Foundations of Financial Risk

The Global Association of Risk Professionals (GARP) is a not-for-profit association consisting of 74,890 individuals around the world who are involved in financial risk management. Members come from more than 100 countries and work in regional and global banks, asset management firms, insurance companies, central banks, securities regulators, hedge funds, universities, large industrial corporations and multinationals.

• Preface xvAcknowledgments xxiiiIntroduction xxvChapter 1 Functions and Forms of Banking 11.1 Banks and Banking 21.1.1 Core Bank Services 21.1.2 Banks in the Economy 41.1.3 Money Creation 51.1.4 Payment Services 81.1.5 Other Banking Services 81.2 Different Bank Types 101.2.1 Retail Banks 101.2.2 Wholesale Banks 111.2.3 Bank Holding Companies 121.2.4 Cooperative Banks 131.2.5 Credit Unions 141.2.6 Micro-finance Institutions 141.2.7 Central Banks 151.3 Banking Risks 161.3.1 Credit Risk 181.3.2 Market Risk 191.3.3 Operational Risk 231.3.4 Liquidity Risk 241.3.5 Systemic Risk 241.3.6 Other Risks That Banks Face 251.4 Forces Shaping the Banking Industry 27Chapter 2 Managing Banks 312.1 Balance Sheet and Income Statement 322.1.1 Bank Assets 322.1.2 Bank Liabilities 342.1.3 Equity 352.1.4 Income Statement 362.1.5 The Role of Bank’s Equity 392.2 Loan Losses 432.2.1 Valuing Assets in the Trading Book 442.2.2 Value of Assets in the Banking Book, Performing Loans 452.2.3 Value of Assets in the Banking Book, Non-performing Loans 462.2.4 Provision for Loan Losses and Loan Loss Reserves 482.2.5 Loan Loss Reserves and Loan Losses 492.3 Asset and Liability Management 542.3.1 Interest Rate Risk 542.3.2 Liquidity Risk 562.3.3 Liquidity Standards in Basel III 602.4 Corporate Governance 612.4.1 Corporate Governance Structures 612.4.2 Corporate Governance Techniques 642.4.3 Senior Management and Corporate Strategies 652.4.4 Values and Culture 652.4.5 Financial Incentives 662.4.6 Internal and External Auditors 662.4.7 Transparency 66Chapter 3 Banking Regulation 693.1 The Evolution of Risk Regulation in Banking 703.1.1 Why Banks Are Special and Need to Be Regulated 713.1.2 Liquidity Crises and Bank Runs 713.1.3 Bank Panics 733.2 Foundations of Bank Regulation 763.2.1 Regulatory Objectives 773.2.2 The Regulatory Process 773.2.3 Stabilization: The Lender of Last Resort 783.3 International Regulation of Bank Risks 803.3.1 Bank for International Settlements 803.3.2 The Basel Committee 823.3.3 The Basel I Accord 833.3.4 The Market Risk Amendment 863.3.5 Weaknesses of Bank Capital Requirements in Basel I Accord 873.3.6 The Basel II Accord 883.3.7 Adopting Basel II 903.3.8 Limitations of Basel II 913.3.9 The Basel III Accord 923.4 Deposit Insurance 933.4.1 Deposit Insurance Coverage 943.4.2 Deposit Insurance Around the World 95Chapter 4 Credit Risk 974.1 Introduction to Credit Risk 984.2 Lenders 1004.2.1 Investment Banks 1014.3 Borrowers 1014.3.1 Retail Borrowers 1014.3.2 Corporate Borrowers 1024.3.3 Sovereign Borrowers 1054.3.4 Public Borrowers 1054.4 Characteristics of Credit Products 1054.4.1 Maturity 1064.4.2 Commitment Specification 1084.4.3 Loan Purpose 1104.4.4 Repayment Source 1104.4.5 Collateral Requirements 1114.4.6 Covenant Requirements 1134.4.7 Loan