Financial Risk

Management
KPMG
ADVISORY
A spate of high-profile business failures and the emergence of tougher regulations have put organizations under pressure to
manage financial risk more effectively. Financial organizations have to be aware of the need to identify, measure and manage
risk, e.g. credit, market, liquidity, and operational risk, as well as maintaining sufficient levels of regulatory and economic
capital to support the risks they face. Also, there is a need for adequate disclosure and presentation of information to
stakeholders and third parties.
What We Do – And What You Get
Your potential benefits are :
• A
 n adequate and tailor-made
approach to any kind of financial
instruments valuation.
• T
 hird party valuation where you
benefit from our valuation tools and
knowledge.
• C
 ompliance with regulatory and
accounting frameworks.
• E
 ffective implementation of Hedge
Accounting and other valuation tools
to mitigate volatility of accounting P&L.
Your potential benefits are :
• F
 ull compliance with regulatory
requirements in Luxembourg.
• S
 ound capital requirement
calculations especially for IRB
approach for credit risk and AMA
approach for operational risk.
• Integrated and comprehensive
methods to implement or refine
existing processes to fulfill
regulatory requirements.
Your potential benefits are :
• Improved transparency and enhanced
understanding of risks the company
is exposed to.
• Identification of the different kinds of
relevant risks and their key drivers.
• D
 evelopment and implementation of
appropriate risk management models
and procedures.
• S
 etting up a sound risk management
practice for those risks.
Financial Instruments –
Valuation / Accounting and Disclosure
Financial instrument valuations encompass valuations of a variety of simple, complex and
structured products. Examples of such products are credit derivatives (e.g. Credit Default
Swaps), interest rate and foreign exchange derivatives (e.g. Interest Rate Swaps, Cross
Currency Interest Rate Swaps, Interest and Foreign Exchange Rate Options, Swaptions,
etc.), Credit Link Notes and Total Return Swaps. Moreover, recent developments have
raised issues around the valuation of Asset Backed Securities (ABS), Collateralized Debt
Obligations (CDO) and related structures. Clients often raise questions such as: Do we
have a reliable market value? Do we use an appropriate valuation model? Is the outcome
of the model reasonable? We can assist in providing solutions in this area.
Our practice also provides support in the correct accounting of Financial Instruments,
in accordance with IFRS, US-GAAP or other accounting standards. An example would
be the review and implementation of Hedge Accounting where the appropriateness of
(Fair Value/Cash Flow) Hedge Accounting model and Hedge Accounting effectiveness
tests are evaluated . In addition, we have wide experience in the preparation of financial
reporting disclosures of financial instruments, risk management methods and models
(e.g. IFRS 7, Disclosure requirements acc. to Pillar 3 of Basel II).
Capital Adequacy, Regulatory Reporting & Compliance
Capital Adequacy for banks is calculated and Basel II Framework - 3 Principle Pillars
Regulatory Reporting is made according to
regulators’ rules and methodologies, defining
for each bank a minimum regulatory capital
requirement and reporting. It comprises, but
is not limited to, the Basel II framework as,
e.g., transposed in Luxembourg with respect to Minimum Supervisory Market
Regulatory Process Discipline
FinRep (Financial Reporting based on IFRS) and Capital
Requirement
CoRep (Common Reporting for the Solvency
Ratio based on IFRS) by the Commission de
Surveillance du Secteur Financier (“CSSF”).
Management of Financial Risks
The management of credit risk, market risk
(comprising interest rate risks, foreign exchange
risks, equity risk as well as commodity risks),
operational and reputational risk, insurance
risk as well as liquidity risk should be part
of every sound financial risk management
system within a company. The scope
depends on the relevance of each risk
category for a company. Most institutions
measure their risks based on Value-at-
Risk Models. Many of these risks are highly
relevant for most of the financial institutions
and are interrelated. As such, they need to
be measured and managed accordingly. Recent
developments have revealed significant weaknesses in the management of credit risk
and liquidity risk within many organizations. Sound credit risk management can mitigate
or avoid a significant financial impact of such events on an organization.
 Model Building and Model Validation

Your potential benefits are : A model is a tool used to calculate or estimate

• D
 evelopment of effective models and
assistance in validating those models
as well as assessment of the overall
reliability of the model output.
• A
 ccurate pricing of financial
instruments based on efficient
and precise models.
• L
 eading risk management models for
sound financial risk management.
results based on a series of inputs often used
for analysis or quantification. Models are used
to make decisions easier and as such they
support the decision process. They do not
have an own purpose. Organizations use
a wide variety of models or spreadsheets,
which can be broadly categorized into
three areas: Decision Support, Financial
and Risk Management models.

