financial risk management 4003
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Financial RiskManagementKPMGADVISORY
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A spate o high-profle business ailures and the emergence o tougher regulations have put organizations under pressure to
manage fnancial risk more eectively. Financial organizations have to be aware o the need to identiy, measure and manage
risk, e.g. credit, market, liquidity, and operational risk, as well as maintaining sufcient levels o regulatory and economic
capital to support the risks they ace. Also, there is a need or adequate disclosure and presentation o inormation to
stakeholders and third parties.
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Financial Instruments Valuation / Accounting and Disclosure
Financial instrument valuations encompass valuations o a variety o simple, complex andstructured products. Examples o such products are credit derivatives (e.g. Credit Deault
Swaps), interest rate and oreign exchange derivatives (e.g. Interest Rate Swaps, Cross
Currency Interest Rate Swaps, Interest and Foreign Exchange Rate Options, Swaptions,
etc.), Credit Link Notes and Total Return Swaps. Moreover, recent developments have
raised issues around the valuation o Asset Backed Securities (ABS), Collateralized Debt
Obligations (CDO) and related structures. Clients oten raise questions such as: Do we
have a reliable market value? Do we use an appropriate valuation model? Is the outcome
o the model reasonable? We can assist in providing solutions in this area.
Our practice also provides support in the correct accounting o Financial Instruments,
in accordance with IFRS, US-GAAP or other accounting standards. An example would
be the review and implementation o Hedge Accounting where the appropriateness o
(Fair Value/Cash Flow) Hedge Accounting model and Hedge Accounting eectiveness
tests are evaluated . In addition, we have wide experience in the preparation o fnancial
reporting disclosures o fnancial instruments, risk management methods and models
(e.g. IFRS 7, Disclosure requirements acc. to Pillar 3 o Basel II).
Capital Adequacy, Regulatory Reporting & Compliance
Capital Adequacy or banks is calculated and
Regulatory Reporting is made according to
regulators rules and methodologies, defning
or each bank a minimum regulatory capital
requirement and reporting. It comprises, but
is not limited to, the Basel II ramework as,
e.g., transposed in Luxembourg with respect to
FinRep (Financial Reporting based on IFRS) and
CoRep (Common Reporting or the Solvency
Ratio based on IFRS) by the Commission de
Surveillance du Secteur Financier (CSSF).
Management o Financial Risks
The management o credit risk, market risk
(comprising interest rate risks, oreign exchange
risks, equity risk as well as commodity risks),
operational and reputational risk, insurance
risk as well as liquidity risk should be part
o every sound fnancial risk management
system within a company. The scope
depends on the relevance o each risk
category or a company. Most institutions
measure their risks based on Value-at-
Risk Models. Many o these risks are highly
relevant or most o the fnancial institutions
and are interrelated. As such, they need to
be measured and managed accordingly. Recent
developments have revealed signifcant weaknesses in the management o credit risk
and liquidity risk within many organizations. Sound credit risk management can mitigate
or avoid a signifcant fnancial impact o such events on an organization.
What We Do And What You Get
Basel II Framework - 3 Principle Pillars
Minimum
Regulatory
Capital
Requirement
Supervisory
Process
Market
Discipline
Your potential benefts are :
An adequate and tailor-madeapproach to any kind o fnancial
instruments valuation.
Third party valuation where youbeneft rom our valuation tools and
knowledge.
Compliance with regulatory andaccounting rameworks.
Eective implementation o Hedge
Accounting and other valuation tools
to mitigate volatility o accounting P&L.
Your potential benefts are :
Full compliance with regulatoryrequirements in Luxembourg.
Sound capital requirementcalculations especially or IRB
approach or credit risk and AMA
approach or operational risk.
Integrated and comprehensive
methods to implement or refne
existing processes to ulfll
regulatory requirements.
Your potential benefts are :
Improved transparency and enhanced
understanding o risks the company
is exposed to.
Identifcation o the dierent kinds orelevant risks and their key drivers.
Development and implementation oappropriate risk management models
and procedures.
Setting up a sound risk management
practice or those risks.
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Model Building and Model Validation
A model is a tool used to calculate or estimate
results based on a series o inputs oten used
or analysis or quantifcation. Models are used
to make decisions easier and as such they
support the decision process. They do not
have an own purpose. Organizations use
a wide variety o models or spreadsheets,
which can be broadly categorized into
three areas: Decision Support, Financial
and Risk Management models.
