Banking as a financial intermediary sector, faces numerous controllable and uncontrollable risks in their daily operation. It is the nature of banking that is to manage risk, to control risk, and to balance alternative strategies in terms of their risk/return characteristics with the goal of maximizing shareholder's wealth. However, as the development of banking industry, the business of modern banks becomes far more complex than ever before. The comprehensive use of derivatives complicates the business of banks and poses a challenging task on risk management, as well as the balance of risk and return.
China, as the largest developing country and emerging financial market in the world, enjoys a rapid growth in recent decades. Among all the Chinese commercial banks, Industrial and Commercial Bank of China is the leading bank and plays an important role in the market. This passage takes ICBC as example, and examines the influence of derivatives on the risk management of Chinese commercial banking.
The past five years have witnessed a great challenge to the global banking industry. The financial crisis, which was triggered by the US subprime mortgage crisis in 2007, posed enormous burden on the banking industry. By taking the US financial sector as an example, we can have a general idea about its impact. "After growing steadily for years, employment in the financial sector fell by 128,000 in 2007, 273,000 in 2008, and another 310,000 in 2009. Between January 2009 and December 2010, 297 banks have failed; most were small and medium-size banks. The number of small banks on the FDIC's list of troubled institutions rose from 829 in the second quarter of 2010 to 860 in the third quarter, the largest number since March 1993" (The Financial Crisis Inquiry Report 401). Besides these failed local banks, such as Washington Mutual, and Nevada silver State Bank, some well-known international banks went bankrupted during the crisis as well, such as Lehman Brothers Holding Inc.,.
When we look into the detail that how a single industry crisis could develop into a global financial crisis, we can find a strong tie between the derivatives uses and the commercial banking. "Failure in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages" (The Financial Crisis Inquiry Report 418). Moreover, the shadow banking institutions play a significant role. In this case, the shadow banking refers to any financial activity that transforms short-term borrowing to long-term lending without a government backstop. These shadowing banking institutions include the tri-party repo market, Structured Investment Vehicles and other off-balance-sheet entities used to increase leverage, Fannie Mae and Freddie Mac, Credit default swaps, and hedge fund, mono-line insurers, commercial paper, money market mutual funds, and investment banks.
The derivatives use may put the commercial banking at risk, but why did the risk management system fail to control it? There are several reasons to name: concentration of highly correlated risk, insufficient capital, the imbalance between the solvency and liquidity, and the poor risk management system.
In response to the deficiencies in financial regulation reveled by this financial crisis, the Basel Committee introduced the third Basel Accord, in order to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and bank leverage. For example, the Basel III requires banks to hold 4.5% of common equity and 6% of Tier I capital of risk-weighted assets, while the Basel II requires the bank to reserve 2% of common equity and 4% of Tier I capital. The strictness of Basel III is also demonstrated on its additional capital buffers requirements: (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios, namely the liquidity coverage ratio and net stable funding ratio. The liquidity coverage ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the net stable funding ratio requires the available amount of stable funding to exceed the required amount of stable funding over one-year period of extended stress.
Under this complex international financial background, Chinese banking industry, which has enjoyed a rapid growth of banking industry in recent years, faces severe challenges right now.
First, China has introduced and localized the Third Basel Accord, which posts more strict requirements. For minimum Capital Adequacy Ratio for core Tier I, Tier I, and total capital are set as 5%, 6%, and 8% respectively. On top of the minimum CAR, banks are also required to set aside 2.5% extra capital.This new regulation demands the bank for reserving more capital and thus is intractable for the whole Chinese banking industry, because, before the financial crisis, the capital reservation has not been much sufficient.
Second, although the macroeconomic condition of China returned to a previous stable way of development and thus created an opportunity for the banking industry in 2011, some banks and other financial intermediaries managed the risk in a wild way or even sometimes overlooked the great importance of risk management For example, the fast development of real estate in China has attracted the financial institutions to take part in. But too much focus on a single industry leads to a risky situation for these financial intermediaries. The mid-or-long-term loan for real estate is indeed an important part of business. However, it contributed a lot to the increase of the real estate bubbles. The chase of profit made banks blind of the non-rational factors in real estate industry, resulting to a rising platform risk.
Third, some banks lack the knowledge of risk management. Wen can see a large gap between Chinese banks and foreign banks, especially when Chinese banks faces the change of monetary policies, the increase of reserve rate and the challenge of foreign rate transformation.
It is time for Chinese banks to build up or to improve their own internal risk management system.
But not always these two objectives - the general and sector - accord with each other. It may that, in some cases, the cost of implementation and operation of risk management procedures designed to be greater than potential exposure to risk. Which only means that these programs should be selected according to efficiency criteria. In other cases it may be that the bank's strategy to involve greater risk taking or of new risks.
In this case the decision should always be taken in view the additional costs necessary to ensure adequate protection and greater potential losses. But if the decision is such, then minimization bank should under no circumstances become a goal in itself.
Moreover, bank management objectives are three: maximizing return, minimizing risks exposure and compliance with banking regulations in force. None of them has an absolute primacy, a bank management's task is to establish objective and that the central management of each period.
