Risk Management and Capital Adequacy

Copyright......Page 5
CONTENTS......Page 11
ACKNOWLEDGMENTS......Page 10
INTRODUCTION......Page 19
1.1 BACKGROUND......Page 23
1.2 RISKS: A VIEW OF THE PAST DECADES......Page 27
1.3 DEFINITION OF RISK......Page 29
1.4 RELATED TERMS AND DIFFERENTIATION......Page 30
1.5 DEGREE OF RISK......Page 32
1.6.2 History of Modern Risk Management......Page 33
1.6.3 Related Approaches......Page 37
1.7.1 Definition......Page 45
1.7.3 Factors That Support Systemic Risk......Page 48
1.7.4 Regulatory Mechanisms for Risk Management......Page 49
1.8 SUMMARY......Page 51
1.9 NOTES......Page 52
2.1 BACKGROUND......Page 55
2.2 DEFINITION OF MARKET RISK......Page 56
2.3 CONCEPTUAL APPROACHES FOR MODELING MARKET RISK......Page 59
2.4 MODERN PORTFOLIO THEORY......Page 61
2.4.1 The Capital Asset Pricing Model......Page 63
2.4.2 The Security Market Line......Page 65
2.4.3 Modified Form of CAPM by Black, Jensen, and Scholes......Page 67
2.4.4 Arbitrage Pricing Theory......Page 68
2.4.5 Approaches to Option Pricing......Page 69
2.5 REGULATORY INITIATIVES FOR MARKET RISKS AND VALUE AT RISK......Page 76
2.5.1 Development of an International Framework for Risk Regulation......Page 78
2.5.2 Framework of the 1988 BIS Capital Adequacy Calculation......Page 79
2.5.3 Criticisms of the 1988 Approach......Page 80
2.5.4 Evolution of the 1996 Amendment on Market Risks......Page 81
2.6 AMENDMENT TO THE CAPITAL ACCORD TO INCORPORATE MARKET RISKS......Page 82
2.6.2 Countable Capital Components......Page 83
2.7 THE STANDARDIZED MEASUREMENT METHOD......Page 85
2.7.1 General and Specific Risks for Equity- and Interest-Rate-Sensitive Instruments......Page 87
2.7.2 Interest-Rate Risks......Page 89
2.7.3 Equity Position Risk......Page 102
2.7.4 Foreign-Exchange Risk......Page 107
2.7.5 Commodities Risk......Page 108
2.7.6 Treatment of Options......Page 112
2.7.7 Criticisms of the Standard Approach......Page 118
2.8 THE INTERNAL MODEL APPROACH......Page 119
2.8.1 Conditions for and Process of Granting Approval......Page 120
2.8.2 VaR-Based Components and Multiplication Factor......Page 121
2.8.3 Requirement for Specific Risks......Page 122
2.8.5 Specification of Market Risk Factors to Be Captured......Page 123
2.8.6 Minimum Quantitative Requirements......Page 125
2.8.7 Minimum Qualitative Requirements......Page 127
2.9 THE PRECOMMITMENT MODEL......Page 132
2.10 COMPARISON OF APPROACHES......Page 133
2.11.1 The E.U. Capital Adequacy Directive......Page 134
2.12 REGULATION OF NONBANKS......Page 135
2.12.2 Insurance Companies......Page 136
2.12.3 Securities Firms......Page 137
2.12.5 Disclosure Requirements......Page 138
2.13 MARKET INSTRUMENTS AND CREDIT RISKS......Page 139
2.15 NOTES......Page 142
3.1 BACKGROUND......Page 151
3.3 CURRENT CREDIT RISK REGULATIONS......Page 152
3.4 DEFICIENCIES OF THE CURRENT REGULATIONS......Page 153
3.5 DEFICIENCIES OF CURRENT CONCEPTUAL APPROACHES FOR MODELING CREDIT RISK......Page 155
3.6 CONCEPTUAL APPROACHES FOR MODELING CREDIT RISK......Page 157
3.6.1 Transaction and Portfolio Management......Page 158
3.6.2 Measuring Transaction Risk–Adjusted Profitability......Page 162
3.7 MEASURING CREDIT RISK FOR CREDIT PORTFOLIOS......Page 163
3.7.1 Economic Capital Allocation......Page 164
3.7.2 Choice of Time Horizon......Page 168
3.7.3 Credit Loss Measurement Definition......Page 169
3.7.4 Risk Aggregation......Page 172
3.8.1 Background......Page 173
3.8.2 BIS Risk-Based Capital Requirement Framework......Page 175
3.8.3 Traditional Credit Risk Measurement Approaches......Page 176
3.8.4 Option Theory, Credit Risk, and the KMV Model......Page 182
3.8.5 J.P. Morgan’s CreditMetrics and Other VaR Approaches......Page 190
3.8.6 The McKinsey Model and Other Macrosimulation Models......Page 201
3.8.7 KPMG’s Loan Analysis System and Other Risk-Neutral Valuation Approaches......Page 207
3.8.8 The CSFB CreditRisk + Model......Page 214
3.8.9 CSFB’s CreditRisk + Approach......Page 217
3.8.10 Summary and Comparison of New Internal Model Approaches......Page 222
3.9.1 Background......Page 229
3.9.3 Nonnormal Returns......Page 231
3.9.6 Modeling Risk–Return Trade-Off of Loans and Loan Portfolios......Page 232