For example, structured products or Asset
Backed Securities are rarely priced on active
markets. Thereore, adequate fnancial models are
necessary to price those fnancial instruments. Furthermore, appropriate risk
management models adapted to the companies specifc purpose and needs, such as
Value-at-Risk or Expected Shortall, are needed to measure, manage and control the risk
thereo. The models underlying the Hedge Accounting eectiveness tests are another
example o models used in accounting.
ICAAP & Economic Capital Calculation
ICAAP (Internal Capital Adequacy Assessment Process), part o Pillar 2 within the Basel II
Framework, represents a fnancial institutions own assessment o the capital needed to
run the business. This capital may dier rom the minimum regulatory capital requirement
since, or instance, a fnancial institution may include risks that are not ormally subject to
the minimum regulatory capital (e.g. liquidity risk, reputational risk or interest rate risk in
the banking book) or may use dierent parameters or methodologies (this is particularly
the case or operational risk).
Restrictions dueto Basel II, Pillar II
!Economic
CapitalAvailableFinancial
Resources
Free Financial
Resources
Restrictions dueto Basel II, Pillar I
!Regulatory
CapitalPillar I
Own Funds
Capital Surplus
Your potential benefts are :
Development o eective models and
assistance in validating those models
as well as assessment o the overall
reliability o the model output.
Accurate pricing o fnancialinstruments based on efcient
and precise models.
Leading risk management models orsound fnancial risk management.
Your potential benefts are :
A risk management rameworkconsistent with fnancial risk strategy.
Efcient process in response to thesecond pillar requirements o
Basel II (ICAAP).
Full compliance with regulatory
requirements and in line with
best practice.
Adequate economic capital modelsand risk management processes and
procedures consistent to the risk
management ramework resulting
in a comprehensive and integrated
fnancial risk management approach.
Understanding o the dierent typeso risks fnancial institutions are
exposed to and how they impact
the company, incorporating theseinto their business operations and
monitoring.
Awareness o potential weaknessesin the fnancial risk management
strategy, rameworks and processesas well as in the risk mitigation
methods and being able to prepare
the management actions to be takento avoid unexpected or surprising
losses.
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Financial strategies could be risk avoidance, reduction, limitation, transerence or
acceptance. An integral part o fnancial strategies is the management o fnancial risks and
resources and comprises identifcation, measurement, assessment, controlling, monitoring,
reporting and stress testing o the several risks including risks essentially not integrated.
Risk Adjusted Perormance Calculations
Risk-adjusted perormance measures compare return with capital employed in a way
that incorporates an adjustment or risk. The most amous measures are RAROC
(risk-adjusted return on capital) and RORAC (return on risk-adjusted capital).
Risk-adjusted perormance measures are based on either risk adjusted return or
economic capital.They can be used or comparing past perormance or as a orward
looking measure to decide on the long-term viability o a business unit, whether
it should be expanded or scaled back.
Integrated Planning & Target Setting
Added Value (e.g., EVA)
Risk Cost
Cap. Cost
Value drivers/Operational Drivers/KPIs
Risk-Return Ratio (e.g., RORAC)
Revenue
Risk Aggregation
Cost
1
OrganizationalUnit
LegalEntity
Product
Customer
2 3 4 5
Market Risk Credit Risk Op. Risk Other Risks
Simulations & AnalysisReports/Cockpits
Expected Loss
Unexpected Loss
99.95% (AA)
EL
UL
0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35%
ECAPPR
OBABILITY
LOSS RATE (%)
EL = expected loss
UL = unexpcted loss
ECAP = economic capital
AA = banks creditrating
Your potential benefts are :
Implementation o perormancemeasures or improvement o your
current measures.
Risk-adjusted perormance
calculations consistent and integrated
into existing capital planning and risk
management process.
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New Product Process (NPP) or Asset Management
Current market trends show that innovations o products and instruments will become
more signifcant over the coming years because o a decrease in market growth and a gain
in margin o traditional products. Standardized products such as index unds have lately
become more and more attractive or investors and alternative products are becoming
increasingly mainstream or asset managers.
An efcient and high quality New Product Process (NPP) is necessary to keep up
with the market demands and regulatory requirements or asset managers
Based on the increasing importance o new unding vehicles there is a need to accelerate
the time-to-market o new products while complying with applicable rules and regulations.
By launching new products asset managers are aced with a variety o challenges, e.g.
regulatory, economic, process-related and technical challenges. An efcient new product
process takes all essential departments and unctions o the value chain into account.
