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Market Risk: Solving for Basel II and IFRS7 with SIAG

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coins madridMarket (Price) Risk - Abstracting the Liquidity Component

Market Risk is different. Liquidity Risk is different even further. Conceptually they are in bed together, although Liquidity risk has risen up the food chain recently as the impregnability of the banking book has been seen to be a chimera as the tide of the crisis went out. One thing is for certain these are the two biggest headaches from Bishopsgate to the Barbican. The Liquidity risk story is well documented here so this blog has a focus on the Market Risk (Price) problem and how to solve it for its two currently key variables – Basel II and IFRS7.

Market Risk has a specific locus in the trading book and can be broken out into a set of sub-risks which clearly constitute the concept (of Market Risk) - Interest Rate risk, Liquidity Risk, Model Risk and Market Risk Proper; where Market Risk means a risk to prices or capital values. Here we are focussed on Market risk proper and where it coincides in the supervisory and transparency requirements of Basel II and IFRS7; the incremental risk charge and reporting Value at Risk (VaR). Looking at this another way, there are two broad types of Market Risk - directional risk and relative value risk. They can be differentiated into two related risks - price risk and liquidity risk. Our focus here is on the Price Risk aspect.

Market Price Risk - The Specifics

A trader intentionally takes relative value risk when he expects the relative value of two market factors to change in a particular direction (i.e. the relative difference in value will become either smaller or larger). Price risk is the risk of decrease in the market value of a portfolio as a consequence of trading decisions. Liquidity risk refers to the risk of being unable to transact a desired volume of contracts at the current market price, this would happen if the size of transaction is materially large. Market Price Risk and Liquidity Risk then are essentially different but within the Trading Book the latter is an aspect of the former. That is Liquidity challenges actually impact market price when transactions are materially or relatively large in the market for that security.

On an holistic perspective of course Liquidity Risk threatens both the trading and the banking book. In effect, Liquidity Risk today (2010) is a balance sheet issue whereas Market (Price) Risk brings the rubber to the road in the Profit and Loss Account (P&L) - of course any P&L number passes through. Today Liquidity risk has come to mean something very different to what it commonly denoted pre-credit crunch, it is an holistic concept now, it does not exist simply as an aspect of the Trading book anymore. No matter what you do, the buck stops with the CFO (as it always does, right?).

In the Trading Book, banks bring their valuations in line with the market, which means that they consider liquidating their positions or hedging out their derivative risks in a normal timeframe and in a normal market environment, without moving the markets. Therefore Fair Value is assessed under the assumption of “normality” prevailing. The normal distribution is suitable as a model of that assumption and the VaR technique is thus appropriate to assess fair value of exposure to risk at given confidence intervals (levels) over a selected holding period. Thus VaR is essentially denotative of a three-dimensional array, constructed of;-

  • Distribution Type
  • Confidence Interval (levels)
  • Holding Period

The question, the challenge for the CFO and her team today is to optimise that three-dimensional array, solve it for Basel II and IFRS7; not just once, continuously, quarterly for reporting outside the door, monthly for internal reporting and daily for control.

It has been solidly demonstrated mathematically and now validated by common experience that the assumption of normality is basically naive in regard to returns on securities but let us just retain it here for the moment so that we have some kind of simple heuristic as a torch in this tunnel.

The Challenge for the CFO

The challenge for the CFO and her team is not a simple task, it cannot be done with pencil and paper anymore, it’s simply not achievable that way; you cannot hire enough people, nor now do I believe that the VaR challenge can be met with a sophisticated Model Development Environment (MDE) – the idea of a bunch of pointy heads in sandals, cranking and re-cranking some highly sophisticated hand built and utterly inexplicable regression analytic in the office of the CFO has disappeared out of the window this year! Why? You can’t hire enough people, you just can’t hire enough of the right people, our Universities are not producing enough of them yet, not only in the UK but all over Europe our school system can’t teach mathematics. Would the CFO want to anyway? I doubt it. The challenge is complex enough and it is an immediate and operational process which the CFO has to build, he/she cannot even envisage a process which encompasses revisiting applied mathematical theory, every time a number is produced.

The concept of appliance in IT is now current and in essence that is what the CFO needs, a set of engines, powering the GL, optimized under the control of the CFO, CRO and their teams, that is the Siag toolset, in my view.

integrated finance and riskTransparency - Basel II and IFRS7

More than twelve months ago I caused some consternation when I drilled into the devilish detail of the incremental risk charge flowing out of the Basel Committee’s revisions to capital requirements in the trading book (link here) then again last autumn I pointed out that this intensifying of capital requirements in the trading book would increase capital requirements by two or three times (link here) but despite all of this we can see investment banks sufficiently capitalised moving into (not “out of”) equities trading and commodities trading.  They are playing their capital strength card but that means as the opportunity cost of that capital rises up the yield curve, the recurring question is one of optimisation of that capital through the prism of the 3dimensional array of VaR. Capital requirements are a tax on operations just as surely as the etymology of that word in the role of the “tacksman” literally taking his pound of flesh.

Waxing lyrical about accounting standards is surely a contradiction in terms. Asymptotix has tried to be helpful (link here) but I have argued that IFRS7 integrates regulatory and supervisory standards with accounting standards thus defining “transparency” and that your IT solution architecture for risk management has to recognise that (link here) otherwise you are ab initio designing in redundancy and inefficiency (and more to the point confusion).

