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AFMA Core > Ch 7 Risk and Risk Management Frameworks > Flashcards

Ch 7 Risk and Risk Management Frameworks Flashcards

1
Q

Global Framework for Risk Management: Most work comes from 3 members; list members of joint forum

A
  1. Basel Committee on Banking Supervision (BCBS, set up in 1974)
  2. International Association of Insurance Supervisors (IAIS, 1994)
  3. International Organisation of Securities commissions (IOSCO, 1983)
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2
Q

Basel Committee on Banking Supervision (BCBS)

  • comprised of:
  • responsible for:
A

Basel Committee on Banking Supervision (BCBS)

  • comprised of: central bank governors of G10 nations
  • responsible for: formulating broad supervisory standards and guidelines, recommends statements of best practice in banking supervision

Note: BCBS is not a regulator itself; but influences global standards.

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3
Q

BCBS has developed Basel Accords. Discuss (3)

A
  1. Basel 1: introduced 1988; provided framework for min capital requirements banks must hold
  2. Basel II: introduced 2004; advocated capital sensitive risk management that was quantified based on data and formal techniques for measuring risk. updated as financial crisis evolved in 2008/9
  3. Basel III: developed to include international framework for liquidity risk measurement, standards and monitoring
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4
Q

New Basel III requirements (3)

A

New Basel III requirements (3)
1. Changed capital adequacy requirements - more, higher quality
2. New liquidity requirements - more liquid assets and stable funding sources
3. New leverage ratios - to prevent excessive leverage
Adopt from 31 Dec 2012, phase in over 10 years

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5
Q

Capital Adequacy Requirements
- define
- measured as:
-

A

Capital Adequacy Requirements

  • define: ratio of a bank’s capital to its risk, determined then tracked by regulators to ensure that each bank can absorb a reasonable amount of loss based on the assets it holds
  • measured as:Tier 1 & Tier 2 capital divided by risk weighted assets
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6
Q

Tier 1 assets

- define

A

Tier 1 assets

- define: going concern capital such as shares and retained earnings that can be used without causing insolvency

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7
Q

Tier 2 assets

- define

A

Tier 2 assets
- define: gone concern: capital that can be depleted without affecting depositors, such as debt with a maturity of no less than 5 years

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8
Q

Liquidity Requirements

- 2 new ratios

A

Liquidity Requirements

  • 2 new ratios
    1. Liquidity Coverage Ratio
  • requires bank to hold enough capital to cover a stress scenario of 30 days (current Aus prudential standard requires only 5 days)
  • divided into level 1 (gov bonds & cash) and level 2 assets (risk weighted sov bonds or corp bonds)
  • in Aus there are no level 2 assets, and Aus may struggle to meet L1 assets, therefore RBA provides dedicated liuqidity funding facility (with haircut)
    2. net Stable Funding Ratio
  • addresses funding stability for periods up to 1 year
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9
Q

Leverage Ratio

- define

A

Leverage Ratio

  • define: series of caps based on the amount of Tier 1 capital that a bankholds vs total exposures.
  • volume based, not risk adjusted
  • BCBS proposed ratio of 3%; that is bank’s exposure can only be 33 times its Tier 1 Capital
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10
Q

International Organisation of Securities Commissions (IOSCO)

  • define
  • ASIC
A

International Organisation of Securities Commissions (IOSCO)

  • define: regulates the world’s securities and futures markets; members typically the securities commission or main financial regulator from each country. Members from >100 countries, representing >90% of world’s securities markets
  • ASIC: member.
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11
Q

ASIC expects form’s risk management systems will meet obligation by: (4)

A

ASIC expects form’s risk management systems will meet obligation by:

  1. identifying & evaluating risks
  2. focusing on risks that adversely affect consumers or market integrity
  3. establishing & maintaining controls designed to manage or mitigate those risks
  4. fully implementing and monitoring those controls to ensure they are effective
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12
Q

Regulatory Risk

  • define
  • cost
A

Regulatory Risk

  • define: risk of a regulator revoking a firm’s ability to operate, or applying conditions that compliance will with cause increased cost burden or deterioration in profitability
  • cost
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13
Q

Industry Standards: ISO 31000

- define

A

Industry Standards: ISO 31000

  • define: applies globally to all risks and in all sectors.
  • detailed guidance on the implementation of a risk management framework, defining principles against which organisations can evaluate their approach and use the standard to provide a road map for their future development
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14
Q

Risks in Financial Markets:

  1. Market Risk
    - define
    - common types
A

Risks in Financial Markets:

  1. Market Risk
    - define: risk of loss/profit from movements in market rates that affect the value of a portfolio. Can be traded or non traded.
    - common types of traded: interest rate risk; FX risk; price risk; hedge sensitivity risk. Also basis risk
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15
Q

Measuring market risk

a) VaR
b) Greeks

A

Measuring market risk
a) VaR: attempts to predict max loss that could arise from positions held within a given level of confidence over a set period of time. Monetary measure of absolute loss. Weakness: does not take into account fat tail (extreme) events.

