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Banking and Risk Principles Reassessed Following Subprime

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Published Date : Oct 2012

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No. of Pages : 245 Pages


This report details risk management solutions for compliance with the Basel framework. It contends that:

  • Risk management is not merely an analytical exercise
  • Risk management strategies should be in line with rating agency principles
  • Credit risk control should be multi-dimensional in nature
  • Standard product pricing risk tools alone are not sufficient


Risk management should not merely be an analytical exercise. Large market events are followed by periods of illiquidity, significantly impacting assumed risk. Market risk management should be customized and dynamic. Operational risk management frameworks should reflect standard practices and firms insights. Standard product pricing risk tools alone are not sufficient. Risk management strategies should be in line with rating agency principles.


This report will provide you with:

  • A comprehensive understanding about risk management and risk management frameworks
  • An understanding of the multi-dimensional nature of different kinds of risk and the required provisioning
  • An understanding of the responsibilities of a risk manager
  • Case studies on risk management frameworks

Reasons To Buy

  • Devise appropriate risk management frameworks
  • Understand the multi-dimensional nature of different kinds of risk and provision accordingly
  • Understand the responsibilities of risk managers
  • Gain practical insights through case studies of risk management frameworks

Key Highlights

  • Assessment of credit risk through credit rating and according to BIS standards.
  • Understanding risk in finance and the role of a risk manager.
  • Risk based pricing and applicable rules.
  • Understanding capital adequacy and Basel rules on capital adequacy.

1 Executive Summary

2 Introduction
2.1 Overview of the Report
2.2 Global Risk Report, 2012
2.3 The US Subprime Collapse - Background and After-Effects
2.4 Impact on Leading Economies
2.5 Risk Exposure of European Banks
2.6 Sovereign debt crisis and banking risk in US
2.6.1 The Need for Banks to Reassess Their Risk Appetite

3 Risk Defined
3.1 Risk as a Chance Event
3.2 Risk in Finance
3.3 The Science of the Unlikely
3.4 Uncertainty is Both a Precondition of, and a Broader Concept Than, Risk
3.5 Financial Risk in the Banking System
3.6 Systemic Risk in Global Banking
3.7 Being in Charge of the Risk Pattern
3.8 Appendix: An Introduction to Normal Distribution

4 Counterparty Risk
4.1 Credit Risk, Collateral and Credit Spread
4.2 The Evaluation of Credit Risk
4.3 Default Risk with Counterparties
4.4 Credit Rating
4.5 Transition Probabilities in Default Rates
4.6 Credit Risk Models and Power Curves
4.7 BIS Assessment of Bank\'s Management of Credit Risk
4.8 Appendix: Level of Confidence and OC Curves

5 Market Risk
5.1 General and Specific Market Risk and the Notion of Hedging
5.2 Pure and Speculative Hedging Of Market Risk
5.3 Cash Flows and the Evaluation of Hedges
5.4 Market Uncertainty and Orders of Exposure
5.5 Factors Affecting Stock Market Behaviour

6 Operational Risk
6.1 Dealing With Operational Risk Issues
6.2 The Basel Committee Operational Risk Matrix
6.3 Fraud is a Major Operational Risk
6.4 A Bird\'s-Eye View of Legal Risk
6.5 High-Impact and Low-Impact Events
6.6 Operational Risk and Business Continuity

7 Pricing Risk
7.1 Risk-Based Pricing
7.2 Derivative Financial Instruments and Implied Volatility
7.3 The Search for Fair Value Through Models
7.4 Default Swaps and the Pricing of Credit Risk
7.5 Credit Derivatives and Earnings-at-Risk
7.6 Asset Prices and Inefficient Markets
7.7 Pricing Performance, Bid/Ask Uncertainty and Risk
7.8 Risk-based Pricing Rule Revision in the US

8 Risk Management Defined
8.1 The Concept of Risk Management
8.2 The Functions of Risk Management
8.3 Transparency of Information and Concentration of Risk
8.4 A Lesson in Risk Management
8.5 The New Perspectives of Risk Management

9 The Basel Framework and Risk Management
9.1 The Concept Underpinning Capital Adequacy
9.2 For How Long May a Bank Be Well Capitalized?
9.3 International Supervisory Collaboration
9.4 Basel III and the Integration of Financial Markets
9.5 The Nexus Between Regulation and Risk Appetite of Banks

10 Case Studies on Risk Management
10.1 Risk Management is Like Pre-Trial Preparation
10.2 Discovering the Pattern of Risk

11 Learning Lessons from Physical Sciences
11.1 Science and the Heisenberg Principles That Apply in Finance
11.2 The Physicist\'s Method and Risk Control
11.3 Philosophers/Scientists and Scientific Investigation
11.4 Scientific Method, Financial Environments and Fuzzy Engineering
11.5 Fuzzy Engineering and Implied Volatility
11.6 Concepts Underpinning Genetic Algorithms

12 Case Studies with Expert Systems for Credit Risk Control
12.1 Case Studies on Expert Systems for Private Loans
12.2 The Sophistication of Expert Systems Has Been on the Rise: A Barclays Bank Example
12.3 The Expert System for Loans Screening at Deutsche Bundesbank
12.4 A Credit Card Expert System by Diamond Credit, Mitsubishi Group
12.5 Nuts and Bolts of an Expert Systems Application
12.6 Credit Card Expert Systems by American Express and Citibank

13 An Integrated Risk Management System
13.1 An Integrated Approach to Detect Patterns of Risk
13.2 Normal Cases, Tail Cases and Risk Integration Through Fuzzy Engineering
13.3 Watching Out For Default Points and Distance to Default
13.4 Financial Analysis, Business Analysis and Non-financial Reporting
13.5 Technology\'s Contribution to a Risk Control Policy

14 The Risk Manager\'s Job
14.1 Risk Management is a Metalevel of Quality assurance
14.2 The Job is Not Avoiding Risk, But Measuring and Containing it
14.3 Research at the Roots of Market Exposure
14.4 Risk Management and Internal Control
14.5 Controlling Operational Risk: A Practical Example

15 Criticality, Stress Testing and Unexpected Losses
15.1 Stress Testing Defined
15.2 Expected Losses and Unexpected Losses
15.3 Stress Testing Exposure at Default
15.4 Unexpected Losses and Extreme Value Theory

16 A Methodology for Risk Management
16.1 Emerging Risks and Methods for Exposure Control
16.2 Human Factors Affecting the Pattern of Risk
16.3 A Statistical Methodology for Calibration of Risk
16.4 Risk Managers Must Be Aware of Model Risk
16.5 The Synergy Between Methodology and Organizational Characteristics
16.6 A Case Study on Model Risk: VAR and CAR
16.7 Primary Risks, Consequential Risks and Risk Factor Models

17 Appendix
17.1 Methodology
17.2 Contact Us
17.3 About Timetric
17.4 Disclaimer

List of Table

Table 1: Exposure of European Banks to Sovereign Debt, 2011
Table 2: Exposure of US Banks to Stressed European Markets (US$bn) as of Sept 30, 2011
Table 3: Capital Requirements of Basel II and Basel III Compared
Table 4: Status of Implementation of Basel III in Different Countries