The importance of bank risk management, however, is not confined only to minimize costs. Permanent concern to minimize exposure to risk management has positive effects on employee behavior that are more rigorous and conscientious in carrying out the work tasks, it is not negligible either psychological effect to deter fraudulent activities. The existence of adequate programs for prevention and control banking risks contributes to impose banking institution in the community, little or no experience of such conditional admission or participation in programs such bank inter-bank associations or obtain higher qualifications in the banking authority.
And not the least, an effective management of banking risks will imprint on his public image of the bank. Customers want a bank safe and shareholders alike. Soundness of the banks attracts depositors but given that deposits are not necessarily assured. If banks are not obliged to provide for civil liability to the depositors, then their interest to choose the most secure institutions is diminished and the main criterion is the profitability of investments. It may occur then a selection effect, which is very likely that bank with the biggest problems in lack of liquidity to pay the highest interest. To avoid this adverse selection, it is preferable for the insurer to charge differentiated insurance premiums higher for banks with weak risk management so that there is an explicit penalty for them.
In the banking sector growth has become an essential attribute of bank performance. It is not an end in itself but is required for profitable investments in new technologies, possible only in conditions of "mass production". The growth in the banking sector has two components: growth in traditional banking services (loans to customers, make transfers, property management) and growth in the new banking services (cash management, capital market operations, computer and information services, insurance). It is characterized by the competitive context and results in the financial institution providing a wide range of services. Some of these services are new and the staff is inexperienced and others involving the operation of the markets where banks are not familiar with, fact that make it seem like the staff lacks professionalism.
Therefore the image of banks in financial markets tends to be a loss, because they risk being treated by specialists as a conglomerate formed partnership to chance, run by people unaware of the new areas and unconscious net gain or specific risks.
Under a management right, increasing operations in two large areas - traditional services and new services - should have a synergistic effect. But losses incurred by some shareholders and the volatility of revenues are going to reduce the market value of banks, which is extremely expensive acquisition of additional capital (necessary for the general protection of the institution in terms of growth). Because communication with the public banks and even shareholders, in terms of bank risk management, is poor, the market tends to treat all banks equally. Bad management can affect several banks and public image of the other.
In conclusion, because the risks banks are a source of unexpected expenses, their proper management to stabilize revenue over time serves a shock damper. At the same time, strengthening the value of bank shares can only be achieved through effective communication with financial markets and implementing appropriate risk management programs bank.
All banks and financial institutions must improve their understanding and practice of banking risk management to be able to successfully manage different product range. If the process of bank risk management and global management system is effective, then the bank will be successful. Banks can successfully manage the risks that banks recognize the strategic role of risk, if used paradigm for analysis and management to increase efficiency.
The Banking industry takes the majority of Chinese financial industry. according to the characteristics and duty of banks, Chinese banks can be sorted into three categories: central bank, commercial bank, and political bank.
In recent rears, the reform and creation of banking industry have a great breakthrough, and thus make the whole banking industry renovated. The banking industry supports and boosts the development of social economy.
By the end of 2010, the total asset of Chinese banking is 95300 billion yuan, which is increased by 19.9%, compared to that of 2009. The total liability is 89500 billion yuan, increased by 19.2%, compared to that of 2009. The shareholder's equity increased to 5800 billion yuan, a 31.2% increase. The financial institutions in banking industry took a different share in the whole market. The rank, according to the asset from the largest to the smallest, is large commercial bank, limited commercial bank, and medium and small countryside financial institution and China post bank. The market share they take is 49.2%, 15.6%, 14.9%.
Since 2011, the asset of commercial banking have been growing steadily. By the end of the third quarter of 2011, the total asset of commercial banking reached 83300 billion yuan, increased by 16.7% than last year. The total liability reached 78000 billion yuan, increased by 16.2%.
In 2011, Industrial and Commercial Bank of China Limited ("ICBC") remained committed to serve the real economy during an extraordinarily difficult year. The Bank forged ahead business re-orientation and development advance by better aligning the diversified needs of financial services from customers. Through spreading effort on a global scale and integrated operation, ICBC stepped up its reform backed by robust corporate governance practices and risk management. ICBC was well- positioned to remain as the world's largest bank by market value, customer deposit.
At the end of the year, ICBC had 408,859 employees under payroll. ICBC provided a wide range of financial products and services to 4.11 million corporate clients and 282 million individual customers through 16,648 outlets across China, 239 overseas subsidiaries and a global network of more than 1,669 correspondent banks as well as Internet Banking, Telephone Banking and Self-service Banking. ICBC established strong presence by its commercial banking operation and rapid expansion to markets worldwide. ICBC held the top slots in the country in many business areas of commercial banking.
At the end of 2011, total assets reached RMB 15,476.868 billion, representing an increase of RMB 2,018.246 billion, or 15.0% over the end of previous year; Total liabilities reached RMB 14,519.045 billion at the end of 2011, up RMB 1,882.08 billion, or 14.9% from a year earlier. Having a 25.6% increase against previous year in net profit to RMB 208.445 billion in 2011, ICBC defended its position as the world's most profitable bank. Return on average total assets and return on weighted average equity on par with the international standard, were at 1.44% and 23.44% respectively. Earnings per share rose RMB 0.12 from a year earlier to RMB 0.6. Ratio of non-performing loans fell to 0.94 percent, down 0.14 percentage points against previous year. Bad loan balance and ratio "both declined" in the twelve years in a row. ICBC scaled up its capital strength and sustainable development by securing capital adequacy ratio and core capital adequacy at 13.17% and 10.07% respectively.
