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Operation Risk

Operation Risk

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Published by Chen Lee Kuen

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Categories:Types, School Work
Published by: Chen Lee Kuen on Jun 16, 2008
Copyright:Attribution Non-commercial

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IV. OPERATIONAL AND INTEGRATED RISK 
IV. 1. EXTENDING VAR TO OPERATIONAL RISK .......................................................................... 4
 
Operational Risk ................................................................................................................................4
 
Top-Down Approaches .......................................................................................................................4
 
Bottom-up Approaches ......................................................................................................................6
 
Top-Down Models .............................................................................................................................7
 
Bottom-Up Models ............................................................................................................................8
 
Catastrophic Loss ...............................................................................................................................9
 
Catastrophe Options and Catastrophe Bonds .................................................................................... 10
 
Limitations to Operational Risk Hedging ........................................................................................... 11
 
IV. 2. CAPITAL ALLOCATION AND PERFORMANCE MEASUREMENT .................................. 12
 
Economic and Regulatory Capital ..................................................................................................... 12
 
Economic Capital and Risk-Adjusted Return on Capital (RAROC) ........................................................ 13
 
Attribution of Capital ....................................................................................................................... 14
 
Capital Charge ................................................................................................................................. 14
 
Allocation of Economic Capital ......................................................................................................... 16
 
Drawback of RAROC Approach ......................................................................................................... 16
 
Adjusted RAROC .............................................................................................................................. 16
 
IV. 3. LIQUIDITY RISK - CULP ........................................................................................................... 17
 
Definitions ....................................................................................................................................... 17
 
Funding Liquidity Risk and Market Liquidity Risk ............................................................................... 17
 
Measuring Liquidity Risk .................................................................................................................. 18
 
Cash Flow at Risk (CFaR) ................................................................................................................... 20
 
Liquidity-adjusted VAR (LVAR) .......................................................................................................... 20
 
Monitoring Liquidity Risk ................................................................................................................. 21
 
Metallgesellschaft Case .................................................................................................................... 21
 
IV. 4. AMA APPROACH TO OPERATIONAL RISK ........................................................................ 22
 
Severity distributions ....................................................................................................................... 22
 
Frequency distributions.................................................................................................................... 23
 
Business-line diversification (correlation) ......................................................................................... 26
 
IV. 5. REGULATION .............................................................................................................................. 29
 
History............................................................................................................................................. 29
 
Regulation ....................................................................................................................................... 29
 
1988 Basel Accord ............................................................................................................................ 30
 
Basel II Accord ................................................................................................................................. 31
 
IV. 6. MODEL RISK ............................................................................................................................... 34
 
Model Risk ....................................................................................................................................... 34
 
Quantifying Model Risk .................................................................................................................... 35
 
Managing Model Risk ....................................................................................................................... 36
 
Quantification .................................................................................................................................. 36
 
Institutional Methods ...................................................................................................................... 37
 
Definition ........................................................................................................................................ 37
 
Efficient Market Hypothesis (EMH) ................................................................................................... 38
 
Role of Model Risk Manager............................................................................................................. 39
 
 
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IV. 7. CASE STUDIES ............................................................................................................................ 40
 
Financial Crisis at Metallgesellschaft ................................................................................................. 40
 
Stack-And-Roll Hedging Strategy ...................................................................................................... 40
 
Losses at Sumitomo ......................................................................................................................... 41
 
Collapse of Long-Term Capital Management (LTCM) ......................................................................... 41
 
Bankruptcy of Barings ...................................................................................................................... 42
 
Risk Management Measures ............................................................................................................ 42
 
IV. 8. OPERATIONAL RISK ................................................................................................................. 43
 
Approaches to estimating operational risk under Basel II .................................................................. 47
 
IV. 9. FINANCIAL CONGLOMERATES .............................................................................................. 52
 
Aggregating Risk .............................................................................................................................. 52
 
Silo Approach to Capital Regulation .................................................................................................. 52
 
Regulatory Debate ........................................................................................................................... 53
 
Capital Management of a Financial Conglomerate ............................................................................ 54
 
Economic Capital as a Common Currency for Risk ............................................................................. 54
 
Risk Aggregation: The Building Block Approach ................................................................................. 55
 
Diversification Benefits from Risk Aggregation .................................................................................. 55
 
Diversification Benefits at Each Aggregation Level ............................................................................ 56
 
Current Industry Practices ................................................................................................................ 56
 
3+1 Pillars ........................................................................................................................................ 57
 
IV. 10. ERM ............................................................................................................................................. 58
 
