GUIDELINES ON MARKET RISK MANAGEMENT
(Appendix to Sec. 144)
II. Statement of policy
• Understands, measures, monitors and controls the risk assumed,
• Adopts risk management practices whose sophistication and effectiveness are commensurate to the risk being monitored and controlled, and
• Maintains capital commensurate with the risk exposure assumed.
1. The major sources of market risk exposure and the complexity and level of risk posed by the assets, liabilities, and off- balance-sheet activities of the FI;
2. The FI’s actual and prospective level of market risk in relation to its earnings, capital, and risk management systems;
3. The adequacy and effectiveness of the FI’s risk management practices and strategies as evidenced by:
• The adequacy and effectiveness of Board and senior management oversight;
• Management’s knowledge and ability to identify and manage sources of market risk as measured by past and projected financial performance;
• The adequacy of internal measurement, monitoring, and management information systems;
• The adequacy and effectiveness of risk limits and controls that set tolerances on income and capital losses;
• The adequacy and frequency of the FI’s internal review and audit of its market risk management process.
III. Market risk management process
1. Identify market risk. Identifying current and prospective market risk exposures involves understanding the sources of market risk arising from an FI’s existing or new business initiatives. An FI should have procedures in place to identify and address the risk posed by new products and activities prior to initiating the new products or activities.
2. Measure market risk. Once the sources and desired level of market risk have been identified, market risk measurement models can be applied to quantify an FI’s market risk exposures. However, market risk cannot be managed in isolation. Market risk measurement systems should be integrated into an FI’s general risk measurement system and results from models should be interpreted in coordination with other risk exposures. Further, the more complex an FI’s financial market activities are, the more sophisticated the tools that measure market risk exposures arising from such complex activities should be.
3. Control market risk. Quantifying market risk exposures help an FI align existing exposures with the identified desired level of exposures. Controlling market risk usually involves establishing market risk limits that are consistent with an FI’s market risk measurement methodologies. Limits may be applied through an outright prohibition on exposures above a pre-set threshold, by restraining activities or deploying strategies that alter the risk-return characteristics of on- and off- balance sheet positions. Appropriate pricing strategies may likewise be used to control market risk exposures.
4. Monitor market risk. Ensuring that market risk exposures are adequately controlled requires the timely review of market risk positions and exceptions. Monitoring reports should be frequent, timely and accurate. For large, complex FIs, consolidated monitoring should be employed to ensure that management’s decisions are implemented for all geographies, products, and legal entities.
IV. Definition and sources of market risk
a. Interest rate risk
1. Sources of interest rate risk
a. Re-pricing risk
b. Basis risk
c. Yield curve risk
d. Option risk
2. Measuring the effects of interest rate risk.
a. Earnings Perspective
b. Economic value perspective
c. Managing earnings and economic exposures
b. Foreign exchange risk
V. Sound market risk management practices
1. Active and appropriate Board and senior management oversight;
2. Adequate risk management policies and procedures;
3. Appropriate risk measurement methodologies, limits structure, monitoring and management information systems; and
4. Comprehensive internal controls and independent audits.
A. Active and appropriate board and senior management oversight1
Responsibilities of the board of directors
1. Establish and guide the FI’s strategic direction and tolerance for market risk. While it is not possible to provide a comprehensive list of documents to consider, the Bangko Sentral should see a clear and documented pattern whereby the Board reviews, discusses and approves strategies and policies with respect to market risk management. In addition, there should be evidence that the Board periodically reviews and discusses the overall objectives of the FI with respect to the level of market risk acceptable to the FI.
2. Identify senior management who has the authority and responsibility for managing market risk and ensure that senior management takes the necessary steps to monitor and control market risk consistent with the approved strategies and policies. The Bangko Sentral should be able to discern a clear hierarchal structure with a clear assignment of responsibility and authority.
3. Monitor the FI’s performance and overall market risk profile, ensuring that the level of market risk is maintained within tolerance and at prudent levels supported by adequate capital. The Board should be regularly informed of the market risk exposure of the FI and any breaches to established limits for appropriate action. Reporting should be timely and clearly presented. In assessing an FI’s capital adequacy for market risk, the Board should consider the FI’s current and potential market risk exposure as well as other risks that may impair the FI’s capital, such as credit, liquidity, operational, strategic, and reputation risks.
4. Ensure that the FI implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of market risk. The board of directors should encourage discussions among its members and senior management – as well as between senior management and others in the FI – regarding the FI’s market risk exposures and management process.
5. Ensure that adequate resources, both technical and human resources, are devoted to market risk management. While board members need not have detailed technical knowledge of complex financial instruments, legal issues or sophisticated risk management techniques, they have the responsibility to ensure that the FI has personnel available who have the necessary technical skills to evaluate and control market risk. This responsibility includes ensuring that there is continuous training of personnel on market risk management and providing competent technical staff for the internal audit function.
