Market Risk

Black Diamond Risk Enterprises (BDRE) provides specialized market risk consulting services where market risk is defined as the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio.  BDRE services include helping organizations decompose equity and interest rates risk into their general market risk component (the risk that the market as a whole will fall in value) and specific market risk components.  The specific risk component is unique to the particular financial transaction e.g., it reflects the credit risk embedded in the instrument.

Market risk is given many different names in different contexts.  BDRE provides consulting services for the four major types of market risk:

  • Interest Rate Risk in its simplest form is the risk that the value of a security will fall as a result of an increase in market interest rates.
  • Equity Price Risk is the risk associated with volatility in stock prices.
  • Foreign Exchange Risk arises from open or imperfectly hedged positions in a particular currency.
  • Commodity Price Risk differs considerable from interest-rate and foreign exchange risk, since most commodities are traded in markets in which the concentration of supply in the hands of a few suppliers can magnify price volatility.

Publications

Black Diamond Market Risk Services Include:

Asset/Liability Management (ALM)

We help financial institutions achieve  three key goals of ALM.These are to:

• Stabilize net interest income (NII), that is, the difference between the amount the bank pays out in interest for funding and the amount it receives from holding assets such as loans (as measured by accounting earnings).

• Maximize shareholder value or net worth (NW), as reflected by long-term economic earnings.

• Make sure the bank doesn’t assume too much risk from the mismatching of maturities and amounts between assets and liabilities and from funding liquidity risk (*see box immediately below) .Funding liquidity risk is the danger that the bank won’t be able to raise funds quickly and cheaply enough to fulfill its obligations and remain solvent).

     *  BASEL III’S LIQUIDITY RISK MECHANISMS

Basel III introduced an entirely new framework for managing bank liquidity risk by means of two key mechanisms: 

·      The Liquidity Coverage ratio (LCR) requires that banks maintain high-quality liquid assets sufficient to withstand a 30-day stressed funding scenario specified by supervisors. The stress scenario will include a number of shocks such as the run-off of a proportion of retail deposits, the partial loss of unsecured, short-term financing; rating downgrade; and so on.

·      The Net Stable Funding ratio (NSFR) is a longer-term (one year) structural ratio designed to address liquidity mismatches and reduce reliance on wholesale funding.

We provide policies,methodologies and infrastructure tools to facilitate Liquidity Risk Management and Monitoring .Key Activities and Considerations include:

Cashflow and contractual maturity mismatch analysis – Analyzing  how cashflows develop across various time periods to examine their liquidity requirements. The analysis is  extended to include a series of stressed scenarios.

Funding concentration and diversification – Examining  where the funding comes from (e.g., on-demand deposits), the “stickiness” of these funds, and  the diversity of that funding across various dimensions (e.g., number of names but, more importantly, product type,  counterparty type, nature of funding market)

Monitoring liquidity ratios – Constructing key funding liquidity ratios such as wholesale funding to total liabilities, particular types of short-term borrowings, and so on

Monitoring asset concentrations –  Analyzing  for too much investment in particularly illiquid (e.g., complex, structured) and unsaleable assets at the enterprise level , and act to limit concentrations even when this threatens business models (e.g., of bank divisions or the bank as a whole)

Monitoring contingent liabilities – Analyzing  contingent liabilities such lines of credit that  represent a threat to liquidity (i.e., if they cannot be canceled)

Liquidity reserves or cushions – Drawing  up a list of unencumbered assets that, crucially, would remain saleable in a series of stressed scenarios, together with the relevant haircuts to the value of each asset

Currency considerations – Examining foreign currency exchange risk that can contribute to liquidity risk in stressed conditions

Early warning mechanisms – Constructing early warning mechanisms  for potential liquidity difficulties in funding markets, and in markets where they might need to sell assets to raise cash during a crisis

Basel III

International Regulatory Framework For Banks

Highlights:

“Basel III” is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:

•   Improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source

•   Improve risk management and governance

•    Strengthen banks’ transparency and disclosures.

The reforms target:

•   Bank-level, or micro-prudential regulation, which will help raise the resilience of individual banking institutions to periods of stress.

