Credit Risk and Market Risk - Assignment Example

Question Credit Risk and Market Risk For many reasons, practical as well as historical, credit and market risks have often been handled in a manner suggesting that they are unrelated sources of risk that is both types have been managed disjointedly, measured disjointedly and their corresponding economic capital assessed disjointedly. However, the adoption of mark-to-market accounting technique for the fractions of held-to-maturity banking book positions and the growth of credit risk transfer markets have diffused the differentiations between the two risks and generated questions about approaches addressing them disjointedly. Also, arguments presented by market participants indicate prospects of significant divergent benefits that can be enjoyed from integrated management and measurement of the two risks. Further, the recent global financial crisises has demonstrated how credit and market risks reinforce each other pointing out that illiquidity can exacerbate losses during such hard times (White, 2000). These developments generate significant questions as to the definitions of these two risks and the correlation between them- their aggregation and accurate measurement of joint risk; liquidity’s role in their interaction; and suitability of securitisation as an approach to risk management. This paper explores the credit risk and market risk and the interaction between them. It also presents critical analyses of the evolution of Basel Regulations on risks generated by credit and market factors and critical review on counterparty credit risk (CCR) and credit valuation adjustments (CVR) in light of the Basel III regulations. Credit risk, also known as default risk, counterparty risk or performance risk, is described as the probability that a contractual party will fail to meet its obligation as stipulated by terms of agreement to a specific contract. It is typified by three characteristics namely exposure, default likelihood and recovery rates all of which have implications on the firm’s transactions hence performance. On the other hand, market risk refers to the potential loss resulting from dwindling prices in the financial market relative to equities, commodities and/or interest rate; it usually has two drivers- market volatility and investment position. Thus, in one way or another, the two risks, credit and market risk, are generated by same factors thereby raising a number of issues as to their interaction- conceptual issues, aggregation issues, liquidity issues and securitisation issues. i) Conceptual issues: relationships and distinction Credit and market risks can be differentiated on the grounds of associating credit risk to expected or actual default which is described as the failure to fulfil predetermined contractual obligation or obligations. In practical risk management and measurement, distinguishing the two risks becomes difficult because they are affected by same economic factors; more they regularly interact appreciably with each other to influence values of assets (Rosenberg and Schuermann, 2006). Thus, risk management and measure ought to undeniably address for their combined influence. In practice, relatively simple ways based on holding periods, instruments used, accounting treatments and market liquidity have been adopted to distinguish credit risk from market risk. However, care ought to be exercised to ensure that risk managers are not blindfolded by such ways from significant risks emerging from the interactions between credit and market risks. Economic risk, as differentiated from operational risk, for banks, refers to the future economic uncertainty, rather than future accounting uncertainty, of values attached to liabilities and assets. Very often, a similar criterion is adopted in differentiating credit risk from market risk- by basing on their respective components of economic risk hence explanation to why credit risk is basically associated to the notion of default which is generally described as the non-delivery of an obligation under a contract by the obligor counterparty. From the above assumption on credit risk, market risk can then be defined as potential or actual fluctuations resulting from relative prices’ changes, for instance commodity prices and exchange rates; the discount factor, for instance risk premia and interest rates; and/or cash flow levels that are not supposedly fixed by contract (Cuenot et al., 2006). However, the difference between market and credit risks on the ground of default should not be emphasised since fluctuations in prices of assets may affect default (Masschelein and Tsatsaronis, 2008). For instance, values of bonds and stocks both change with affect companies’ capital structure and management, shift in asset prices and other macroeconomic environment factors. Dwelling on common drivers for credit and market risk presents significant interactions between them and as a result, it becomes very tricky to differentiate clearly credit risk from market risk. Even in incidences where each is associated with distinct set of drivers, they are still correlated. On the one hand, models exploring credit and market risks independently sometimes turn out inadequate; on the other hand, precise risk measurement calls for consideration of the joint influence generated by the two risks. Hassan, Siddique and Xian (2009) note that both credit risk and market risk are influenced by correlations between values of assets and macroeconomic variables that reveal the effect of charge-offs and default rates; interest rates; default-sensitive instruments’ prices; and equity prices. More so, Fiori and Iannotti (2008), in Italy, found that short-term interest shock has a larger impact on the firms’ default rates when