Risk Integration - Fordham

FORDHAM UNIVERSITY

THE JESUIT UNIVERSITY OF NEW YORK

Dr. Ren-Raw Chen 1

Risk Integration

Dr. Ren-Raw Chen

Fordham University

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Dr. Ren-Raw Chen 2

Basel Accords

• First Accord in 1988

– orig meant for G10 countries

– now used over 100 nations

• Accord II in 1998

– formally published in 2004

• Accord III in 2011 (?)

– on going

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Basel I

• The bank must maintain capital (Tier 1 Tier 2) equal to at least 8% of its RWA

– 0% - cash, any OECD government debt

– 0%, 10%, 20% or 50% - public sector debt

– 20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection

– 50% - residential mortgages

– 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks

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Tier 1 Capital

• Tier 1 capital is the core measure of a bank's financial strength. It is composed of

– common stock and

– disclosed reserves (or retained earnings), but may also include

– non-redeemable non-cumulative preferred stock.

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Tier 1 Capital

• The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital.

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Tier 2 Capital(supplementary capital)

• Tier 2 is limited to 100% of Tier 1 capital

– Undisclosed reserves

– Revaluation reserves

– General provisions/general loan-loss reserves

– Hybrid debt capital instruments

– Subordinated term debt

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Tier 3 Capital

• Banks will be entitled to use Tier 3 capital solely to support market risks as defined in paragraphs 709 to 718(Lxix).

• Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to support market risks.

– This means that a minimum of about 28½% of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the book;

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Capital

• Regulatory (reg) capital

– Fixed (8%)

– IRB

• Risk-adjusted return on capital (RAROC)

– = (Expected Return)/(Economic Capital)

– = (Expected Return)/(Value at Risk)

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Capital

• Economic capital

– It is the amount of risk capital which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, and operational risk.

– Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital.

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Capital Ratios

• Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6%

• Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10%

• Leverage ratio = Tier 1 capital / Average total consolidated assets >=5%

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Capital Ratios

• Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets

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Basel II

• Three pillars

– framework encompassing risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1);

– supervisory review of capital adequacy (Pillar 2);

– and market discipline through enhanced public disclosures (Pillar 3).

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Basel II

• June 2006, A Revised Framework

– risk-based capital for credit risk and for operational risk

• December 7, 2007, OCC, FDIC, OTS issued a final rule

– advanced internal ratings-based approach for credit risk and the advanced measurement approach for operational risk

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Basel II

– the advanced approaches rule defines a core bank as a bank that has consolidated total assets of $250 billion or more, has consolidated on-balance sheet foreign exposure of $10 billion or more, or is a subsidiary of a core bank.

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Basel III

• Increased overall capital requirement

– Between 2013 and 2019, the common equity component of capital (core Tier 1) will increase from 2% of a bank’s risk-weighted assets before certain regulatory deductions to 4.5% after such deductions.

– A new 2.5% capital conservation buffer will be introduced, as well as a zero to 2.5% countercyclical capital buffer.

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Basel III

• Increased overall capital requirement

– The overall capital requirement (Tier 1 and Tier 2) will increase from 8% to 10.5%over the same period.

• Increased capital charges

– Commencing 31 December 2010, re-securitization exposures and certain liquidity commitments held in the banking book will require more capital.

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Basel III

• Increased capital charges

– In the trading book, commencing 31 December 2010, banks will be subject to new “stressed” value-at-risk models, increased counterparty risk charges, more restricted netting of offsetting positions, increased charges for exposures to other financial institutions and increased charges for securitisation exposures.

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Basel III

• New leverage ratio

– A minimum 3% Tier 1 leverage ratio, measured against a bank’s gross (and not risk-weighted) balance sheet, will be trialled until 2018 and adopted in 2019.

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Basel III

• Two new liquidity ratios

– A “liquidity coverage ratio” requiring high-quality liquid assets to equal or exceed highly-stressed one-month cash outflows will be adopted from 2015.

– A “net stable funding ratio” requiring “available” stable funding to equal or exceed “required” stable funding over a one-year period will be adopted from 2018.

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Subprime Crisis

• Where this all began

– size of subprime

• prime is $8~10 trillion (secured by agencies)

• subprime is 4% of prime ($400 billion)

• recovery of prime 80~90% (due to loan to value requirement LTV>0.8)

• recovery of subprime 40% or so (LGD=0.6)

• total loss of subprime $240 billion = 1.7% of GDP

• So my assessment (talks in 2007) -- NO BIG DEAL

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Subprime Crisis

• Why was it a crisis?