•   Macro-prudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.

These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks

Basel III phase-in arrangements:

 

 

Basel III overview table:

 

 

Regulatory Capital—Basel III the Standardized and Advanced Approach

“Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, and Transition Provisions” (Basel III), agencies are proposing to revise their risk-based and leverage capital requirements consistent with agreements reached by the Basel Committee on Banking Supervision (Basel III). Basel III applies to all national banks and federal savings associations, collectively, banks. The Basel III proposes a new common equity tier 1 minimum capital requirement, a higher minimum tier 1 capital requirement, and, for banks subject to the advanced approaches capital rules, a supplementary leverage ratio that incorporates off-balance-sheet exposures. Additionally, consistent with Basel III, the agencies propose to apply limits on a bank’s capital distributions and certain discretionary bonus payments if the bank does not hold a specified “buffer” of common equity tier 1 capital in addition to the minimum risk-based capital requirements. The revisions set forth are consistent with section 171 of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank), which requires the agencies to establish minimum risk-based and leverage capital requirements.

“Regulatory Capital Rules: Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements” (Standardized Approach), agencies propose to revise and harmonize rules for calculating risk-weighted assets to enhance risk sensitivity and address weaknesses identified over recent years. Revisions include incorporating aspects of the Basel II standardized framework and alternatives to credit ratings, consistent with section 939A of Dodd–Frank.  The revisions also include methods for determining risk-weighted assets for residential mortgages, securitization exposures, and counterparty credit risk. The Standardized Approach introduces disclosure requirements that would apply to U.S. bank holding companies with $50 billion or more in total assets.

“Regulatory Capital Rules: Advanced Approaches Risk-Based Capital Rule; Market Risk Capital Rule” (Advanced Approaches and Market Risk), proposes to revise the advanced approaches risk-based capital rules consistent with Basel III and other changes to the Basel Committee’s capital standards. The agencies also propose revising the advanced approaches risk-based capital rules to be consistent with section 939A and section 171 of Dodd–Frank. Additionally in this NPR, the OCC, the FDIC, and the Board propose to expand the scope of the market risk rule to apply it to federal and state savings associations and savings and loan holding companies with significant trading activity. Generally, the advanced approaches rules would continue to apply to national banks and FSAs with $250 billion or more in consolidated assets or $10 billion or more in foreign exposure.

The Basel III and Standardized Approach include addenda that provide a summary of the proposed rules that are more relevant for community banks. The agencies intend for these addendums to act as a guide for community bankers, helping them to navigate the proposed rules and identify the changes most relevant for their institution. The addenda do not, however, by themselves provide a complete understanding of the proposed rules and the agencies expect and encourage all banks to review the proposed rules in their entirety.

 

Basel III Standardized Approach

Basel III Advanced Approach

Commodity Price Risk

Black Diamond Risk Enterprises (BDRE) provides specialized Market Risk consulting services where Market Risk is defined as the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio.  Commodity Price Risk differs considerably from interest-rate and foreign exchange risk, since most commodities are traded in markets in which the concentration of supply in the hands of a few suppliers can magnify price volatility.

 

Commodity Price Risk is a part of the following services:

Emerging Risks

Black Diamond Risk Enterprises (BDRE) works with firms to define and manage emerging risk related to:

A.    Major losses from unmanaged supply chains

B.    Model Risk in illiquid and extreme markets

C.    Global Infrastructure contagion effects

D.    Climate Change / Severe Weather

E.    Reputation risks caused by outsourcing operations to poorly regulated markets

F.    Ideological conflicts giving rise to security exposures

G.    Inefficient markets and regulatory models

H.    Volatility in the supply of natural resources

I.    Abandonment of traditional insurance structures, players and capacity

J.    Increasingly severe catastrophe losses due to increased coastal housing, commercial density & shifting demographics.

K.   Cyber Risk

 

Emerging Risks is a part of the following services:

Equity Price Risk

Black Diamond Risk Enterprises (BDRE) provides specialized Market Risk consulting services where Market Risk is defined as the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio.  Equity Price Risk is the risk associated with volatility in stock prices.

