Bet­ter man­age­ment of mar­ket risk

Daily Mirror (Sri Lanka) - - FINANCE -

With in­creased role of non-banks in fi­nan­cial in­ter­me­di­a­tion, the statu­tory liq­uid­ity ra­tios (the por­tion of funds to be in­vested by banks in gov­ern­ment se­cu­ri­ties) are grad­u­ally com­ing down.

Banks in the busi­ness of mo­bi­liz­ing de­posit re­sources have to de­ploy funds in (i) Cen­tral bank man­dated form – cash with cen­tral bank and sub­scrib­ing gov­ern­ment se­cu­ri­ties (ii) dis­sem­i­na­tion of credit in the mar­ket (iii) re­main­ing funds to be de­ployed in in­vest­ments to earn prof­its us­ing the syn­ergy of mar­ket move­ments of in­ter­est rates/yields. As part of busi­ness strat­egy banks are in­creas­ingly di­ver­si­fy­ing into mar­ket driven in­vest­ments to im­prove the bot­tom-line.

Cor­po­rate sec­tor ear­lier de­pend­ing on bank fi­nance have be­gun to ac­cess funds from other sources such as eq­uity, bonds, deben­tures, ex­ter­nal bor­row­ings and seek­ing in­vest­ments from pri­vate eq­uity. As a re­sult, the in­vest­ment mar­kets are deep­en­ing. The fi­nan­cial sec­tor too is fast ex­pand­ing its reach to even move to­wards peer-to-peer lend­ing. In the process, banks ear­lier con­cen­trat­ing ex­po­sure to credit risk is get­ting ex­posed to mar­ket risk.

Basel Com­mit­tee on bank­ing su­per­vi­sion de­fines mar­ket risk as the risk of losses in on or off bal­ance sheet po­si­tions that arise from move­ment in mar­ket prices. It is also known as ‘sys­temic risk’ that can­not be elim­i­nated through di­ver­si­fi­ca­tion though it can be hedged against. Sources of mar­ket risk, among many in­clude losses aris­ing out of re­ces­sions, po­lit­i­cal tur­moil, changes in in­ter­est rates, bond yields, nat­u­ral dis­as­ters and cy­ber at­tacks.

In­vest­ment pol­icy of banks

In or­der to en­able banks to fol­low a stan­dard pro­ce­dure in man­ag­ing in­vest­ment port­fo­lio of the banks, a board ap­proved in­vest­ment pol­icy is in­sti­tu­tion­al­ized tak­ing cue from the cen­tral bank guid­ance and bank’s own re­source po­si­tion. In or­der to sug­gest best prac­tices in man­ag­ing in­vest­ments of banks, Basel Com­mit­tee on Bank­ing Su­per­vi­sion (BCBS) guide­lines ap­ply to all forms of in­vest­ments – eq­uity, hedge funds, man­aged funds, in­vest­ment funds, deben­tures and bonds.

It is based on the prin­ci­ple that banks should ap­ply a look – through ap­proach to iden­tify the un­der­ly­ing as­sets when­ever in­vest­ing funds. The risk-weight­ing frame­work built into it en­ables the ap­pli­ca­tion of con­sis­tent risk – sen­si­tive cap­i­tal frame­work that pro­vides in­cen­tives for im­proved mar­ket risk man­age­ment prac­tices. It is de­sired that the in­vest­ment pol­icy of banks should in­te­grate best prac­tices to in­su­late or mit­i­gate the mar­ket risk. The pol­icy should rest on three pil­lars. (i) Look Through ap­proach (LTA) (ii) Man­date based ap­proach (MBA) and fi­nally (iii) fall back ap­proach (FBA).

Clas­si­fi­ca­tion of se­cu­ri­ties

Based on this phi­los­o­phy, banks in­sti­tu­tion­al­ize in­vest­ment pol­icy with three dis­tinct clas­si­fi­ca­tions. It may dif­fer from coun­try to coun­try de­pend­ing upon its mar­ket prac­tices and cen­tral bank di­rec­tion. (a) Held to ma­tu­rity (HTM) – these are non-mar­ketable fixed in­come se­cu­ri­ties not gen­er­ally in­flu­enced by the mar­ket volatil­ity. In­vest­ments in such in­stru­ments will ma­ture on a fixed fu­ture date. These se­cu­ri­ties are not meant for trad­ing and are there­fore not sub­ject to ‘mark to mar­ket’ de­pre­ci­a­tion of val­ues. (b) Avail­able for Sale (AFS) – These se­cu­ri­ties do not nec­es­sar­ily have ready mar­ketabil­ity but can be sold by banks within a du­ra­tion of one year.

They are semi mar­ketable but when­ever banks have liq­uid­ity crunch, they can be sold in­stead of re­sort­ing to mar­ket bor­row­ings at higher in­ter­est rates. But since they are under AFS cat­e­gory, they are to be ‘mar­ket to mar­ket’. (c) Held for Trad­ing (HFT) - the most liq­uid se­cu­ri­ties that have on­go­ing mar­ket quo­ta­tions are placed in it. The trad­ing profit is tar­geted from this port­fo­lio that has to be most vi­brant and mar­ket con­nected. Since the val­ues of se­cu­ri­ties under this cat­e­gory is sus­cep­ti­ble to mar­ket volatil­ity, they are marked to mar­ket. Nor­mally, as per in­vest­ment pol­icy, the clas­si­fi­ca­tions of se­cu­ri­ties are shuf­fled once in a year to up date trad­ing ca­pa­bil­i­ties and to ease their val­u­a­tion.

