The Essentials of Risk Management

669 Pages·2014·6.78 MB·English

by  Michel Crouhy

THE
ESSENTIALS OF
R I S K
MANAGEMENT
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THE
ESSENTIALS OF
R I S K
MANAGEMENT
S E C O N D E D I T I O N
MICHEL CROUHY, DAN GALAI, ROBERT MARK
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CONTENTS
Foreword vii
Foreword xi
Introduction to the Second Edition:
Reforming Risk Management for the Post-Crisis Era xv
1. Risk Management: A Helicopter View 1
1.1 Typology of Risk Exposures 23
2. Corporate Risk Management: A Primer 45
3. B anks and Their Regulators:
The Post-Crisis Regulatory Framework 67
3.1 Basel I 117
3.2 The 1996 Market Risk Amendment 125
3.3 Basel II and Minimum Capital Requirements for Credit Risk 131
3.4 Basel 2.5: Enhancements to the Basel II Framework 137
3.5 Contingent Convertible Bonds 143
4. Corporate Governance and Risk Management 151
5. A User-Friendly Guide to the Theory of Risk and Return 183
6. Interest Rate Risk and Hedging with Derivative Instruments 203
7. M easuring Market Risk: Value-at-Risk,
Expected Shortfall, and Similar Metrics 233
8. Asset/Liability Management 265
9. Credit Scoring and Retail Credit Risk Management 305
10. Commercial Credit Risk and the Rating
of Individual Credits 333
10.1 Definitions of Key Financial Ratios 363
v
vi •  Contents
11. Quantitative Approaches to Credit
Portfolio Risk and Credit Modeling 365
11.1 The Basic Idea of the Reduced Form Model 407
12. The Credit Transfer Markets—and Their Implications 411
12.1 Why the Rating of CDOs by
Rating Agencies Was Misleading 467
13. Counterparty Credit Risk: CVA, DVA, and FVA 471
14. Operational Risk 499
15. Model Risk 529
16. Stress Testing and Scenario Analysis 555
16.1 The 2013 Dodd-Frank Severely Adverse Scenarios 581
17. Risk Capital Attribution and
Risk-Adjusted Performance Measurement 583
Epilogue: Trends in Risk Management 609
Index 619
FOREWORD
T
he world changed after the global financial crisis of 2007–2009, and the
change was especially dramatic for banks. The second edition of this book
is therefore very welcome and helps to clarify both the implications of
the crisis for risk management and the far-reaching process of regulatory
change that will come into full force over the next few years.
Banks are reforming their risk management processes, but the chal-
lenge goes much deeper. Banks must rethink their business models and
even question the reason for their existence. Do they exist to take pro-
prietary risks (on or off their balance sheet) or to provide a focused set of
services and skills to their customers and business partners?
At Natixis, our business adopts the latter model. We have recently
completed an aggressive push to adapt to post-crisis regulatory constraints,
end our proprietary activities, reduce our risk profile, and refocus on
our three core businesses: wholesale banking, investment solutions, and
specialized financial services.
The far higher capital costs under Basel III are likely to shift many
other banks toward a more service-based business model with less risk
retained. The new regulations are also obliging banks to change their fund-
ing strategies—e.g., by making use of new funding tools in addition to
reformed approaches to securitization and traditional funding avenues.
This change of philosophy may mean developing trusted partnerships
with different kinds of financial institutions, such as insurance companies
and pension funds, that can absorb the risks that banks no longer wish to
carry on their balance sheets—a process that Natixis has already begun.
As banks change their approach, they must also take a fresh look at
their corporate governance. The crisis showed that banks had been driven
vii
viii •  Foreword
by too simplistic a notion of growth and short-term profitability. Going
forward, firms must build a wider and longer-term view of stakeholder
interests—e.g., by defining long-term risk appetites explicitly and con-
necting these securely to strategic and operational decisions. Ensuring the
right kind of growth will require many of the best-practice mechanisms of
corporate governance discussed in this book.
The crisis also showed that banks need to pay more than lip service
to the concept of enterprise risk management. They must improve their
understanding of how a wide range of risks—credit, market, liquidity,
operational, reputation, and more—can interact with and exacerbate
each other in a bank’s portfolios and business models when the financial
system is under strain.
In turn, this requires the development of new risk management
methodologies and bankwide infrastructures—for example, in the area
of macroeconomic stress testing. One of the accomplishments of this book
is that it helps set out these new methodologies and explains their strengths
and also their limitations. The authors believe that financial institutions
must not rely on any single risk measure, new or old. Risk measurement
and management methodologies are there to help decision makers, not to
supply simplistic answers.
It is critical that institutions (as well as regulators) develop a better
understanding of the interconnected nature of the global financial system.
As this book explains in its various chapters, systemic risks, counterparty
interconnections, liquidity risks, credit risks, and market risks all feed on
one another in a crisis. Understanding how risks concentrate during good
times and then spread through systemic interconnections during bad times
needs to become part of the philosophy of bank risk management. Without
this understanding, it is difficult for financial institutions to resist activities
that boost growth and profitability in the short term, but that may create
unsustainable levels of risk in the longer term.
The global economy is trying to find a path toward sustainable growth
at the same time that developed nations have begun to unwind the unprec-
edented support given to economies and banking systems during the
crisis years. This will give rise to many challenges as well as opportunities.
Natixis plays a frontline role in financing the real economy, but we know
that this must be built on solid risk-managed foundations.
Foreword • ix
In this sense, the book supports the business philosophy we are
developing at Natixis. We believe that long-term success comes to institu-
tions and economies that can deliver growth while managing downside
risks through both improved risk management and the careful selection of
fundamental business models.
Laurent Mignon
Chief Executive Officer of Natixis
September 13, 2013