 

Equity Price is a part of the following services:

Foreign Exchange Risk

Black Diamond Risk Enterprises (BDRE) provides specialized Market Risk consulting services where Market Risk is defined as the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio.  Foreign Exchange Risk arises from open or imperfectly hedged positions in a particular currency.

 

Foreign Exchange is a part of the following services:

Interest Rate Risk

Black Diamond Risk Enterprises (BDRE) provides specialized Market Risk consulting services where Market Risk is defined as the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio.  Interest Rate Risk, in its simplest form, is the risk that the value of a security will fall as a result of an increase in market interest rates.

 

Interest Rate Risk is a part of the following services:

Rating Agency Review Preparation

Black Diamond Risk Enterprises (BDRE)  works with organizations to prepare for rating agency reviews and to leverage the opportunity to sustain or enhance their credit rating.  For example, rating agencies recognize that superior risk management organizations  allocate capital to business units on a risk-adjusted basis and hold managers accountable for risk-adjusted profitability.  Empowered with this information, pro-active organizations will make necessary adjustments to position themselves to optimize their credit assessment.

S&P’s ERM Quality Classifications – Scoring Definitions for Non-financial firms:

A.  Weak

  • Missing complete controls for one or more major risks
  • Firm has limited capabilities to consistently identify, measure and comprehensively manage risk exposures
  • Execution of its RM program is sporadic
  • Losses may be widespread
  • Risk and RM may sometimes  be considered in the firm’s corporate judgment

B.  Adequate

  • Manage risk in separate silos but maintain complete control processes
  • Firm has capabilities to identify, measure, and manage most major risk exposures and losses
  • Unexpected losses are somewhat likely to occur
  • Risk and RM are often important considerations in the firms corporate judgment

C.  Strong

  • Demonstrate an enterprise-wide view of risks but are still focused on loss control
  • Have control processes for major risks
  • Firm can consistently identify, measure and manage risk exposures and losses in predetermined tolerance guidelines
  • Unlikely to experience unexpected losses outside of its tolerance level
  • Risk and RM are usually important considerations in the firm’s corporate judgment

D.  Excellent

  • All of the characteristics of the strong category, plus demonstrate risk/reward optimization
  • Firm has very well developed capabilities
  • Risk and RM are always important considerations in the firm’s corporate judgment
  • Highly unlikely that the firm will experience losses outside of its risk tolerance

Rating Agency Review is a part of the following services:

Stress Testing and Scenario Analysis

Black Diamond Risk Enterprises (BDRE) works with firms to help upgrade their approach to Stress testing.  Stress Testing and Scenario Analysis are used to determine the size of potential losses related to specific extreme events that lie outside of normal market conditions.

Challenge: Managing Risk in Stress Markets

Solution: Construct Relevant Stress Scenarios

Example: Historical Stress Test (2007/2009 Financial Crises)

stress_trsr

Supervisory Stress Testing of Bank Holding Companies

Dodd-Frank Act Stress Test :Supervisory Stress Test Methodology

The Federal Reserve expects large, complex bank holding companies (BHCs) to hold sufficient capital to continue lending to support real economic activity, even under adverse economic conditions. Stress testing is one tool that helps bank supervisors to measure whether a BHC has enough capital to support its operations throughout periods of stress. 

In the wake of the financial crisis, the Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which requires the Federal Reserve to conduct an annual stress test of large BHCs and all nonbank financial companies designated by the Financial Stability Oversight Council (FSOC) for Federal Reserve supervision to evaluate whether they have sufficient capital to absorb losses resulting from adverse economic conditions. The Dodd-Frank Act also requires BHCs and other financial companies supervised by the Federal Reserve to conduct their own stress tests. The Federal Reserve adopted rules implementing these requirements in October 2012. 

The Dodd-Frank Act requires the Federal Reserve to conduct an annual supervisory stress test of BHCs with $50 billion or more in total consolidated assets and nonbank financial companies designated by the FSOC for Federal Reserve supervision (collectively, “covered companies”). The Dodd-Frank Act also requires covered companies to conduct their own stress tests (company-run stress tests) semiannually. Together, the Dodd-Frank Act supervisory stress tests and the company-run stress tests are intended to provide BHC management and boards of directors, the public, and supervisors with forward-looking information to help identify downside risks and the potential effect of adverse conditions on capital adequacy of these large banking organizations. The Federal Reserve adopted rules implementing these requirements in October 2012.

