Risk Management and Shareholders' Value in Banking

ANDREA RESTI, formerly an officer at one of Italy's largest banks, has worked on Basel II issues for the Centre for European Policy Studies (Brussels). A consultant to several major banks, as well as to the Bank of Italy, he has held courses on credit risk for GARP and PRMIA. ANDREA SIRONI, formerly with Chase Manhattan Bank in London, has been a visiting scholar at the Stern School of Business (NYU) and at the Federal Reserve Board of Governors (Washington). He is currently Dean for International Affairs at Bocconi University (Milan) and a member of the Fitch Academic Advisory Board. The authors are both professors of Financial Markets and Institutions at Bocconi and have been teaching banking and finance for more than 15 years. Their publications comprise many articles in major international academic journals, as well as several risk management and banking textbooks, including a best-selling title on recovery risk.

• Foreword xixMotivation and Scope of this Book: A Quick Guided Tour xxiPart I Interest Rate Risk 1Introduction to Part I 31 The Repricing Gap Model 91.1 Introduction 91.2 The gap concept 91.3 The maturity-adjusted gap 121.4 Marginal and cumulative gaps 151.5 The limitations of the repricing gap model 191.6 Some possible solutions 20Selected Questions and Exercises 25Appendix 1A The Term Structure of Interest Rates 28Appendix 1B Forward Rates 322 The Duration Gap Model 352.1 Introduction 352.2 Towards mark-to-market accounting 352.3 The duration of financial instruments 392.4 Estimating the duration gap 422.5 Problems of the duration gap model 45Selected Questions and Exercises 47Appendix 2A The Limits of Duration 493 Models Based on Cash-Flow Mapping 573.1 Introduction 573.2 The objectives of cash-flow mapping and term structure 573.3 Choosing the vertices of the term structure 583.4 Techniques based on discrete intervals 593.5 Clumping 643.6 Concluding comments 68Selected Questions and Exercises 69Appendix 3A Estimating the Zero-Coupon Curve 714 Internal Transfer Rates 774.1 Introduction 774.2 Building an ITR system: a simplified example 774.3 Single and multiple ITRs 794.4 Setting internal interest transfer rates 844.5 ITRs for transactions with embedded options 884.6 Summary: the ideal features of an ITR system 93Selected Questions and Exercises 94Appendix 4A Derivative Contracts on Interest Rates 96Part II Market Risks 103Introduction to Part II 1055 The Variance-Covariance Approach 1155.1 Introduction 1155.2 VaR derivation assuming normal return distribution 1155.3 Sensitivity of portfolio positions to market factors 1265.4 Mapping of risk positions 1335.5 Summary of the variance-covariance approach and main limitations 143Selected Questions and Exercises 151Appendix 5A Stockmarket Betas 154Appendix 5B Option Sensitivity Coefficients: “Greeks” 1576 Volatility Estimation Models 1636.1 Introduction 1636.2 Volatility estimation based upon historical data: simple moving averages 1636.3 Volatility estimation based upon historical data: exponential moving averages 1676.4 Volatility prediction: GARCH models 1726.5 Volatility prediction: implied volatility 1796.6 Covariance and correlation estimation 181Selected Questions and Exercises 1827 Simulation Models 1857.1 Introduction 1857.2 Historical simulations 1897.3 Monte Carlo simulations 2057.4 Stress testing 218Selected Questions and Exercises 2218 Evaluating VaR Models 2258.1 Introduction 2258.2 An example of backtesting: a stock portfolio VaR 2258.3 Alternative VaR model backtesting techniques 232Selected Questions and Exercises 244Appendix 8A VaR Model Backtesting According to the Basel Committee 2469 VaR Models: Summary, Applications and Limitations 2519.1 Introduction 2519.2 A summary overview of the different models 2519.3 Applications of VaR models 2539.4 Six “False Shortcomings” of VaR 2609.5 Two real problems of VaR models 2639.6 An Alternative Risk Measure: Expected Shortfall (ES) 268Selected Questions and Exercises 269Appendix 9A Extreme Value Theory 272Part III Credit Risk 275Introduction to Part III 27710 Credit-Scoring Models 28710.1 Introduction 28710.2 Linear discriminant analysis 28710.3 Regression models 29910.4 Inductive models 30110.5 Uses, limitations and problems of credit-scoring models 307Selected Questions and Exercises 309Appendix 10A The Estimation of the Gamma Coefficients in Linear Discriminant Analysis 31111 Capital Market Models 31311.1 Introduction 31311.2 The approach based on corporate bond spreads 31311.3 Structural models based on stock prices 321Selected Questions and Exercises 340Appendix 11A Calculating the Fair Spread on a Loan 342Appendix 11B Real and Risk-Neutral Probabilities of Default 34312 LGD and Recovery Risk 34512.1 Introduction 34512.2 What factors drive recovery rates? 