Liquidity and credit risk
Banks need to better integrate solvency and liquidity stress testing, a potential issue highlighted by the financial crisis. Credit risk also impacts the reputations of financial institutions. For example, a local bank in a region where the unemployment rate and therefore the number of defaults is high, will find it more difficult to get money from other banks who consider the bank more risky because of the local economy.
Liquidity and interest rates
ALM teams have always worked on interest rate risk and liquidity risk. Basically, the maturity mismatch between assets and liabilities could be analysed for both risks. Retail banks, for example, tend to lend money with longer maturities for mortgage loans and have short- term resources with non-term deposits. Contractually, all customers could go to their banks and withdraw money from their savings accounts.
For long-term loans, there is generally an implicit option for a customer to prepay their loan. This can be a so-called behavioural option (e.g., a customer decides to prepay because he is selling his house), or a financial option, because interest rates have decreased and a customer wants to renegotiate his loan.
FX and credit risk
When a bank decides to enter a new market, with a different currency, they have two possible options. They can lend money in the local currency, only dealing with FX risk; that is, their exposure to unanticipated changes in the exchange rate between two currencies. A bank could also lend money in a more liquid currency. Their customers would benefit because interest rates are generally lower in Euros or US dollars than in less liquid currencies, but they would then be exposed to currency risk as their salaries are generally paid in local currencies. Hence, in the case of a stress scenario, an increase in the exchange rate could lead to many more defaults than what was initially assessed. Therefore, this link must be modelled carefully in the context of a stress testing exercise.
FX and liquidity
FX rates can have a big impact on liquidity. Most of the reports required by the different supervisors now have to be produced per currency, as there is a difference between having cash in a local currency and the US dollar. Even when the exchange rate is indexed on the dollar, some differences can appear when a crisis occurs. It is therefore very important to calculate two metrics in each currency.
THE BENEFITS OF THE INTEGRATION OF RISKS Better understand the risks
In some banks, the fact that there are silos (e.g., people in charge of credit risk and others in charge of FX risk), leads to unmonitored - and so unmanaged - risk. The credit risk team could categorise a risk as FX whilst the market risk team could say that it is credit risk. This illustrates that risk departments will need to better understand all the connections between all the risks - particularly powerful when creating a contingency plan in case a similar scenario occurs.
Sharing information and having a common framework fosters communication across an entire organisation, as input data, calculation engines, and reports are based on one platform. Using the same data, framework, and metrics also enable people to speak the same language. Everyone will then have the same level of knowledge about each type of risk. In the end, the strongest benefit is overcoming the barriers between different departments.
Challenges and methodology in practice
A few years ago, measuring different types of risk at the same time was only used to better define a diversification strategy. Only a few banks managed to implement comprehensive stress tests for two main reasons.
Quantifying the impact of the combined risk factors is a difficult task
Methodologies have always been at the heart of risk management. Many quantitative experts write complex models that precisely describe the different risks that a bank can face. This is obviously difficult for combined risk factors.
Stress testing is about a few macroeconomic variables. Most economists only provide frequently used statistics, such as gross domestic product, unemployment rates, consumer price index, equity index, and only two points on the yield curve. A bank must then translate this information to retrieve all the variables needed for every type of risk.
Having the adequate framework to store data, models, and scenarios
The main types of risk have different risk drivers, time horizons, and metrics, making integrating everything complex. That is why it is necessary to have a framework and methodology. A framework often does not exist in banks because risk management is typically organised by a silo-based approach. Building a framework leads to internal political discussions, which determine who is in charge and what priority is given to the unified project. Banks implement this type of project when senior management realises that risk appetite can only be defined for the entire balance sheet, not just for a single risk department. In this case, a bank would create a team to define the different needs of each department (risk, finance, treasury, capital management, etc.).
The workflow concept is an important requirement for trading portfolios and is also relevant for balance sheet management. In a world where decisions must be made by the right person at the right moment in the right market, information that travels lightning fast through an organisation is beneficial. This is indeed the case for limit monitoring and the origination process.
Integrating different risks in a single framework benefits all financial institutions - leading to better communication, risk assessment, and long-term performance. Most financial institutions started working on a framework because of regulatory pressure. Senior management, however, now see the real benefits of having a system that can quickly provide the information required to make the right decision at the right time.
Integrated stress testing tools can achieve this goal. Unfortunately, this is not an easy task. The people building a framework must acknowledge the limitations and try not to create an ultimate model that will never exist. They must also accept that each person in a bank has a field of expertise and can help in the design of the global framework. This is a team effort which will provide a real-time big picture of their institution under different stressed scenarios. The outcome is for senior management to know all the options to better define their strategy and the risk appetite of their financial institution; thus increasing value for shareholders.
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