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MARKET RISK MANAGEMENT IN BANKS

Conference Paper · September 2013

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13th International Conference
Research and Development in Mechanical Industry
RaDMI 2013
12-15 September 2013, Kopaonik, Serbia

MARKET RISK MANAGEMENT IN BANKS


Vladimir Mirković1, Boban Dašić2, Boris Siljković2
1
SBERBANK a.d. Beograd, SERBIA, e-mail: vladamirkovic@orion.rs
2
High Economic School of Professional Studies of Peć, Leposavić, SERBIA, e-mail:
bobandasickg@gmail.com and boris_siljkovic@yahoo.com

Summary: Although long-lasting tradition, competent public pay attention on risk management in banks in a
period of time when global economic crisis have already escalated. Risk management became integral function
in banking systems, whilst regulators intend to constitute discipline amonng financial institutions and discourage
potentially negative consequences for banks worldwide. Central part of this paper occupy the theme of market
risks, as well as methodologies of market risk quantifying (Value-at-Rik and stress testing), which nowadays
have the largest and almost irreplaceable role in banking systems.

Keywords: banks, market risk, risk management, stres testing, Value-at-Risk.

1. INTRODUCTION

In theory, banks are usually considered as financial institutions mostly focused on collection of
deposits and loan placements to its clients. From abovementioned functions of banks, it could be
exactly derived the presence of focus on those activites which are directly connected to achievement
of adequate return on investment. Although, final goal of each economic activity is impersonated in
profit-making function, it should not be ignored the other side of this fact: every profit-oriented
objective is closely related to certain level of risk. Legal entities are solely responsible for risk
quantifying by application of concrete methods and techniques and units, which are specialized in risk
control and monitoring, give guidelines to the top management for decision-making, with a purpose of
effective future business. Risk management process should contain developed methodologies and
procedures, which would take effect in efficient and comprehensive observation of potential risks and
possibilities of reaction before it would be too late from the point of view of bank and its business as
well as from the aspect of financial sector stability.
The whole history of universe could be chronologically observed through people exposure to various
kinds of risk. Instinctive desire of people for survival managed man through avoiding risky situations,
whilst people existence nowadays is result of successful implementation of risk management strategies
recognized by our ancestors. Origination of business risks is related to appearance of starting forms of
trade, with clear emphasizing that every technological revolution in past brought new forms of risk
and necessity of people for finding out of solutions in newly created circumstances. Trade was
conducted on barter arrangement basis until introduction of the money as a financial asset. Emergence
of money bring new forms of risk in relationship between traders, but universe made large and
unstopablle steps in all spheres in the direction of further development. Increased influence of risk is
not only the consequence of higher number of risky situations to who are people exposed rather its
severity and frequency and their significant rose. Furthermore, every unpredictable (unusual) event

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which is currently performed from the point of view of modern human, seems to be matchlessly harder
and serious than event performed in past.

2. THE CONCEPT OF RISK MANAGEMENT IN BANKS

The concept of risk management has its origin in corporate governance of insurance companies, with
notation that focus was on the possibility of occurrence of accident cases which reflects on assets and
revenues of the companies. People, that are responsible for risk management in organizations, are
called risk managers.
The term risk management is newly dated expression, but the practice of risk management is old same
as whole civilization. In the broader context, risk management is a process of personal and
organizational protection in the sense of assets and revenues. In narrow context, risk management
represents business function, which provide adequate manner of facing with risk immanent to business
operations. Among pioneer works in this area was published in 1956 in Harvard Business Review. In
the article of author Russell Gallagher, as a proposal was introduced the idea of individuals (risk
managers) responsible for risk management within certain organization. The point was on proclaiming
of basic principles for risk management sector operations, which provide efficient functioning in
variable market conditions to organization. (Gallagher, 1956)
Currently accepted definition of risk management has its origin from the beginning of 50’s in XX
century. Operational research started during the Second World War, when scientists were engaged in
resolution of logistic problems, methodologies development for resolution of coded messages and
other military operations. Those reasons refer to impression of risk management emergence
simultaneously in industry and as an academic discipline. The first economist who involved risk as the
element of portfolio theory and discussion regarding diversification was Harry Markowitz. Hary
Markowitz explained the connection between return and utility with the concept of risk. In that way,
he made the basis for later research in the field of finance, which resulted in creation of modern
portfolio theory in the first instance as well as in Fischer-Black theory of options later.
Risk management could be also observed as the function in bank formed for the purpose of risk
hedging and involved the set of activities, such as:
 defining of bank exposure with evaluation of potential losses;
 risk assessment based on measurement and analysis of losses in the past as well as assessment of
variables which will have the impact in future;
 decreasing and neutralizing of losses by using of different kinds of collaterals;
 risk financing through reserves providing;
 development of certain techniques and implementation of expertised opinions.
Primary goals of risk management are: avoiding of potential insolvency in banks and maximization of
RAROC (Risk Adjusted Rate of Return on Capital). If actual losses of bank would be underestimated,
it means that profitability of bank would be decreased due to the fact that losses would be significantly
annulling expected rate of return on capital.

3. ROLE AND POSITION OF MARKET RISK WITHIN RISK MANAGEMENT

According to Basel Accord, market risk represents“risk of loss in balance and off-balance sheet items
due to changes in market prices” (Basel Committee on Banking Supervision, 2005). Dominant factors
which may cause emergence of market risk are: equity prices, interest rates, foreign exchange rate and
commodity risk. Equity risk is related to risk of equity prices changes which have impact on balance
and off-balance sheet items of bank. Equity risk contains: general price risk – related to changes on
whole stock market; and specific price risk – related to changes of individual securities. Total
exposure is expressed as net open position, after which all positions (balance and off-balance items
that include securities) are subject of stress testing. If the bank has high level of exposure in several
securities, then scenario analysis is much more adequate bearing in mind high concentration of trading
securities portfolio.

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Commodity risk is related to potential losses based on market prices movements of bank’s balance and
off-balanced items, which influenced on commodity prices. Commodity prices indirectly influence on
bank’s credit portfolio, when the repayment capacity of the client is attacked by prices movement. Net
position in certain commodities is usually tested with historical scenarios application, due to
significant volatility of commodity prices in the past, so historical scenario make easier assessment of
price movement range in the future period.
Total market risk is the sum of abovementioned risk factors and also other, so-called residual risks
such as:
 spread risk – as a result of spread in two different financial instruments. For example, credit spread
risk government bonds and corporate bonds;
 basis risk – as a potential loss due to prices differences between equivalent instruments, such as:
futures, bonds and swaps;
 specific risk – related to issuer;
 volatility risk – potential risk due to fluctuation in financial instruments prices.
In order to define global prices risk of financial instruments, market risk and residual risk should be
treated aggregate.
Market risk could influence on company’s business on several ways. Direct impact of market risk is
impersonated in, for example, operational spread decline due to increase of raw material prices or
devaluation of currency in countries marked as a targeted markets for observed company. Changes in
market environment could enforce companies to adjust its prices of products and services,
simultaneously changing sales volumes or competitiveness, depending upon positioning and market
exposure of the main competitors (indirect impact of market risk on business operations of the
company). In that sense, most companies intend to manage market risk on financial result of the
company, especially it is case with non-financial institutions. With financial institutions, there exist
overlapping of business and market risk. Namely, their “raw materials” are: currencies, interest rates
etc. and financial institutions try to separately operate from market risk in order to achieve success
based on applicaton of business strategies and decisions, as well as based on return-risk trade-off that
lies in the ground of decisions.
Market risk management process should encompass regular scenario analysis and stress tests.
Financial institutuion could choose scenario based on either historical data or based on empirical
models of movements in market risk factors. The aim is assessment of significant changes effects in
market risk factors on financial conditions. Therefore, chosen scenario may involve unfavorable
scenarios of low profitability which could result in extraordinary losses. Scenario analysis and stress
testing could be qualitative and quantitive with the respect of effects of unpredictable movements on
the market as well as factors of non-market risk. Those factors of non-market risk are: prices,
volatility, market liquidity, historical correlations and assumptions in the condition of stress testing
conducting, vulnerability of institutions in “the worst case scenario”, default of large clients, as well as
assumptions on maximum amount of cash flow inflow and outflow in new circumstances.
Adequate scenario analysis and stress testing should provide the important help to the bank’s top
management in order to make better assessment of market movements on net profit and equity of the
bank. Executive Board of the bank regularly monitors and controls the results of prepared scenarios
and stress tests, as well as reviewing of assumptions which were used in the analysis. If the achieved
results show high level of probability of future losses, top management of the bank makes additional
measures for risk management or decides to introduce plans for the case of emergence of
extraordinary events (known as contingency plans).

4. METHODS OF MARKET RISK MEASUREMENT

Models or methodologies for market risk management could be divided into 2 categories:
1. Value-at-Risk (VaR) models and
2. stress testing or scenario analysis.

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4.1 Value-at-Risk (VaR)

Value-at-Risk (VaR) represents standard measure for market risk measurement, often used by
financial analysts worldwide. Value-at-Risk (VaR) is defined as the maximum potential change in the
value of financial instruments portfolio for the given probability during observed horizon. In other
words, VaR is the number which show how much financial institution could lose during observed time
horizon with the certain confidential level (probability level).
In the late 80’s of XX century, JP Morgan developed widely used VaR system well known as
RiskMetrics, which contained a few hundreds of risk factors, whilst matrix of covariance were updated
based on historical data quarterly. This system replaced massive system of nominal market limits with
simple VaR limits. During 1993 and 1995 were made amendments on Basel Accord from 1988, which
predict changes in the field of market risk in terms of bank’s obligation to accept standardized VaR
approach, consistence with measure of 10-day VaR at the level of confidence of 95% or to apply
internally developed VaR system. At the same time, with VaR approach development, there were
present hard tons which emphasized critical aspect of approach in several senses:
 different implementation of VaR approach means inconsistency in results;
 VaR concept, as risk measurement, is conceptually wrong;
 widespread of this method result in arising of systemic risk.
Some of this questions were initiated by Harry Markowitz in 1952 (Markowitz, 1952), who pinpointed
that if probabilities are subjective; there is no sense to talk about “updated VaR measure or about
correlation matrix projection”. From the subjective point of view, VaR measure or correlation matrix
is the only objective expressions of subjective perceptions of users. Results of applied VaR models are
multi applicable, especially in the field of risk management because they contribute to the assessment
of performances risk-taken as well as evaluations that are necessary for fulfillment of regulatory
requirements. The key point is providing of adequate and updated assessments. If risk is not properly
assessed, it could result in sub-optimal allocation of capital, which will directly have consequences on
profitability or financial stability of the bank. One of the shortcomings of VaR model is the fact that
VaR does not give complete picture of exposure to market risk, so it is recommended to be used
complementary with stress testing, which overcome mentioned shortcoming of VaR model.

4.2. Stress testing

In 2000 Basel Committee defined stress testing as “general concept which describes different
techniques used by financial institutions, in order to assess the level of stability on extraordinary and
extreme events”. (Bank for International Settlements, 2013) In this definition extraordinary and
extreme event represents the event which occur once or several times but with catastrophic
consequences. The example of such event is crash of stock exchange market in October 1987, so-
called “Black Monday”.
The simplest answer on the question “why financial institutions conduct stress testing?” could be
given in regulatory requirements defined by Basel Agreement from 1996. In the first instance it seems
that stress testing is only an obligation, but during time stress testing became the subject of detailed
analysis made by managers, after which were made conclusions regarding benefits of applied methods
of stress testing. Concretely, all management’s level recognized benefits from conducted stress testing
and results, simultaneously having insight into key risk indicators through technique that consider
unpredictable, extreme market events. The most important aspect is that stress testing provide
information which are not available to the management if it apply standard techniques of risk
measurement, like VaR technique, as well as stress testing should be observed complementary with
VaR method.
Results of conducted stress tests have double impact on risk management: first, as a source of
information and the second, as controlling mechanism used in risk management process. As a source
of information, stress tests have an extraordinary importance especially in crisis period, due to fact that
stress testing provide perception of risk taken, identifying of main factors which cause stress situations
and contribution of factors to stress event and detection of latent source of risk. Availability of those
information provide to management that made decisions in the proper time will decrease exposure to
total risk through hedging transactions or decline in self-trading position. On the other hand, stress

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testing results could be in function of risk controlling within existing limit structure as well as the part
of calculation of internal market risk for the need of capital allocation. Stress tests with their results
influence on future allocaton of resources and behavior upon occasion of risk-taken situations.
Dramatic events on the financial markets and crisis situations together have the important influence on
higher implementation of stress testing. Although stress testing continues to develop, it became
important tool in risk management which should be based on robust theoretical background. One of
the potentially the most successful basis of future developments in stress testing is directed toward
VaR method. Those idea starts from involvement of stress events into VaR calculation and represents
an alternative solution. Then, market price changes and movements of interest rates defined by stress
testing became parameter within VaR method, which determine “region” of interest rate changes
analyzed for the purpose of possible losses calculation. In that context, VaR is defined as a certain
percentage of distribution achieved as a result of conducted testing. Final result of integration between
VaR method and stress testing is extremely attractive from the point of view of consistency. In the
future it is very realistic to expect a lot of challenges in this area and many authors will pay attention
much more on this topic. Until the moment of implementation of more perfect solutions different from
current existing, stress testing will be in use and will develop as an irreplaceable tool in the field of
risk management.

5. MARKET RISK MANAGEMENT IN CRISIS PERIOD

Large indebtedness of citizens, that in extreme cases exceeded the value of money in circulation, is
characteristic of all financial crises that emerged as a consequence of financial bubbles. Crisis occur
when group of investors, realized that shares value do not have any growth capacity, started with
shares sale and trading volumes grew causing the fall in shares value.
Investors lose their money and assets, banks became illiquid and went to bankruptcy, industry
production went to stagnation, whilst employment continuously declined. Consequence of all crises
was recession. Sometimes crises encompass just those economies that were in trouble, but nowadays
through expansion of globalization process, recession in one country spillover on other countries.
Modern global financial crisis is directly related to USA, historically observed the country which
passed through the great crisis during 30’s of XX century. In XXI century, USA allow itself again to
went into the crisis of great extent due to combination of inadequate monetary policy and banking
system “greed” for higher profits. Modern global financial crisis put under the question mark
usefulness and validity of certain techniques of risk measuring, in the first line VaR. Some economist,
for example, Nassim Nicholas Taleb criticized the main postulates of VaR methodology, going further
in his critics where VaR method was blamed and subscribing the largest responsibility to VaR for
financial crisis escalation. (Taleb, 2010 translation of the second edition).
Although, just short overview of historical events is enough to help in assessment that all crises in the
past were not initiated due to reliance on risk measurement models and optimization models. On the
contrary, the reasons are following: over-indebtedness of legal entities and retail, greed for higher
profits, difficulties in business operations and fraud cases. VaR was introduced as a mandatory tool for
banks, but it does not mean that managers were delighted with such solution. The most often situation
could be described as intention of risk managers to send “warning signals” to the top management, but
top management did not respect those signals in adequate manner due to focus on profitability, not
focus on risk. Obviously, problem does not lie on the risk management side, rather in the field of
corporate management.
Problem, which originates in VaR concept, is related to impossibility of VaR usage as a tool for
complete embracement of leverage and liquidity risk. Therefore, careful risk managers look on VaR as
one of the possible techniques in the assessment process of risk taken. In his critics of VaR technique,
Taleb emphasized that risk managers rely on assumption of normal distribution and argued in favor of
Monte Carlo simulation application. He considers that Monte Carlo simulation provide for us in the
best manner the conclusions from future simulations which is superior than the past, which learnt us a
lot of usefull things, but people are willing to ignore and forgot lessons from the past.
Besides theoretical attitudes, logical consideration directs us on the fact that if market movements are
going oppositely of our expectations and desires, then neither VaR nor some other technique could not

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preserve the system from financial crisis. Crucial dilemma is: how much we should believe in VaR in
those extraordinary situations? Philippe Jorion, famous economist and one of the supporters of VaR
method, has qualified VaR as „wobbly compass in a dense forest. It can point you in the right
direction, but it never gives you a proper coordinates where exactly you need to go“. (Jorion, 1997)
That opinion regarding VaR is maybe the closer definition of VaR, which simbolically show us the
level of their usefulness. Consequently, VaR needs complement tools for risk measuring, in order to
make reliable conclusions. As a result of research, parametar VaR model does not give satisfactory
results because of large number of limit excessess, if we compare daily VaR prices with daily gains
and losses in portfolio. Taleb stressed significantly this argument, while Monte Carlo simulation,
although burdened with a lot of shortfalls, performed better results in a period of high volatility
(Mirković, 2013).
Financial crisis changed risk measurement models for optimization of daily capital requirements.
Different risk models were optimal in pre-crisis and post-crisis periods. Mixture of various models for
VaR assessment is the basic strategy which has been performed in crisis circumstances. Aggressive
strategy for risk management brings the lowest average capital requirements and has the highest
frequency of daily capital requirements during assessment period, but also too often limit breaches
(which can cause negative publicity and temporaty trading ban). On the other side, conservative
strategy is followed by less number of limit breaches and relatively higher daily average of capital
requirements. It is considered as optimal that strategy of risk management which allows using of
different combinations of alternative risk models for VaR assessment and minimizing of daily capital
requirements.

6. CONCLUSION

It is clearly that bouncing changes occur in all spheres of life, neither banking sector represent
exception from that rule. According to some assessments, global financial crisis started in 2007 is also
the largest crisis in history of civilization, with notation that such flamboyant conclusions should be
abandoned to judgment of time. Invulnerable fact is that global financial crisis opened many questions
in the field of finance and from those resolution depend the future of financial sector at whole.
Among numerous questions, one of the most frequent is related to determination of vulnerability
causes in financial system and possible prevention in future from similar events. There are efforts
made to quantify uncertainty and risk if it is feasible, in order to increase the level of financial system
resistency on unpredictable events in future. For that purpose, the very important role has the method
of market risk measurement, in the first line Value-at-Risk methodology and stress testing, while the
results of applied techniques are crucial from the point of view of bank’s management.
Assurely, credit risk is the most widespreaded category of bank’s risks, but it shoud not be ignored the
importance of market risk, especially bearing in mind a numerous methods of risk measurement that
are of extraordinary significance for economists and analysts. Also it is clear that methods of market
risk quantification have its shortcomings and deficiencies, which appear in normal circumstances as
well as in the condition of global economic disruption. However, those mehods represent irreplaceable
tool in process of encompassing of total risk at which are banks exposed and their results certainly
contribute to higher level of efficiency in banking and financial sector.

REFERENCES

[1] Bank for International Settlements: www.bis.org (retrieved: August 10, 2013)
[2] Basel Committee on Banking Supervision. (2005). Trading book survey: a summary of responses. Retrieved
August 10, 2013, from www.bis.org: www.bis.org/publ/bcbs112.htm
[3] Gallagher, R. B. (1956). Risk Management: A new Phase of Cost Control. Harvard Business Review.
[4] Jorion, P. (1997). Value-at-Risk:the new benchmark for controlling market risk. New York, USA: McGraw-
Hill.
[5] Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 77-91.
[6] Mirković, V. (2013).Soundness of market risk measurement techniques during global financial turmoil.
Ekonomika, br. 1, pp. 221–230.
[7] Taleb, N. N. (2010 translation of the second edition). Crni Labud - uticaj krajnje neverovatnih zbivanja.
Smederevo: Heliks.

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