The CFO needs his dashboards to be saying the same thing, measuring the same source data; that is a no brainer, surely! My recent perspective change is that cannot be achieved with all the vagaries of MDEs – no way! I have seen the future in operation and its in Madrid at Santander. Particularly in the UK we know they got it right, guided by a supervisor and regulator with a long memory of hyper inflation and an absolute determination that will never happen again (link here). VaR just is the standard for Fair Value of trading book portfolios, it is de facto and de jure too, however much the standards bodies tie themselves in knots right now, they cannot go further down the track of more and more sophisticated and mathematically purist methods; Why? Forgive the refrain, you cannot hire the people, they don’t exist & those that do are wholeheartedly discredited. The CFO needs an engine, a set of motors, an appliance, behind the GL which allows him to optimise that three dimensional array across the sub-asset classes, capable of aggregation throughout their global portfolios. The only engine in production in a tier one bank in the world with this on demand intraday performance is Siag.

Siag Risk Management

The business problem resolved by Siag technology is the elimination of overnight batch processing in order to obtain yesterday’s view of risk based upon yesterday’s market volatility. This is not a situation which has arisen resultant from client preference. It is a situation which has been imposed by the performance limitations of core legacy systems. The Siag Market Risk system combines two technologies to create an ultra fast on demand Market Risk system for Tier 1 portfolio clients.

Siag Price Manager which has the capability to take intraday on demand “snapshots” of market volatility at Tier 1 portfolio data volume level for all assets under management. It provides the following business benefits:

  • Siag PM Acquires on user demand actual market pricing for all assets in all client portfolios from any number of pricing data sources.
  • Normalises all pricing received from numerous data sources to establish one single optimised “golden price” per asset.
  • Passes all pricing received and normalised through user definable business rules which, if compliant, the system automatically validates.
  • Calculates Greeks and a range of risk metrics: curves, surfaces, matrices, TSIR’s etc.
  • Retains all non business rule compliant pricing in separate storage preventing distribution of non compliant pricing until user certified manually.
  • Retains a 10 year audit trail history with user ident of all manual price interventions and certifications.
  • Can recreate on demand any historical pricing scenario for which pricing exists within its database.
  • Can be used as a hub for the distribution of other types of risk data from other systems.

Price Manager therefore is the ideal complement to Siag Market Risk Engines ensuring that only one golden price per asset which is validated or certified and has been passed through client business rules filters ever enters Siag’s Risk Engines. Siag’s Market Risk Engines are capable of Tier 1 on demand intraday market risk modelling and reporting, for which they require accurate and validated intraday market pricing data supplied by Price Manager.

The Siag Market Risk Engines have the ability to calculate and model all types of VaR, VaE, ESF and P&L vectors at Tier 1 portfolio level on demand and intraday. This moves risk management in Tier 1 portfolio into an active and dynamic intraday process based on real intraday market volatilities. Today’s view of market volatility and today’s view of portfolio level risk exposure.

banca de Espana iconSiag’s calculation engines have the capability to fully model a range of VaR’s, what if scenarios, stress tested and back tested at portfolio level to full portfolio revaluation with each on demand processing run intraday. Risk in multi entity organisations is consolidated and aggregated even in the largest institutions from position > portfolio > sector > branch > country > region > group holding. This provides CRO’s and CFO’s with dynamic intraday aggregated risk visibility which may permit intraday responses to rising or limit exceeding risk exposure in the institution as risk is fully visible from position to aggregated group level in any or the entire global portfolio. Currently no technology company is able to deliver this level of aggregated dynamic risk visibility at Tier 1 portfolio data volume level on demand and intraday and client’s are typically limited to yesterdays risk report on yesterday’s market data produced in very long and expensive overnight batch processing. This is a fully scalable system, permitting the easy inclusion of new pricer files, new asset classes and permitting portfolio and data volume growth through its innovative architecture.

Siag is the only Tier 1 portfolio level on demand intraday market risk system, proven and available as a standard risk management application (even though it requires configuration to client environment), which from market price volatility through to consolidated and aggregated risk modelling and measurement can deliver fully analysed and calculated risk visibility to Tier 1 clients on demand intraday.

Siag Price Manager is a relatively straightforward installation (6-8 weeks start to finish typically), whereas Siag Market Risk engines require functional analysis in terms of analysis of all portfolios and their composition, parameterisation of instruments, detailed analysis of legal and reporting structures within the group and the regions and countries where branches and portfolios may reside, definition of the consolidation and aggregation model, definition of risk factors and groups, definition of stress scenarios and many other risk management considerations that are required to install, configure, parameterise and calibrate Siag risk engines correctly for production use. A Siag installation can be managed with agility in a pragmatic manner but the key is that the supervisory documentation comes with the installation, simply expressed and already proved to European supervisory standards.

If we consider a full range of VaR calculations, what if scenario modelling, stress testing and back testing to full portfolio revaluation at Tier 1 portfolio level; this is currently a 10 - 15 hour overnight batch process to produce a once daily VaR report at portfolio level with 100% of legacy systems.

Siag would expect to reduce this 10 - 15 hours to around 40 minutes typically (subject to portfolio size and complexity) which is most definitely intraday and on demand; but it is not "real time" for which millisecond response times would be expected by a client. With the hundreds of millions of calculations necessary, no core legacy or risk system is currently able to offer "real time" Tier 1 risk calculation at aggregated and consolidated global portfolio level. To reduce 10 - 15 hours (900 minutes) to around 40 minutes (a time reduction of 95%) which Siag have achieved is a very significant technological breakthrough.

Siag technology is multi-platform and is compatible with all leading technologies. Siag can deliver on Sybase, Oracle or indeed on any other platform including the Microsoft platform.

For more information on Siag and how to contact Asymptotix:

http://www.asymptotix.eu/content/siag-risk-management

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