Edited by Carol Alexander and Elizabeth Sheedy
Introduced by David R. Koenig

Contents

Introduction ................................................................................................................................................7
Preface to Volume III: Risk Management Practices.......................................................................9
III.0 Capital Allocation and RAPM..........................................................................................................13
III.0.1 Introduction ..........................................................................................................................13
III.0.2 Economic Capital .................................................................................................................17
III.0.3 Regulatory Capital ................................................................................................................24
III.0.4 Capital Allocation and Risk Contributions.......................................................................31
III.0.5 RAROC and Risk-Adjusted Performance........................................................................35
III.0.6 Summary and Conclusions..................................................................................................39
References ...............................................................................................................................................40
III.A.1 Market Risk Management .............................................................................................................43
III.A.1.1 Introduction.....................................................................................................................43
III.A.1.2 Market Risk.......................................................................................................................43
III.A.1.3 Market Risk Management Tasks....................................................................................45
III.A.1.4 The Organisation of Market Risk Management..........................................................47
III.A.1.5 Market Risk Management in Fund Management........................................................49
III.A.1.6 Market Risk Management in Banking...........................................................................57
III.A.1.7 Market Risk Management in Non-financial Firms .....................................................66
III.A.1.8 Summary...........................................................................................................................72
References ...............................................................................................................................................73
III.A.2 Introduction to Value at Risk Models.........................................................................................75
III.A.2.1 Introduction.....................................................................................................................75
III.A.2.2 Definition of VaR............................................................................................................76
III.A.2.3 Internal Models for Market Risk Capital......................................................................78
III.A.2.4 Analytical VaR Models....................................................................................................79
III.A.2.5 Monte Carlo Simulation VaR.........................................................................................81
III.A.2.6 Historical Simulation VaR..............................................................................................86
III.A.2.7 Mapping Positions to Risk Factors ...............................................................................95
III.A.2.8 Backtesting VaR Models.............................................................................................. 109
III.A.2.9 Why Financial Markets Are Not ‘Normal’................................................................ 111
III.A.2.10 Summary........................................................................................................................ 112
References ............................................................................................................................................ 113
III.A.3: Advanced Value at Risk Models ............................................................................................. 115
III.A.3.1 Introduction................................................................................................................... 115
III.A.3.2 Standard Distributional Assumptions........................................................................ 117
III.A.3.3 Models of Volatility Clustering................................................................................... 121
III.A.3.4 Volatility Clustering and VaR...................................................................................... 126
III.A.3.5 Alternative Solutions to Non-normality.................................................................... 134
III.A.3.6 Decomposition of VaR................................................................................................ 142
III.A.3.7 Principal Component Analysis.................................................................................... 149
III.A.3.8 Summary........................................................................................................................ 154
References ............................................................................................................................................ 155
III.A.4 Stress Testing ............................................................................................................................... 157
III.A.4.1 Introduction................................................................................................................... 157
III.A.4.2 Historical Context......................................................................................................... 158
III.A.4.3 Conceptual Context...................................................................................................... 163
III.A.4.4 Stress Testing in Practice ............................................................................................. 164
III.A.4.5 Approaches to Stress Testing: An Overview............................................................ 166
III.A.4.6 Historical Scenarios ...................................................................................................... 168
III.A.4.7 Hypothetical Scenarios................................................................................................. 174
III.A.4.8 Algorithmic Approaches to Stress Testing ............................................................... 182
III.A.4.9 Extreme-Value Theory as a Stress-Testing Method................................................ 186
III.A.4.10 Summary and Conclusions .......................................................................................... 187
Further Reading................................................................................................................................... 187
References ............................................................................................................................................ 188
III.B.1 Credit Risk Management ............................................................................................................ 193
III.B.1.1 Introduction................................................................................................................... 193
III.B.1.2 A Credit To-Do List..................................................................................................... 194
III.B.1.3 Other Tasks.................................................................................................................... 207
III.B.1.4 Conclusions.................................................................................................................... 208
References ............................................................................................................................................ 209
III.B.2 Foundations of Credit Risk Modelling..................................................................................... 211
III.B.2.1 Introduction................................................................................................................... 211
III.B.2.2 What is Default Risk?................................................................................................... 211
III.B.2.3 Exposure, Default and Recovery Processes ............................................................. 212
III.B.2.4 The Credit Loss Distribution...................................................................................... 213
III.B.2.5 Expected and Unexpected Loss ................................................................................. 215
III.B.2.6 Recovery Rates .............................................................................................................. 218
III.B.2.7 Conclusion ..................................................................................................................... 223
References ............................................................................................................................................ 223
III.B.3 Credit Exposure.......................................................................................................................... 225
III.B.3.1 Introduction................................................................................................................... 225
III.B.3.2 Pre-settlement versus Settlement Risk....................................................................... 227
III.B.3.3 Exposure Profiles.......................................................................................................... 228
III.B.3.4 Mitigation of Exposures .............................................................................................. 236
References ............................................................................................................................................ 241
III.B.4 Default and Credit Migration .................................................................................................... 243
III.B.4.1 Default Probabilities and Term Structures of Default Rates................................. 243
III.B.4.2 Credit Ratings ................................................................................................................ 247
III.B.4.3 Agency Ratings.............................................................................................................. 252
III.B.4.4 Credit Scoring and Internal Rating Models .............................................................. 258
III.B.4.5 Market-Implied Default Probabilities........................................................................ 262
III.B.4.6 Credit Rating and Credit Spreads ............................................................................... 268
III.B.4.7 Summary........................................................................................................................ 270
References ............................................................................................................................................ 271
III.B.5 Portfolio Models of Credit Loss ............................................................................................... 273
III.B.5.1 Introduction................................................................................................................... 273
III.B.5.2 What Actually Drives Credit Risk at the Portfolio Level?...................................... 276
III.B.5.3 Credit Migration Framework ...................................................................................... 279
III.B.5.4 Conditional Transition Probabilities– CreditPortfolioView.................................. 292
III.B.5.5 The Contingent Claim Approach to Measuring Credit Risk ................................. 294
III.B.5.6 The KMV Approach.................................................................................................... 300
III.B.5.7 The Actuarial Approach............................................................................................... 307
III.B.5.8 Summary and Conclusion............................................................................................ 312
References ............................................................................................................................................ 312
III.B.6 Credit Risk Capital Calculation.................................................................................................. 315
III.B.6.1 Introduction.................................................................................................................. 315
III.B.6.2 Economic Credit Capital Calculation ........................................................................ 316
III.B.6.3 Regulatory Credit Capital: Basel I ............................................................................. 320
III.B.6.4 Regulatory Credit Capital: Basel II............................................................................. 324
III.B.6.5 Basel II: Credit Model Estimation and Validation .................................................. 334
III.B.6.6 Basel II: Securitisation.................................................................................................. 336
III.B.6.7 Advanced Topics on Economic Credit Capital ....................................................... 338
III.B.6.8 Summary and Conclusions .......................................................................................... 340
References ............................................................................................................................................ 341
III.C.1 The Operational Risk Management Framework.................................................................... 343
III.C.1.1 Introduction................................................................................................................... 343
III.C.1.2 Evidence of Operational Failures............................................................................... 345
III.C.1.3 Defining Operational Risk........................................................................................... 347
III.C.1.4 Types of Operational Risk.......................................................................................... 348


