mohi risk management
TRANSCRIPT
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Risk Management in Banking (B-505)
Presented By
Shah Mohammad Mohiuddin
ID#12-038
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Chapter -26FTP Systems
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Introduction
Two main tools for integrating global riskmanagement with Decision-making.
Funds Transfer Pricing (FTP) system
Capital allocation system.
FTP serves to allocate interest incomeCapital allocation system serves to
allocate risks
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FTP Systems addresses Three major issues
for commercial banking
The goals of the transfer pricingsystem
The transfer of funds acrossbusiness units and with the ALMunits
The measurement of performancegiven the transfer price
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FTP system specifications
Transferring funds between units.
Setting target profitability for business units.
Transferring interest rate risk, which is beyond the
control of business units, to ALM.ALM missions are tomaintain interest rate risk within limits.
Pricing funds to business units with economicbenchmarks, using economic transfer prices.
Eventually combining economic prices with commercialincentives.
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GOALS OF THE TRANSFER PRICING SYSTEM
Allocate funds within the banks
Calculate the performance margins ofa transaction
Define economic benchmarks forpricing and performancemeasurement
Define pricing policiesTransfer liquidity and interest rate risk
to the ALM unit
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Funds Transfer Pricing system and its
applications
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INTERNAL MANAGEMENT OF FUNDS AND
NETTING
Internal Pools of Funds
Netting:
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Pricing all Outstanding Balances
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MEASURING PERFORMANCE
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The FTP System and margin calculations
The Accounting Margin: Example
Given,Transfer Price = 9.20%
Direct calculation of the accounting margin
2000 12% 1200 6% 800 9%= 96
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ALM Profitability and Risks
Cost center: If its target profit is set to zero.
responsibility is to minimize the cost of funding hedge the bank against interest rate risk. This cost saving is its Profit and Loss (P&L).
Profit center: Has a target profit. Optimize the funding policy within specified limits
on gaps, earnings volatility or Value at Risk (VaR).
Liquidity and interest rate risks should actually beunder ALM control.
commercial margins should not have any exposureto interest rate risk
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RATIONALE OF TRANSFER PRICES
Financial standpoint: Transfer prices should reflect market conditions
Commercial standpoint:
Customer prices should follow business policy
guidelines subject to constraints from competition.
Mispricing:
Mispricing is the difference between economicprices andeffective pricing. Mispricing is not an error since it isbusiness-driven. Nevertheless, it deserves monitoring forprofitability and business management. Monitoringmispricing implies keeping track of target prices andeffective prices, to report any discrepancy between the two.
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Chapter -27
Economic Transfer Prices
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Economic Transfer Pricing
Arbitrage opportunitiesbetween bank rates &market rates wheneverdiscrepancies appear
Economic Benchmarkderive from market price
Economic Benchmark fortransfer prices all-in costof funds, which is applied
to lending activates
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Commercial Margin & Maturity spread
Spread means difference between lending long &
borrowing short
Commercial margin contributes to the accountingmargin & under the control of ALM
Bank can borrow the money on the market &
have a positive margin whatever the maturity
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Pricing Schemes
Lending Activities
Risk based pricing is the benchmark & should bepurely economic. It implies two basic elements
Cost of funds
Mark-up
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Pricing Schemes (contd.)
Commercial pricing refers to mark-
ups & mark-down over economic
benchmark to drive the businesspolicies
To get the economic transfer priceother economic cost should be
added-up
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Transaction vs. Client Revenues & Pricing
Bank provides products & services &
obtain interest spread & fees ascompensation
Client revenue is the relevant measure forcalculating profitability
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The cost of funds for loans
Volumes of assets & resources of a given
category(Long term, short term) should be
matched For the business unit, any deficit needs matching
resources of other business unit. The collection
of cheap resources should rather increase the
profitability of the unit getting
Any cheap resource, such as deposits, subsidizes
the profitability of assets. Matching a long-termloan with the core fraction of demand deposits
might be acceptable in terms of maturity
The cost ofexisting
resources
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The cost of funds for loans
The Notional Funding ofAssets:
It does not depend on the existing
resources
It serves as a benchmark fordetermining the cost of funds backing
any given asset
Outstanding balance varies over time
until maturity where the market rateof this maturity is not adequate & it
would assume that the loan does not
amortize over time
DebtSpot 1year
Debt Spot 2year
40
60
2 Year1 Year
Outstandingbalance
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The cost of funds for loans
The Benefits of Notional Funding
The margin of the asset is immune to interest ratemovements
There is no need for conventions to assign existingresources to usages of funds
There is no transfer of income generated by
collecting resources to the income of lendingactivities
The calculation of a transfer price is mechanical &easy
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Benchmarks For Excess Resources
Under a global view, the bank
considers global management of both
loan and investment portfolios
The management of invested fundsintegrates with ALM policy
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Chapter 51
Capital Allocation & Risk Contributions
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Risk Contributions are two kinds:
Absolute risk contributions (ARC)
Marginal risk contributions (MRC)
ARCCapital allocation
MRCPricing purpose
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Capital Allocation Goals
The goals of capital allocation :Aims at allocating both credit and market risk to the business units
and the transactions that originate them
To provide the top-down and bottom-up links between the post-
diversification risk of the bank and individual transactionsRisk contributions of facilities to the overall portfolio risk.
Allows to break down and aggregate risk contributions according
to any criteria as long as individual transaction risk contributions
are available
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DEFINITIONS AND NOTATION
DEFINITIONSThe standalone risk is the loss volatility of a single facility
Marginal risk contribution is the change in portfolio loss
volatility when adding a facilityfto portfolio p
Absolute risk contribution of an existing facility i to
portfoliop is the covariance of the random loss of this single
facility i with the random loss aggregated over the entire
portfolio (including i), divided by the loss volatility of this
aggregated loss.
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DEFINITIONS AND NOTATION (Contd.)
NOTATION:
For the single facility i, the loss is Li .
The exposures are Xi , i = 1 to N. Li , i = 1 to N. Exposures
are certain and identical to losses given default.
To make random losses distinct from certain exposures, we
use Li
for losses andXifor exposures
a random variable describing the credit state of the facility
di
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Properties of Risk Contributions
The absolute risk contributions serve to allocate
capital. Marginal risk contributions serve to make
incremental decisions
Absolute risk contributions: To make ex post
allocations of capital based on effective usage of line
Marginal risk contributions: To make ex ante risk-
based pricing decisions.
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Definition of ARCs to Volatility:
This formula defines the absolute risk contribution to portfolio volatility,ARCP:
Simplified Formulas for Risk Contributions:The two main formulas of absolute risk contributions to portfolio volatility are
either in terms of the correlation of in visual losses with aggregated lossesor in terms of the i coefficient, which is the coefficient of the relation
between individual losses and the portfolio loss: i
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The Capital Allocation Model & ARCs Risk Contributions Capture Correlation Effects:
Risk contributions combine the correlation effect with the portfolioand the magnitude of the standalone risk.
These risk contributions sum to the loss volatility, not the capital:
From Absolute Risk Contributions to Capital Allocation:
In order to proceed to capital allocation, we need the multiple ofloss volatility providing the capital at a given confidence level.
To obtain the capital allocations, we need to multiply the riskcontributions by a multiple m(),
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The Capital Allocation Model & ARCs (Contd.)
From Absolute Risk Contributions to Capital
Allocation:
In order to proceed to capital allocation, weneed the multiple of loss volatility providing the
capital at a given confidence level. To obtain the capital allocations, we need to
multiply the risk contributions by a multiplem(),
Absolute risk contributions to portfolio lossvolatility and capital allocation:
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Chapter 52
Marginal Risk Contributions
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General Properties of Marginal Risk Contributions
MRC to the portfolio risk volatility < ARC.MRC