Risk Management in Emerging Markets

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Risk Management in Emerging Markets

• BSCH Experience in Latin America

Trinidad, February 2000
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Risk Management in Emerging Markets

• AGENDA
• BSCH - Firmwide Risk Management
• Risk Factors in Emerging Markets
• Implemementing Market Risk Management in
  Emerging Markets
• Summary

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Risk Management in Emerging Markets
BSCH - Firmwide Risk Management BSCH
Mission Risk Management Philosophy Detailed
Functions Business and Risk Management
Organization Market Risk Management Group
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BSCH Risk Management Mission ...
Firmwide Risk Management

• The primary objective is to protect the capital
  of the firm,
• maximizing the return on the capital invested.
• Senior Management has assigned the Market Risk
  Function the responsibility to gather, analyze
  control and report the information regarding the
  market risks held by the firm in order to allow
  the risk takers, managers and other personnel to
  understand and make informed decisions regarding
  the management and control of risks taken.

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BSCH Risk Management Philosophy ...
Firmwide Risk Management

• Independence from the Business Units
• Support for Informed Business Decision-making
• Local Expertise in Each Products
• Flexible Policies Adaptable to Local Risks and
  Structures
• Key Characteristics
• Countries
• Global Products
• Business Objectives
• Maximized Return on Risk Adjusted Capital
  (RORAC) Reduced Risk
• Firms Directive No surprises in unexpected
  losses

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BSCH Risk Management Function ...
Firmwide Risk Management

• Ensure that business within the Firm do not
  expose the organization to unexpected losses that
  could threaten the financial stability.
• Identify, analyze, measure and assess risk, with
  no surprises.
• Establish risk management policies and
  procedures.
• Monitor and Control Risk parameters and
  Management PL.
• Set new product development guidelines and
  inclusion of new exposures within the current
  framework.
• Propose capital allocation and portfolio
  management methodologies.

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BSCH Business Organization ...
Firmwide Risk Management
SECURITIES TRADING GROUP
FUND MANAGMNT GROUP
CORPORATE FINANCE GROUP
EUROPE
OFFICES
OFFICES
OFFICES
AMERICAS
OFFICES
OFFICES
OFFICES
FUNCTIONAL MANAGEMENT
ASIA PACIFIC
OFFICES
OFFICES
OFFICES
REGIONAL MANAGEMENT
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Firmwide Risk Management
Risk Management Mirrors the Business
Sr Management By Country Risk Aooetite
By Risk Taker Trading/ALM
PROPOSAL
GLOBAL RISK COMMITTEE
APPROVAL
GLOBAL MARKET RISK
MINIMUM REQUIRED CAPITAL
Sens MVE Sens NIM Gap Concentration
LOCAL ALCOCOMMITTEE
Risk Apetite by Local Sr. Management Global
Limits Distribution Sublimits by Business Lines
LOCAL MARKET RISK
BALANCE
VarD Loss Trigger Stop Loss Greeks Vol Eq,...
NEGOCIACIÓN
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Risk Management Organization
Firmwide Risk Management
Global Head of Risk Management
Global Market Risk
Corp./Cpty Risk
Credit RORAC
Commercial Banking
CRMG
Regional Coordinator
Market Risk Control
Methodology and Infrastructure
RORAC
Capital Markets/ Structured Products
the ultimate responsible for Risk Management is
the Chairman of the Firm
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The Risk Management Landscape
Firmwide Risk Management
Trading Book
Banking Book
Global Structural Products

• Price Risk
• Liquidity Risk
• Credit Risk
• Settlement Risk
• Operational Risk
• Legal Risk

Loss in market value of a position Inability to
unwind a position/meet payment obligations Loss
due to inability of counterparty to perform legal
commintment Risk of no receiving
funds/instruments at the expected time Loss due
to execution error Risk that contracts are not
legally enforceable or documented correctly
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Global Market Risk Principles...
Global Market Risk Group. Underlying Principles

• Independence from the Business Areas
• Mirror the business structure in the organization
  of the market risk function.
• Help to Manage dein a global view the Price and
  Liquidity Risks for the
• different portfolios like Trading,
  Investment, ALM ...
• Identify and measure the Risk effect in the
  economic value of the Balance Sheet
• ? Assign the economic capital in a homogeneous
  and consistent way.
• Measure the risk from an economic perspective
  independent from accounting effects
• ? The accounting effect is another variable that
  affects the economic capital.

