New direction for Market Risk: Issues and Challenges
1. 3rd Annual RISK AMERICAS, May 12-13, Marriott Downtown, New York City
Presenter: Anshuman Prasad, Director, Risk and Analytics
NEW DIRECTION FOR MARKET RISK:
ISSUES AND CHALLENGES
May 12-13, 2014
2. Agenda
Market Risk Management: Outstanding Issues
Impact of Regulations
– Measures of Market Risk
– Regulatory Stress Tests
Modeling Challenges
– Valuation of Illiquid Instruments
– Illiquidity Discount
– Computational Trade-offs
Data Management Issues
Trends in Market Risk Systems
Organizational Culture
2
3. Market Risk Management: Outstanding Issues
3
Reliability of various measures of risk
Validation and back-testing of models
to reduce model risk
Trading vs. banking book boundaries
Regulatory stress tests
Regulatory Issues
Silo approach to risk management
Limited role of risk managers in
decision making
Narrow, compliance-focused
approach
Organizational Culture
Valuation of illiquid products
Correlation under stressed
environment
Model calibration
Tradeoffs: speed vs. accuracy
Incomplete and/or inaccurate data
Lack of unified data processing
model
Limited involvement of business
Real-time computation, lack of
integrated systems
System and Data Issues
Modeling Challenges
4. Impact of Regulations
4
Newer regulations impacting market risk management frameworks
Fundamental Review
of the Trading Book
(BCBS 219)
Regulation
Stress Testing
(Dodd-Frank, CCAR)
Model Risk
Management
(OCC SR-11/7)
Difficult to move assets between the trading and banking
books
Shift to Expected Shortfall from VaR
Varying liquidity horizons
Impact
Handling granular market shocks
Requires calculation of various parameters under stress
Widened the definition a “model”
Enhanced model validation and model governance framework
Emphasis on rigorous testing, model documentation and
quantifying model uncertainty
Data aggregation and
Reporting
(BCBS 239)
Early warning systems
Comprehensive and granular reporting
Overhaul of systems and processes
5. Measures of Market Risk
5
There is no single measure of risk that can provide a consistent view of risk
across market participants and regulators
Simple, established
Single view of risk
Pros
Conservative
Size and likelihood
of losses
Reduces cyclicality
Easy to interpret
Simple modeling
procedure
Lacks coherence
Extreme tails
Inconsistencies
Cons
Difficult to back-test
Prone to
optimization errors
Can be misleading
Cannot be
aggregated
Regulatory reporting
Setting risk limits
Key Use
Regulatory reporting
Economic risk
capital
Key measure used
for hedging risk
Setting risk limits
Value at
Risk (VaR)
Measure
Expected
Shortfall
(ES)
Sensitivities
6. Regulatory Stress Tests (CCAR, EBA)
Regulators provide a varying degree of granularity in their market shock
variables
Some of the key requirements in dealing with these stress tests from a
market risk perspective include
– Comprehensive understanding of risk drivers
– Customized scenario expansion models to expand regulatory scenarios
– Robust input-output templates to ensure quick turnarounds
– Organizational focus and coordination across functions
Real GDP Growth
Unemployment
Equity Market
Index
House Price Index
Stressed:Macrovariables
Econometric
Modeling
Credit Spreads
IR Term Structures
IV Term
Structures/Skews
Correlations
Valuation Models
Market Risk
Modelling
CCP Exposure
Modelling
6
7. By discounting cashflows at
future dates
Description
Closed-form pricing for low
factor/low dimension
models; path independent
Closed-form pricing for low
factor/low dimension
models; path dependent
IRS, Bonds, Floaters
Type of Products
First generation structures
Caps/Floors, CBs, TS
models
Simulation pricing for high
factor/high dimension
models; path dependent
Highly complex structures
Modeling Challenges: Model Calibration
7
Discounting
Technique
PDE-based
Lattice-based
MC Simulation
FASB valuation categories are based on complexity – Level 1/2/3
Level 3 assets are priced using in-house valuation models
Models built can only be as good as the underlying data !
8. Modeling Challenges: Illiquidity Discount
Driven by stress testing requirements, initial steps are being taken towards
better management of the market impact of illiquidity; measures include
– Checking for variability in liquidation times for illiquid positions
– Setting up processes for measuring impact of trade volumes on market prices
– Monitoring widening bid-ask spreads, specially in times of adverse market conditions
CCPs started for most liquid OTC derivatives; liquidity adjustment
challenges seen in more exotic products
Methods for incorporating the illiquidity discounts in OTC valuation models
8
Adjustment of bid-ask spread for specific market risk
parameters
Determine lower and upper limit price by relying on
reasonable limits to trade performance
Bid-ask
Spread
Adjustment
Bounding
Approach
9. Computational Trade-offs
9
Choice between delta-based methods and the full revaluation method
Most banks still use sensitivity-based approaches due to computational
challenges associated with the full-revaluation approach
Newer technology (GPUs, multi-core processors) helping reduce
computation times and trade-offs
Sensitivity Based
Approaches
Ease of implementation
Approximations (Taylor
expansion/grids)
Full Revaluation Approach
Robust
Computationally intense
CONTROL
AGILITY
10. Data Management Issues
10
Increased regulatory focus on providing granular and frequent analysis of
real time data
Traditional Extract-Transform-Load (ETL) processes not amenable to real-
time computation of risk. Alternatives may include:
– ELT: Data transformation after the data load, includes data virtualization
– Data Federation: Single virtual view without actually moving the data
Typical Data Management Processes
Trade Data
Market Data
Extract
Validate
Enrich
Transform
Reports
Ad hoc Queries
Load
11. Trends in Market Risk Systems
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Increase ‘risk velocity’ and ‘risk management’ clock-speed
Automation of stress testing and reporting framework
GPU-based farms enabling move to full revaluation
approach
Measure
Cloud Computing, a natural solution for higher data
capacity needed for granular regulatory reporting
Service-based architecture with detailed data captured at
trade level
Flexible data capture and storage solutions
Timeliness and
Accuracy
Data/Reporting
Attribute
Comprehensive
ness
Adaptability
12. Organizational Culture
12
Front office alignment
– Financial incentives being aligned with risk-informed performance indicators
– RWA consumption by trade becoming an important statistic
Model validation and model development functions being strengthened
– Investments in internal/external resourcing
Robust middle office and IT processes becoming a differentiator
– Cost of funding (CVA, FVA etc) getting incorporated
– Granularity/Speed/Flexibility in risk calculations and reporting
Organizational structure and incentives are getting better aligned to market
risk management objectives
Market risk management will need to be more tightly integrated with strategic
objectives, diversity of business and level of complexity