the model for the credit risk integrates market risk proxies. Analyses revealing strong interactions as well as common drivers between credit and market risks imply some cautions to the simple ways utilised to differentiate the two risks on the grounds of exposure to specific characteristics. First, distinguishing the two risks basing on liquid markets’ existence is tricky because what was previously described as a liquid tradable position exposed to market risk can be a held-to-maturity position exposed to credit risk rather than market risk. Second, the distinction between the two risks can be made basing on the identities of the instrument to which they are attached; however, many assets exhibit/comprise elements of the two risks. Significant dangers exist in linking the two risks to the period of holding an investment and/or intended use; banks’ trading portfolio are generally considered exposed to market risk but this is not the case, occurrence of unexpected defaults gives rise to credit risk. Finally, accounting methods and/or treatments are not suitable bases to differentiate the two risks, for instance, loan portfolios may be accounted for using the fair-value accounting method whereas marked-to-market option may be applied to the credit instruments traded on the market (Tarashev and Zhu, 2008). ii) Aggregation issues: compounding versus diversification Interactions between credit and market risks can be better addressed by an integrated risk modelling technique, a techniques that calls for, among others, consistent capturing of losses and gains across the two risks. Thus, adjustments are necessary when weighed against currently adopted approaches- to consider also interest earnings on the held-to-maturity loan portfolios and not just only losses on such portfolios. Likewise, non-linear relationship between the two risks exists in some portfolios. Because of their inextricable relationship, notable biases are made in the overall estimates of risks when the conventional techniques such as top-down risk aggregation are applied. These sizable biases arise from treating the risks separately and then aggregating the results to arrive at the value of the overall risk; non-linear interactions between the risks generate compounding effect exuberate the final value. Despite the correlation between credit and market risks explored in section (i) above, measurement of risk in the industry is still carried out in a compartmentalised manner; each risk is aggregated at every position/division of the organisation and summed together at the top level, often in a linear manner. The interaction of market risk and credit risk under the integrated risk modelling approach are discussed in the following paragraphs. They include diversification, compounding and obstacle effects. Compounding effect there is a common assumption that conservative estimates of the aggregate risk care achieved by summing up the estimates attributed to each risk using the top-down approach. However, this is not correct since such consideration ignores the non-linear relationship between the two risks- credit and market- hence overestimation of the overall risk. Changes in market risk factors determine losses resulting from default on held instrument; equally, rating migration and/or default influence the changes in market risk factors. For instance, a bank providing lending services to clients in a foreign currency faces credit risk (from default) as well as market risk (from exchange rate). Thus, attempts to disjointedly measure credit and market risks and combine the resulting answers to arrive at the estimated overall value of risk causes substantial biases. Diversification effect is opposite to the compounding effect. On the dark side of the profits realised by banks exists the limiting effect of interest rates that is when interest rates are high, interest income is reduced because of increased defaults by borrowers caused by compression of margin between long term lending and short term borrowing. However, profitability is regained by banks overtime from increased margins resulting from charging high interest rates that transfer credit risk to borrowers. This explanation indicates diversification benefits between credit and market risks; the gains realised from transferring the credit risk to borrowers through high interest rates in the long run are significantly large making the economical capital reserved for credit risk and interest rate lower than capital that would have been reserved only for the credit risk considered in isolation. Therefore, there are diversification benefits that require collective recognition of profits and all risks on a regular basis. Obstacles are experienced in utilising integrated risk measurement because risk modelling and measurement are stretched past the consideration of a portfolio or position displaying compounding or diversification effects between credit risk and market risk. First, metrics utilised in measuring each of the risks are not wholly comparable since credit risk models centre on neglecting gains and default losses whereas market risk models incorporates returns’ full distribution. For instance, the “dirty” mark-to-market risk measurement approach applied to market risks integrates losses and profits born by changes in pricing factors implying that as the measurement period gets longer , value-at-risk approximation methods change and the importance of economic loss and/or profit components such as dividend earnings, interest earnings and accrued fees increases. On the contrary, few capital or credit risk models incorporate full loss or profit distribution on positions held to maturity. Most of the methods utilised in measuring credit risk disregard the portfolio-funding interest