Risk Management in Banking -- Contents -- Foreword -- Preface -- About the Author -- 1: Risks and Risk Management -- 1.1 UNCERTAINTY, RISK AND EXPOSURE TO RISK -- 1.2 BROAD CLASSES OF FINANCIAL RISK -- 1.2.1 Credit Risk -- 1.2.2 Market Risk -- 1.2.3 Liquidity Risk -- 1.2.4 Interest Rate Risk -- 1.2.5 Foreign Exchange Risk -- 1.2.6 Solvency Risk -- 1.2.7 Operational Risk -- 1.3 BUSINESS LINES IN BANKING -- 1.4 BANKING REGULATIONS AND ACCOUNTING STANDARDS -- 1.5 RISK MANAGEMENT -- 1.5.1 Motivations -- 1.5.2 The Risk Processes -- 1.5.2.1 Credit Risk Limits and Delegations -- 1.5.2.2 Market Risk and Trading Activities -- 1.5.3 Risk Management Organization and Roles -- 1.5.3.1 The Risk Department and the ``Three Lines of Defense ́́Model -- 1.5.3.2 The Asset and Liability Management Department -- 1.5.3.3 Enterprise-wide Risk Management (ERM) -- 2: Banking Regulations Overview -- 2.1 REGULATION PRINCIPLES -- 2.2 CAPITAL ADEQUACY -- 2.3 SOME LESSONS OF THE FINANCIAL CRISIS -- 2.3.1 Liquidity -- 2.3.2 Fair Value -- 2.3.3 Solvency -- 2.3.4 Pro-cyclicality -- 2.3.5 Securitizations and Contagion of Credit Risk -- 2.3.6 Rating Agencies and Credit Enhancers -- 2.4 THE RESPONSES OF REGULATORS TO THE FINANCIAL CRISIS -- 3: Balance Sheet Management and Regulations -- 3.1 THE NEW REGULATORY RATIOS -- 3.1.1 Capital Adequacy -- 3.1.2 The Liquidity Coverage Ratio (LCR) -- 3.1.3 The Net Stable Funding Ratio (NSFR) -- 3.1.4 The Leverage Ratio -- 3.2 COMPLIANCE OF A COMMERCIAL BALANCE SHEET: EXAMPLE -- 3.2.1 Capital Base -- 3.2.2 Risk Weights, Asset Mix and Capital -- 3.2.3 Compliance with NSFR -- 3.2.4 LCR Compliance -- 3.3 CREATION OF VALUE -- 4: Liquidity Management and Liquidity Gaps -- 4.1 LIQUIDITY AND LIQUIDITY RISK -- 4.1.1 Liquidity and Financing -- 4.1.2 Liquidity Risk in the Banking Book -- 4.2 LIQUIDITY GAP TIME PROFILES -- 4.3 TYPES OF LIQUIDITY GAPS.

4.4 MANAGING INCREMENTAL GAPS -- 4.5 DYNAMIC LIQUIDITY GAPS -- 4.6 FUNDING LIQUIDITY MANAGEMENT -- 4.7 LIQUIDITY CRISES AND STRESS SCENARIOS -- 5: Interest Rate Gaps -- 5.1 INTEREST RATE RISK -- 5.1.1 Interest Rate Risk, the Term Structure and Mismatch Risk -- 5.2 INTEREST RATE GAPS -- 5.3 CALCULATIONS OF INTEREST RATE GAP -- 5.3.1 Calculation of Interest Rate Gaps -- 5.3.2 Mapping Interest Rates to Selected Risk Factors -- 5.3.3 Sample Gap Reports -- 5.4 THE GAP MODEL -- 5.5 NET INTEREST INCOME AND INTEREST RATE GAPS -- 5.6 GAP MANAGEMENT AND HEDGING -- 5.7 LIMITATIONS OF INTEREST RATE GAPS -- 5.7.1 Customers' Rates -- 5.7.2 Regulated Rates -- 5.7.3 Embedded Options -- 5.8 APPENDIX: GAPS AND INTEREST RATE SENSITIVITY -- 6: Hedging and Gap Management -- 6.1 THE TRADE-OFFS OF GAP MANAGEMENT -- 6.2 MANAGING INTEREST RATE GAPS WITH INTEREST RATE DERIVATIVES -- 6.3 MANAGING INTEREST RATE GAPS -- 6.4 SETTING LIMITS TO GAPS -- 6.5 HEDGING THE VARIATIONS OF THE TERM STRUCTURE OF INTEREST RATES (CASE STUDY) -- 6.6 HEDGING BUSINESS RISK AND INTEREST RATE RISK -- 7: Economic Value of the Banking Book -- 7.1 ECONOMIC VALUE AND ITS SENSITIVITY -- 7.2 ECONOMIC VALUE AND NET INTEREST INCOME -- 7.2.1 Sample Bank Balance Sheet -- 7.3 THE SENSITIVITY OF ECONOMIC VALUE TO INTEREST RATES -- 7.3.1 Sensitivity of Fixed Income Assets or Debts -- 7.3.2 Sensitivity of Economic Value and Duration Gaps -- 7.3.3 Behavior of Value with Shocks on Interest Rates -- 7.4 APPENDIX: CONVEXITY -- 8: Convexity Risk in Banking -- 8.1 CONVEXITY RISK AND ECONOMIC VALUE -- 8.2 AN EXTENDED FRAMEWORK FOR STOCHASTIC CASH FLOWS: VALUATION -- 8.2.1 Customers' Rate Models -- 8.2.2 Volume Models -- 8.2.3 Interest Rate Models -- 8.2.4 A Comprehensive Framework -- 8.3 APPENDIX: THE VALUE OF CONVEXITY -- 9: Convexity Risk: the Case of Mortgages -- 9.1 THE CONVEXITY RISK OF MORTGAGES.