ICBC's approach to risk was to create a global risk management system to strike a balance between business development and control of risk. In 2011, ICBC ramped up its credit risk consolidated management, authorization control, credit line approval process for overseas branches and set up one credit authorization system that spanned the entire ICBC Group. Instructions and assistance were provided on overseas loan approval under a unified internal rating system for all ICBC branches at home and abroad. Market risk consolidated management, reporting of market risk in the Group and limit management have been completed. A new Global Market Risk Management ("GMRM") with the first version has been installed in overseas branches. Through capital injection or self-funding, ICBC improved the capital strength of overseas branches and expanded funding sources. All overseas branches were now responsible for operational risk monitoring, reporting of material events and data collection on the loss arising from operational risk incidents. A system was in place to manage country risks. Group-wise guidelines have been set on the management of concentration risk. ICBC set up a system to control M&A risk and approve acquisition/exit based on a corporate governance framework of "Three Committees, One Management Level" and capital management.
In this passage, I would like to discuss (1) how the derivatives use affect the risk management of commercial banks, (2) to what degree the derivative use affect the risk management as well as the profitability of commercial banks, (3) the differences in usage of derivatives between ICBC and the average level of banking industry, (4) the differences in usage of derivatives between the average level of Chinese banking industry and that of developed country, such as France, (5) the reason why these differences occur.
This passage is divided into 4 parts. The first part is an introduction to the main financial background, the reason why derivatives use matters, the current status of Chinese financial industry, and the reason why I choose ICBC as an example. The second part is the literature review. In this part, I summarize the main methods used in risk management, both quantitative and qualitative. The third part is the main body of the thesis. First, I will collect the data from the annual reports during the period from 2004 to 2011, and then do the analysis. I will use the linear regression model and make comparison of key financial ratios. The main body will answer the five questions I raised in the introduction. The last part is conclusion and suggestion.
Literature Review
Financial risk management is the process by which financial risks are identified, assed, measured, and managed in order to create economic value. Risk cannot be entirely avoided. But for the risk that is measurable, people can use risk management tools to manage the risk. The goal of risk management is not to minimize the risk, but to take risk smartly, because risk is always associated with opportunity to earn a profit.
Centralized risk management tools such as value at risk (VAR) were developed in the early 1990s. They combine two main ideas. The first is that risk should be measured at the top level of the institution or the portfolio. This idea is not new. It was developed by Harry Markowitz (1952), who emphasized the importance of measuring risk in a total portfolio context. A centralized risk measure properly accounts for hedging and diversification effects. It also reflects the fact that equity is a common capital buffer to absorb all risks. The second idea is that risk should be measured on a forward-looking basis, using the current position.
In order to manage risk, the first thing needs to be done is to measure the risk. First, we can use a probability density function to describe the random variable, and then use the historical data to produce a distribution graph. The vertical axis describes the frequency, meanwhile the horizontal axis describes the gain or loss. The curve follows the shape of a normal distribution, which means that most of the weight focuses in the center and there are smaller probabilities for large gain or loss. We can use several statistics to summarize the characteristics, such as the mean, the standard deviation, and the value at risk.
We can describe the risk by using absolute risk or relative risk. Absolute risk assumes that the risk is measured in absolute terms, while relative risk describe the risk against a benchmark.
Absolute risk:
relative risk:
The second assignment of risk measurement process is to construct the distribution of future rates of return. In some cases, the rate of return is probably constant over a period, but it doesn't mean the rate will not change in the future. So it is important to evaluate the quality of risk measurement process. When a large loss occurs, we have to distinguish that this loss is due to a flaw in the risk model or bad luck.
We can classify risk into three categories: (1) known knows, (2) known unknows, (3) unknown unknows.
The risk belongs to the known knows can be identified and measured. The second category contains model weakness that are known or should be known to exist but are not properly measured. It happens in the case that human ignores the important risk factors, in the case that the distribution of risk factors could be measured inaccurately, as well as in the case that the mapping process, which consists of replacing positions with exposures on the risk factor, could be incorrect. Such risks can be evaluated by stress testing. A best example of risk from known unknows is liquidity risk.The third category is very difficult to identify, because it's out of most scenarios. Indeed, a 2010 survey reports that the top concern of risk managers is "government changing the rules". This category is also called Knightian uncertainty.
Risk management can fail if one of the following tasks has not been met. (1) identifying all risks faced by the firm, (2) assessing and monitoring those risks, (3) managing those risks if given the authority to do so, (4) communicating these risks to the decision makers.
The portfolio construction process involves the expected return and risk. Investors face a trade-off between two choices.
