While the framework exists to express and constrain a firm’s exposures, it also helps risk managers and business leaders to monitor and manage risks on an ongoing basis. It becomes, in essence, a central means of managing firm-wide market, credit and liquidity risk, and a tool that can be used to alter risk levels as market conditions change. As markets enter new medium- term cycles and it becomes less attractive to take risk, the firm should use the framework to lower its profile in places where it is more dangerous or returns are no longer attractive.
Conversely, when it becomes more compelling to take risk, it can use the framework to adjust its profile upward.
We have found that the framework is also a particularly useful way of reviewing exceptions, concentrations or temporary increases in the firm’s stated risk appetite. It helps ensure those in the governance structure are aware of, and approve, larger pockets of risk. For instance, if the framework caps unsecured credit exposure to $100 million per BBB counterparty and an attractive opportunity arises to increase that to $150 million, a formal exception process – driven by the corporate risk group – should exist so that the exception is debated and either
Table 11.3 Sample market risk framework Interest rates: by market
Developed markets
Direction −100 bps,−50 bps,−10 bps,+10 bps,+50 bps,+100 bps
Volatility −10%,−2%,+2%,+10%
Curve −25 bps,+25 bps for 1–3 mo, 3–6 mo, 6 mo–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Volatility curve −10%,+10% for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10% out/in-the-money
Emerging markets
Direction −500 bps,−200 bps,−100 bps,−25 bps,+25 bps,+100 bps, +200 bps,+500 bps
Volatility −25%,−10%,+10%,+25%
Curve −100 bps,+100 bps for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Volatility curve −25%,+25% for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10% out/in-the-money
Credit spreads: by market Developed markets
AAA–AA −50 bps,−25 bps,−5 bps,+5 bps,+25 bps,+50 bps A −50 bps,−25 bps,−5 bps,+5 bps,+25 bps,+50 bps BBB −50 bps,−25 bps,−5 bps,+5 bps,+25 bps,+50 bps Spread volatility −50%,−25%,−10%,+10%,+25%,+50%
High-yield markets
BB −500 bps,−200 bps,−100 bps,−10 bps,+10 bps,+100 bps, +200 bps,+500 bps
B −500 bps,−200 bps,−100 bps,−10 bps,+10 bps,+100 bps, +200 bps,+500 bps
CCC −500 bps,−200 bps,−100 bps,−10 bps,+10 bps,+100 bps, +200 bps,+500 bps
CC −500 bps,−200 bps,−100 bps,−10 bps,+10 bps,+100 bps, +200 bps,+500 bps
C −500 bps,−200 bps,−100 bps,−10 bps,+10 bps,+100 bps, +200 bps,+500 bps
Spread volatility −50%,−25%,−10%,+10%,+25%,+50%
Emerging markets(price)
BBB −50%,−25%,−5%,+5%,+25%,+50%
BB −50%,−25%,−5%,+5%,+25%,+50%
B −50%,−25%,−5%,+5%,+25%,+50%
CCC −50%,−25%,−5%,+5%,+25%,+50%
CC −50%,−25%,−5%,+5%,+25%,+50%
C −50%,−25%,−5%,+5%,+25%,+50%
Price volatility −50%,−25%,−10%,+10%,+25%,+50%
Currencies: by market Developed markets
Direction −5%,−2%,−1%,+1%,+2%,+5%
Volatility −10%,−2%,+2%,+10%
(continued overleaf)
Table 11.3 (continued)
Volatility curve −10%,+10% for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10%
out/in-the-money Emerging markets
Direction −50%,−25%,−10%,+10%,+25%,+50%
Volatility −50%,−10%,+10%,+50%
Volatility curve −50%,+50% for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10% out/in-the-money Equities: by market
Developed markets
Direction −25%,−5%,−2%,−1%,+1%,+2%,+5%,+25%
Volatility −25%,−10%,−2%,+2%,+10%,+25%
Volatility curve −10%,+10% for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10% out/in-the-money Emerging markets
Direction −50%,−25%,−10%,+10%,+25%,+50%
Volatility −50%,−10%,+10%,+50%
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10% out/in-the-money Commodities:
by market
Direction −10%,−5%,−2%,−1%,+1%,+2%,+5%,+10%
Volatility −10%,−2%,+2%,+10%
Volatility curve −10%,+10% for 0–1 yr, 1–2 yr, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 1–20 yr, 20+yr
Skew −10%,+10% for at-the-money, 5% out/in-the-money, 10% out/in-the-money
Table 11.4 Sample credit risk framework Direct/trading credit risk
Default risk∗
By counterparty/legal entity∗ Sum within each counterparty/legal entity Loans, securities, deposits 100% of notional, by counterparty/legal entity Derivatives 5–50% of notional, by counterparty/legal entity Repos/reverses 1–10% of notional, by counterparty/legal entity Contingent risk 100% of notional, by counterparty/legal entity By rating∗ Sum across all counterparties/legal entities within each
rating category (AAA, AA, A, BBB)
Sum across all counterparties/legal entities within each, and across all, sub-investment grade categories (BB, B, CCC) Loans, securities, deposits 100% of notional, by counterparty/legal entity
Derivatives 5–50% of notional, by counterparty/legal entity Repos/reverses 1–10% of notional, by counterparty/legal entity Contingent risk 100% of notional, by counterparty/legal entity
By country∗ Sum across all counterparties/legal entities within country Loans, securities, deposits 100% of notional, by counterparty/legal entity