Responsibilities of senior management
1. Develop and implement policies, procedures and practices that translate the board’s goals, objectives and risk tolerances into operating standards that are well understood by personnel and that are consistent with the board’s intent. Senior management should also periodically review the organization’s market risk management policies and procedures to ensure that they remain appropriate and sound.
2. Ensure adherence to the lines of authority and responsibility that the board has established for measuring, managing, and reporting market risk exposures.
3. Maintain appropriate limits structure, adequate systems for measuring market risk, and standards for measuring performance.
4. Oversee the implementation and maintenance of management information and other systems to identify, measure, monitor, and control the FI’s market risk.
5. Establish effective internal controls over the market risk management process.
6. Ensure that adequate resources are available for evaluating and controlling market risk. Senior management of FIs, including branches of foreign banks, should ensure that analysis and market risk management activities are conducted by competent staff with technical knowledge and experience consistent with the nature and scope of the FI’s activities. There should be sufficient depth in staff resources to manage these activities and to accommodate the temporary absence of key personnel and normal succession.
Lines of responsibility and authority
B. Adequate risk management policies and procedures
1. Description of the relevant product or strategy;
2. Use/purpose of the new product/ activity;
3. Identification of the resources required and unit/s responsible for establishing sound and effective market risk management of the product or activity;
4. Analysis of the reasonableness of the proposed activities in relation to the FI’s overall financial condition and capital levels; and
5. Procedures to be used to measure, monitor, and control the risks of the proposed product or activity.
C. Appropriate risk measurement methodologies, limits structure, monitoring, and management information system
Market risk measurement models/ methodologies
Market risk measurement systems should:
1. Assess all material market risk associated with an FI’s assets, liabilities, and OBS positions;
2. Utilize generally accepted financial concepts and risk measurement techniques; and
3. Have well-documented assumptions and parameters.
(1) Model input. All market risk measurement methodologies require various types of inputs, including hard data, readily observable parameters such as asset prices, and both quantitatively and qualitatively- derived assumptions. This applies equally to simple gap as well as complex simulation models.
(2) Model risk. While accuracy is key to an effective market risk measurement system, methodologies cannot be expected to flawlessly predict potential losses arising from market risk. The use of models introduces the potential for model risk. Thus, model risk is the risk of loss arising from inaccurate or incorrect quantification of market risk exposures due to weaknesses in market risk methodologies. It may arise from relying on assumptions that are inconsistent with market realities, from employing input parameters that are unreliable, or from calibrating, applying and implementing models incorrectly.
a. Model development/acquisition, implementation and revisions. The Bangko Sentral expects larger, complex FIs to adopt policies governing development/acquisition, implementation and revision of market risk models. These policies should clearly define the responsibilities of staff involved in the development/acquisition process. FIs should ensure that modeling techniques and assumptions are consistent with widely accepted financial theories and market practices. Policies and procedures should be duly approved by the board of directors and properly documented. An inventory of the models in use should be maintained along with documentation explaining how they operate.
b. Model validation. Before models are authorized for use, they should be validated by individuals who are neither directly involved in the development process nor responsible for providing inputs to the model. Independent model validation is a key control in the model development process and should be specifically addressed in an FI’s policies. Further, the Bangko Sentral expects that the staff validating the models will have the necessary technical expertise.
1. Tests of internal logic and mathematical accuracy;
2. Development of empirical support for the model’s assumptions;
3. Back-testing. The Bangko Sentral expects FIs to conduct backtesting of model results. Back- testing is a method of periodically evaluating the accuracy and predictive capability of an FI’s market risk measurement system by monitoring and comparing actual movements in market prices or market risk factors with projections produced by the model. To be more effective, back-testing should be conducted by parties independent of those developing or using the model. Policies should address the scope of the back-testing process, frequency of back-testing, documentation requirements, and management responses. Complex models should be back-tested continually while simple models can be back-tested periodically. Significant discrepancies should prompt a model review.
4. Periodic review of methodologies and assumptions. The Bangko Sentral expects that FIs will periodically review or reassess their modeling methodologies and assumptions. Again, the frequency of review will depend on the model but complex models should be reviewed at least once a year, when changes are made, or when a new product or activity is introduced. Model review could also be prompted when there is a need for the model to be updated to reflect changes in the FI or market. The review process should be performed by an independent group as it is considered to be part of the risk control and audit function.
c. Stress testing. The underlying statistical models used to measure market risk summarize the exposures that reflect the most probable market conditions. Regardless of size and complexity of activities, the Bangko Sentral expects FIs to supplement their market risk measurement models with stress tests. Stress testing are simulations that show how a portfolio or balance sheet might perform during extreme events or highly volatile markets.