costs and performing-credits’ interest earnings. Another integration obstacle is experienced because of the differential time horizons/periods over which the two risks are measured as revealed by present practices regardless of credit risk’s increased tradability through expansion of financial innovations and securitisation in the past 10 years. The corresponding period for each risk has not been revised to reflect the changes in technological infrastructure- financial innovations and increased securitisation. Thus, challenges arise in combining risks having different measurement horizons. The horizon over which assets are liquidated marks the interactions between credit risk, market risk and liquidity conditions. Particularly, banks are forced to elongate their risk management strategies’ execution time by worsening market liquidity, and as such time grows longer the exposure to overall risk increases and so do the contributions of market and credit risks. All other things remaining constant, highest impact is recorded in prices of portions having high credit risk. Similarly, the current global financial crisis demonstrates that shocks and uncertainties augmenting credit risk adversely affect liquidity and deteriorates credit products’ liquidity as well as market prices (Ferguson Jr. et al., 2007). Among the important determinants of banks’ risk profiles is asset market liquidity because majority of risk management strategies count on liquid market for unwinding positions and/or hedging of positions to minimise losses. Thus, unexpected shocks in market liquidity factors can alter banks’ liquidity horizons hence changing the blend of credit and market risk portfolio because of two reasons: idiosyncratic nature of defaults and differential growth rates of market and credit risks. Securitisation enables banks to control credit risk and market risk through selective selling rather than hedging or unwinding. It allows the banks to focus on selective and intermediated risk bearing. However, it is vulnerable to it faces several challenges such as distorted investments and inadequate information about pricing parameters. Question 2: reinforcement between market and credit risks and treatment of credit and market risk factors under evolution of Basel Regulations Reinforcement between credit and market risks The relationships between different risks and market liquidity do not necessarily assume one direction; from changes in the liquidity observed to the variances in credit and market risks’ exposures (Collin-Dufresne, Goldstein and Martin, 2001; Kobayashi, 2007). This statement implies that changes in market liquidity affects and is affected by exposures to credit, as well as market, risk. For instance, changes in uncertainty and risk about models utilised in valuation of positions/risks can lead to deterioration of market liquidities that in turn elongates liquidity horizons. Such elongations buttress credit and market risks that market participants face resulting into further inflated price movements on the market. Therefore, worsening of credit risk factors results into worsening of market risk factors; the opposite still holds true. Financial markets are typified by unpredictable changes in liquidity as reflected by risk premiums incorporated in asset prices. Changes in the liquefiable periods of the assets result into changes in prices of assets relative to their corresponding risk exposures since differential risk premiums are required for differential risk exposure periods (Xiong, 2001). However, not all assets are equally affected by the changes in the liquidity of financial markets, assets having more credit risk than market risk are worse affected, and this serves as the basis for interaction between credit and market risks (Kobayashi et al., 2008). Thus, it calls for excellent risk management and measurement models otherwise credit risk will reinforce and be reinforced by market risk as explained in the following paragraph. Crisis reports at financial markets makes investors lose faith in structured products’ rating-related and model-implied prices. In consequence, increasing higher premiums are required to compensate the decreasing appetite for structured products embodying the risk; this usually happens during stress factors such as economic deterioration and increasing interest rate that causes increasing default correlations (Brigo and Pallavicini, 2007). All these factors generate a downward spiral between structured-product-markets’ liquidity and market prices; more fluctuations in prices and more elongation of liquidity horizons are recorded. Elongated liquidity horizons lead to increased price fluctuations that in turn lead to increased default (Bernardo and Welch, 2004; Chordia, Sarkar, and Subrahmanyam, 2005). Therefore, credit risk factors enhance market risk factors as more as market risk factors enhance credit risk factors. Evolution of Basel regulations and market and credit risks factors The overriding theme of Basel regulations, for the initial stipulations and subsequent reforms, is the growing complexity of analyses needed to adequately cater for the sophisticated approaches adopted in computing minimum regulatory capital that will enable banks and other financial institutions to withstand market, operational and credit risks (Kupiec, 2004; Balthazar, 2006). Basel I was addressed explicitly with credit risk providing a simple approach to use but Basel II increased complications (Wellink, 2007) and Basel III presented further complications. There are three standout features from the Basel regulations namely minimum requirements, supervisory review process and market discipline. Credit risk factors Basel regulations stipulate coverage of all factors/instruments contributing