Two possible risk-adjusted performance measurement: one is the Sharpe ratio, and the other is information ratio
SR
IR
More generally, a portfolio can be divided between the two assets. Define wi as the weight placed on the asset i. with full investment, we must have Wi = 1, where N is the total number of assets. In other words, the portfolio weights must sum to 1. Start with a portfolio fully invested in bonds, represented by w1= 1.00, w2= 0.00. As we shift the weight to stocks, we can trace a line that represents the risk and expected return of the portfolio mix. Eventually, this moves to the stock-only position, wi=0.00, w2=1.00. Figure 1.4 shows the line that line that describe all of these portfolios. This is an example of an asset allocation problem, where the investor has to decide how much to allocate across asset classes. The shape of this line depends on the correlation coefficient, p, which measures the extent to which the two assets comove with each other. the correlaiton coefficient is scaled so taht it must be between -1 and +1. If p = 1, the two asset move perfectly proportionately to each other and the line becomes a straight line. More generally, the line is curved. This leads to an interesting observation. The line contains a portfolio with the same level of risk as that of bonds but with a higher return. Thus, a diversified portfolio can dominate one of the assets. The portfolio variance is calculated as follow.
Row P 2
Hence the portfolio volatility, which is the square root of the variance, is a nonlinear function of the weights. In contrast, the portfolio expecte return is a simple linear average.
U = w1u1 + w2u2
efficient portfolios
in a more general condition, a portfolio contains a large number of stocks. The starting point is the assumption that all assets follow a jointly normal distribution. If so, the entire distribution of portfolio returns can be summarized by two parameters only, the mean and variance. To solve the diversification problem, all that is needed is the identification of the efficient set in the mean-variance space. This the locus of points that represent portfolio, defined by a set of weights, is such, that, for a specified value of expected return Up, the risk is minimized. MINwD2
When there are no short-sale restrictions on the portfolio weights, a closed-form solution exists for the efficient set. Any portfolio os a linear combination of tow portfolios. The first is the global minimum-variance portfolio, thich has the lowest volatility across all fully invested portfolios. The second is the portfolio with the highest Sharpe ratios. This framework can be generalize to value at risk, which is especially valuable when return distributions have fat tails. In the general case, no close-form solution exists.
These insights have led to the capital aseet pricing model CAPM, developed by William Sharpe (1964). Sharpe's first step was to simplify to covariance structure of stocks with a one-factor model. Define Ri,t as the return on the stock i during month t, Rf,t as the risk-free rate, and Rmt as the market return Then run a gression of the excess return for i on the market across time.
formula
The slope coefficient betai measures the exposure of i to the market factor and is also known as systematic risk. The intercept is alfai. For an actively managed portfolio alfa is a measure of management skill finally, Ei is the residual, which has mean zero and is uncorrelated to Rm by construction and to all other residuals by assumption. This is a one-factor model because any ineractions between stocks are due to their exposure to the market. To simply, ignore the risk free rate and alfa, which is constant anyway. We now examine the covariance between two random variables, and is explained firther in Chapter 2.
COV(Ri, Rj) =
becasue all e are uncorrelated with RM and with each other. Hence, the asset-specific risk, or e is called idiosyncratic.
This type of approximation lies at the heart of mapping , a widely used process in the risk management. Mapping replaces individual positions by a smaller number of exposures on fundamental risk factors.
Sharpe (1964) then examined the conditions for a capital market equilibrium. This requires that the total demand for which asset, as derived from the investors' portfolio optimization, match exactly the outstanding supply of assets. The total demand can be aggregated because investors are assumed to have homogeneous expecttions about the distribution of rates of return, which is also assumed normal.
In addition, teh model assumes the existence of a risk-free asset, which can be used for borrowing or lending, at the a,e rate. As is usual in most economic models, caital markets are assumed perfect. That is, there are no transaction costs, securities are infinitely divisible, and short sales are allowed. Under these conditions, Sharpe showed that the market portfolio, defined as the value0weight average of all stocks in the portfolio, must have the highest Sharpe ratio of any feasible portfolio. Hence, it must be mean-variance efficient. This line is called capital market line CML. It dominates any combination of cash and stock investment.
Portfolios located between F and M have a positive fraction allocated to each. Investors that are very risk-averse would hold a mix closer to F. Risk-tolerant investors would choose portfolios closer to, or even higher than, the market M. Portfolios above M represent a levered position in the market.
Figure demonstrates the concept of two-fund separation.
E(Ri) =
Measurement of performance
Treynor ratio TR=
Jensen's alpha=
Arbitrage Pricing Theory APT
The capm specification starts from a single-factor model. This can be generalized to multile factors.
The arbitrage pricing theory APT developed by Stephen Ross (1976) relies on such a facotr structure and the ssumption that thre is no arbitrage in the financial markets. Formally, portfolios can be constructed that are well-diversified and have little risk. To prevent arbitrage opportunities, these portfolios should have zero expected returns. These conditions force a linear relationship because the expected returns and the factor exposures
E[Ri]
where landak is the market price of factor k.
APT expected return is very similiar to the capm.
Value of risk management
Companies could use financial derivatives to hede their volatility. If this changes th volatility but not the market beta, however, the copany's cost of capital and hence valuation cannot be affected. Such a result holds only under the perfect capital market assumptions that underlie the CAPM.
Classic Modigliani and Miler MM theory, which says that the value of a firm cannot depend on its financial policies.
risk management can add value if some of these assumptions do not hold.
Hedging should increase value if it helps avoid a large cost of financial distress
Corporate income taxes can be viewed as a form of friction.
Other friction arise when external financing is more costly than internally generated funds.
A form of information asymmetry is due agency costs of managerial discretion
Another information asymmetry arises when a large shareholder has expertise in the firm's business.
