Apr 30

Risk concentrations at financial conglomerates - learning objective "in the news"

by David Harper, CFA, FRM, CIPM

FRM |

Basel's Joint Forum published last week an informative survey of risk concentration management practices at conglomerates. Risk concentration refers to exposures that "arise within or across different risk categories throughout [across] the financial conglomerate" rather than single-name or sector concentration risk. Another way to view risk concentration? it's risk that cannot be diversified away. Highlights:

Practices

  • "Silo management" is still common; i.e., concentrations measured within separate risk categories and business lines. Exposure limits common, with firms monitoring exposures both against gross and net limits
  • But several seeking to implement more progressive methods, in particular economic capital frameworks that (theoretically) enable "horizontal" risk aggregation
  • For credit risk, most firms manage credit risk concentrations via internal risk limits on exposures (obligor names, industry (sub-) sectors, geographic regions and countries, and product types)
  • For market risk, VaR is most common. For fixed income products, common are dollar value of '01 (DV01) and/or VaR, often "combined with limits, and traditional gap analysis."
  • For non-trading positions, interest rate risk concentrations are "usually defined in terms of loss of economic capital, with materiality measured  using firm-wide evaluations of earnings- and capital-at-risk under various interest rate scenarios. These could include parallel and non-parallel rate shocks, maximum volatility, and sudden crises simulations.

Liquidity risk

Three definitions of liquidity risk (in the FRM, contingent liquidity risk would be a type of funding liquidity risk). But much is made of the interdependence and mutual causality funding and market liquidity risk:

  • Funding mismatch risk: "risk that the firm will not have sufficient cash to meet obligations in the normal course of business, as a result of ineffective matching of cash inflows and outflows"
  • Market liquidity risk: "risk that a firm will not be able to convert assets to cash or access market funding in an economical manner (whether owing to a lack of buyers or uncertainty in valuation)"
  • Contingent liquidity risk, "risk that arises when a firm has insufficient funds to meet its obligations as a result of firm-specific or market-wide unexpected events"

Operational risk

Relative to the other risk categories, "the taxonomy for identifying, measuring, and managing operational risk exposures is less developed." Reputational risk is a major concern (but Basel II excludes it). A prominent risk: a firm’s dependence on one specific IT platform and its provider. 

Credit risk transfer (CRT) products

Nice summary of the unique characteristics of CRT products (e.g., CDOs) as opposed to single-name obligors:

  • By pooling collateral, (higher grade) structured notes can represent significant systematic risk even while reducing specific risk
  • If defaults become more correlated (e.g., systematic credit event), the probability of losses to higher-rated tranches increases
  • Structured credit products can exhibit negative convexity: a widening of credit spreads has a stronger impact on prices than a narrowing such that "prices decline at an increasing rate the more spreads widen"
  • Additional leverage "increases the 'extent' and the 'speed' of a systemic event materialising during a period of price declines."
  • The dependency between securitisation notes is generally stronger than correlation between common single name bonds and loans

Basis risk

Hedges for structured credit products are typically imperfect. Note the trade-off between liquidity and basis risk (i.e., an index is liquid but not tailored, an OTC instrument is tailored but not standardized):

For instance, the hedging of subprime mortgage exposures via the ABX index proved to be quite difficult. Nevertheless, in some cases reference indices were the only hedging instruments that maintained their liquidity, forcing firms to alter their hedges from the instruments that lost their liquidity towards these reference indices. This often led to significant increases in basis risk. Additionally, the stress events also showed that some model-based valuations methods may not have fully captured the entire risk profile of the exposure under these market conditions, giving rise to additional unexpected basis risk. As some hedging strategies proved inadequate or had to be altered in the midst of a market liquidity squeeze, some firms were exposed to unexpected concentrated risk exposures and basis risk

Challenges to integrated risk management

Many practical challenges to ERM due to differences across the firm:

  • Lack a common IT system platform across business units; and/or lack of a common database
  • Lack of consistency in data types and collection
  • Challenged by the "silo-line risk culture in some groups"
  • Measurement differences: different VaR horizons, (10 days vs. one year)

Economic capital

Economic capital has a key advantage: "it seeks to report a common measure of risk across businesses and risk categories."  Related metrics include

  • Capital-at-Risk: lower confidence (e.g., 90%)
  • Earnings-at-Risk (EaR): fluctuations in profit. Like cash flow at risk, but accrual-based

Weaknesses of economic capital

  • Can be (highly) subjective
  • Can be hard to capture true dependencies and second-order effects
  • Can be hard to aggregate. Of course, some firms model dependencies with copulas. Some firms that aggregate economic capital "view the models primarily as a means to analyze capital and review business performance and not as a risk management tool"

Survey's verdict is that "while the correlations introduced in the economic capital models may provide a way to aggregate risk exposures, they are less suited to measuring risk concentrations"

Stress testing is on the rise

Stress testing has two main categories:

  • scenario tests, either hypothetical or historical
  • sensitivity tests: "specify risk parameters that will be shocked without identifying the specific source of the shock"

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