to emergence of credit risks including but not limited to securities financing, derivatives and corporate loans. All banks are required to develop and implement internal systems for managing and measuring various sources of credit risk; they include exposure-at-default (EAD), loss given default (LGD) and probabilities of default (PD) (BCBS, 2011). However, the regulations fail to specify which method to apply leaving the choice of the method at the discretion of the financial institution, a bank in this case. Although such stipulation serves as a wakeup call to managers of financial institutions to actively manage, monitor and evaluate risks, it does provide little for uniformity and comparison. Financial institutions do have varying considerations to their internal operations (Crouhy, Galai and Mark, 2000) and failure to specify considerations to be included in the calculations leads to divergent results that are incomparable. Basel regulations stipulate that at segment level, retail probabilities of default should be based on scorecards and be utilised in credit sanctioning, for instance, linking creditworthiness drivers such as loan-to-value ratio and income multiplicity through logistic regression. Second, models of retail mortgage loss given default should integrate forced sale discounts, time to repossession, cure rates and movements in house price index in determining non-recoverable exposure. Third, for drawdown facilities such as credit cards and bank overdrafts, retail exposure-at-default amounts not yet drawn but will actually be drawn, latest by default time. These stipulations address factors contributing to the emergence of credit risk (Crouhy Galai, and Mark, 2001). In the opening years of the 1990s decade market risk contained in mark-to-market book became a significant risk hence calling for revised measures to address it. In response, Basel regulations introduced a supplemental capital charge through the market risk amendment to capture this growing risk. However, despite its proposal in 1993, its development and implementation was complex delaying its adoption which eventually happened on January 1, 1998. The overriding feature of the market risk amendment is the permission to utilise internal Value-at-Risk models in estimating capital charge subject to regulatory approval of operational and analytical methods of the bank and meeting of particular structural requirements (Kashyap and Stein, 2004). This proved essential at that time because majority of the drivers of market risk during that period fall under structural variables such as commodity prices, foreign exchange rates and interest rates (Kamakura Corporation, 2011). Early 21st century witnessed spectacular growth of securitised debt obligations and credit default swaps in financial markets (Weill, 2007). Among the striking effects of such dramatic growth in securitised debt obligations and swaps was the migration of credit risk from banking books to trading books of large financial institutions, especially banks. The global financial crisis that started in 2007 amplified the effect further. In response, Basel regulations introduced the supplemental capital requirement for market risk to the previously established Value-at-Risk capital requirement that included specific risk and long-term incremental risk charges and long-term capital and comprehensive risk capital requirements. Again, these additional requirements and charges incorporated the new practices and measures that had be adopted and implemented by financial institutions in response to the global financial crisis. For instance, stressed long-term capital requirement incorporates data on the bank’s portfolio for the previous 12 months contrary to VaR of Basel II that did not. Question 3: Counterparty credit risk and credit valuation adjustment under Basel III Regulations Counterparty risk is experienced by banks when their respective counterparties go bankrupt making it impossible to continue with the contract between them that in turn leads to the banks incurring losses. Counterparty exposure refers to the derivative contract amounts a bank may lose as a result of default by counterparty before maturity of the contract between them (Gregory, 2009); it is generally summing up the respective values at different future time buckets. On the other hand, credit valuation adjustment (CVA) refers to credit products’ marked-to-market price that includes counterparties, therefore, credit valuation adjustment change when market risk factors surrounding the deal, as well as the counterparty’s credit worthiness, changes. For instance, it is estimate that default and credit valuation adjustment accounted for a third and two-thirds of losses suffered by financial institutions during the global financial crisis between years 2007 and 2010. As a result, Basel III regulations on counterparty credit risk and credit valuation adjustment requires require banks operating under them to recognise and allocate credit value adjustment capital and wrong-way risk (WWR). Credit value adjustment is basically the future value of the expected exposures whereas counterparty exposure profiles calls for calculating prospective exposures at specific times, for example, banks’ ideal time buckets and/or counterparties’ contract maturity times. Giesecke (2006), Jarrow et al. (2007) and Brigo and Capponi (2010) Monte Carlo simulation models that works best in calculating credit value adjustment cannot be applied to in calculating counterparty exposure simply because the first phase fails to cover all exposure profile’s prefixed time buckets (Glasserman and Li, 2005). Both credit value adjustment and counterparty credit risk cannot be successfully measured using Monte Carlo simulation model. Thus, measurement