Market Risk may be defined as the possibility of loss to a bank caused by changes in the market variables. The Bank for International Settlements (BIS) defines market risk as " the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices". Thus, Market Risk is the risk to the bank's earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. Besides, it is equally concerned about the bank's ability to meet its obligations as and when they fall due. In other words, it should be ensured that the bank is not exposed to Liquidity Risk. This Guidance Note would, thus, focus on the management of Liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity price risk and equity price risk. An effective market risk management framework in a bank comprises risk identification, setting up of limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk reporting, etc.
The Importance of Safeguarding against Market Risk
The Indian financial markets, in the last few years have seen wide ranging changes due to the deregulation of interest rate and foreign exchange markets. Intense competition for business coupled with increasing volatility in the domestic interest rates as well as foreign exchange rates have brought pressure on banks to maintain a balance among spreads, profitability and long-term viability. Banks have to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Further, the Core Principles for Effective Banking Supervision (Principles 11, 12 and 13) of the Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS) mandate that Supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling credit, market, operational, country and transfer risks. It is thus essential that the banks adopt a more structured and comprehensive approach to Market Risk Management.
2 Market Risk Management provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the bank's business strategy.
Market Risk Management of a bank thus involves management of interest rate risk, foreign exchange risk, commodity price risk and equity price risk. Besides, it is equally concerned about the bank's ability to meet its obligations as and when they fall due. In other words, it should be ensured that the bank is not exposed to Liquidity Risk. This Guidance Note would, thus, focus on the management of Liquidity Risk and Market Risk, further categorized into
interest rate risk,
foreign exchange risk,
commodity price risk and
equity price risk.
Risk Identification
All Risk Taking Units must operate within an approved Market Risk Product Programme; this should define procedures, limits and controls for all aspects of the product.
New products may operate under a Product Transaction Memorandum on a temporary basis while a full Market Risk Product Programme is being prepared. At the minimum this should include procedures, limits and controls. The final product transaction program should include market risk measurement at an individual product and aggregate portfolio level
Limits and Triggers
All trading transactions will be booked on systems capable of accurately calculating relevant sensitivities on a daily basis; usage of Sensitivity and Value at Risk limits for trading portfolios and limits for accrual portfolios (as prescribed for ALM) must be measured daily. Where market risk is not measured daily, Risk Taking Units must have procedures that monitor activity to ensure that they remain within approved limits at all times.
Mandatory market risk limits are required for Factor Sensitivities and Value at Risk for mark to market trading and appropriate limits for accrual positions including Available-for-Sale portfolios. Requests for limits should be submitted annually for approval by the Risk Policy Committee. The approval will take into consideration the Risk Taking Unit's capacity and capability to perform within those limits evidenced by the experience of the Traders, controls and risk management, audit ratings and trading revenues.
Approved Management Action Triggers or Stop-loss are required for all mark to market risk taking activities.
Risk Taking Units are expected to apply additional, appropriate market risk limits, including limits for basis risk, to the products involved; these should be detailed in the Market Risk Product Programme.
Risk Monitoring
A rate reasonability process is required to ensure that all transactions are executed and revalued at prevailing market rates; rates used at inception or for periodic marking to market for risk management or accounting purposes must be independently verified.
Financial Models used for revaluations for income recognition purposes or to measure or monitor Price Risk must be independently tested and certified.
Stress tests must be performed preferably quarterly for both trading and accrual portfolios. This may be done when the underlying assumptions of the model/ market conditions significantly change as decided by the Asset Liability Committee.
Models of analysis
Line Management must ensure that the software used in Financial Models that value positions or measure market risk is performing appropriate calculations accurately.
The Risk Policy Committee is responsible for administering the model control and certification policy, providing technical advice through qualified and competent personnel. It is left to the bank to seek any independent certification.
Financial Models must be fully documented and minimum standards of documentation must be established.
Someone other than the person who wrote the software code must perform certification of models; testers must be competent in designing and conducting tests; records of testing must be kept, including details of the type of tests and their results. Assumptions contained in the Financial Models must be documented as part of the initial certification and reviewed annually. Unusual parameter sourcing conventions require annual approval by the Risk Policy Committee.
Any mathematical model that uses theory, formulae or numerical techniques involving more than simple arithmetic operations must be validated to ensure that the algorithm employed is appropriate and accurate.
Persons who are acceptable to the Risk Policy Committee and independent of the area creating the model must validate models in writing. It is left to the bank to decide on who should validate, whether internal or external, at the discretion of the Risk Policy Committee.
Models to calculate risk measures like Sensitivities to market factors either at transaction or portfolio level and Value-at-Risk should be validated independently.
Unauthorised or unintended changes should not be made to the models. These standards should also apply to models that are run on spreadsheets until development of fully automated processors for generating valuations and risk measurements.
The models should also be subject to model assumption review on a periodic basis. The purpose of this review is to ensure applicability of the model over time and that the model is valid for its original intended use. The review consists of evaluating the components of the financial model and the underlying assumptions, if any.
Risk Reporting:
Risk report should enhance risk communication across different levels of the bank, from the trading desk to the CEO. In order of importance, senior management reports should:
