RISK MODEL BUILDING BLOCKS

Risk-return is the centrepiece of risk management

processes. All bank systems provide common measures of
income such as accrual revenue, fees and interest income
for the banking portfolio and profit and loss (P&L) for the
market portfolio.

Measuring risk is a more difficult challenge. Risk models

provide a measure of risk. The models have a common
basic structure consisting of main building blocks and
modules.
 BLOCK I : STANDALONE RISK
Block I requires risk and transaction data to capture individual transaction risks.
Modules
1. Risk Drivers
Risk drivers are those parameters whose uncertainty alters values and
revenues.
For ALM, the risk drivers are the interest rates that drive the interest income. For
market risk, risk drivers are all market parameters that trigger changes in the value
of the transactions. They differ across the market compartments: fixed income,
foreign exchange or equity. The credit risk drivers are all parameters that influence
the credit standing of counterparties and loss for the bank if it deteriorates. They
include exposure, recoveries under default, default probability (DP) and its
changes( migration risk) when time passes. Risk factors alter risk drivers which
then directly influence risk events such as default or change in the value of the
transaction. In risk models, risk drivers directly relate to risk events while risk
factors serve for modeling risk drivers.
• For risk drivers such as interest rates, instability over time
is readily observable. Interest rate models can also be used
to derive multiple scenarios of interest rates that are
consistent with their observed behaviour. In case of credit
risk, ratings are obtained from rating agencies or from
internal rating systems. Rating models attempt to mimic
ratings from agencies through some observable
characteristics of firms such as financial data. Default
probability models such as KMV’s Credit Monitor or
Moody’s RiskCalc provide modeled estimates of default
probabilities.
2. Exposures and Valuation

• Exposure size is denoted by book value or notional amount

(for derivatives). Economic valuation is the fair value- risk
and revenue adjusted. It requires mapping exposures to
relevant risk drivers and deriving values from them.
Because it is risk adjusted, any change in the risk drivers
materializes in a value change, favourable or unfavourable.

• ALM uses both book values and economic values. ALM’s

first stage is to consolidate all banking portfolio exposures
by currency and type of interest rates, thereby capturing
the entire balance sheet view from the very beginning.
• For market risk, exposures are mark to market and change
continuously with market movements. Exposures for credit
risk are at book value for commercial banking. Since book
values do not change when default probabilities change,
economic values serve for full valuation of credit risk.
Exposure data include the expected size under a default
event [exposure at default (EAD)] plus the recoveries that
result in a loss given default (Lgd) lower than exposure.
3. Standalone Risk Valuation

• Standalone risk valuation looks at future events and

involves marking to future for events such as deviation of
interest rates for the banking portfolio, all market
parameters for market risk and all factors influencing the
credit standing of borrowers for credit risk. Marking to
future is the technical process for calculating potential
values at a future date and deriving losses from this
distribution (since future values are uncertain, they follow a
distribution at this horizon).

• Standalone risk does not take into account the

diversification effect.
BLOCK II : PORTFOLIO RISK
The goal of Block II is to capture the risk profile of the portfolio
rather than the risk of single transaction considered in isolation.
4. Correlations
Diversification requires new inputs characterising the portfolio risk,
mainly the sizes of individual exposures and correlations between
risk events of individual transactions.
The adverse deviations of interest income, a usual target variable for
ALM policies, result from interest rate variations. The correlation
between interest rates tends to reduce the diversification effect. All
interest revenues and costs tend to move simultaneously in the same
direction. Asset and liability exposures to interest rates are offset to
the extent that they relate to the same interest rate reference.
• The adverse deviations of the market value of trading
portfolio correlate because they depend on a common set
of market parameters, equity indexes, interest rates and
foreign exchange rates. While some of the risk drivers are
highly correlated, the others are not and sometimes they
vary in the opposite directions giving rise to diversification
effect. Moreover positions in opposite directions offset.
• Credit defaults and migrations tend to correlate because
they depend on the same general economic conditions
although with different sensitivities. Portfolio risk is very
sensitive to such correlation. The opposite of
diversification is concentration. If all the firms in the same
region tend to default together, there is a credit risk
concentration in the portfolio because of very high default
correlation. Granularity designates risk concentration due
to size effect. A single exposure of Rs. 1,000 might be
riskier than 10 exposures of Rs. 100 each, even if the
borrowers’ defaults correlate. A small number of losses is
much more frequent than a simultaneous failure of all of
them. There is also no diversification for the large
exposure whereas there is some across 10 small exposures.
• Obtaining correlations requires modeling. Correlation
between risk events of each individual transaction results
from the correlation between their risk and value drivers.
Correlations for market risk drivers and interest rates for
ALM are directly available. Correlations between credit
risk events such as defaults suffer from a scarcity of data.
This difficulty is overcome by inferring correlations
between credit risk events from the correlations of
observable risk factors that influence them.
5.Economic Capital
VaR is also the economic capital at a preset confidence
level.
After obtaining the correlations, the next step is to
characterise the downside risk of the portfolio. Since the
portfolio is subject to various levels of losses, its risk
profile can be characterised with the help of distribution of
losses, assigning probability to each level of portfolio loss.

From the loss distributions, the main risk characteristics

extracted are the expected loss, the loss volatility i.e. the
dispersion around the mean and the loss percentiles at
various confidence levels for measuring downside risk and
VaR.
BLOCK III : REVENUE & RISK ALLOCATION
Calculation of overall portfolio risk and required global
return are not sufficient to develop risk management
practices within business lines and for decision making
purposes.
Moving downwards to risk processes requires other tools.
They are top-down links sending signals to business lines
and the bottom up links consolidating and reporting. Two
basic devices serve for linking global targets and business
policy:
• The Funds Transfer Pricing (FTP) System

It allocates income to individual transactions, business

lines, product families or market segments. Transfer prices
are internal references used to price financial resources
across business units. Transfer pricing applies essentially
to the banking book. The interest income allocated to any
transaction is the difference between the customer rate and
internal reference rate or the transfer price applicable to
that transaction. Transfer prices also serve as a reference
for setting customer rates. They should represent the
economic cost of making the funds available.
• The Capital Allocation System
It allocates risk to any portfolio subset and down to
individual transactions. Portfolio risk models help
determine the overall portfolio risk taking into account the
diversification effects. But the problem is to divide it into
risk retained by each transaction, after diversification
effects. This is because pre-diversification risks of
individual transactions do not arithmetically add up to
diversified portfolio risk. For this purpose Capital
Allocation Model is required.
• The Capital Allocation Model assigns to any subset of a
portfolio, a fraction of the overall risk called the ‘risk
contribution’. Risk contributions are much smaller than
‘Standalone’ risk measures, or measures of the intrinsic
risk of transactions considered in isolation before
diversification effects because they measure only a
fraction of risk retained by transactions post-
diversification. The Capital Allocation System allocates
capital in proportion to the risk contribution.
• Example:

• The standalone risks of three transactions are 20,30 and 30

adding up to 80. However the portfolio model shows the
VaR at 40. The capital will be allocated in the ratio of
2:3:3 i.e. 10,15,15 to the three transactions.
•
• The FTP and Capital Allocation Systems provide the
necessary link between global portfolio management and
the business decisions. They complement each other in
obtaining risk adjusted performance and lead to the
ultimate stage of defining risk and return profiles, risk
based performance and pricing
BLOCK IV : RISK AND RETURN MANAGEMENT

Risk Adjusted Performance Measurement (RAPM)

designates the risk adjustment of individual transactions
that allows comparison of their profitability on the same
basis. It is an ex-post measure of performance. RAPM
simply combines the FTP and the Capital Allocation
Systems. For example:

Transa Capital Reve Risk adjusted

ction Allocati nue return on
on capital
(RaRoc)
A 5 0.5 0.5/5 = 10%
B 3 0.4 0.4/3= 13.33%
The less risky transaction B has a better risk adjusted
profitability than the riskier transaction A even though
B’s revenue is lower.
• Risk based Pricing (RBP) relates to ex-ante
decision making, when we need to define
the target price ensuring that the transaction
profitability is in line with both risk and the
overall target profitability of the bank.
• Risk Modeling and Risk Decisions
All model blocks lead ultimately to risk and return profiles for transactions, sub-portfolios of
business units, product families or market segments plus the overall bank portfolio.
The purpose of characterising this risk-return profile is to provide essential inputs for
decision making. The spectrum of decisions include:
New transactions
Hedging both individual transactions (micro-hedges) and sub-portfolios (macro-hedges)
Risk return enhancement of transactions through restructuring etc.
Portfolio management consisting of enhancing the portfolio risk-return profile.

• The spectrum includes both on-balance sheet and off-balance sheet decisions. On balance
sheet actions refer to any decisions altering the volume, pricing and risk of transactions
while off- balance sheet decisions refer more to hedging risk.