– subprime size grew (estimated to be 10% of prime = $1 trillion

– LGD went higher due to collapse of housing market

– so impact was higher

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Bailout

• TARP (Troubled Asset Relief Program)

• Originally authorized expenditures of $700 billion

• Reduced to $475 billion

• Mostly repaid

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Bailout

• AIG bailout $182 (total) / $50 (2008) billion

– Goldman $40 / $6 billion

– Deutsche Bank

– Societe Generale

• BofA’s (BAC) Merrill Lynch $50 billion ,

• Citigroup $27 billion of preferred stock

• IndyMac Bank $32 billion

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Bailout

• Size of the crisis

– 1% of GDP

– compared to S&L (savings and loan) crisis in the 80’s 3.5% of GDP

• So why fear?

– panic

– bank runs

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Issues of Crisis

• Marking to market

• Wall street bonus system – excess risk taking (free trader option)

• Regulation (1986 Act)

• Liquidity pricing (price of bailout)

• Rating agency reform (history based model)

• Financial innovations – hedge funds?Issues

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Issues of Crisis

• Financial Education – ethics

• Prepare for a more-risky-than-ever future

– happens every time

• What are the opportunities

– risk management

– IT investment

– more difficult pricing modelssues

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Impact of Crisis

• Is crisis really over

– double dip (W) or triple dip (WV or WW)

– in a situation never before – stock market high and yet unemployment high

– longest recession ever

• Past monetary weapons failed

– how to boost economy (i.e. reduce unemployment) and keep real estate cool

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Impact of Crisis

• Change of landscape

– increase influence of China

– US remains a superpower?

• How to avoid TBTF in the future

– conflict of tight regulation

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Impact of Crisis

• Is mathematical modeling dead or more live then ever

– conflict of MTM failure (failure of models) and high frequency trading (more use of models)

• Where are the jobs

– MBA dies and MQF lives???

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Impact of Crisis

• Questioning marking to market

• Calibration is Wall street standard

– reliable market prices

– market prices better than any model (collective wisdom of the entire participants population)

– prevent model manipulation

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Impact of Crisis

• Questioning of marking to market

• Is price under panic reliable?

– panic = liquidity

– how to model panic?

– without modeling panic, no MTM

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Impact of Crisis

• Excess risk taking

• Wall street bonus system is wrong

– how to eliminate free trader option (talked about it last time)

– how to reward effort correctly

– how to eliminate principal-agent problem

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Impact of Crisis

• Optimal regulation

– regulation should not impair free economy (the Invisible Hand)

• carefully choose tools

– regulation should not destroy innovations

– regulation should be liquidity driven

• liquidity index

– regulation should punish bad guys

• legal solution

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Impact of Crisis

• Rating agency reform

• Modified historical based model

• Remove conflict of interest

– Arthur Anderson bankruptcy

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Future Financial Innovations

• Is hedge funds our hope?

– somebody has to take risk

– there is a supply, as long as there is demand

– how hedge funds should be regulated

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• How to teach ethics?

– learn from grandma’s laps, not from school

– learn by example, not by preaching

• Emphasize

– value of life

– happiness (utililty?) – Harvard popular course: How to be happy, positive psychology by Dr. Tal Ben-Shahar

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• 2011 terrorist case in NYC

– last minute capture at the airport highlights the importance of fast information

– quick gathering of the ID of the suspect highlights the importance of information integration

• 2013 terrorist case in Boston

– failure to trace

• New technology in data mining

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• Risk management more important than ever

• New derivatives

– liquidity derivatives

• More IT investment

• More pricing models

• Global market to play withunities

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Quantitative Easing

• $700 billion and $800 billion of Treasury notes on its balance sheet before the recession

• November 2008, the Fed started buying $600 billion in Mortgage-backed securities (MBS)

• Peak at $2.1 trillion in June 2010

• Anticipate to fall (debt maturing) to $1.7 trillion by 2012

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Quantitative Easing

• Fed's revised goal became to keep holdings at the $2.054 trillion level

– August 2010, bought $30 billion in 2–10-year Treasury notes

• November 2010, the Fed announced a second round of quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011 (QE2)

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Quantitative Easing

• QE3 was announced on 13 September

• 2012

– $40 billion per month, open-ended, purchasing of mortgage-backed securities

– Federal Open Market Committee (FOMC) announced to maintain the federal funds rate near zero "at least through 2015.“

– Because of open-ended, QE3 has earned the popular nickname of "QE-Infinity."

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Quantitative Easing

– On 12 December 2012, the FOMC announced increased the amount of openended purchases from $40 billion to $85 billion per month.