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Global Market Risk Group. Process
Global Market Risk Process...
Business
Capital Allocation
Take Risk?
NO
Risk Identification
Risk Estimated
Analysis of Portfolios
PL Measurement
SI
Risk Measurement
Information and Control
Policies Aprovals Measures Committees
Methodologies Valuation Measurement
Limits Global Local
Reports Daily Weekly Monthly
Eficiency Measures Numerical RORAC Cualitative
ALCO Committee
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Global Market Risk Group. Process
Breaking down the risks...

• Along different dimensions
• Risk type - Interest Rate, FX, Equity,
  Commodity, Other (Basis, Vol, ...)
• to identify
• Risk Concentrations
• - whether large risks are due to size/nature of
  the position
• Diversification Benefits - Risk is not additive
• - Total risk is less that the sum of the parts
• Opportunities
• and apply synergies from different business
  units
• Analysis (Valuation, Risk Measurement)
• Information Technology (Intratet, Databases,
  Development)
• Management Information Systems

Flexible risk analysis and reporting us essential
!!!
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Market Risk Methodologies
Global Market Risk Group. Process
Static measures (FX, Equity exposure), IR
sensitivity, Gap analysis, Greeks. VaR
(Correlation) Scenarios from a Normalize market
environment VaR (Monte Carlo) Scenarios from
historical returns VaR (Historical Simulation),
Ad-hoc scenarios, MaxVaR, Marginal
VaR Scenarios set in a complete social,
political and economic context

• PARAMETRIC
• MONTECARLO SIMULATION
• HISTORICAL SIMULATION
• STRESS TEST/ SCENARIO ANAL
• EVENT RISK ANALYSIS

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The Risk Management Group Should do more than
just control...
Global Market Risk Group. Process

• Evaluate Risk/Return
• Explore the exposures in a flexible way to
  identify Key Risk Sources / Concentrations
• Report your risk flexibly to deliver the right
  amount of detail
• Experiment with alternative strategies

THE RISK MANAGEMENT GROUP SHOULD PLAY AN ACTIVE
DECISION-MAKING ROLE
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Local Market Risk Function
Global / Local Market Risk Interaction

• Local Market Risk Unit provides local control and
  local product expertise
• Global Market Risk Areas (e.g., Technology,
  Quantitative Analysis) provide specific support
  services
• Global Market Risk Unit is fully informed of all
  local Market Risk decisions
• Requests for limits are coordinated by local
  Market Risk Function and forwarded to the Global
  Team for review and approval

Global
Proposals
Approvals
Local
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Local Market Risk Function
Key Elements Local Presence

• Determine and Apply the Methodologies of
• Portfolio Valuation Risk Measurement
• Identify, Measure and Analyze all Market Risks
• Management (MTM) PL
• Define the valuation criteria Implement Global
  models
• Propose and Control of all Market Risks Limits
• Fulfil the Market Risk Policies
• Adapt the Recommendations of
• Local Regulators Central Banks

Look for Efficiency Act where the Risk arises
OBJETIVE REINFORCE THE LOCAL UNIT ROLE
CREATE A GLOBAL RISK
CULTURE
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Risk Management in Emerging Markets
Risk Factors in Emerging Markets Fixed Income
Products Local and International Equities Foreign
Exchange
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Fixed Income Products

• Local External Debt Brady, Eurobond, Govt
• There is no homogeneous Country Yield curve
• There is almost no country with the same
  structure of local FI markets
• There are almost no mechanisms to
  arbitrage/hedge the local curves
• Different measures quote bonds that create
  inefficiencies
• Sobretasa (Mex), Nominal-Real curve
  (Chile,Mex,Col)
• Amortising/Capitalising Debt (Argentina), 15 day
  - 20 year 5 quote YC (Chile)
• Business-days daycount (Brazil), Survey YC quotes
  (Peru)
• Stripped Yield, Blended Yield, IR Duration,
  Stripped Duration
• The products are driven by exogenous factors
  (liquidity, investors, )
• Limited repo market, almost no short sales
  (except synthetic products)

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Local and International Equities

• Equities Betas? Correlation? Liquidity?
• The Liquidity in the market is far below the
  Developed markets (see table)
• The Market Valuations are not comparable with
  Developed Markets (see table)
• Volatility needs to be measured in local and US
  dollar returns
• Correlation has limited effect and may be
  volatile
• The CAPM model needs to be adjusted but how?
• Proxy assignment?? How?
• There is still a chance the ADR and GDR market
  

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Foreign Exchange Markets

• FX Is the history reliable?
• Most EM countries have experienced FX control
  regimes (bands, fixed rate)
• The last five years has witnessed the change in
  those controls, with important adjustments in
  the FX rate.
• Volatility changes considering the historical
  period.
• Correlation has limited effect between
  currencies and may be volatile
• Macroeconomic models are not reliable to measure
  the timing of a FX crisis

