translation risk, currency, 180 261 treasury bills money market, 146–7 treasury bonds, debt, 149–50 twin peaks structure, 107 uptick rule, 238n2 US economy credit easing, 52–3 financial crisis, 52, 131 quantitative easing, 52–3 VAT (value added tax), 34–8 discounted expected revenue from, 35, 36 mechanism of irregularities, 36 mechanism of reverse charge, 38–9 VAT gap in Poland, 37, 38 warrants, derivatives, 166–7 Warsaw Stock Exchange, 156, 163, 166–7, 175, 177, 192, 193, 203, 215, 218 Z-score model by Maczyńska, 75 ... possibilities for managing risk in the Polish financial system In particular, a map of risk in the Polish financial system 2015+ serves to achieve this aim by way of indicating the wide institutional.. .Risk Management in the Polish Financial System This page intentionally left blank Risk Management in the Polish Financial System A Systemic Approach Konrad Raczkowski... supervision with a systemic approach The next two chapters, that is Chapters and 5, present the current risk involved in investing in financial instruments and the risk of strategic investing in stock