Risk management strategy
Credit risk
Market risk
operational risk
investment portfolio risk
structural interest and exchange rate risk
liquidity risk
strategic risk
business risk
ICBC risk department
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There are a lot of financial derivatives for dealing with a financial firm's exposure to interest rate risk, such as financial futures contracts, interest-rate options, interest-rate swaps, and the use of interest-rate caps, collars, and floors.
one of the most vulnerable financial industries as the 21st century began was the life insurance business, which soon began to wish it had made even heavier use of risk management tools such as futures and options. some of the largest life insurers in Asia (especially China and Japan), Western Europe, and the United States had promised their customers high-interest yields on their savings, only to be confronted subsequently with record low market interest rates that made it close to impossible to deliver on some of their promises.
The bank is one of the heaviest users of derivative contracts and its usage of derivative instruments is well documented , because of the regulation requirement.
According to a report by the Office of the comptroller of the Currency, approximately 10 percent of all banks surveyed reportedly employ the use of derivative contacts. As of the second quarter of 2005, 769 banks operating in the United States held derivatives having a combined notional value of $96.2 trillion. The dollar amount of derivatives employed by banks in the United States has increased almost 500 percent over the preceding 10 years.
interest-sensitive gap
interest sensitive gap=interest-sensitive assets - interest-sensitive liabilities
IS GAP = ISA -ISL
where interest -sensitive assets and liabilities are those items on a balance sheet whose associate interest rates can be changed, up or down, during a given interval of time.
the leveraged-adjusted duration gap measures the difference in weighted-average maturity between a financial institution's asset and its liabilities.
Duration gap = average dollar-weighted duration of assets - average dollar-weighted duration of liabilities * total liabilities / total assets
or
DG = Da - Dl * TL/TA
positive duration gap , interest rate increases, the net worth will decline because the firm's assets will decline faster than its liabilities
negative duration gap, falling interest rates will cause the value of its liabilities to rise faster than the value of its asset portfolio, it's net worth will decline, lowering the value of the stockholder's investment. One of the most popular methods for neutralizing these gap risks is to buy and sell financial futures contracts.
A financial futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a particular security in exchange for cash at some future date.
Basis Risk
there are some limitations to financial futures as interest rate hedging devices among them a special form of risk known as basis risk. Basis is the difference in interest rates or process between the cash market and the futures market
Basis = cash-market price - futures market price
If the basis changes between the opening and closing of a futures position, the result can be significant loss, which subtracts from any gains a trader might make in the cash market. Basis risk is usually less than interest risk in the cash market.
Basis Risk with a short hedge
$return from a combined cash and futures position = Ct - C0 + F0 -Ft
this can be rearranged as
$return form a combined cash and futures position = Ct-Ft - (C0 - F0)
Thus, with a short hedge in futures
Dollar return = Basis at termination of hedge - Basis at initiation of hedge
Basis Risk with a Long Hedge
$return from a combined cash and futures position = C0 - Ct + Ft -F0
this can be rearranged as
$return form a combined cash and futures position = C0 - F0 - (Ct - Ft)
Thus, with a short hedge in futures
Dollar return = Basis at termination of hedge - Basis at initiation of hedge
With an effective hedge, the positive or negative returns earned in the cash market will be approximately offset by the profit or loss from futures trading.
change in futures price/ initial futures price = - duration of the underlying security named in the futures contract * change expected in interest rates/ 1+ original interest rate
Ft - F0)/F0 = -D * delta i / (1+i )
Ft - F0 = -D * F0 * N * delta i / (1 + i)
picture 8-
number of futures contacts needed
change in net worth = - Dasset - Total liabilities/ total assets * Dliabilities* total assets * change expected in interest rates/ (1+ original interest rate)
number of futures contacts needed = Dasset - Total Liability/ Total Assets * Dliability * Total assets///duration of the underlying
Interest Rate Option
The interest-rate option grants a holder of securities the right to either 1 place those instruments with another investor at a prespecified exercise price before the option expires or 2 take delivery of securities from another investor at a prespecified price before ht option's expiration fate.
Interest-Rate Swaps
is a way to change a borrowing institution's exposure to interest-rate fluctuations and achieve lower borrowing costs.
Quality swap, a borrower with a lower credit rating enters into an agreement to exchange interest payments with a borrower having a higher credit rating. In this case, the lower credit-rated borrower agress to pay the higher credit-rated borrower's fixed long-term borrowing cost. At the same time, the borrower with the higher credit rating covers all or a portion the lower-rated borrower's short-term floating loan rate, thus converting a fixed long-term interest rate into a more flexible and possible cheaper short-term interest rate.
A financial firm can use swaps to alter the effective duration of its asset and liabilities. On the negative side, swaps may carry substantial brokerage fees, credit risk, basis risk, and interest risk.
An interest rate cap protects its holder against rising market interest rates. An interest rate floor protects its holder against falling interest rates. An interest rate collar combines a rate floor and a rate cap.
Survey of risk measurement
Main Body
The Introduction of Enterprise Risk Management System of ICBC
The enterprise risk management system is a process where the Board of Directors, the Senior Management and other employees of the Bank perform their respective duties and responsibilities to take effective control of all the risks at various business levels in order to provide reasonable guarantee to the achievement of objectives of the Bank. The principles of risk management include matching of return with risk, internal checking and balance with consideration as to efficiency, risk diversification, combination of quantitative and qualitative analysis, use of dynamic adaptability adjustments and gradual improvement, etc.