of counterparty credit risk through credit value adjustment is not exact. This inaccuracy is inherent in Basel III regulations that provide for measuring credit value adjustment capital by incorporating exposure profiles in credit value adjustment calculations. Basel III regulations on counterparty credit risk and credit value adjustment provides flexibility in computing risk-weighted capital among members guided by such regulations that is controlled members are allowed to use their respective internal models rather than uniformly strictly sticking to a standard approach. Because of the limitations and discrepancies witnessed in internal models of different banks, this provision is defective in ensuring adequacy of risk-weighted capital because of two reasons; provision of loopholes and enhancement of inconsistency (Badik, 2005). Allowing banks to sue their respective internal models in calculating and establishing risk-weighted capital gives them more freedom to manipulate and forge utilised components/parameters that enable them circumvent the proscribed practices. More so, permitting banks to utilise their respective internal models in calculation of risk-weighted will lead to the banks operating on different risk-weighted capital bases that in turn fuels claims of unfairness and favouritism since they operate in distinct, similar environments. Thus, this provision is not satisfactory; it will require additional measures to ensure adequacy, uniformity and transparency of the risk-weighted capital fixed by member banks. Analytics (16%), scalability and performance (18%) and data management are critical components of an efficient risk management model as indicated by a survey by Quantifi (Markets Media, 2013); as a result many (50%) banks are continuing to establish centralised groups in efforts to effectively manage counterparty risks, lesser number of banks (35%) still manages counterparty risks through multiple groups. The provisions in Basel III Regulations such as minimum capital ratios are likely to disrupt this trend because it forces banks to restructure their systems as well as processes- Pugachevsky as quoted in (Markets Media, 2013). Basel III Regulations requires banks to reserve more, high quality capital to cover credit valuation adjustment risk. Thus, it can be said that the Basel III Regulations on counterparty credit risk and Credit valuation adjustment will likely reshape processes and systems currently adopted by banks. Basel III Regulations have explained credit valuation adjustment as the difference in the values of a derivative made when the counterparty is assumed with to be default-risk and when assumed not that is CVA equals to the derivate value including counterparty’s default-risk minus the value of the derivate including counterparty’s default-risk. Such a definition presents difficulties in calculation of CVR since debt value adjustment (DVA) mirror the transaction’s debit side that is represents the different in value of the derivate considered at default-risk and default-risk-free of the bank (Duffie and Singleton, 1999). Also, Generally Accepted Accounting Principles (GAAPs) and International Finance Reporting Standards (IFRSs) stipulate incorporation of credit risk in derivatives’ fair value measurements. Further, requirement by the regulations to integrate acceleration effects referred to s Wrong-Way Risk (WWR) add up to the complexity of determining counterparty credit risk (Brigo, 2011). For instance, WWR include macroeconomic and contagion effects that are difficult to model, particularly for counterparties that are systematically important, especially in stressed economic conditions such as those prevailing during counterparty’s default times (Prakash, 2008). Issues of integrating risks’ margin periods into a model addressing counterparty credit risk are also evident in Basel III Regulations regarding counterparty credit risk and credit valuation adjustment. The regulations vividly illustrate the shortest margin period to be utilised during modelling of Exposure-At-Default (EAD). However, given the convolution of counterparty credit risk assessing models because of the diverse nature of the products transacted by banks, this proviso may be resource consuming (Ayuso, Perez and Saurina, 2004; Kroszner, 2008). Another notable issue regarding application of Basel III Regulations to counterparty credit risk and credit valuation adjustment regards the time to apply real world or neutral risk probabilities in computing credit risk. They leave the choice open to the banks- to choose which probability to use in modelling counterparty. Incidentally, the correct answer as to what probability to use depends on the bank’s strategy. If the bank’s strategy is a long term one, real world measures such as incremental risk charges would be required in completing capital calculations; on the other hand, if the bank has excellent model for managing and measuring the risk, market implied probabilities are preferred. In summary, usage of real world probabilities is best suited to less advanced financial institutions, banks in this case, whereas market based measures are appropriate for more advance financial institutions. References Ayuso, J., Perez, D., and Saurina, J. (2004). Are Capital Buffers Procyclical? Evidence from Spanish Panel Data. Journal of Financial Intermediation, 13(2), 249-264. Badik, P. (2005). Use of the VAR method for measuring market risks and calculating capital adequacy. BIATEC, 18(3), 17-21. Balthazar, L. (2006). From Basel 1 to Basel 3: The Integration of State-of-the-Art Risk Modelling in Banking Regulation. [Palgrave- Macmillan]. BCBS (2011). Revisions to the Basel II market risk framework. 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