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Risk Management in Emerging Markets
Implementing Market Risk Management in Emerging
Markets Risk Management tools for Latin
America IADB - BSCH Project
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Risk Management in Latin America
Risk Management tools for Latin America

• Markets are illiquid, with an absence of
  financial benchmarks for valuation and risk
  measurement.
• Some countries trade with a fixed or captive FX
  market.
• There are serious limitations with time series,
  being unable to compute reliable volatilties and
  correlations.
• Some local products have unique characteristics.
• There is a limited investment in IT systems and
  valuation tools.
• Difficult to find qualified professionals in
  Risk Management, which stresses the need to
  increase training in the Risk Management arena.

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Risk Management tools for Latin America
In Emerging Markets the numerical measures are
just the begining ...

• Markets without memory
• Very Illiquid
• Risk Factors not measurable
• Mix of Price/Liquidity Credit Risk
• The Models are unable to reflect the extreme
  cases

Additional Qualitative Measures

• QUALITATIVE
• CONTINGENCY PLANS
• NON MEASURABLE FACTORS
• DETAILLED KNOWLEDGE OF POSITIONS AND
• MARKETS
• CONTINUOUS COMMUNICATION BUSINESS/RISKS

• CUANTITATIVE
• BACKTESTING
• STRESS TEST
• ESCENARIOS

NUMERICAL RESULTS
MARKET RISK MANAGEMENT
DISCUSSION ARENA ALCO COMMITTEE
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BSCH Market Risk Profile in Latin America
TOTAL PORTFOLIO Management PL vs Value at Risk
(VaR)
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Starting point BS Chile - BS PerúMarket Risk
Model Proposal
IADB - BSCH Project

• Common Issues
• Both are companies within BSCH, with a common
  culture in Risk Management and Control
• Have a previous Risk Management and Control model
• Control has Independence from the Business group
• Past Culture in IR Gaps
• Employ Market Risk methodologies, although not
• Absence of an integrated system solution
• Problems with the MIS system, procedures and
  training

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Differences and Strategies
IADB - BSCH Project
BS Chile
BS Perú
Differences
Low Liquidity
Market
Medium Liquidity
Total Assets
8.000 MM USD (2º)
1.000 MM USD (7º)
In BSCH for
15 years
3 years
Strategy
Organizational Structure
Creation of the Market Risk group
Minor changes in functions committees
Market data captured daily
Market Variables
Data estimation
GlobalRisk Implementarion
Customized application
Information Systems
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Market Risk model proposed
IADB - BSCH Project
Determine the criteria to take risk
Limit Structure
Implementation Organization Policies Procedures M
ethodologies Systems Controls Training
Decision Making Process
Risk Management
Análisis y Evaluación de los Riesgos Existentes
Risk Analysis
Control del perfil de Riesgo
Risk Control
M.I.S.
PL Behaviour vs Risk Taken
Performance Measurement
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Risk Management in Emerging Markets
Summary
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Risk Management Project - Key Factors for Success
IADB - BSCH Project

• Country Analysis
• Clear determination of Goals
• Compromise from Local Senior Management
• Total commitment from the key departments
• Personalized solutions for each market/financial
  institution
• Training and Mentoring the local personnel

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But always be careful with ...
IADB - BSCH Project

• Liquidity and Market environment
• Discontinuities in prices
• Market Depth and characteristics
• Model Risk
• Training and Human Resources conflicts
• Regulatory Issues

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Summary - Risk Management in Emerging Markets
The Management Tool goes Beyond VaR
Market Risk goes Beyond Risk Measurement
OBJETIVES Short Term - No surprises to
unexpected losses Long Term Achieve an Efficient
Managemnt of the Firms Capital
Limit Structure
Policies and Procedures
Methodology
CAPITAL
Control and Reporting
Measurement and Valuation Tools
Infraestructure and Systems
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Risk Management in Emerging Markets
Annex - Graphs for External Interest Rate
Risk Internal/Local Interest Rate Risk Equity
Risk Foreign Exchange Risk
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Fixed Income Products
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Fixed Income Products
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Fixed Income Products

• Long Term Interest Rates Behaviour

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Fixed Income Products

• Long Term Interest Rates Behaviour

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Fixed Income Products
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Local and International Equities
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Local and International Equities
Indices expresados en base USD. Punto
referencia 1 Enero 97.
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Local and International Equities
Indices expresados en base USD. Punto
referencia 1 Enero 97.
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Foreign Exchange Markets
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Foreign Exchange Markets