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Quantitative Easing

• Why QEs did not cause inflation (which is almost a certain consequence)

– China accounted for three-fourths of rise in non-oil goods trade deficit

• from $500 billion in 2010 to $558 billion in 2011, an increase of $58 billion (11.6 percent)

• increased surplus in services trade by $33.2 billion in 2011, resulting trade deficit in goods trade, from $645.9 billion to $737.1 billion (an increase of $91.2 billion or 14.1 percent)

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Quantitative Easing

• QEs meant to boost liquidity

• QEs meant to build infrastructure

– push centralized trading of exotic products

– push centralized clearing

– build healthier smaller, regional banks (where most defaults occur)

– keep rates low so borrowings can be easy

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Quantitative Easing

• Prices deviate from fundamental values

– prices high and fundamentals weak

• domestic

– unemployment high

– real estate weak

• global

– Euro crisis

– Japan recession

– China slow growth

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Quantitative Easing

• Four consequences if QEs stop

– hurting stock market (converging to fundamentals?)

– rising inflation

• China growth slows down

– rising interest rates

• bonds being dumped back into the market

• hurting real estate (which has not been fully recover)

– banks unhealthy again (lack of liquidity)

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Risk Integration

• Technology integration

– various platforms

• Model integration

– match technology platforms

– modulization (plug and play)

– different but consistent

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Risk Integration

• Credit and liquidity are

– inseparable

– highly correlated

• Liquidity driven credit risk

– separate bankruptcy risk of credit from market risk of credit

– ultimate goal: probability of default (PD) and loss given default (LGD)

– importance of endogeneity

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Risk Integration

• Equity = residual claim on assets = call– K = face value; D = current value

– spread = -ln[D/K] - risk free rate

– PD (probability of default) = Prob(A<K)

– LGD (loss given default) = A (when A<K)

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Risk Integration

• Geske extends it to multiple debts

– term structures of PDs, LGDs, spreads

– possible to seek optimal capital structure

• LTD (long term debt) vs. STD (short term debt)

• debt vs. equity

– first theoretical pursuance of optimal capital structure

• as oppose to the mean-reversion empirical model

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Risk Integration

• Structural models

– Two building blocks

– Degrees of endogeneity

– Applications

• Regulatory capital (Lehman case study)

• Liquidity pricing (bail out)

• MTM

• Free trader option

• Optimal capital structure

• Others ...

Standard

Model

Structure

52

Standard

Model

With

Input/Output

53

Standard

Model

With

Input/Output

Input:

Standard

Factors

Output:

Value

Analytics (1)

Analytics (1) = sensitivities to the standard factors

54

Model

with

Ports for

Additional

Factors

Input:

Standard

Factors

Output:

Value

Analytics (1)


55

Model with

Additional Factor

Modules

“Plugged-in”

Input:

Standard

Factors

Output:

Value

Analytics (1)

Analytics (2)

F2

F1

F3

F5

F4 Fn


Analytics (2) = sensitivities to additional factors

Inputs for additional factor modules provided by the operator 56

Additional Factors

Imbedded

in the Model

Input:

Standard

Factors

Output:

Value

Analytics (1)

Analytics (2)

F2

F1

F3

F5

F4 Fn


Analytics (2) = sensitivities to additional factors

Inputs for additional factor parameters calculated within the model 57

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Model Integration

• Problems with reduced-form models

– industry standards

– models are segmented

– models assume perfect market -- no longer true

• Example

– IR and credit are separated

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Model Integration

• silos

– cannot model correlation properly

• What is the main core of modeling?

– what is a company?

– where do risks come from?

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Reality to Plug-n-Play

Equity Credit

IR FX

Mortgage

...

Risk Neutral

Space Equity Credit

IR FX

Mortgage ...

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IR Risk Considered

Risk Neutral

Space

IR

Forward

Measure Space Equity Credit

FX

Mortgage ...

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Swap Risk Considered

Risk Neutral

Space

IR

Forward

Measure Space Swap Credit

FX

Equity ...

Swaption CMS

Swap related

derivatives

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Credit Default Swap

Equity Credit

IR FX

Mortgage

...

Real World

Equilibrium

Measure

Equity Credit

IR FX

Mortgage Liquidity

Fundamentals Capital

Structure

Local

Economy

Global

Economy

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Risk Integration

Equity Credit

IR FX

Mortgage

...

Risk

Neutral Equity Credit

IR FX

Fundamentals Capital

Structure

Local

Economy

Global

Economy

Real World

Equilibrium Mortgage Liquidity

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Risk Integration - Fordham