3.9.7 Differences in Credit versus Market Risk Models......Page 248
3.10.1 Background......Page 249
3.10.3 Stress Testing Based on Time-Series Versus Cross-Sectional Approaches......Page 250
3.11.1 Credit Lines......Page 253
3.11.2 Secured Loans......Page 254
3.11.3 Money Market Instruments......Page 256
3.11.4 Futures Contracts......Page 260
3.11.5 Options......Page 263
3.11.6 Forward Rate Agreements......Page 266
3.11.7 Asset-Backed Securities......Page 268
3.11.8 Interest-Rate Swaps......Page 271
3.12 PROPOSAL FOR A MODERN CAPITAL ACCORD FOR CREDIT RISK......Page 274
3.12.1 Institute of International Finance......Page 275
3.12.3 Basel Committee on Banking Supervision and the New Capital Accord......Page 276
3.13 SUMMARY......Page 287
3.14 NOTES......Page 289
4.1 BACKGROUND......Page 305
4.2 INCREASING FOCUS ON OPERATIONAL RISK......Page 307
4.2.1 Drivers of Operational Risk Management......Page 308
4.2.2 Operational Risk and Shareholder Value......Page 310
4.3 DEFINITION OF OPERATIONAL RISK......Page 311
4.4 REGULATORY UNDERSTANDING OF OPERATIONAL RISK DEFINITION......Page 315
4.5 ENFORCEMENT OF OPERATIONAL RISK MANAGEMENT......Page 318
4.6 EVOLUTION OF OPERATIONAL RISK INITIATIVES......Page 321
4.7 MEASUREMENT OF OPERATIONAL RISK......Page 324
4.8 CORE ELEMENTS OF AN OPERATIONAL RISK MANAGEMENT PROCESS......Page 325
4.9 ALTERNATIVE OPERATIONAL RISK MANAGEMENT APPROACHES......Page 326
4.9.1 Top-Down Approaches......Page 327
4.9.2 Bottom-Up Approaches......Page 336
4.9.3 Top-Down Versus Bottom-Up Approaches......Page 341
4.9.4 The Emerging Operational Risk Discussion......Page 342
4.10 CAPITAL ISSUES FROM THE REGULATORY PERSPECTIVE......Page 343
4.11 CAPITAL ADEQUACY ISSUES FROM AN INDUSTRY PERSPECTIVE......Page 346
4.11.1 Measurement Techniques and Progress in the Industry Today......Page 349
4.11.2 Regulatory Framework for Operational Risk Overview Under the New Capital Accord......Page 352
4.11.3 Operational Risk Standards......Page 357
4.12 SUMMARY AND CONCLUSION......Page 359
4.13 NOTES......Page 360
5.1 BACKGROUND......Page 363
5.2.1 Background......Page 364
5.2.2 Existing Framework......Page 365
5.2.3 Impact of the 1988 Accord......Page 367
5.2.4 The June 1999 Proposal......Page 368
5.2.5 Potential Modifications to the Committee’s Proposals......Page 370
5.3.1 Pillar I: Minimum Capital Requirement......Page 374
5.3.2 Pillar II: Supervisory Review Process......Page 375
5.3.3 Pillar III: Market Discipline and General Disclosure Requirements......Page 376
5.4.1 Background......Page 378
5.4.2 Historical Development of VaR......Page 379
5.4.3 VaR and Modern Financial Management......Page 381
5.4.4 Definition of VaR......Page 385
5.5 CONCEPTUAL OVERVIEW OF RISK METHODOLOGIES......Page 387
5.6 LIMITATIONS OF VAR......Page 388
5.6.1 Parameters for VaR Analysis......Page 390
5.6.2 Different Approaches to Measuring VaR......Page 395
5.6.3 Historical Simulation Method......Page 402
5.6.4 Stress Testing......Page 404
5.6.5 Summary of Stress Tests......Page 410
5.7.1 Portfolio VaR......Page 411
5.7.2 Incremental VaR......Page 414
5.7.3 Alternative Covariance Matrix Approaches......Page 416
5.8.1 Event and Stability Risks......Page 425
5.8.3 Changing Holdings......Page 427
5.8.5 Model Risks......Page 428
5.8.6 Strategic Risks......Page 430
5.8.7 Time Aggregation......Page 431
5.8.8 Predicting Volatility and Correlations......Page 435
5.8.9 Modeling Time-Varying Risk......Page 436
5.8.10 The RiskMetrics Approach......Page 443
5.8.11 Modeling Correlations......Page 447
5.9 LIQUIDITY RISK......Page 452
5.10 SUMMARY......Page 457
5.11 NOTES......Page 458
6.2 OVERVIEW OF CASES......Page 463
6.3.1 Background......Page 467
6.3.2 Cause......Page 470
6.3.3 Risk Areas Affected......Page 479
6.4.2 Cause......Page 483
6.4.4 Risk Areas Affected......Page 486
6.5.1 Background......Page 488
6.5.2 Cause......Page 490
6.5.3 Effect......Page 494
6.5.4 Risk Areas Affected......Page 495
6.6.1 Background......Page 501
6.6.2 Cause......Page 502
6.6.3 Effect......Page 507
6.6.4 Risk Areas Affected......Page 508
6.7 NOTES......Page 512
GLOSSARY......Page 517
BIBLIOGRAPHY......Page 541
INDEX......Page 561