The Bank's organizational structure of risk management comprises the Board of Directors and its special committees, the Senior Management and its special committees, the Risk Management Department, the Internal Audit Department, etc. The risk management organizational structure is illustrated below:
In 2011, the Bank proactively improved the enterprise risk management system, made more effort in the formulation of enterprise risk management regulations, and stepped up the pace in strengthening the risk management capability at the group level. It enhanced the dissemination and execution of risk appetite, regularly inspected and reported the execution of risk appetite, improved a reporting system covering various risks of the Group and established the assessment methods and coverage for major risks. It also defined the governance framework and management flow for internal capital adequacy assessment and regularized the system operation mechanism and reporting mechanism for internal capital adequacy assessment process (ICAAP). Furthermore, the Bank enhanced the country risk management, and improved the country risk system building; strengthened the concentration risk management system, standardized the management flow for concentration risk and achieved the concentration risk management at the group level. Accordingly, the Bank further improved the overall level of its enterprise risk management.
Preparations for the Implementation of the New Capital Accord
Pillar 1
In respect of credit risk, the Bank further improved the internal rating system, and kept deepening the application of quantitative results of internal rating to different areas of risk management. The Bank also carried out the measurement validation and optimized the internal rating model in an all-round way to make rating results reflect risk characteristics of credit assets more accurately. Furthermore, the Bank steadily promoted the development and upgrade of related systems, and optimized the rating of the systemized management of the entire process involving the front, middle and back offices; promoted the application of internal rating results and carried out rigid controls of risk-adjusted return on invested capital of each credit business to continuously improve the operating result of the credit business.
In respect of market risk, the Bank continued to promote the establishment of internal model approach (IMA), and has basically built a market risk management system based on IMA implementation. The Bank also improved the internal model measurement method, and set up a market risk limit management system and risk reporting system centering on Value at Risk (VaR) and combing with multiple indicators. Moreover, the Bank used the self-developed global market risk management system (GMRM) to comprehensively enhance the measurement approach and management level of market risk.
In respect of operational risk, the Bank continued to push forward the building of the advanced measurement approach (AMA) for operational risk, and established the AMA system. The Bank completed the development of the AMA model, and set up the AMA information system for operational risk and the data market for operational risk covering all business lines. Besides, the Bank actively boosted the application of project outcomes under AMA, and performed operational risk and control self-assessment (RCSA) and scenario analysis (SA), thus further enhancing the risk forewarning capability of the Bank.
Pillar 2
During the reporting period, the Bank completed the internal capital adequacy assessment process (ICAAP), built the assessment system for substantive risks and the integrated stress testing system, and set out risk appetite management system. The Bank also formulated the forecasting methodology compatible with the actual capital adequacy ratio of the Bank, regularized the operating mechanism and reporting mechanism for ICAAP, and realized the comprehensive assessment of all substantive risks of the Bank.
Pillar 3
The Bank closely followed the progress of regulatory requirements of CBRC on information disclosure in the New Capital Accord, and made an active effort to prepare for information disclosure under Pillar 3 by referring to the disclosure practices of its international peers.
Credit Risk Management
The Bank is exposed principally to credit risk. Credit risk is the risk that loss is caused to banking business when the borrower or counterparty fails to meet its contractual obligations. The Bank's credit risks mainly originate from loans, treasury operations (including due from banks, due to banks, reverse repurchase agreements, corporate bonds and financial bonds investment), receivables, off-balance-sheet credit business (including guarantees, commitments and financial derivatives trading), and businesses with capital raising or financing and investment functions which, although do not expose the Bank directly to investment risk or credit risk, and therefore are not categorized as on and off-balance-sheet credit business on the balance sheet, may expose the Bank to passive credit risk in the future. These businesses include wealth management, leading bank, agent trust schemes and other services as well as innovative products with the above characteristics.
The Bank strictly observed the guidance from CBRC regarding credit risk management and other regulatory requirements, earnestly executed established strategies and objectives under the leadership of the Board of Directors and the Senior Management, implemented an independent, integrated and vertical credit risk management mode, continuously optimized the credit flow, and formed a management organizational structure featuring the separation of the front office, the middle office and the back office of the credit business. The Board of Directors assumes the final responsibility to the effectiveness of the implementation and monitoring of credit risk management. The Senior Management is responsible to execute the strategies, overall policy and system regarding credit risk management approved by the Board of Directors. The Credit Risk Management Committee of the Senior Management is the review and decision-making organ of the Bank in respect of credit risk management, and is responsible to review material and important affairs of credit risk management, and performs its duty in accordance with the Working Regulations for the Credit Risk Management Committee. The credit risk management departments at different levels undertake the responsibility to coordinate the work of credit risk management at respective levels, and the business departments play their roles in implementing credit risk management policies and standards in respective business areas.
The Bank's credit risk management has the following characteristics: (1) standardized credit management processes are followed throughout the Bank; (2) the principles and processes of risk management focus on the entire process of credit business, covering customer investigation, credit rating, loan evaluation, loan review and approval, loan payment and post-lending monitoring; (3) special organization is set up to supervise the entire process of credit business; (4) the qualification of the employees who are responsible for credit review and approval is strictly reviewed; and (5) a series of information management systems are designed to monitor the risks on a timely basis.