Mark to Mar­ket (MTM)

The se­cu­ri­ties held by banks as part of in­vest­ment port­fo­lio are sus­cep­ti­ble to mar­ket volatil­ity. Their val­u­a­tions are sub­ject to down­side risks as bond yields dip with in­ter­est rate curve chang­ing. Mark to Mar­ket (MTM) is to cal­cu­late the value of a fi­nan­cial in­stru­ment or port­fo­lio of such in­stru­ments at cur­rent mar­ket rates or prices of un­der­ly­ing se­cu­ri­ties com­pared to its ac­qui­si­tion value. For ex­am­ple, if a se­cu­rity (bond/eq­uity) is ac­quired by a bank at US $ 100 on say, April 1, 2017, as part of in­vest­ment port­fo­lio and if its quo­ta­tion in the mar­ket is down to US $ 87.43 on De­cem­ber 31, 2017. It has di­min­ished in its value by US $ 12.57. Then the MTM loss is said to be US $ 12.57.

Under the pru­den­tial stan­dards, bank has to re-price the se­cu­rity in its in­vest­ment book at mar­ket rate at US $ 87.43 and debit MTM loss to profit and loss ac­count of the bank ab­sorb­ing the po­ten­tial fall in value. In­stead, if the price is quoted at US $ 102.33 there is MTM gain which can­not be taken as profit un­less the se­cu­rity is ac­tu­ally sold and value is re­al­ized. MTM is an in­ter­na­tional pru­den­tial stan­dard meant to ring fence banks against loss of value in se­cu­ri­ties from time to time.

Thus MTM is a process of mark­ing the price of se­cu­ri­ties to the cur­rent mar­ket value at which it can be sold. Though an MTM on a daily ba­sis is of­ten de­sired but is done as per bank’s own pol­icy in or­der to crys­tal­lize MTM losses and ab­sorb them well in time to pre­vent their ac­cu­mu­la­tion. The pe­ri­od­ic­ity of as­sess­ing MTM losses and its ab­sorp­tion pol­icy is de­fined in in­vest­ment pol­icy to make in­vest­ment port­fo­lio shock proof.

Risk weighted as­sets

Like loans, the se­cu­ri­ties have risk weights to on the ba­sis of their in­her­ent risks. Gov­ern­ment se­cu­ri­ties hav­ing sovereign guar­an­tee are as­signed zero risk weight. All other in­stru­ments carry risk weights as per their per­ceived risk. The in­ten­tion of as­sign­ing risk weight is to ar­rive at risk weighted as­sets of the port­fo­lio so that cap­i­tal ad­e­quacy ra­tios can be worked out. The risk weights are also linked to the credit rat­ing of is­su­ing or­ga­ni­za­tion. In a scale of say, rat­ings ac­corded from AAA to BBB, AAA is con­sid­ered the safest in­stru­ment and BBB may be the risky one. Basel III pro­vides for as­sign­ing risk weight on se­cu­ri­ties rang­ing from zero to 150 de­pend­ing upon the per­ceived risk. Basel III ac­cord clearly a spell out that cap­i­tal ad­e­quacy is to be cal­cu­lated on the ba­sis of risk-weighted as­sets.

Banks have to keep in mind the risk weights and likely MTM losses in select­ing an in­stru­ment for in­vest­ing bank funds. Even non-funded fa­cil­i­ties carry MTM risk and risk weighted as­sets are reck­oned for the pur­pose of ar­riv­ing at po­ten­tial mar­ket risk.

Way for­ward

As banks move to­wards more mar­ket driven in­vest­ments as part of busi­ness strat­egy, it is nec­es­sary to fine tune mar­ket risk man­age­ment process and in­ter­nal sys­temic con­trols so that trad­ing prof­its are kept as safe from mar­ket volatil­ity as pos­si­ble. Clas­si­fi­ca­tion of in­vest­ments, as­sess­ing MTM losses, per­ceiv­ing im­pact of risk weights on cap­i­tal ad­e­quacy, work­ing out risk mit­i­ga­tion strate­gies, adapt­ing bet­ter pru­den­tial norms in pur­su­ing trad­ing sys­tems, re­in­forc­ing in­ter­nal con­trols and keep­ing a scrupu­lous check on op­er­a­tional as­pects can en­hance qual­ity of mar­ket risk man­age­ment.

The team en­gaged in mar­ket risk man­age­ment has to be well trained and ex­posed to non-bank trea­suries and over­seas trea­suries to help ex­pand span of em­ployee knowl­edge so that risk mit­i­ga­tion and timely preven­tion of po­ten­tial losses can be en­sured in mar­ket risks.

(The au­thor is Di­rec­tor, Na­tional In­sti­tute of Bank­ing Stud­ies and Cor­po­rate Man­age­ment – NIBSCOM, Noida, Na­tional Cap­i­tal Re­gion – NCR, Delhi, In­dia. The views are his own)

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