A GlobeRisk Perspective on Market Risk, ALM and Funding
Market Risk and ALM are different perspectives on the sensitivity of portfolios to changes in financial markets or commodity prices. Both consider assets and liabilities. The key differences between the two perspectives are:
- Market Risk is concerned with changes to some form of “today” valuation whereas ALM is concerned with changes to future cash flows
- ALM is balance sheet oriented whereas Market Risk is value oriented
A reconciliation exists between the two perspectives through taking an ALM approach and then executing a present valuation of the net cashflows.
Since the early 1990’s Market risk has been the “sexy” area. This was partly due to technical innovations (e.g. Value at Risk), partly due to the huge growth in off balance sheet instruments (which require the creation of exciting models) and partly due to the difference in salaries between “investment bankers” and everyone else.
Recent years have seen massive growth in trading profits leading to a situation in which many firms have outstripped the capacity of their control frameworks, particularly in the following areas
- Credit asset inventory
- Credit derivatives
- Interest Rate derivatives
Until the second half of 2007 many firms had a large structural long position in credit assets seeking to benefit further from carry and declining spreads. Whilst July 2007 has seen some unwinding of these positions, the huge inventory across the trader/hedge fund sector means that spreads are likely to widen much further. Volatility will be the order of the day with “fear” and “greed” alternating as the primary market force
When credit derivatives were first developed in the early 1990’s they were linked to specific actual traded bond instruments and volumes were small in relation to the issued credit instrument base.
As at 2007 factors are very different:
- Credit derivatives now exceed the capital market issued base by a large factor
- In addition to which, much of the volume has occurred in so called synthetic credit derivatives (instruments which trigger payment based on bond spread measures or indices)
- Modern instruments are frequently “basket” based rather than being based on a single underlying obligor.
- Securitisation and tranching (i.e. the splitting of a risk into senior, mezzanine and junior elements) have grown enormously, particularly for baskets
The net impact is that banks have valuation and risk modelling issues whilst the underlying instrument market is too small to sustain significant hedging without collapse. Arguably, this effect explains much of the widening in investment grade credit spreads in June/July 2007.
The market standard for modelling (CDO) basket options is to use a single factor copula model to measure the relationship between the components of the basket. This has the advantage that tranching can easily be accommodated within the model but the disadvantage that it works badly – especially for the senior or junior tranches – must inevitably respond badly to economic cycle effects.
Moving to Interest Rate derivatives, the last 10 years has seen considerable progress. The Heath Jarrow Morton model is now the most widely used full term structure interest rate derivatives model in its discrete or “LIBOR model” form. More recent innovations include the BGM model which adds in mean reversion and stochastic volatility (although GlobeRisk has long held the view that stochastic volatility models do not work well preferring “jump” style models which are capable of replicating the increase in volatility smile that normally occurs as contract expiration decreases rather then the opposite effect, as generated by stochastic volatility models) The modelling technology has enabled a large increase in volume, but only at the expense of two key issues:
- Control over mark to market valuation
- Assessing the overall risk of a derivatives book which may consist of a large position at one point in the maturity/strike/volatility surface supposedly hedged by positions at rather different maturity/strike/volatility points – GlobeRisk frequently sees situations in which the construction of the overall portfolio goes beyond the power of the model(s)
An older problem which continues to grow despite the introduction of formal “day1 profit recognition standards” is that of “valuation adjustments”, that is to say the adjustments that one need to make to inventory marked-to-market at mid price to deliver an overall valuation that is consistent with the firms accounting policy
To be fair, many adjustments have been introduced since the early 1990’s. However two major areas remain – in the context that an off balance sheet book essentially represent a future revenue stream conditional on certain management/IT/Operations “conditions” being met. These areas are
- An adjustment for the cost of the Tier2 and 3 debt required to creating capital capacity
- An adjustment to recognise the cost of the equity (and other Tier1) supporting the portfolio over its average life
For banks with long average life derivatives portfolios, these adjustment could be very large.
Outside financial trading businesses, ALM is far more important than Market Risk. Modern ALM issues include:
- Asset prepayment characteristics (often called behavioural modelling)
- Liability profile and stickiness characteristics
- The variability of asset and liability margins against general interest rate levels
- The variability of asset or liability volumes against general interest rate levels
- Modelling asset/liability “gaps” at different maturities
To meet these challenges a new generation of ALM software is emerging and many firms will find a very strong business case to make changes to legacy ALM systems, particularly banks with a significant retail lending element.
Funding and Liquidity are both concerned with capacity to meet short term liabilities as they fall due. The two terms are often used interchangeably, although trading businesses can use liquidity risk to refer to capacity to sell assets without material movement to the existing price.
In ordinary times, funding risk is not given much importance by many financial sector firms. In times of stress, however, funding risk can be the key factor determining whether a firm will survive or fail. In ordinary times, funding risk is about the price of liabilities whereas in stress situations funding risk is about the amount of liabilities that can be re financed...
- Can the firm refinance liabilities due?
- Does the firm need to fire-sale assets to reduce refinancing needs?
Progressively since the late 1800’s regulators have imposed minimum funding standards on firms. This will be enhanced further in 2008 as the UK regulator introduces a new funding risk management regime. This will build on the principles already set out within GENPRU 1.2.26/30/34/37 and GENPRU 1.2.42. Banks will be required to assess funding needs in a range of stress conditions including behavioural modelling of assets and liabilities.
GlobeRisk Market Risk, ALM, Funding and Liquidity services
In 2007 GlobeRisk can offer the following Market Risk, ALM, Funding and Liquidity services:
- Market risk management, ALM and Funding review and controls design
- Derivative valuations
- valuation control reviews
- CAD2 program management
- Improved Risk Reporting
- Design and implementation of funding, ALM or market risk frameworks
- Systems selection