For example, structured products or Asset

Backed Securities are rarely priced on active
markets. Therefore, adequate financial models are
necessary to price those financial instruments. Furthermore, appropriate risk
management models adapted to the companies’ specific purpose and needs, such as
Value-at-Risk or Expected Shortfall, are needed to measure, manage and control the risk
thereof. The models underlying the Hedge Accounting effectiveness tests are another
example of models used in accounting.

ICAAP & Economic Capital Calculation

Your potential benefits are : ICAAP (Internal Capital Adequacy Assessment Process), part of Pillar 2 within the Basel II
Framework, represents a financial institution’s own assessment of the capital needed to
• A
 risk management framework run the business. This capital may differ from the minimum regulatory capital requirement
consistent with financial risk strategy.
since, for instance, a financial institution may include risks that are not formally subject to
• E
 fficient process in response to the the minimum regulatory capital (e.g. liquidity risk, reputational risk or interest rate risk in
second pillar requirements of
Basel II (ICAAP). the banking book) or may use different parameters or methodologies (this is particularly
the case for operational risk).
• F
 ull compliance with regulatory
requirements and in line with
best practice.

• A
 dequate economic capital models
and risk management processes and
procedures consistent to the risk
management framework resulting
in a comprehensive and integrated Restrictions due Restrictions due
financial risk management approach. to Basel II, Pillar II to Basel II, Pillar I
• U
 nderstanding of the different types
of risks financial institutions are Free Financial
exposed to and how they impact Resources
the company, incorporating these
into their business operations and Capital Surplus
monitoring.

• A
 wareness of potential weaknesses
in the financial risk management
strategy, frameworks and processes
as well as in the risk mitigation
methods and being able to prepare ! !
≤ ≤
the management actions to be taken “Economic Available Regulatory Pillar I
to avoid unexpected or surprising
Capital” Financial Capital Own Funds
losses.
Resources
 Financial strategies could be risk avoidance, reduction, limitation, transference or
acceptance. An integral part of financial strategies is the management of financial risks and
resources and comprises identification, measurement, assessment, controlling, monitoring,
reporting and stress testing of the several risks including risks essentially not integrated.

EL
EL = expected loss
UL = unexpcted loss
ECAP = economic capital
PROBABILITY

AA = bank’s creditrating

UL
99.95% (AA)
ECAP

0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35%

LOSS RATE (%)

Risk Adjusted Performance Calculations

Your potential benefits are : Risk-adjusted performance measures compare return with capital employed in a way
that incorporates an adjustment for risk. The most famous measures are RAROC
• Implementation of performance
(risk-adjusted return on capital) and RORAC (return on risk-adjusted capital).
measures or improvement of your
current measures. Risk-adjusted performance measures are based on either risk adjusted return or
economic capital.They can be used for comparing past performance or as a forward
• R
 isk-adjusted performance
calculations consistent and integrated looking measure to decide on the long-term viability of a business unit, whether
into existing capital planning and risk it should be expanded or scaled back.
management process.

Integrated Planning & Target Setting

Reports/Cockpits Simulations & Analysis

1 Added Value (e.g., EVA)

Organizational Unit

Risk-Return Ratio (e.g., RORAC)

Legal Entity

Customer
Product

Risk Aggregation
Cost
Market Risk Credit Risk Op. Risk Other Risks
Revenue
5
234
Risk Cost Expected Loss

Cap. Cost Unexpected Loss

Value drivers/Operational Drivers/KPIs

 New Product Process (NPP) for Asset Management

Current market trends show that innovations of products and instruments will become
more significant over the coming years because of a decrease in market growth and a gain
in margin of traditional products. Standardized products such as index funds have lately
become more and more attractive for investors and alternative products are becoming
increasingly mainstream for asset managers.

