Market Risk

Definition
Possibility of loss due to changes in the market factors
Market risk affects the banks earnings
Market risk reduces the capital position of banks
Volatility of market values
Affects banks ability to meet its obligations

Bank for International Settlements (BIS)

Adverse change in value of balance sheet positions

on balance sheet positions
Off balance sheet positions

Movements in
Equity market
Interest rate market
Currency exchange rate
Commodity prices

Focus of Market Risk

Liquidity risk
Market risk
Interest rate risk
Foreign exchange risk
Commodity price risk
Equity price risk

Organizational Structure of Market Risk

Board of Directors
Risk Management Committee
Asset Liability Management Committee
Market Risk Group

Structure of the Market Risk Group in Banks

Board of
Directors

Risk
Management
Committee

Asset Liability
Management
Committee

Market Risk
Group

Board of Directors
Overall responsibility for market risk
Risk Management Policy of the bank
Setting of limits for
Liquidity
Interest rate
Foreign exchange rate
Commodity trade
Equity trade

Risk Management Committee

Board level sub committee
Chief executive officer
Head of credit
Head of market
Head of operations

Strategy for integrating bank risk

Responsible for
Guidelines for market risk measurement
Compliance with market price risk policy
Review of market risk limits, triggers, stop-loss positions
Effectiveness of market risk system
Quality of staff

Asset Liability Management Committee

Responsible for adherence of limits, targets, stop-loss orders
Product prices for deposits and advances
Decision on maturity profile of assets and liabilities of the
bank
Forecast interest rate views of the bank
Decision on business strategies
Review funding policy
Decide the transfer pricing policy
Review economic and political impact on balance sheet

Market Risk Group

Responsible for analyzing risk
Responsible for monitoring risk
Responsible for reporting risk profiles to ALM Committee
Preparation of forecasts
Simulation models

Value-at-Risk Concept of Market Risk

Potential gain or loss
In a position
In a portfolio
Associated with a price movement
Measured as a probability
In relation to a time horizon

Value-at-Risk Requirement
Instantaneous price shock for a specified holding
period
One tailed confidence interval of 99%
Historical observation of at least one year
Adjustments in terms of correlation
Within risk factors
Across risk factors

Capital Requirement for Market Risk

Tier 1 capital
Shareholders equity
Retained earnings
Tier 2 capital
Supplementary capital
Tier 3 capital
Short term subordinated debt (Tertiary capital held
by banks to meet part of market risk undisclosed
reserves and general loss reserves)

Requirements for Consideration of Tier 3 Capital

Initial maturity of at least two years
Limited to 250% of banks Tier 1 capital that is allocated
to support market risk
Tier 2 capital could be substituted for Tier 3 up to 250%
Tier 3 capital subject to lock-in provisions

Difficulties in Implementing Market Risk Capital

Adequacy Requirements
Market price movements are not normally distributed
Wide dispersion
Fat tails
Extreme events
Event risk is difficult to account for
Exceptional market scenarios
Difficult to account for intra-day trading risks

Historical representations may not repeat and market

risk may be due to factors not encountered earlier