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16
Q

Measuring market risk

b) Greeks

A

Measuring market risk

b) Greeks
- Absolute price risk (delta) (ie change in value for given change in market price
- Convexity risk (gamma): ie how quickly the delta changes and so how often a hedge needs to be rebalanced
- Volatility risk: (vega): not a greek letter - how a value of a portfolio will change as the implied volaility of its components change
- Time decay (theta): sensitivy to changesw in time to maturity
- Discount rate risk (rho): change in the value of the option with a change in interest rates

17
Q

Measuring market risk

c) Present value of a basis point

A

Measuring market risk

c) Present value of a basis point
- sensitivity of a bond or portfolio’s price (in dollars) to changes in yield by 1 basis point (0.01%)

18
Q

Risks in Financial Markets:

  1. Credit Risk
    - define
    - common types
A

Risks in Financial Markets:
2. Credit Risk
- define: risk that a counterparty will not be able to make payments as they fall due. Presettlement risk and settlement risk, can be traded or non traded
- common types:
pre settlement risk: coiunterparty defaults on contractual obligfation prior to settlement and the portfolio of transactions held has a positive replacement value. Also, sovereign risk
Settlement risk: counterparty fails to pay and the firm is at risk for the entire amount of principle. eg when there is a non simultaneous exchange of items of equiv value

19
Q

Measuring credit risk

a) Standardised approach (APS 112)
b) Internal Ratings Based approach (IRB), banks expected to use APS 113

A

Measuring credit risk

a) Standardised approach (APS 112)
b) Internal Ratings Based approach (IRB), banks expected to use APS 113: typically involves more sophisticated approach to calculate and provide for potential exposure at default. eg use Monte Carlo simulation

20
Q

Risks in Financial Markets:

  1. Liquidity Risk
    - define
    - common types
A

Risks in Financial Markets:

  1. Liquidity Risk
    - define: the risk that an organsiation may be unable to meet its payment obligations when they fall due (funding risk) or that losses will arise from being exposed to an illiquid market (transactions risk)
    - common types
21
Q

Measuring liquidity risk

A

Measuring liquidity risk

  • positions analysed compared with observable behaviour
  • daily CF reports & projections
  • maturity gap
  • funding tenor analysis
  • liquidity source diversification analysis
  • stress testing on external, internal and ad hoc scenarios
  • crisis modelling and contingency funding plan tests
22
Q

Risks in Financial Markets:

  1. Operational Risk
    - define
    - common types
A

Risks in Financial Markets:

  1. Operational Risk
    - define: risk of loss resulting frmo inadequate or failed internal processes, people and systems or from external events. Includes legal and regulatory risk, excludes strategic risk.
  • common types
    • internal fraud (unauthorised transactions, etc)
    • external fraud (theft, forgery)
    • poor employment practices or workplace safety breaches
    • clients, products and business practices that arise from unintentional or negligent failure to meet professional obligations
    • natural disasters
    • business disruption
    • execution, delivery and process management events arising from failed transaction processing etc.
23
Q

Measuring operational risk

A

Measuring operational risk

  • VaR
  • Advanced Measurement Approach
24
Q

Risk Management through deal cycle:

1. Predeal

A

Risk Management through deal cycle:

  1. Predeal
    - KYC, AML, pre deal credit checks, ISDA documentation, CSA (credit support annex),
    - also collateral agreement, based around the use of CSA. Agreement to provide collateral to guarantee payment for a transaction
    - in the past most firms had a threshol level of counterparty exposuyre they were willing to tolerate, but post GFC many firms have reverted to zero threshold of tolerance.
    - segregation of frnot & back office
25
Q

Risk Management through deal cycle:

2. Pitch

A

Risk Management through deal cycle:

  1. Pitch
    - Trading limits - tactical and operational (regulatory and organisational)
    - authorisation
26
Q

Risk Management through deal cycle:

3. Deal execution & capture // position management

A

Risk Management through deal cycle:
3. Deal execution & capture // position management
- operational risk = biggest consideration
-

27
Q

Risk Management through deal cycle:

4. Confirmation

A

Risk Management through deal cycle:

  1. Confirmation
    - confirmation is critical
    - segregation of duties
28
Q

Risk Management through deal cycle:

5. Settlement

A 
Risk Management through deal cycle:
5. Settlement
- collateral agreements
- time zones
- payment vs payment system, or DVP
- payment netting
-
29
Q

Risk Management through deal cycle:

6. Reconciliation

A

Risk Management through deal cycle:
6. Reconciliation
- breaks need to be identified properly and escalated
-

30
Q

Risk Management through deal cycle:

7. P& L management

A

Risk Management through deal cycle:

  1. P& L management
    - independent verification and validation of the rates used to value all of the instruments traded
    - APS 116: APRA has mandated that back testing must be done of the theoretical P&L against VaR and any excveptions investigated
    - operational risk: tight segregation of duties
    - complex products
31
Q

Three Lines of Defence

A
  1. Front line business unit - eg global markets team; ownership & accountabiliyt sits with these executives
  2. Risk management function
  3. Internal audit team.

AFMA Core (8 decks)

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