9.1.1 Mortgages: Runoff Function -- 9.1.2 Optional Hedges -- 9.2 THE VALUATION OF THE PREPAYMENT OPTION AND ITS PRICING -- 9.2.1 Payoff of Prepayment -- 9.2.2 Payoff of Prepayment with Immediate Exercise -- 9.2.3 Modeling Prepayments -- 9.2.4 The ``Binomial ́́Model of Short-term Interest Rates -- 9.2.5 Valuation of the Loan with all Interest Rate Scenarios -- 9.2.6 The Payoffs from the Prepayment Option -- 9.2.7 Pricing the Option: the Option-adjusted Spread -- 9.3 APPENDIX 1: VALUATION OF A BOND USING AN INTEREST RATE TREE -- 9.4 APPENDIX 2: CALIBRATION OF THE BINOMIAL TREE -- 10: Funds Transfer Pricing Systems -- 10.1 INTERNAL FUND PRICING SYSTEMS -- 10.2 FUNDS TRANSFER PRICING IN THE BANKING BOOK -- 10.2.1 Transfers of Funds -- 10.2.2 The Allocation of Net Interest Income -- 10.3 ECONOMIC TRANSFER PRICES IN THE BANKING BOOK -- 10.3.1 Using Market Rates as Benchmarks -- 10.3.2 Transfer Prices for Loans -- 10.3.3 Transfer Prices for Resources -- 10.3.4 Transferring Liquidity and Interest Rate Risks to the ALM Books -- 10.3.5 Economic and Commercial Transfer Prices -- 10.4 RISK-BASED PRICING: LENDING -- 11: Returns, Random Shocks and Value-At-Risk -- 11.1 VALUE-AT-RISK -- 11.2 RANDOM SHOCKS AS ASSET RETURNS -- 11.3 STOCHASTIC PROCESSES -- 11.4 MODELING RANDOM SHOCKS -- 11.5 VaR CALCULATION FOR A SINGLE ASSET -- 11.6 DISTRIBUTION OF VALUE UNDER NORMAL RETURNS -- 11.7 FROM SHOCKS ON RISK FACTORS TO SHOCKS ON ASSET VALUE -- 11.8 APPENDIX 1: CONTINUOUS RETURNS AS LIMIT OF DISCRETE RETURNS -- 11.9 APPENDIX 2: COMMON PROCESSES -- 11.9.1 General Form of Processes -- 11.9.2 The Stock Price Process -- 11.9.3 The Mean-reverting Process and Interest Rates -- 11.9.4 The ``Rare Event ́́Process and Defaults -- 12: Portfolio Risk and Factor Models -- 12.1 PORTFOLIO RETURN VOLATILITY, CORRELATIONS AND COVARIANCES -- 12.2 FACTOR MODELS -- 12.2.1 A Single-factor Model.