In 2011, in response to the changes in the overall economic environment and financial regulatory requirements, the Bank studied the macroeconomic policy adjustments and market changes in depth, actively satisfied the credit demand of the real economy, adjusted and improved various credit policies in a timely manner, and continued the building of the credit system. The Bank improved the credit policy system, strengthened the adjustment of credit structure, strictly controlled the credit risks of key areas, reinforced credit risk management of institutional customers and off-balance-sheet businesses, improved the consolidated statement management, and accelerated the building of the overseas credit risk management system. The Bank also promoted stringent credit operations flow and compliance management of credit business, strengthened the mechanism for post-lending management, continued to strengthen credit risk monitoring and analysis, and constantly advanced collection and disposal of NPLs, thereby fully enhancing credit risk management.
Market Risk
Market risk is the risk of loss, in respect of the Bank's on and off-balance sheet activities, arising from adverse movements in market rates (including interest rates, exchange rates, stock price and commodity prices). The Bank is primarily exposed to interest rate risk and exchange rate risk (including gold).
The Bank's market risk management is the process of identifying, measuring, monitoring, controlling and reporting market risk for the purposes of setting up and enhancing the market risk management system, specifying responsibilities and process, determining and standardizing the measurement approaches, limit management indicators and market risk reports, controlling and mitigating market risk and improving the level of market risk management. The objective of market risk management is to control market risk exposures within a tolerable level and maximize risk-adjusted return according to the Bank's risk appetite.
The Bank strictly complies with the Guidelines on Market Risk Management of Commercial Banks issued by CBRC and other related regulatory requirements, implements an independent, centralized and coordinated market risk management model under the leadership of the Board of Directors and the Senior Management, and formed a management organizational structure featuring the segregation of the front office, the middle office and the back office in the financial market business. The Board of Directors assumes the final responsibility to implementation and monitoring of market risk management. The Senior Management is responsible to execute the strategies, overall policy and system regarding market risk management approved by the Board of Directors. The Market Risk Management Committee of the Senior Management is the review and decision-making organ of the Bank in respect of market risk management, and is responsible to review material affairs of market risk management and performs its duty in accordance with the Working Regulations for the Market Risk Management Committee. The market risk management departments at different levels undertake the responsibility to coordinate the work of market risk management at respective levels, and the business departments play their roles in implementing market risk management policies and standards in respective business areas.
In 2011, the Bank further strengthened the construction of its market risk management system and enhanced the market risk management standard at the Group's level. The Bank accelerated the preparation for the implementation of IMA for market risk to build a market risk management system based on the IMA, and established a self- developed pricing valuation model and market risk measurement methodology. Moreover, the Bank fully launched the construction of the global market risk management system (GMRM) to establish an integrated and unified data management platform and risk measurement management platform, and implemented the measurement and monitoring of interest rate risk, exchange rate risk and commodity risk of the trading book under the IMA. The Bank also proactively advanced the expansion of overseas institutions and gradually carried out verification work for financial products valuation models, thereby laying a foundation for the application and implementation of the market risk internal model approach of the New Capital Accord.
Market Risk Management of the Trading Book
The Bank adopted multiple methods including value at risk (VaR), sensitivity analysis and exposure analysis to measure and manage products in the trading book. The Bank improved its limit management policy, set up its market risk limit management system based on trading portfolios which covered the Head Office, branches and domestic and overseas institutions and included various types of financial market businesses, built its limit indicator system centering on the VaR, and applied its global market risk management (GMRM) system to carry out market risk measurement and monitoring of the trading book.
The Bank applied the Historical Simulation Method (adopting a confidence interval of 99%, holding period of one day and historical data of 250 days) to measure the VaR of the interest rate risk, foreign exchange rate risk, and commodity risk of fundamental commodity products and standard derivative products of the trading books of the Head Office and two overseas branches.
Liquidity Risk
Liquidity risk is the risk that the Bank, despite its solvency, is unable to raise funds on a timely basis or at a reasonable cost to fund the asset growth or to settle liabilities as they fall due. Liquidity risk includes financing liquidity risk and market liquidity risk. Financing liquidity risk refers to the risk that the Bank fails to satisfy the funding needs in a timely and effective manner without affecting daily operation or financial position of the Bank, while market liquidity risk refers to the risk that the Bank is unable to raise funds through the disposal of assets at a reasonable market price as a result of market illiquidity or market volatility.
Liquidity risk may arise from the following events or factors: withdrawal of customers' deposits, drawing of loans by customers, overdue payment of debtors, mismatch of asset and liability, difficulties in realization of assets, operating losses, derivatives trading risk and risk associated with its affiliates.
Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, employees and IT systems or from external events, including legal risk, but excluding strategic and reputational risk. There are seven major types of operational risks faced by the Bank, including internal fraud, external fraud, customers, products and business activities, execution, delivery and process management, employment system and workplace safety, damage to physical assets and IT system events. Among these, the execution, delivery and process management and the customers, products and business activities constitute major sources of operational risk losses of the Bank.