Our project management approach or the multidisciplinaryNPP A cube-based Illustration
Particular business unctions are involved in one or more phases o the NPP.
Cross-sectional issues come up or several business unctions during various phases.Our project management approach recognizes this variety and interconnection among
the various unctions.
- Callable Yield Notes- Callable Path Dependant Floaters- Certificates, Discount, Bonus, Express etc.- Basket Structures- Snowballs- Target Range Accrual Notes- Exotic Options Equity, Commodity etc.- Triggerable Reverse Floater- Inflation products, e. g. Zero Inflation Swaps,Inflation Swaps
- CPPI- Variance Swap- []
- Compliance with international regulatory guidelinesand local requirements (e.g. IFRS, InvG, SolvV, MiFID, AnlV,Derivative regulation)
- Coverage of permanently increasing requirements(Reporting, Corporate and Governance and Risk Management)in regard to regulatory law, accounting- and taxation law
- New products and instruments need to match with
the market expectations
- Product profitability
- Liquidity and risk performance
- Adequate mapping within the system and correct treatment
in the day-to-day business activities have to be assured
- Utilization of synergies
Modification / mixof existing products
Real innovations
New products
Regulatory
Economic
challenges
Process-related
technical
challenges
Fund managementMarket research
Legal
TaxInternal audit
Economic analysisTrading
Compliance
Order controlPricing & valuation
Risk analysisPerform. analysis
Fund accounting
Reporting
Initiation &Analysis Design Implementation Testing
Appproval &Going Live
Business
Functions
21
Cross-sectional
Issues
NPP Phases
3
Coordination
Communication
IT architectureInterfaces
Data
Execution (by default)
Your potential benefts are :
Ability to introduce new productsadequately and smoothly, minimizing
the time span rom the initiation
to going live and keeping track o
the expenses or related structures,
processes and IT.
Assurance o appropriate pricesand risk fgures with regard to new
products accommodating both
true innovations and modifcations
efciently.
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Financial Risk Management
Why ? Risk management is highly complex, with risks oten interrelated, which requiresophisticated tools and techniques. Sarbanes-Oxley, Basel II, Solvency II and the
cost o capital require organizations to improve their risk management practices.
This ultimately helps management to view risk as a major part o corporate
strategy. Financial risks are more and more interrelated to fnancial accounting
and reporting (e. g. IAS 39 and IFRS 7) as well as to the calculation o the solvency
ratio (e. g. calculation o the regulatory own unds based on IFRS). These require
integrated and comprehensive management rameworks to optimize Financial Risk
Management, Asset-Liability Management and overall product processes.
How can we help ? Based on an integrated approach, we can help design and implement rameworksto manage and/or reduce risk. We can provide assistance in creating an overall
ramework that helps to identiy, measure, monitor and report risks leading,
ultimately, to better strategic decision making and efcient processes.
Our quality ? In striving to provide high quality services, we participate in a global accreditationprogram, we work closely with proessionals rom other KPMG member frms,
liaise regularly with our global KPMG Financial Risk Management group and
share experiences on a variety o dierent national and international projects.
We also cooperate with universities to be able to provide the most up to date
methodologies to our clients.
Your beneft ? KPMG Financial Risk Management is committed to ensure that we are alwaysavailable to help identiy opportunities, solve problems and as a result add value
frm wide based on a multidisciplinary approach. You can beneft rom our cross-
border knowledge and experience in Luxembourg and abroad. Whatever problem
you might have regarding Financial Risk Management, we can provide you with a
tailored approach.
Your Needs Our Approach
Bank
s
InvestmentFu
nds
I
nsurances
Com
panie
s
Corpora
tes
Valuation
o FinancialInstruments
Capital Adequacy /
RegulatoryReporting
ICAAP&Economic
Capital
Calculation
Integrated and
Comprehensive
Risk Management
Model
Building &
Validation
Risk-adjusted
Perormance
Calculations
New
Product
Process
Accounting &
Disclosure oFinancial Instruments
Financial RiskManagement
(FRM)
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circumstances o any particular individual or entity. Although we endeavor to provide accurate and
timely inormation there can be no guarantee that such inormation is accurate as o the date it is
received or that it will continue to be accurate in the uture. No one should act on such inormation
without appropriate proessional advice ater a thorough examination o the particular situation.
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o KPMG International, a Swiss cooperative.
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