12.2.2 Multi-factor Models -- 12.3 SENSITIVITIES OF COMMON INSTRUMENTS -- 12.3.1 Bonds and Loans -- 12.3.2 Options -- 12.3.3 Forward Contracts and Interest Rate Swaps -- 12.4 NON-LINEAR INSTRUMENTS -- 12.5 VOLATILITY OF THE PORTFOLIO RETURN -- 12.6 CLOSED-FORM MATRIX FORMULAS FOR THE VOLATILITY OF THE PORTFOLIO RETURN AND FOR VaR -- 12.7 APPENDIX 1: CORRELATION AND VOLATILITY OF A SUM OF RANDOM VARIABLES -- 12.8 APPENDIX 2: MAPPING AN INSTRUMENT TO RISK FACTORS -- 13: Delta-Normal Var and Historical Var -- 13.1 DELTA-NORMAL VaR -- 13.1.1 A Forward Foreign Exchange Contract -- 13.1.2 The Framework of Delta-normal VaR -- 13.1.3 Deriving Sensitivities -- 13.1.4 Volatility and Delta-normal VaR of the Forward Value -- 13.1.5 Limits of the Delta-normal VaR -- 13.2 HISTORICAL VaR: FORWARD CONTRACT EXAMPLE -- 14: Extensions of Traditional Var -- 14.1 E-VaR OR EXPECTED SHORTFALL -- 14.1.1 Calculation of E-VaR -- 14.1.2 Property of E-VaR -- 14.2 MONTE CARLO SIMULATIONS -- 14.2.1 Normal Distributions -- 14.2.2 Simulations of Random Variables -- 14.2.3 Market Simulations of Non-normal Variables -- 14.3 APPENDIX: CHOLESKY DECOMPOSITION -- 15: Volatility -- 15.1 VOLATILITY -- 15.2 EXPONENTIALLY WEIGHTED MOVING AVERAGE MODEL (EWMA) -- 15.3 GARCH MODELS -- 15.4 MAXIMUM LIKELIHOOD METHODOLOGY -- 15.5 ESTIMATING EWMA VOLATILITY -- 16: Simulation of Interest Rates -- 16.1 INTEREST RATES AND FACTOR MODELS -- 16.2 MODELING THE TERM STRUCTURE OF INTEREST RATES WITH PRINCIPAL COMPONENT ANALYSIS -- 16.3 INTEREST RATE SIMULATIONS -- 16.4 APPLICATION TO MARKET VaR -- 16.5 SIMULATIONS OF INTEREST RATES FOR THE BANKING BOOK -- 17: Market Risk Regulations -- 17.1 THE MARKET RISK REGULATIONS AS OF JUNE 2006 -- 17.1.1 The Standardized Approach -- 17.1.2 The Internal Model Approach -- 17.1.3 Back-testing Value-at-Risk -- 17.2 REVISION TO THE MARKET RISK FRAMEWORK (2011).

17.2.1 Internal Model Approach -- 17.2.2 Securitizations and Credit Products -- 17.2.3 Specific and Incremental Risk Charge -- 17.2.4 Overall Capital Charge Revisions -- 17.2.5 Counterparty Credit Risk and Credit Value Adjustment (CVA) -- 17.3 REVISIONS TO THE BASEL 2 MARKET RISK FRAMEWORK -- 17.3.1 The Trading Book/Banking Book Boundary -- 17.3.2 Treatment of Credit-related Products -- 17.3.3 Approach to Risk Measurement -- 17.3.4 Incorporation of the Risk of Market Illiquidity -- 17.3.5 Treatment of Hedging and Diversification -- 17.3.6 Revised Standardized Approach -- 17.3.7 Internal Model Approach -- 17.3.8 Back-testing the VaR -- 18: Credit Risk -- 18.1 CREDIT RISK COMPONENTS -- 18.1.1 Default Event -- 18.1.2 Default Probability and Default Event -- 18.1.3 Exposure and Exposure Risk -- 18.1.4 Recovery Risk and Loss Given Default -- 18.1.5 Credit Risk Mitigation: Collateral -- 18.1.6 Credit Risk Mitigation: Third Party Guarantee -- 18.2 CREDIT RISK MODELING -- 18.3 LOSS DISTRIBUTIONS FOR CREDIT RISK -- 19: Credit Risk Data -- 19.1 DEFAULT STATISTICS -- 19.1.1 Annual Default Rates -- 19.1.2 Cumulative Default Rates -- 19.2 RECOVERY STATISTICS -- 19.3 TRANSITION MATRICES -- 19.4 CUMULATIVE AND MARGINAL DEFAULT PROBABILITIES -- 19.5 MIGRATION MATRICES AND CUMULATIVE PROBABILITIES -- 20: Scoring Models and Credit Ratings -- 20.1 SCORING -- 20.1.1 Scoring Functions -- 20.1.2 Logit Models -- 20.1.3 Scoring in Retail Banking: Behavioral versus Origination Models -- 20.1.4 Implementation of Scoring in Retail Banking -- 20.1.4.1 Comparing Attributes for Defaulters and Non-defaulters -- 20.1.4.2 Non-linear Relationships between Attributes and Credit Standing -- 20.1.4.3 Scoring Models and Default Frequencies -- 20.2 ACCURACY OF SCORING MODELS: THE ``CAP ́́-- 20.3 CREDIT RATINGS -- 20.3.1 External and Internal Credit Ratings.

20.3.2 The Bank's Counterparties.