Derivatives 5–50% of notional, by counterparty/legal entity Repos/reverses 1–10% of notional, by counterparty/legal entity Contingent risk 100% of notional, by counterparty/legal entity
Table 11.4 (continued) Collateralized credit risk
By asset held as collateral Sum across all counterparties/legal entities, 100% of notional underlying all transactions
Collateral $ max by rating, % of outstanding issue size By correlated exposures Sum across all correlated exposures, 100% of notional
underlying all transactions
Collateral $ max by rating, % of outstanding issue size Sovereign risk
Default risk By sovereign
Loans, securities, deposits 100% of notional, by sovereign Derivatives 5–50% of notional, by sovereign Financings 1–10% of notional, by sovereign Convertibility risk
Currency assets 100%
Derivative receivables 100% of receivable Local equity 100% of position Settlement risk
By counterparty 100% of notional on currency, free deliveries
∗Can be adjusted for recovery assumptions.
Table 11.5 Sample liquidity risk framework Balance sheet targets
Total footings $ max
Liquid investments/total assets % min
“Less liquid” investments/total assets % max
Aged assets over 90 days $ max
Asset/liability mismatch max $ gap per maturity: 1–3 mo, 3–6 mo, 6–12 mo, 12–18 mo, 18–24 mo, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 15–20 yr, 20–30 yr, 30+yr
Forward balance sheet
Footings $ max at 6, 12, 24, 36 mo forward horizons
Funding $ max at 6, 12, 24, 36 mo forward horizons
Asset concentrations Balance sheet positions
By issuer $ max per issuer
By issue $ max per issue
By ratings category $ max per AAA, AA, A, BBB, BB, B ratings categories By asset type $ max per emerging markets, high yield, syndicated loans,
equity blocks
Off-balance sheet positions $ max per off-balance sheet category Funding diversification
Funding source (% of funding)
By instrument type % max
By market % max
By lender % max
By maturity % max per maturity: 1–3 mo, 3–6 mo, 6–12 mo, 12–18 mo, 18–24 mo, 2–5 yr, 5–7 yr, 7–10 yr, 10–15 yr, 15–20 yr, 20–30 yr, 30+yr
Commitment % with true commitments
% with uncertain commitments
% uncommitted
approved or rejected by the relevant people in senior management. The process should not be bureaucratic and time-consuming. This is especially important when a firm has to re- spond to large underwriting transactions (capital commitments) or credit-sensitive deals that require short timeframe responses (e.g. bidding on a large block of shares from an institutional customer, buying a bond deal from an issuer for subsequent distribution to investors or exe- cuting a time-sensitive derivative). It must, however, be rigorously enforced. If the framework is a reflection of a firm’s risk appetite, then exceptions must be vetted diligently. Exceptions should be kept to a bare minimum and always accompanied by a short expiration. A related issue to consider is how high, within the overall boundaries of the firm’s risk appetite, to set limits: high enough that they are never breached, or low enough so that they are close to being breached and require periodic dialog and exceptions? In our view the latter approach is more constructive as it forces continuous dialog between risk takers and risk managers – reinforcing communication and awareness of the risk profile.
In our opinion, the creation and use of such a risk framework is an essential part of any good risk process: it simultaneously places a cap on exposures and concentrations (i.e. a reflection of the firm’s appetite), allows easy monitoring of exposures, and explicitely involves executive management when exceptions occur.
12
Automated Management: Automating Discipline on the Front Lines
Part of the management of risk within a corporation can be automated. By this we do not mean that machines will magically perform the work, or that “stuff” will just happen without thinking. Instead, we use this term to refer to the elements in the risk management process that can be institutionalized through the disciplined adherence to well-thought-out rules. By making certain processes and behaviors automated, they become second nature and help to move every person in the organization toward the common goal of creating a properly controlled environment. These rules have to permeate the entire organization – starting from the top. In our experience eight key automated rules can help reinforce sound risk management behaviors.
These are illustrated in Figure 12.1.
We have noted several times that risk policies work best when they are not merely imposed, but inculcated into daily discipline and accompanied by a spirit of partnership between the busi- ness and control sides of the organization. This remains a guiding principle in the application of these rules. Additionally, they work best when taken to the lowest common denominator within the firm: the closer the rules are to the person pulling the trigger on a daily basis the better!