List of Chart

Figure 1: Breakdown of Variables Considered for FICO Scoring
Figure 2: Correlation Between Sovereign and Banking CDSs
Figure 3: Claims on Peripheral Sovereigns by Major Banks
Figure 4: Major Holders of Greek Government Debt (Bonds and Bills), EUR Billion, June 2011
Figure 5: The Bell-Shaped Curve Of Normal Distribution
Figure 6: Paretos Law and Risk
Figure 7: Classification of Bank Capital Requirements According to Risk
Figure 8: Uncertainty The Restructured Risk Pattern
Figure 9: Financial Risk in the Banking System
Figure 10: Systemic Crises Since 1980
Figure 11: Constituent Parts of Business Risk
Figure 12: Framework for Enterprise-wide Risk Management Solutions
Figure 13: Omega Curve and Three Different Risk Control Solutions
Figure 14: Normal Distribution and Leptokyrtotic Distribution From Different Parent Populations
Figure 15: Relationship Between Counterparty, Credit and Market Risk
Figure 16: The Interactive Management of Credit Exposure Requires Much More Than Knowing Counterparty Risk
Figure 17: Default Frequencies Increases With Increase in Current Liabilities and Decrease in Liquid Funds
Figure 18: An Example of Different Rating of Bonds Issued by the Same Obligor
Figure 19: An Example of Different Rating of Bonds Issued by the Same Obligor
Figure 20: Comparing a Company to Quantiles of Probability of Default in the Economy
Figure 21: Global Structure Finance 2011 Transition by Rating Upgrade and Downgrade Rates (%)
Figure 22: A Transition Matrix Based on Average One-Year Transition Rates
Figure 23: Power Curves Help Predict Defaulters According to Chosen Criteria
Figure 24: An Operating Characteristic Curve for Credit Risk in Connection With Fine Grainscoring
Figure 25: Capital At Risk As A Percentage Of Unexpected Risks And Extreme Events
Figure 26: Each of the Four Quarter Spaces of Risk Management Needs a Different Solution
Figure 27: Market Risk Uncertainty is Reflected in the Trend Line of Market Returns
Figure 28: Delta and Gamma Graphs for 30 Day and 120 Day Options in the Function of Spot Price
Figure 29: Payoff Diagram of Target Option and Delta Slope as First Derivative of the Underlier
Figure 30: Stock Markets Around the World Slipped to Red as Greek Bonds Were Downgraded to Junk Status
Figure 31: S&P and Shanghai Indices Since March 2003
Figure 32: Operational Risk is Characterized by Many Exposures
Figure 33: Each Level of Management Should Have Operational Risk Goals
Figure 34: Using Taylors Method and the Normal Distribution Curve to Evaluate the Likelihood of Fraud
Figure 35: High-Frequency Events and Low Frequency Events are at the Two Ends of Distribution of Operational Risk
Figure 36: Operational Risk Solutions Should be Studied Along Two Channels
Figure 37: Pricing Risk Finds Itself at the Junction of Other Major Risks on Which it Impacts, While Also Being Subject to Their Effects
Figure 38: A Flat Rate for Capital Adequacy is Insufficient Because it Takes No Account of Assumed Risk
Figure 39: Risk-based Pricing Starts With Instruments and Morphs Into Successive Frames of Reference With Volatility and Liquidity in Key Roles
Figure 40: Risk Management is Both a Control Activity and the Link Which Keeps the Enterprise Dynamic While Observing Limits
Figure 41: Dynamic Change in Risk Management Environment
Figure 42: The Management of Risk is a Polyvalent Enterprise With a Wide Catchment Area
Figure 43: Dynamic Change in Risk Management Environment
Figure 44: A Companys Governance is Conditioned by a Three-layered Structure With Accounting at the Bottom and Regulation at the Top
Figure 45: The Aftermath of Basel I on Aggregate Capital Reserves in the Banking Industry
Figure 46: An Order of Magnitude Evaluation of Market Capitalization of Industrial Commercial Banks and Brokers (Market Value in US$ Billion)
Figure 47: The Forces Which Have Created New Market Opportunities and Major Risks
Figure 48: Assets in the Balance and Off-Balance Sheets of a Major Financial Institution
Figure 49: Liabilities in the Balance and Off-Balance Sheets of a Major Financial Institution
Figure 50: A Tick-by-Tick Follow-up on Exposure by Means of Statistical Quality Control Charts
Figure 51: Two Interactive Frames of Reference for Total Risk Management, Through a Virtual Balance Sheet
Figure 52: Nothing Walks on a Straight Line There Are Always Tolerances and There Should be Control Limits
Figure 53: In the Modern Economy Disequilibrium Conditions for Current Products Develop in Three-Dimensional Space
Figure 54: Fuzzy Engineering is Able to Map Uncertainty Into the Pattern of Variation of a Chosen Factor Compared to Another Variable or Standard
Figure 55: Visualisation of Risk Computed Through a Fuzzy Engineering Model and Possibility Theory
Figure 56: From Counterparty Exposure to the Assumed Risk
Figure 57: Credit Assessment of the Deutsche Bundesbank, April 2010
Figure 58: Radar Chart for Crucial Variables Distinguishing Where a Loan is Eligible or Ineligible for Central Bank Refinancing
Figure 59: Crucial Variables Distinguishing Loan Eligibility for Central Bank Refinancing
Figure 60: CDO Issuance by Citigroup
Figure 61: Risk Estimates From Different Channels Using Fuzzy Engineering
Figure 62: Default is at the Junction of Declining Asset Value and Growing Liabilities
Figure 63: Risk Patterns Tend to Change in Function of Instruments, Markets and Counterparties
Figure 64: Risk Management is a Metalayer to Quality Assurance Exploiting its Feedback
Figure 65: Capital Reserves For Market Risk at Three Levels of Confidence Intervals
Figure 66: The Keywords in Modern Finance are Research, Development and Risk Control
Figure 67: Sound Practices Require a Sense of Balance in Risk Management
Figure 68: Internal Control, Risk Management, Auditing and Accounting Complement one Another and Partly Overlap
Figure 69: Daily Test on Forex Exposure Based on Percentage Change in Parities
Figure 70: Time Series Under Normal Distribution Hypothesis and in Real Life
Figure 71: The Statistical Distribution of Loans Losses Classified Into Two Major Categories
Figure 72: The Distribution of Risk and Return Cannot be Approximated Through Normal Distribution. It Should Be Lognormal and Shifted by 2s
Figure 73: A Methodology For Risk Management, Validation and Verification Should Cover Both Regulatory Standards and the Institution\'s Own Processes and Tools
Figure 74: Operating Characteristics Curves For Sampling Plans and Levels of Confidence
Figure 75: The Framework of New Risk Management

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