Repayment 1144.5 Types of Credit Products 1164.5.1 Agricultural Loans 1164.5.2 Asset-Based or Secured Lending 1174.5.3 Automobile Loans 1174.5.4 Commercial Paper 1184.5.5 Corporate Bonds 1184.5.6 Covered Bonds 1194.5.7 Factoring 1194.5.8 Leasing 1204.5.9 Mortgages 1234.5.10 Overdraft Facilities 1244.5.11 Home Equity Credit Lines and Home Equity Loans 1244.5.12 Project—or Infrastructure—Finance 1254.5.13 Revolving Lines of Credit 1264.5.14 Syndicated Loans 1274.6 The Credit Process 1284.6.1 Identifying the Credit Opportunity 1294.6.2 Credit Evaluation—Companies 1294.6.3 Credit Decision Making 1304.6.4 Credit Disbursement 1314.6.5 Credit Monitoring 1314.7 The Credit Analysis Process 1324.7.1 The Five Cs of Credit 1324.7.2 The Credit Analysis Path 1394.7.3 Business or Macroeconomic Risks 1414.7.4 Financial or Microeconomic Risks 1444.7.5 Structural Risk 1454.7.6 SWOT Analysis 1464.8 Information Services 147Chapter 5 Credit Risk Management 1495.1 Portfolio Management 1515.1.1 Portfolio Management Terminology 1515.1.2 Concentration Risk 1525.1.3 Default Correlation Risk 1535.1.4 Contagion Risk 1545.2 Techniques to Reduce Portfolio Risk 1545.2.1 Syndication 1545.2.2 Whole Loan Sales 1545.2.3 Securitization 1565.2.4 Credit Default Swaps 1565.3 Portfolio Credit Risk Models 1575.4 Credit Monitoring 1575.5 Credit Rating Agencies 1585.6 Alternative Credit Risk Assessment Tools 1625.7 Early Warning Signals 1625.7.1 Accounting Issues 1625.7.2 Company Issues 1635.7.3 Management Issues 1635.7.4 Liquidity Issues 1645.7.5 Industry/Peers 1645.8 Remedial Management 1645.9 Managing Default 1655.9.1 Documentation and Perfection 1655.9.2 Review Collateral 1665.9.3 Review the Borrower’s Plans 1665.9.4 Exercise Prudence 1665.9.5 Additional Credit Support 1665.9.6 Intercreditor Agreements 1675.10 Practical Implications of the Default Process 1675.11 Credit Risk and the Basel Accords 1675.11.1 The Standardized Approach 1685.11.2 Internal Ratings-Based Approaches 1685.11.3 Common Features to IRB Approaches 1695.11.4 Minimum Requirements for IRB Approaches 1695.11.5 Basel III Rules Regarding Securitization 171Chapter 6 Market Risk 1736.1 Introduction to Market Risk 1746.2 Basics of Financial Instruments 1756.2.1 Currencies 1756.2.2 Fixed Income Instruments 1776.2.3 Interbank Loans 1816.2.4 Equities 1826.2.5 Commodities 1836.2.6 Derivatives 1846.3 Trading 1896.3.1 Fundamental Trading Positions 1896.3.2 Bid-Ask Spreads 1926.3.3 Exchange and Over-the-Counter Markets 1936.4 Market Risk Measurement and Management 1986.4.1 Types of Market Risk: The Five Risk Classes 1986.4.2 Value-at-Risk 2016.4.3 Expected Shortfall 2056.4.4 Stress Testing and Scenario Analysis 2056.4.5 Market Risk Reporting 2066.4.6 Hedging and Basis Risk 2066.4.7 Market Risk Measurement of Credit Risk (CS01, DTS, RR05) 2116.5 Market Risk Regulation 2136.5.1 The Market Risk Amendment 2136.5.2 Basel II 2146.5.3 Basel III 215Chapter 7 Operational Risk 2177.1 What Is Operational Risk? 2187.2 Operational Risk Events 2197.2.1 Internal Process Risk 2217.2.2 People Risk 2227.2.3 Systems Risk 2237.2.4 External Risk 2267.2.5 Legal Risk 2277.3 Operational Loss Events 2277.3.1 High-Frequency/Low-Impact Risks (HFLI) 2287.3.2 Low-Frequency/High-Impact