III.C.1.5 Aims and Scope of Operational Risk Management ................................................ 351
III.C.1.6 Key Components of Operational Risk...................................................................... 354
III.C.1.7 Supervisory Guidance on Operational Risk ............................................................. 357
III.C.1.8 Identifying Operational Risk – the Risk Catalogue ................................................. 358
III.C.1.9 The Operational Risk Assessment Process............................................................... 359
III.C.1.10 The Operational Risk Control Process...................................................................... 364
III.C.1.11 Some Final Thoughts ................................................................................................... 365
References ............................................................................................................................................ 366
III.C.2 Operational Risk Process Models............................................................................................. 367
III.C.2.1 Introduction................................................................................................................... 367
III.C.2.2 The Overall Process ..................................................................................................... 369
III.C.2.3 Specific Tools ................................................................................................................ 372
III.C.2.4 Advanced Models ......................................................................................................... 374
III.C.2.5 Key Attributes of the ORM Framework................................................................... 378
III.C.2.6 Integrated Economic Capital Model.......................................................................... 381
III.C.2.7 Management Actions.................................................................................................... 384
III.C.2.8 Risk Transfer.................................................................................................................. 386
III.C.2.9 IT Outsourcing.............................................................................................................. 388
References ............................................................................................................................................ 393
III.C.3 Operational Value-at-Risk.......................................................................................................... 395
III.C.3.1 The ‘Loss Model’ Approach........................................................................................ 395
III.C.3.2 The Frequency Distribution........................................................................................ 401
III.C.3.3 The Severity Distribution ............................................................................................ 404
III.C.3.4 The Internal Measurement Approach....................................................................... 407
III.C.3.5 The Loss Distribution Approach............................................................................... 411
III.C.3.6 Aggregating ORC.......................................................................................................... 413
III.C.3.7 Concluding Remarks .................................................................................................... 415
References ............................................................................................................................................ 416