The Essentials of Risk Management, 2nd Edition.pdf

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The Essentials of Risk Management, 2nd Edition.pdf
3 Copyright c 2014 by mc graw-Hill Education. all rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher ISBN:978-0-07-182115-5 MHID:0-07-182115-5 The material in this books also appears in the print version of this title: ISBN: 978- 0-07-181851-3MHID:0-07-181851-0 e Book conversion by code mantra Ⅴ ersion1.0 All trademarks are trademarks of their respective owners. rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps McGraw-Hill education books are available at special quantity discounts to u premiums and sales promotions or for use in corporate training programs, 1o Se as contact a representative, please visit the Contact Us pages at www.mhprofessional.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, securities trading, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought -From a Declaration of principles Jointly Adopted by a Committee of the American Bar Association and a Committee of publishers and Associations TERMS OFUSE This is a copyrighted work and McGraw-Hill education and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer reproduce, modify, create derivative works based upon, transmit, distribute disseminate, sell, publish or sublicense the work or any part of it without Mcgraw Hill education's prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDEDAS IS. 22 McGraw-Hill Education and its LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE AND EXPRESSLY DISCLAIM ANY WARRANTY EXPRESS OR IMPLIED INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw Hill education and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill Education nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill Education has no responsibility for the content of any information accessed through the work Under no circumstances shall Mcgraw-Hill education and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract. tort or otherwise CONTENTS Foreword Foreword Introduction to the Second Edition: Reforming risk management for the Post- Crisis era 1. Risk Management: A Helicopter View 1.1 Typology of risk Exposures 2. Corporate risk management: A Primer 3. Banks and Their Regulators: The Post-Crisis regulatory framework 3. 1 Basel i 3.2 The 1996 Market Risk Amendment 3.3 Basel ll and Minimum Capital Requirements for Credit Risk 3. 4 Basel 2.5: Enhancements to the basel lI framew ork 3. 5 Contingent Convertible Bonds 4. Corporate Governance and risk management 5. A User-Friendly guide to the Theory of risk and return 6. Interest Rate Risk and Hedging with Derivative Instruments 7. Measuring Market Risk: Value-at-Risk, Expected Shortfall, and Similar Metrics 8. Asset/Liability Management 9. Credit Scoring and retail credit risk management 10. Commercial Credit Risk and the Rating of Individual Credits 10. 1 Definitions of Key Financial Ratios Quantitative Approaches to Credit Portfolio risk and Credit modeling 11. 1 The basic idea of the reduced form model 12. The Credit Transfer Markets-and Their Implications 12. 1 Why the Rating of CDOs by rating Agencies Was misleading 13. Counterparty Credit risk: CVA, DVA, and FVa 14. Operational risk 15 Model risk 16. Stress Testing and Scenario Analysis 16. 1 The 2013 Dodd-Frank severely Adverse Scenarios 17. Risk Capital Attribution and Risk-Adjusted Performance Measurement Epilogue: Trends in risk management Index FOREWORD The 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 ofregulatory change that will come into full force over the next few years Banks are reforming their risk management processes, but the challenge goes much deeper. Banks must rethink their business models and even question the reason for their existence. Do they exist to take proprietary risks(on or off their balance sheet or to provide a focused set of services and skills to their cus tomers 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 mmi 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 funding strategiese 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 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. g, by defining long-term risk appetites explicitly and connecting 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 ofrisks-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 8 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 grow th 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 unprecedented 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 In this sense, the book supports the business philosophy we are developing at Natixis. We believe that long-term success comes to institutions 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 FORE WORD I think that the concept of the Crouhy, Galai, and Mark book, The essentials of risk Management, Second edition, is brilliant. In my career as an academic and in investment management, I found that there is too large a separation between the technocrats w ho build risk-management models and systems and those who should be using them. In addition, the model builders seem to me to be too far from economics, understanding what risk management can and cannot do and how to structure the risk management problem. Crouhy, Galai, and mark bridge that gap They bring the academic research together with applications and implementation. If risk-management model builders come to appreciate the economics underlying the models, they would be better prepared to build risk-management tools that have real value for banks and other entities. and, as the authors bring up time and again, board members of corporations must also become as familiar with the models and their underlying economics to ask the correct follow-up questions Risk management is often described as being an independent activity of the firm, different from generating returns. Most macro and micro models in economics start from a framework of certainty and add an error term a risk term to represent uncertainty. When describing predicted actions that arise from these models, the error or uncertainty term disappears because the modelers assume that it's best to take expectations as their best guess as to future outcomes In both cases, however, this is incorrect. Risk management is part of an optimization program, the tradeoffs between risk and return. As described in the book, the three tools of risk management are(a) reserves,(b)diversification, and (c)insurance. With greater reserves against adverse outcomes, the risk of the firm or the bank is reduced. Greater reserves, however, imply lower returns. And, the dynamics of the reserve need to be known. For example, if a bank needs capital or liquidity reserves to shield it against shock, is the reserve static or can it be used and how is it to be used at time of shock? If it is a reserve that must always be at a static level, it is not a reserve at all. These are important optimization and planning questions under uncertainty. With more diversification, the bank reduces idiosyncratic risks and retains systematic risks which it might also transfer to the market Diversification has benefits. But, if a bank earns profits because its clients want particular services such as mortgages, it might want to concentrate and make money by taking on additional idiosyncratic risk, for it is not possible to diversify away all risks and sti ll earn abnormal profits the bank must respond to its clients demands and as a result, take on idiosyncratic risks the same is true of insurance Unlike car insurance, wherein, say, the value of the car is knowable over the year and the amount of the insurance is easy to ascertain as the book describes. the bank 10

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