Risks (LFHI) 2297.3.3 Near Miss and Gain Events 2307.4 Operational Risk Management 2307.4.1 Functional Structure of Operational Risk Management Activities 2327.4.2 Three Lines of Defense 2347.4.3 Operational Risk Identification, Assessment, and Measurement 2357.4.4 Example of Operational Risk Measurement and Management 2367.5 Basel II and Operational Risk 2377.5.1 Basic Indicator Approach 2387.5.2 Standardized Approach 2397.5.3 Advanced Measurement Approach 2417.5.4 Criteria for Using Different Approaches 2427.5.5 Basel II and Operational Risk Management 2437.5.6 Basel III and Operational Risk Management 244Chapter 8 Regulatory Capital and Supervision 2458.1 Pillar 1—Bank Regulatory Capital 2478.1.1 Basel II Minimum Capital Standard 2488.2 Types of Bank Regulatory Capital under Basel II 2518.2.1 Tier 1 Capital 2528.2.2 Tier 2 Capital 2528.2.3 Tier 3 Capital 2538.2.4 The Ratio of the Capital Tiers 2538.2.5 Deductions and Adjustments from Regulatory Capital 2538.2.6 New Capital 2548.3 Bank Capital under Basel III 2558.3.1 The Quality and Quantity of Capital 2558.3.2 Capital Conservation Buffer 2568.3.3 Countercyclical Capital Buffer 2568.3.4 Systemically Important Financial Institutions 2568.4 Pillar 2—Supervisory Review 2578.4.1 Four Key Principles of Supervisory Review 2598.4.2 Specific Issues to Address during Supervisory Review 2618.4.3 Supervision—Basel III Enhancements 2648.5 Pillar 3—Market Discipline 2668.5.1 Accounting Disclosures 2678.5.2 General Disclosure Requirements 2688.5.3 Disclosing Risk Exposure and Risk Assessment 2688.5.4 Pillar 3 Market Discipline—Basel III Enhancements 2698.6 International Cooperation 2708.6.1 The Dodd-Frank Act 2718.6.2 EU Capital Requirements Directive 2738.7 Beyond Regulatory Capital 2758.7.1 Defining Economic Capital 2768.7.2 Calculating Economic Capital 2778.7.3 Risk-Adjusted Performance Measures 279Chapter 9 Insurance Risk 2819.1 Introduction to the Insurance Industry 2829.1.1 The Business Model of Insurance Companies 2839.1.2 Differences between Property and Casualty Insurance and Life Insurance 2869.1.3 Insurance Industry Participants 2879.1.4 Significant Risks That Apply to the Insurance Business 2889.2 Property and Casualty Insurance 2899.2.1 Inherent Risks of Property and Casualty Insurance 2899.2.2 Risk Appetite 2909.2.3 Risk Identification, Mitigation, and Management 2909.2.4 Minimum Standards of Risk Management and Controls 2919.3 Life Insurance 2939.3.1 How Does Life Insurance Work? 2939.3.2 Inherent Risks of Life Insurance 2939.3.3 Risk Appetite 2949.3.4 Risk Identification, Mitigation, and Management 2959.3.5 Minimum Standards of Risk Management and Controls 2969.4 Reinsurance 2989.5 Other Types of Risk 3009.5.1 Concentration Risk 3009.5.2 Counterparty Credit Risk 3019.5.3 Market Risk 3019.5.4 Pension Obligation Risk 3019.5.5 Catastrophe Risk 3029.6 Regulation and Supervision—Solvency 2 in the European Union 3039.6.1 Internal Models Under Solvency 2 3059.6.2 Solvency 2 and Basel II/III—Similarities and Differences 3079.6.3 Global Systemically Important Insurers (G-SIIs) 3089.6.4 Proportionality 3099.7 The Role of Lloyd’s of London 3099.8 Summary 310Glossary 311Index 329

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