An efficient and high quality New Product Process (NPP) is necessary to keep up
with the market demands and regulatory requirements for asset managers

New products - Compliance with international regulatory guidelines

and local requirements (e.g. IFRS, InvG, SolvV, MiFID, AnlV,

Regulatory
Modification / mix Real innovations Derivative regulation)
of existing products - Coverage of permanently increasing requirements
(Reporting, Corporate and Governance and Risk Management)
- Callable Yield Notes in regard to regulatory law, accounting- and taxation law
- Callable Path Dependant Floaters
- Certificates, Discount, Bonus, Express etc.
challenges
Economic

- Basket Structures - New products and instruments need to match with

- Snowballs the market expectations
- Target Range Accrual Notes - Product profitability
- Exotic Options – Equity, Commodity etc.
- Triggerable Reverse Floater
Process-related

- Inflation products, e. g. Zero Inflation Swaps, - Liquidity and risk performance

challenges
technical

Inflation Swaps - Adequate mapping within the system and correct treatment
- CPPI in the day-to-day business activities have to be assured
- Variance Swap - Utilization of synergies
- […]

Based on the increasing importance of new funding vehicles there is a need to accelerate
the time-to-market of new products while complying with applicable rules and regulations.
By launching new products asset managers are faced with a variety of challenges, e.g.
regulatory, economic, process-related and technical challenges. An efficient new product
process takes all essential departments and functions of the value chain into account.

Our project management approach for the multidisciplinary

NPP – A cube-based Illustration

Your potential benefits are :
• A
 bility to introduce new products
adequately and smoothly, minimizing
the time span from the initiation
Particular business functions are involved in one or more phases of the NPP.
Cross-sectional issues come up for several business functions during various phases.
Our project management approach recognizes this variety and interconnection among
the various functions.

1
to going live and keeping track of
the expenses for related structures,
processes and IT. NPP Phases

2
Initiation & Appproval &
Analysis Design Implementation Testing Going Live
• A
 ssurance of appropriate prices
and risk figures with regard to new
products accommodating both
Business
true innovations and modifications
Functions
efficiently.

3
Fund management
Market research
Legal
Tax
Internal audit
Economic analysis Cross-sectional
Trading Issues
Compliance
Order control Coordination
Pricing & valuation Communication
Risk analysis IT architecture
Perform. analysis Interfaces
Fund accounting Data
Reporting Execution (by default)
Your Needs – Our Approach
Invest
me
nt
Fu
nd
Accounting & Valuation s
Disclosure of of Financial

Financial Instruments Instruments

nks
Ba
New
Capital Adequacy /

Product
Regulatory
Process
Reporting
Financial Risk
Management

Insurance
(FRM)
Risk-adjusted ICAAP&Economic
Performance Capital
Calculations Calculation

Com s
Model Integrated and

p
Comprehensive

an
Building &
Risk Management

ie
Validation s
es
orat
p
Cor

Financial Risk Management

Why ? Risk management is highly complex, with risks often interrelated, which require
sophisticated tools and techniques. Sarbanes-Oxley, Basel II, Solvency II and the
cost of capital require organizations to improve their risk management practices.
This ultimately helps management to view risk as a major part of corporate
strategy. Financial risks are more and more interrelated to financial accounting
and reporting (e. g. IAS 39 and IFRS 7) as well as to the calculation of the solvency
ratio (e. g. calculation of the regulatory own funds based on IFRS). These require
integrated and comprehensive management frameworks to optimize Financial Risk
Management, Asset-Liability Management and overall product processes.

How can we help ? Based on an integrated approach, we can help design and implement frameworks
to manage and/or reduce risk. We can provide assistance in creating an overall
framework that helps to identify, measure, monitor and report risks leading,
ultimately, to better strategic decision making and efficient processes.

Our quality ? In striving to provide high quality services, we participate in a global accreditation
program, we work closely with professionals from other KPMG member firms,
liaise regularly with our global KPMG Financial Risk Management group and
share experiences on a variety of different national and international projects.
We also cooperate with universities to be able to provide the most up to date
methodologies to our clients.

Your benefit ? KPMG Financial Risk Management is committed to ensure that we are always
available to help identify opportunities, solve problems and as a result add value
firm wide based on a multidisciplinary approach. You can benefit from our cross-
border knowledge and experience – in Luxembourg and abroad. Whatever problem
you might have regarding Financial Risk Management, we can provide you with a
tailored approach.
kpmg.lu

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The information contained herein is of a general nature and is not intended to address the © 2009 KPMG, the Luxembourg member firm
circumstances of any particular individual or entity. Although we endeavor to provide accurate and of KPMG International, a Swiss cooperative.
timely information there can be no guarantee that such information is accurate as of the date it is All rights reserved.
received or that it will continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough examination of the particular situation.