(3) Model output. Reports should be provided to senior management and the board as a basis for making decisions. Report content should be clear and straightforward, indicating the purpose of the model, significant limitations, the quantitative level of risk estimated by the simulation, a comparison to Board approved limits and a qualitative discussion regarding the appropriateness of the FI’s current exposures. Sophisticated simulations should be used carefully so that they do not become “black boxes” producing numbers that have the appearance of precision but may not be very accurate when their specific assumptions and parameters are revealed.
Market limits structure
Market risk monitoring and reporting
1. Summaries of the FI’s aggregate exposures;
2. Reports demonstrating the FI’s compliance with policies and limits;
3. Summary of key assumptions, for example, non-maturity deposit behavior, prepayment information, and correlation assumptions;
4. Results of stress tests, including those assessing breakdowns in key assumptions and parameters; and
5. Summaries of the findings of reviews of market risk policies, procedures, and the adequacy of the market risk measurement systems, including any findings of internal and external auditors and retained consultants.
D. Risk controls and audit
1. A strong control environment;
2. An adequate process for identifying and evaluating risk;
3. The establishment of control activities such as policies, procedures, and methodologies;
4. Adequate information systems;
5. Continual review of adherence to established policies and procedures; and
6. An effective internal audit and independent validation process.
1. The appropriateness of the FI’s risk measurement system(s) given the nature, scope, and complexity of its activities.
2. The accuracy and completeness of the data inputs – This includes verifying that balances and contractual terms are correctly specified and that all major instruments, portfolios, and business units are captured in the model. The review should also investigate whether data extracts and model inputs have been reconciled with transactions and general ledger systems.2
3. The reasonableness and validity of scenarios and assumptions – This includes a review of the appropriateness of the interest rate scenarios as well as customer behaviors and pricing/volume relationships to ensure that these assumptions are reasonable and internally consistent.3
4. The validity of the risk measurement calculations – The scope and formality of the measurement validation will depend on the size and complexity of the FI. At large FIs, internal and external auditors may have their own models against which the FI’s model is tested. FIs with more complex risk profiles and measurement systems should have the model or calculations audited or validated by an independent source. At smaller and less complex FIs, periodic comparisons of actual performance with forecasts may be sufficient.4
5. The frequency and extent to which an FI should re-evaluate its risk measurement methodologies and models depend, in part, on the particular market risk exposures created by holdings and activities, the pace and nature of market rate changes, and the pace and complexity of innovation with respect to measuring and managing market risk.
VI. Capital adequacy
When performing these evaluations, the Bangko Sentral will determine if:
(a) All material market risk associated with an institution’s assets, liabilities, and OBS positions in the accrual book are captured by the risk management systems;
(b) Generally accepted financial concepts and risk measurement techniques are utilized. For larger, complex FIs, internal systems must be capable of measuring risk using both an earnings and economic value approach;
(c) Data inputs are adequately specified (commensurate with the nature and complexity of an FI’s holdings) with regard to rates, maturities, re-pricing, embedded options, and other details;
(d) The system’s assumptions (used to transform positions into cash flows) are reasonable, properly documented, and stable over time;5 and
(e) Market risk measurement systems are integrated into the institution’s daily risk management practices. The output of the systems should be used in characterizing the level of market risk to senior management and board of directors.
- This Section refers to a management structure composed of a board of directors and senior management. The Bangko Sentral is aware that there may be differences in some FIs as regards the organizational framework and functions of the board of directors and senior management. For instance, branches of foreign banks have board of directors located outside of the Philippines and are overseeing multiple branches in various countries. In this case, “board-equivalent” committees are appointed. Owing to these differences, the notions of the board of directors and the senior management are used in these guidelines not to identify legal constructs but rather to label two decision-making functions within a FI.
- It is acceptable for parts of the reconciliation to be automated; e.g., routines may be programmed to investigate whether the balances being extracted from various transaction systems match the balances recorded on the FI’s general ledger. Similarly, the model itself often contains various audit checks to ensure, for example, that maturing balances do not exceed original balances.
- Key areas of review include the statistical methods that were used to generate scenarios and assumptions (if applicable), and whether senior management reviewed and approved key assumptions. The review should also compare actual pricing spreads and balance sheet behavior to model assumptions. For some instruments, estimates of value changes can be compared with market value changes. Unfavorable results may lead the FI to revise model relationships.
- The validity of the model calculations is often tested by comparing actual with forecasted results. When doing so, FIs can compare projected net income results with actual earnings. Reconciling the results of economic valuation systems can be more difficult because market prices for all instruments are not always readily available, and the FI does not routinely mark all of its balance sheet to market. For instruments or portfolios with market prices, these prices are often used to benchmark or check model assumptions.
- This is especially important for assets and liabilities whose behavior differs markedly from contractual maturity or re-pricing, and for new products. Material changes to assumptions should be documented, justified, and approved by management.