Total Risk = Systematic risk + non-diversifiable risk ........................................................................... 58
 
IV. 11. TECHNOLOGY AND OTHER OPERATIONAL RISKS ...................................................... 63
 
Definitions ....................................................................................................................................... 63
 
Risks of Implementing Technological Innovation ............................................................................... 63
 
Technology and Economies of Scale/Scope ....................................................................................... 63
 
Average Cost Curve in Banking ......................................................................................................... 63
 
Economies of Scope ......................................................................................................................... 64
 
Empirical Findings ............................................................................................................................ 64
 
Daylight Overdraft Risk .................................................................................................................... 64
 
IV. 12. A. INVESTORS AND RISK MANAGEMENT........................................................................ 65
 
Covariance/Correlation of Returns between Securities ..................................................................... 65
 
Diversification, Asset Allocation, and Expected Returns .................................................................... 66
 
The Capital Asset Pricing Model (CAPM) ........................................................................................... 67
 
Diversification and Risk Management ............................................................................................... 67
 
Capital Market Line (CML) ................................................................................................................ 68
 
CAPM .............................................................................................................................................. 68
 
Probability Distribution of Returns ................................................................................................... 70
 
Expected Return of a Portfolio.......................................................................................................... 72
 
Strategies for Diversifiable Risk ........................................................................................................ 72
 
Strategies and Policies to Reduce Systemic Risk ................................................................................ 72
 
Effect of Hedging on Firm Value........................................................................................................ 73
 
Risk Management Irrelevance Proposition ........................................................................................ 73
 
IV. 12. B. CREATING VALUE WITH RISK MANAGEMENT ........................................................ 74
 
Risk Management Irrelevance Proposition ........................................................................................ 74
 
 
3 / 119
Bankruptcy and Distress Costs .......................................................................................................... 74
 
Taxes ............................................................................................................................................... 75
 
Optimal Capital Structure ................................................................................................................. 75
 
Large Undiversified Shareholders ..................................................................................................... 76
 
Manager Incentives.......................................................................................................................... 76
 
Debt Overhang ................................................................................................................................ 77
 
Information Asymmetries and Agency Costs of Managerial Discretion ............................................... 77
 
IV. 13. REPORT OF COUNTERPARTY RISK .................................................................................. 78
 
Risk Management and Risk-Related Disclosure Practices ................................................................... 80
 
1. Improving Transparency and Counterparty Credit Assessments ................................................... 80
 
2. Improving Risk Measurement, Management and Reporting ......................................................... 80
 
3. Prime Brokerage ......................................................................................................................... 81
 
Financial Infrastructure .................................................................................................................... 82
 
1. Documentation Policies and Practices ......................................................................................... 82
 
2. Operational Efficiency and Integrity ............................................................................................ 82
 
3. Netting, Close-out and Related Issues ......................................................................................... 83
 
Complex Financial Products .............................................................................................................. 83
 
4. Credit Derivatives ....................................................................................................................... 83
 
1. Governance-Related Guiding Principles ......................................................................................... 84
 
2. Intermediary/Client Relationship ................................................................................................ 85
 
3. Risk Management and Monitoring .............................................................................................. 86
 
4. Enhanced Transparency .............................................................................................................. 87
 
Emerging Issues ............................................................................................................................... 88
 
1. Sale of Complex Products to Retail Investors ............................................................................... 88
 
2. Conflict Management ................................................................................................................. 89
 
3. Risk Management for Institutional Fiduciaries ............................................................................. 89
 
4. Official Oversight of Hedge Funds ............................................................................................... 90
 
Supervisory Challenges .................................................................................................................... 91
 
IV. 14. BASEL II CORE READINGS .................................................................................................... 92
 
Basel II Objectives ............................................................................................................................ 93
 
Scope .............................................................................................................................................. 94
 
Capital Requirements ....................................................................................................................... 95
 
Risk-Weighted Assets (RWA) ............................................................................................................ 97
 
First Pillar: Credit Risk ...................................................................................................................... 98
 
CRM Techniques ............................................................................................................................ 110
 
Asset Securitization ........................................................................................................................ 111
 
Supervisory Backtesting Framework ............................................................................................... 113
 
Three-Zone Supervisory Framework ............................................................................................... 113
 
Operational Risk under the Basel II Accord ..................................................................................... 114
 
Four Principles of 
the Basel II Accord’s Second Pillar
....................................................................... 115
 
Issues to be focused in Second Pillar ............................................................................................... 116
 
Purpose of the Third Pillar .............................................................................................................. 116
 
Potential problems with risk analytics ............................................................................................ 117
 

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