34612.3 The estimation of recovery rates 34712.4 From past data to LGD estimates 35112.5 Results from selected empirical studies 35312.6 Recovery risk 35612.7 The link between default risk and recovery risk 358Selected Questions and Exercises 362Appendix 12A The Relationship between PD and RR in the Merton model 36413 Rating Systems 36913.1 Introduction 36913.2 Rating assignment 37013.3 Rating quantification 37913.4 Rating validation 388Selected Questions and Exercises 39814 Portfolio Models 40114.1 Introduction 40114.2 Selecting time horizon and confidence level 40214.3 The migration approach: CreditMetricsTM 40614.4 The structural approach: PortfolioManagerTM 42314.5 The macroeconomic approach: CreditPortfolioViewTM 42614.6 The actuarial approach: CreditRisk+TM 42814.7 A brief comparison of the main models 43914.8 Some limitations of the credit risk models 442Selected Questions and Exercises 446Appendix 14A Asset correlation versus default correlation 44915 Some Applications of Credit Risk Measurement Models 45115.1 Introduction 45115.2 Loan pricing 45115.3 Risk-adjusted performance measurement 45715.4 Setting limits on risk-taking units 45915.5 Optimizing the composition of the loan portfolio 461Selected Questions and Exercises 462Appendix 15A Credit Risk Transfer Tools 46416 Counterparty Risk on OTC Derivatives 47316.1 Introduction 47316.2 Settlement and pre-settlement risk 47416.3 Estimating pre-settlement risk 47416.4 Risk-adjusted performance measurement 49516.5 Risk-mitigation tools for pre-settlement risk 496Selected Questions and Exercises 504Part IV Operational Risk 505Introduction to Part IV 50717 Operational Risk: Definition, Measurement and Management 51117.1 Introduction 51117.2 OR: How can we define it? 51217.3 Measuring OR 51717.4 Towards an OR management system 53317.5 Final remarks 535Selected Questions and Exercises 537Appendix 17A OR measurement and EVT 539Part V Regulatory Capital Requirements 543Introduction to Part V 54518 The 1988 Capital Accord 54718.1 Introduction 54718.2 The capital ratio 54918.3 Shortcomings of the capital adequacy framework 55518.4 Conclusions 559Selected Questions and Exercises 559Appendix 18A The Basel Committee 56319 The Capital Requirements for Market Risks 56519.1 Introduction 56519.2 Origins and characteristics of capital requirements 56519.3 The capital requirement on debt securities 56819.4 Positions in equity securities: specific and generic requirements 57519.5 The requirement for positions in foreign currencies 57619.6 The requirement for commodity positions 57819.7 The use of internal models 578Selected Questions and Exercises 585Appendix 19A Capital Requirements Related to Settlement, Counterparty and Concentration Risks 58820 The New Basel Accord 59120.1 Introduction 59120.2 Goals and Contents of the Reform 59120.3 Pillar One: The Standard Approach to Credit Risk 59320.4 The Internal Ratings-based Approach 59720.5 Pillar Two: A New Role for Supervisory Authorities 61220.6 Pillar Three: Market Discipline 61420.7 Pros and Cons of Basel II 61620.8 the Impact of Basel II 619Selected Questions and Exercises 63021 Capital Requirements on Operational Risk 63321.1 Introduction 63321.2 The capital requirement on operational risk 63321.3 Weaknesses of the 2004 Accord 64521.4 Final remarks 647Selected Questions and Exercises 647Part VI Capital Management and Value Creation 651Introduction to Part VI 65322 Capital Management 65722.1 Introduction 65722.2 Defining and measuring capital 65822.3 Optimizing regulatory capital 67522.4 Other instruments not included within regulatory capital 685Selected Questions and Exercises 69123 Capital Allocation 69323.1 Introduction 69323.2 Measuring capital for the individual business units 69423.3 The relationship between allocated capital and total capital 70223.4 Capital allocated and capital absorbed 71223.5 Calculating risk-adjusted performance 71523.6 Optimizing the allocation of capital 72223.7 The organizational aspects of the capital allocation process 726Selected Questions and Exercises 728Appendix 23A The Correlation Approach 730Appendix 23B The Virtual Nature of Capital Allocation 73124 Cost of Capital and Value Creation 73524.1 Introduction 73524.2 The link between Risk Management and Capital Budgeting 73524.3 Capital Budgeting in Banks and in Non-Financial Enterprises 73624.4 Estimating the Cost of Capital 73924.4.4 Caveats 74424.5 Some empirical Examples 74524.6 Value Creation and RAROC 75024.7 Value Creation and EVA 75324.8 Conclusions 756Selected Questions and Exercises 757Bibliography 759Index 771