The Bank strictly followed the requirements of the Guidance to the Operational Risk Management of Commercial Banks issued by CBRC. Under the leadership of the Board of Directors and the Senior Management, in accordance with the New Capital Accord, the Bank set up the operational risk governance structure on the basis of the principle of "three lines of defense". The Board of Directors undertakes the final responsibility for the effectiveness of the operational risk management, and the Senior Management is responsible for implementing the strategy, overall policy and system for operational risk management approved by the Board of the Directors. The Operational Risk Management Committee under the Senior Management, as the organizer and coordinator of operational risk management of the Bank, is responsible for reviewing and approving significant matters related to operational risk management and working under the Working Regulations for the Operational Risk Management Committee.
Marketing and product departments at various levels form the first line of defense of operational risk management, which assume direct responsibility for operational risk management in each business line and are responsible for operational risk identification, assessment, monitoring and control in their departments and business lines; internal control and compliance departments at various levels form the second line of defense of operational risk management, which are responsible for the overall arrangement and organization for the establishment and implementation of operational risk management system at each level and for ensuring the consistency and effectiveness of operational risk management within their institutions; internal audit departments form the third line of defense of operational risk management, which are responsible for auditing and evaluating the effectiveness of the Bank's operational risk management framework on a regular basis according to external regulatory requirements and the annual audit plan approved by the Board of Directors.
In 2011, in accordance with latest regulatory requirements concerning operational risk and the trends of operational risk, the Bank continued to improve the operational risk governance structure, actively promoted the implementation of the advanced measurement approach (AMA), and further optimized the operational risk management system, thus continuously enhancing the operational risk management level. The Bank was the first among domestic peers to accept the CBRC's pre-assessment on the Bank's AMA. The Bank completed the operational risk and control self- assessment (RCSA) and scenario analysis (SA), and also completed the credit card application anti-fraud project and its implementation in operation. The Bank formulated administrative measures on internal loss events arising from operational risk, established the major operational risk event reporting system, implemented new operational risk monitoring indicators, and improved the sensitivity and accuracy of operational risk monitoring. The Bank realized centralized management of credit approval and centralized processing of international business documents to ensure operational risk control in terms of management mechanisms, further strengthened the IT operational risk management by enhancing the production and operation management, controlling application and development risks and formulating more stringent information security measures. In addition, the Bank continued to deepen the business centralized processing, expanded the coverage of remote authorization, and continuously improved business operation risk monitoring and identification examination.
Reputational risk
Reputational risk is the risk of negative assessment or comments on a commercial bank from stakeholders as a result of its operation, management and other behaviors or external events. Reputational risk may arise in any part of the Bank's operation and management, and usually co-exists and correlates with credit risk, market risk, operational risk and liquidity risk.
Reputational risk management of the Bank refers to the process and method which provide the basis for ensuring the achievement of the overall objective of reputational risk management, including the establishment and improvement of the reputational risk management system through the identification, assessment, monitoring and handling of reputational risk factors and reputational events. The Bank adheres to the prevention oriented principle and incorporates reputational risk management into each aspect of operational management of the Bank and every customer service process, with a view to controlling and mitigating reputational risk based on its source and minimizing the possibility of occurrence of and influence from reputational events.
As the highest decision-making body of the Bank's reputational risk management, the Board of Directors is responsible for formulating strategies and policies concerning reputational risk management that are in line with the strategic objective of the Bank. The Senior Management is responsible for implementing such strategies and policies established by the Board of Directors and leading reputational risk management of the Bank. The Bank has established a special reputational risk management team to take charge of the daily management of reputational risk.
In 2011, the Bank continuously strengthened the reputational risk management, actively advanced the establishment of the reputational risk management system and working mechanism, carried out the identification, assessment, monitoring, control, mitigation and evaluation of reputational risk in depth, and intensified the consolidated management of reputational risk, thereby leading to the bank-wide reputational risk remaining controllable.
Country risk
Country risk is the risk incurred to a bank arising from the inability or refusal by the borrower or debtor to repay bank debt, losses suffered by the bank or its commercial presence in such country or region and other losses due to economic, political, social changes and events in a country or a region. Country risk may be triggered by deterioration of economic conditions, political and social turmoil, asset nationalization or expropriation, government's refusal to pay external debt, foreign exchange control or currency depreciation in a country or region.
The Bank strictly observes the Guidelines on the Management of Country Risk by Banking Financial Institutions and other regulatory requirements of CBRC, implemented a management model where responsibilities of each department or business line are clearly defined under the leadership of the Board of Directors and the Senior Management. The Board of Directors assumes the ultimate responsibility for the effectiveness of country risk management. The Senior Management is responsible to execute the country risk management policies approved by the Board of Directors. The Credit Risk Management Committee of the Head Office is responsible to review matters regarding credit risk management. The Bank manages and controls country risk through a series of management tools, including country risk assessment and rating, country risk limits for the entire group and continuous statistics, analysis and monitoring of country risk exposure, as well as country risk assessment using stress tests. The Bank reviews the country risk rating and limits at least annually and makes adjustments when necessary.
In 2011, the Bank strengthened country risk management, and improved the country risk management system. The Bank formulated the statistical measure system for country risk exposure to provide data foundation for effective country risk identification, measurement, monitoring and control, reinforced the approval, monitoring, allocation and adjustment of country limits, and carried out annual country risk rating and risk classification, as well as tracking, monitoring and reporting of country risk to further improve the level of country risk management.
