Part 1-Beta Headaches & Project Finance Risk

New model for project finance risk measurement

When a company chooses to fund a project, it can do it in three key ways.   It can raise equity capital by selling shares on the market, sometimes in a private way.  It can borrow either internally from cash reserves by reinvesting profits or it could borrow from a lending institution or even issue bonds in the market.

The idea is that the cost of equity or debt (most projects have a mixture of both) should be representative of the risk within the project. The higher the risk the project has; the more volatile the earnings are likely to be and that will follow through with a larger beta factor as a consequence. 

Advantages of Bayesian Credit Scoring Models

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At a top level credit risk analysts have to solve three problems across both their banking and trading books to fulfill many of their goals.

The first is being able to calculate the amount of notional exposure, leverage and potential loss that may occur from positions clients take with the bank. These calculations are carried out at a trade and portfolio level referencing netting and non-netting offsets.  This is referred to as the Exposure at Default (EAD).

The second problem credit analysts need to be able to quantify is recovery rates from these exposures and to take total losses divided by the Exposure at Default to create a Loss Given Default (LGD) value.  The LGD is also in some respect equivalent to (1 – (Recovery Value/Present Value of Future Cash Flows)).

Click to read more about Probability of Default, our third variable.

Wrong Way Risk the Global Credit Crisis and Basel III

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The Global Financial Crisis (GFC), The Credit Crisis, call it what you may, although I fair the latter title came first; has been debated across the world.  Governments, industry small and large, banks, actually I am not sure there are many people in society that have not at the very least been impacted by it.  However, what is not common consensus is the cause.

Was Wrong Way Risk a cause of the Credit Crisis?

A Real Option framework for Dispute Management

Can risk management practices and instruments be used to solve disputes?

Before I leap into this article, I need to set some boundaries because I am sure this topic is likely to solicit potential criticism without clear delineation on what we are talking about. Perhaps I should say what is not in scope to make that simple.

What a risk management or specifically a real option framework for dispute management cannot fix is an ideological dispute. However, it can potentially solve a dispute around scope creep and conflicts of interest.

Let's see.

Closeout Risk and Exchange Traded Options

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The measurement of counterparty risk for most investment banks is based around Over The Counter instruments, these are derivatives or structured contracts that are sold to the client directly. Banks also take positions through exchanges on behalf of their counterparties and they do this for several reasons:

• Speed of execution
• The ability to transact through one bank account rather than opening another account on the exchange
• Advisory before deal transaction
• The ability to ”hypothecate” or assign available collateral and cash in custody with the bank against exchanged traded positions

Stock exchanges, clearing houses and futures markets keep excess exposure to a minimum and they do this through the process of daily variation margining. However, banks trading on behalf of counterparties, also become responsible for taking care of these margin requirements. In effect, they also need to monitor market volatility to ensure that there isn’t a loss due to close out risk.

Testing Counterparty Risk Systems

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Ahh the world of the OBSI (Off Balance Sheet Instrument) can be a domain full of opacity and while the regulators have been looking to reduce conspicuousness of OTC (Over The Counter) trading practices, investment banks themselves often struggle to embed a pellucid system for measuring counterparty risk.

Like all things, if you want to improve something you are probably going to have to change the way it works or perhaps the way the business works with it.  Additionally investment banks are continually inventing new structured products to capture unique market opportunities or to differentiate themselves from other players in the market and regulators are putting a lot of emphasis on reporting position, depth and leverage for risk – well depth and leverage may not be done cleanly but that requirement will come in time.

Click to read more on how we go about testing counterparty risk systems.

Operational Risk - Process Mapping

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If an organization wants to engage in a risk exercise such as change management, Six Sigma, Basel II operational Risk, Solvency II, COSO, Sarbanes Oxley or ISO standards, gosh there are so many initiatives out there; the company is going to need to be mapped for risk.
  
Such a mapping program may seem straight forward enough but it can become extremely arduous quickly.

Several years ago I was involved in setting up a Basel II framework for a retail bank and before we could register any of the risks along with the associated controls, we needed to understand who actually owns these controls from an institutional perspective. You can nearly guarantee of course that without clearly defined accountability boundaries, finger pointing becomes a typical behavioral outcome on the days when service level agreements are missed in a business unit or worse, when a loss event actually occurs.

The problem with mapping for risk is that traditional flow charts are too granular and miss the main objective of capturing bottlenecks, role assignments and importantly, Product-To-Risk and Process-To-Risk relationships.

Click to read more on what mapping should facilitate.

What are the key elements for Basel II AMA?

Presentation Here

Basel II operational risk is without a doubt a difficult agenda for some banks especially, if those banks are looking to reach Advanced Measurement Approach or AMA accreditation from the regulator.
  

Some years ago I was asked by a group of risk managers to define and outline the key elements for a best practice Basel II AMA Operational Risk framework.  To be specific, what does it come down to, what does a bank need to have in place to ensure that it can internally measure its operational risk in line with the AMA standard.

11 Elements for Basel II

After being engaged on several Basel II projects across the planet, over what is really years now, I identified  eleven  foundational elements which need to interrelate with each other to form a measurement system that can estimate loss for the bank.
  

Eleven Elements for Basel II AMA

These elements are not to be confused with the core initiatives of an operational risk unit such as Loss Data, Key Risk Indicators or Control Self Assessment. They are simply specific components that need to be in place to generate an OpVaR number or the Holy Grail of an Operational Risk capital charge if you prefer.

Risk frameworks suitable for AMA are usually designed unconventionally from back to front. Now this may seem like a slightly abstract way of achieving an end but by starting at the finish line and working backwards, the focus will be on the opVaR result and the program should miss any huge piece of work.

I have been asked for the final presentation for this approach by many people, so I have chosen to share it again here: The top Eleven Elements 

What's Wrong With Risk Management in Financial Institutions?

A recent article about financial institutions what is wrong with risk stimulated me to think broadly about what is truly busted with these banks, what is the crux of the problem?

I fair the industry misses several points in general; one of the most disappointing responses from regulators and governments around the world for the credit crisis was to punish the traders and sales teams of financial institutions by cutting their bonuses. In reality all these people were doing was their jobs, too well perhaps. The risk departments seemed to dodge the spotlight of attention to some degree and it is these control functions which should manage the depth of risk taking.

Risk People
On the point of risk people in general, of which I have met quite a few now, there are two kinds: Academically applied individuals that have insight into the dynamics of how markets work and general plebs who may have incredible qualifications but haven't read a book since they left university. This latter group generally lack expertise across the various disciplines in a bank to be of much use and too often focus on political campaigns to further their careers, they are an unpleasant morbosity for the bank and there are too many of them.

Being a risk manager should be a vocation not a job and interviews should start with the first question "what paper have you written or conference have you spoken at during the last twelve months?"
 
Risk Systems
On risk systems in these banks, there is a lot of rubbish out there when there shouldn't really be. There are some great tools out in the market place now, such as the Algo suite or FRS Global Risk Pro toolset or Sungard and so many others yet, I have seen so little of the profound in many of these banks. Most financial institutions can't measure wrong way risk, they have a silo approach to monitoring risk, the risk systems can't aggregate offsetting exposure on structured deals, historical VaR is still being used when even the janitor knows it is backward looking, risk information isn't presented in a context that can drive decision which is tracked and risk categories such as liquidity, crowded markets, concentration risk are fanciful futuristic notions without to much reality.
 
Too big to fail
This too big to fail concept (which is another debate) in my opinion is a bit of a farce. As banks broaden the revenue lines and differentiate their balance sheets, they become more resilient however as they become useful to a large populous they are deemed hazards. What goes wrong in the too big to fail is they turn into bureaucracy houses full of the type two risk management teams with numerous sometime hundreds of systems that don't interconnect. There is nothing wrong with mixing retail markets with securitisation functions and it will fly but only on the proviso that it is operated as a well governed autocracy. As it stands most to big organisations can't join the dots.

What is the solution for all of this, well I am not sure there is but that is what I see as broken in general.