Risk Management & Capital Adequacy

RISK MANAGEMENT 
AND CAPITAL 
ADEQUACY......Page 4
Copyright......Page 5
ACKNOWLEDGMENTS......Page 9
CONTENTS......Page 10
INTRODUCTION......Page 18
1.1 BACKGROUND......Page 22
1.2 RISKS: A VIEW OF THE PAST DECADES......Page 26
1.3 DEFINITION OF RISK......Page 28
1.4 RELATED TERMS AND DIFFERENTIATION......Page 29
1.5 DEGREE OF RISK......Page 31
1.6.2 History of Modern Risk Management......Page 32
1.6.3 Related Approaches......Page 36
1.7.1 Definition......Page 44
1.7.3 Factors That Support Systemic Risk......Page 47
1.7.4 Regulatory Mechanisms for Risk Management......Page 48
1.8 SUMMARY......Page 50
1.9 NOTES......Page 51
2.1 BACKGROUND......Page 54
2.2 DEFINITION OF MARKET RISK......Page 55
2.3 CONCEPTUAL APPROACHES FOR MODELING MARKET RISK......Page 58
2.4 MODERN PORTFOLIO THEORY......Page 60
2.4.1 The Capital Asset Pricing Model......Page 62
2.4.2 The Security Market Line......Page 64
2.4.3 Modified Form of CAPM by Black, Jensen, and Scholes......Page 66
2.4.4 Arbitrage Pricing Theory......Page 67
2.4.5 Approaches to Option Pricing......Page 68
2.5 REGULATORY INITIATIVES FOR MARKET RISKS AND VALUE AT RISK......Page 75
2.5.1 Development of an International Framework for Risk Regulation......Page 77
2.5.2 Framework of the 1988 BIS Capital Adequacy Calculation......Page 78
2.5.3 Criticisms of the 1988 Approach......Page 79
2.5.4 Evolution of the 1996 Amendment on Market Risks......Page 80
2.6 AMENDMENT TO THE CAPITAL ACCORD TO INCORPORATE MARKET RISKS......Page 81
2.6.2 Countable Capital Components......Page 82
2.7 THE STANDARDIZED MEASUREMENT METHOD......Page 84
2.7.1 General and Specific Risks for Equity-and Interest- Rate- Sensitive Instruments......Page 86
2.7.2 Interest- Rate Risks......Page 88
2.7.3 Equity Position Risk......Page 101
2.7.4 Foreign- Exchange Risk......Page 106
2.7.5 Commodities Risk......Page 107
2.7.6 Treatment of Options......Page 111
2.7.7 Criticisms of the Standard Approach......Page 117
2.8 THE INTERNAL MODEL APPROACH......Page 118
2.8.1 Conditions for and Process of Granting Approval......Page 119
2.8.2 VaR- Based Components and Multiplication Factor......Page 120
2.8.3 Requirement for Specific Risks......Page 121
2.8.5 Specification of Market Risk Factors to Be Captured......Page 122
2.8.6 Minimum Quantitative Requirements......Page 124
2.8.7 Minimum Qualitative Requirements......Page 126
2.9 THE PRECOMMITMENT MODEL......Page 131
2.10 COMPARISON OF APPROACHES......Page 132
2.11.1 The E. U. Capital Adequacy Directive......Page 133
2.12 REGULATION OF NONBANKS......Page 134
2.12.2 Insurance Companies......Page 135
2.12.3 Securities Firms......Page 136
2.12.5 Disclosure Requirements......Page 137
2.13 MARKET INSTRUMENTS AND CREDIT RISKS......Page 138
2.15 NOTES......Page 141
3.1 BACKGROUND......Page 150
3.3 CURRENT CREDIT RISK REGULATIONS......Page 151
3.4 DEFICIENCIES OF THE CURRENT REGULATIONS......Page 152
3.5 DEFICIENCIES OF CURRENT CONCEPTUAL APPROACHES FOR MODELING CREDIT RISK......Page 154
3.6 CONCEPTUAL APPROACHES FOR MODELING CREDIT RISK......Page 156
3.6.1 Transaction and Portfolio Management......Page 157
3.6.2 Measuring Transaction Risk ¨C Adjusted Profitability......Page 161
3.7 MEASURING CREDIT RISK FOR CREDIT PORTFOLIOS......Page 162
3.7.1 Economic Capital Allocation......Page 163
3.7.2 Choice of Time Horizon......Page 167
3.7.3 Credit Loss Measurement Definition......Page 168
3.7.4 Risk Aggregation......Page 171
3.8.1 Background......Page 172
3.8.2 BIS Risk- Based Capital Requirement Framework......Page 174
3.8.3 Traditional Credit Risk Measurement Approaches......Page 175
3.8.4 Option Theory, Credit Risk, and the KMV Model......Page 181
3.8.5 J. P. Morgan’s CreditMetrics and Other VaR
 Approaches......Page 189
3.8.6 The McKinsey Model and Other Macrosimulation Models......Page 200
3.8.7 KPMG’s Loan Analysis System and Other Risk-Neutral
Valuation Approaches......Page 206
3.8.8 The CSFB CreditRisk+ Model......Page 213
3.8.9 CSFB¡¯s CreditRisk+ Approach......Page 216
3.8.10 Summary and Comparison of New Internal Model Approaches......Page 221
3.9.1 Background......Page 228
3.9.3 Nonnormal Returns......Page 230
3.9.6 Modeling Risk ¨C Return Trade- Off of Loans and Loan Portfolios......Page 231
3.9.7 Differences in Credit versus Market Risk Models......Page 247
3.10.1 Background......Page 248
3.10.3 Stress Testing Based on Time- Series Versus Cross- Sectional Approaches......Page 249
3.11.1 Credit Lines......Page 252
3.11.2 Secured Loans......Page 253
3.11.3 Money Market Instruments......Page 255
3.11.4 Futures Contracts......Page 259
3.11.5 Options......Page 262
3.11.6 Forward Rate Agreements......Page 265
3.11.7 Asset- Backed Securities......Page 267
3.11.8 Interest- Rate Swaps......Page 270
3.12 PROPOSAL FOR A MODERN CAPITAL ACCORD FOR CREDIT RISK......Page 273
3.12.1 Institute of International Finance......Page 274
3.12.3 Basel Committee on Banking Supervision and the New Capital Accord......Page 275
3.13 SUMMARY......Page 286
3.14 NOTES......Page 288
4.1 BACKGROUND......Page 304
4.2 INCREASING FOCUS ON OPERATIONAL RISK......Page 306
4.2.1 Drivers of Operational Risk Management......Page 307
4.2.2 Operational Risk and Shareholder Value......Page 309
4.3 DEFINITION OF OPERATIONAL RISK......Page 310
4.4 REGULATORY UNDERSTANDING OF OPERATIONAL RISK DEFINITION......Page 314
4.5 ENFORCEMENT OF OPERATIONAL RISK MANAGEMENT......Page 317
4.6 EVOLUTION OF OPERATIONAL RISK INITIATIVES......Page 320
4.7 MEASUREMENT OF OPERATIONAL RISK......Page 323
4.8 CORE ELEMENTS OF AN OPERATIONAL RISK MANAGEMENT PROCESS......Page 324
4.9 ALTERNATIVE OPERATIONAL RISK MANAGEMENT APPROACHES......Page 325
4.9.1 Top- Down Approaches......Page 326
4.9.2 Bottom- Up Approaches......Page 335
4.9.3 Top- Down Versus Bottom- Up Approaches......Page 340
4.9.4 The Emerging Operational Risk Discussion......Page 341
4.10 CAPITAL ISSUES FROM THE REGULATORY PERSPECTIVE......Page 342
4.11 CAPITAL ADEQUACY ISSUES FROM AN INDUSTRY PERSPECTIVE......Page 345
4.11.1 Measurement Techniques and Progress in the Industry Today......Page 348
4.11.2 Regulatory Framework for Operational Risk Overview Under the New Capital Accord......Page 351
4.11.3 Operational Risk Standards......Page 356
4.12 SUMMARY AND CONCLUSION......Page 358
4.13 NOTES......Page 359
5.1 BACKGROUND......Page 362
5.2.1 Background......Page 363
5.2.2 Existing Framework......Page 364
5.2.3 Impact of the 1988 Accord......Page 366
5.2.4 The June 1999 Proposal......Page 367
5.2.5 Potential Modifications to the Committee’s Proposals......Page 369
5.3.1 Pillar I: Minimum Capital Requirement......Page 373
5.3.2 Pillar II: Supervisory Review Process......Page 374
5.3.3 Pillar III: Market Discipline and General Disclosure Requirements......Page 375
5.4.1 Background......Page 377
5.4.2 Historical Development of VaR......Page 378
5.4.3 VaR and Modern Financial Management......Page 380
5.4.4 Definition of VaR......Page 384
5.5 CONCEPTUAL OVERVIEW OF RISK METHODOLOGIES......Page 386
5.6 LIMITATIONS OF VAR......Page 387
5.6.1 Parameters for VaR Analysis......Page 389
5.6.2 Different Approaches to Measuring VaR......Page 394
5.6.3 Historical Simulation Method......Page 401
5.6.4 Stress Testing......Page 403
5.6.5 Summary of Stress Tests......Page 409
5.7.1 Portfolio VaR......Page 410
5.7.2 Incremental VaR......Page 413
5.7.3 Alternative Covariance Matrix Approaches......Page 415
5.8.1 Event and Stability Risks......Page 424
5.8.3 Changing Holdings......Page 426
5.8.5 Model Risks......Page 427
5.8.6 Strategic Risks......Page 429
5.8.7 Time Aggregation......Page 430
5.8.8 Predicting Volatility and Correlations......Page 434
5.8.9 Modeling Time- Varying Risk......Page 435
5.8.10 The RiskMetrics Approach......Page 442
5.8.11 Modeling Correlations......Page 446
5.9 LIQUIDITY RISK......Page 451
5.10 SUMMARY......Page 456
5.11 NOTES......Page 457
6.2 OVERVIEW OF CASES......Page 462
6.3.1 Background......Page 466
6.3.2 Cause......Page 469
6.3.3 Risk Areas Affected......Page 478
6.4.2 Cause......Page 482
6.4.4 Risk Areas Affected......Page 485
6.5.1 Background......Page 487
6.5.2 Cause......Page 489
6.5.3 Effect......Page 493
6.5.4 Risk Areas Affected......Page 494
6.6.1 Background......Page 500
6.6.2 Cause......Page 501
6.6.3 Effect......Page 506
6.6.4 Risk Areas Affected......Page 507
6.7 NOTES......Page 511
GLOSSARY......Page 516
BIBLIOGRAPHY......Page 540
INDEX......Page 560