Under the Dodd-Frank Act stress test rules, the Federal Reserve conducts annual supervisory stress tests to evaluate whether a covered company has the capital, on a total consolidated basis, necessary to absorb losses and continue its operations by maintaining ready access to funding, meeting its obligations to creditors and other counterparties, and continuing to serve as a credit intermediary under adverse economic and financial conditions. As part of this supervisory stress test for each covered company, the Federal Reserve projects revenue, expenses, losses, and resulting post-stress capital levels, regulatory capital ratios, and the tier 1 common ratio under three scenarios (baseline, adverse, and severely adverse). 

The Federal Reserve generally uses a common set of scenarios for all covered companies in the supervisory stress test. However, the Federal Reserve may use additional scenarios or components of scenarios for all or a subset of the covered companies to capture salient sources of risk, and these scenarios may use data from dates other than the end of the third quarter. In DFAST 2013, large, complex BHCs with significant trading activities are subject to a global market shock that reflects general market stress and heightened uncertainty, which affects trading positions and elevates counterparty credit risk.

The Dodd-Frank Act codified the Federal Reserve’s practice of disclosing a summary of the results of its supervisory stress test. 

Company-Run Stress Tests

As required by the Dodd-Frank Act, the Federal Reserve’s stress test rules require covered companies to conduct two company-run stress tests each year. In conducting the “annual” test, a covered company uses data as of September 30 and reports its stress test results to the Federal Reserve by January 5. In addition, a covered company must conduct a “midcycle” test and report the results to the Federal Reserve by July 5. The Dodd-Frank Act stress test rules align the timing of annual company-run stress tests with the annual supervisory stress tests of covered companies.

In their annual stress tests, covered companies subject to the Dodd-Frank Act stress test rules must use the scenarios provided by the Federal Reserve. Each year, the Federal Reserve will provide at least three scenarios—baseline, adverse, and severely adverse—that are identical to the scenarios the Federal Reserve uses in the annual supervisory stress tests of covered companies.

By providing a common set of scenarios to all firms, the results of company-run and supervisory stress tests  will be based on comparable underlying assumptions. To further enhance comparability, the supervisory stress tests and company-run stress tests conducted under the Dodd-Frank stress test rules use the same set of capital action assumptions. According to these assumptions, over the nine-quarter planning horizon, each BHC maintains its common stock dividend payments at the same level as the previous year; scheduled dividend, interest or principal payments on any other capital instrument eligible for inclusion in the numerator of a regulatory capital ratio are assumed to be paid; but repurchases of such capital instruments and issuance of stock is assumed to be zero.

Finally, each covered company must publicly disclose a summary of the results of its company-run stress test under the severely adverse scenario provided by the Federal Reserve.

Subject Matter Expertise / Testimony

Black Diamond Risk Enterprises (BDRE) provides expert testimony in a variety of risk related areas. BDRE professionals are experienced, credentialed, articulate industry veterans who are passionate about the business of risk.

Value at Risk (VaR)

Black Diamond Risk Enterprises (BDRE) provides Market Risk Value at Risk (VaR) services in many forms.  We define Market VaR as the worst case loss that might be expected from a portfolio of exposures over a given period of time at a specified level of probability.  As such, Market VaR offers a probability statement about the potential change in the value of a portfolio resulting from a change in market factors over a specified period of time.

Vendor Selection

Black Diamond Risk Enterprises (BDRE) understands the nuanced nature of broker/client and vendor/client relations.  BDRE provides an independent, objective evaluation of service provider selection, performance and contractual agreements.  We recognize that developing or improving a relationship with a service provider requires a clear understanding of your needs, expectations, objectives, operations and strategy.

An efficient, informed vendor selection process requires objective factual information unbiased by personal relationships.  It carries profound implications which may lead to changes in current compensation, services, expectations (Service Level Agreements & Stewardship Reports), management reporting and more.

 

Vendor Selection is a part of the following services: