Volume 16 (2023)

Each volume of Journal of Risk Management in Financial Institutions consists of four quarterly 100-page issues. Articles scheduled for Volume 16 are available to view on the 'Forthcoming content' page.

The papers and case studies included in Volume 16 are listed below:

Volume 16 Number 3

Editorial
Julie Kerry, Publisher
Practice papers
Stress testing bank insolvency risk by systemic equity market shock: An expected shortfall approach
Hank Z. Yang, Senior Specialist, Office of the Superintendent of Financial Institutions

This paper proposes a simple intuitive approach for assessing and stress testing the insolvency risk of global systemically important banks (G-SIBs) by shocking systemic risk in the equity market. In particular, the paper introduces two metrics to measure the relative adequacy of total loss absorbing capacity (TLAC) upon resolution of a bank under both real market conditions and stress test settings. The metrics may also be calculated on a regular basis for monitoring bank insolvency risk. Three global systemically important banks, including Credit Suisse, are presented as examples for the analysis. To capture the heavy tail feature of equity market downturns and ensure conservatism for stress testing, an analytical framework is adopted based on extreme value theory with expected shortfall, power law distributions and copula method. The analysis concludes that G-SIBs may have a high probability of loss exceeding TLAC under systemic market stress.
Keywords: systemic risk; total loss absorbing capacity (TLAC); stress test; Credit Suisse; expected shortfall; extreme value theory; copula
Good intentions in risk management and the LDI crisis
Martin Walker, Head of Product, Securities Finance and Collateral Management, Broadridge

This paper describes the part played by repo trading, collateral management and liability driven investment (LDI) strategies (each of which was designed to improve the management of risk) in amplifying the crash in gilt prices following the 23rd September, 2022 UK mini-budget. This was a crisis that ultimately led to the resignations of the British Prime Minister and Chancellor of Exchequer as well as the announcement by the Bank of England of a willingness to spend up to £65bn intervening in the gilt market. It argues that neither the government nor the LDI funds were solely responsible for the crash and that the fragilities in the UK financial system had gradually built up over a number of decades. It also looks at the lessons that could potentially be learned by financial institutions using repo trading or collateral management as well as the potential lessons for policy makers in government and regulatory bodies.
Keywords: liability driven investment; repo; collateral management; credit risk; gilts; trade reporting; European Market Infrastructure Regulation (EMIR); Securities Financing Transactions Regulation (SFTR); market risk
A bottom-up, reduced form credit risk model approach for the determination of collateralised loan obligation capital
Robert Jarrow, Ronald P. and Susan E. Lynch Professor of Investment Management, Cornell University and Donald R. van Deventer, Managing Director, SAS Institute Inc

This paper uses a bottom-up, reduced form credit risk model with hazard rate estimated default probabilities to compute various collateralised loan obligation (CLO) tranches' loss probabilities and capital factors. It is shown that with respect to the loss probabilities, credit rated CLO tranches are less risky than comparably rated corporate bonds. In addition, a similar argument can be made that corporate debt loss rates will be on average larger than equally rated CLO tranche loss rates. And, it is shown that the National Association of Insurance Commissioners (NAIC) capital factors are typically larger than value-at-risk based capital factors. The policy implication is that NAIC capital factors distort investment incentives by requiring too much capital for CLOs relative to equally rated corporate debt.
Keywords: collateralised loan obligations; NAIC capital factors; loss probabilities; credit risk; value-at-risk
Counterparty credit risk: Lessons from recent events
Andreas Ita, Managing Partner, Orbit36 Risk Finance Solutions AG

This paper looks at the lessons learned for risk management from two recent events, the default of Archegos Capital Management in March 2021 and the unusually large price jumps in energy markets in summer 2022. The paper finds that the counterparty exposure from margined derivatives transactions exceeded the required initial margin significantly in both cases, so that the exposures were largely uncollateralised when it mattered. In addition, the standardised approach for counterparty credit risk (SA-CCR) resulted in regulatory capital requirements which were insufficient to cover the banks' losses from the unwinding of large and concentrated derivatives exposures. This made it difficult, even for some large banks, to identify the high loss potential of the transactions with a single client.
Keywords: risk management; derivatives; collateral; standardised approach for counterparty credit risk (SA-CCR); initial margin; Archegos; energy markets
Optimising board oversight of compliance as a risk governance instrument
Ilona Niemi, Global Compliance Executive

Technological advancements, extended understanding of board members' fiduciary duty and corporate scandals have put an increasing focus on board oversight of compliance as a risk governance instrument. To build and sustain board oversight of compliance, which satisfies regulatory obligations, organisational requirements and boards' needs, is an ongoing challenge and requires significant focus by compliance teams at financial services organisations. This paper outlines a framework for board compliance reporting as a two-way communication process to ensure that boards remain on top of their oversight obligations in today's era of trust, in which stakeholders are more broadly seeking an effective demonstration of organisations' compliance responsibilities. In this practice paper five core levers are defined which are required to be in place in the board compliance reporting, in order to optimise board oversight of compliance as a risk governance instrument: adaptability, empathy, active listening, transparency and effective dialogue.
Keywords: risk governance; board; board oversight; board compliance reporting; communication; net promoter score (NPS); compliance risk
Green swans and pink washing: Promoting a strong culture of environmental and social responsibility in financial institutions
Matthew Connell, Director of Policy and Public Affairs, Chartered Insurance Institute

Anyone trying to build a strong culture of social and environmental responsibility within a financial institution must choose from a range of fundamentally different values, not only from legislation, but also from public opinion, experiences of underprivileged groups, religious beliefs and from the world of science and academia. One way to identify, understand and reconcile different values is through a system drawn from across the social sciences known as the theory of the convention. Applying this framework to the range of relationships needed to deliver financial intermediation allows financial professionals to prioritise key values. Many of these key values stem from the technical disciplines needed to evaluate risk and perform the core functions of a financial intermediary. However, institutions must also maintain long-term relationships with clients, staff and a range of groups at higher risk of vulnerability within their community, and that involves adopting a creative approach to combining the values of the technical expert with empathy and a sense of stewardship toward human and environmental resources. An understanding of the relationships and values at play can help actors to create and modify conventions that, in turn, contribute to a strong culture of social and environmental responsibility.
Keywords: ESG (environmental, social, governance); sustainability; environment; social; culture; diversity and inclusion
A review of corporate governance in the Saudi Arabian insurance sector
Shanar Shafi Alsuyayfi, PhD student, Rasidah Mohd Said, Associate Professor, Roslan Ja’afar, Senior Lecturer, UKM-Graduate School of Business, Universiti Kebangsaan Malaysia and Ali Albada, Assistant Professor, Sohar University

This research aims to highlight the gaps in literature on corporate governance and risk management, and their impact on organisational performance in Saudi Arabia, specifically in the insurance sector. Existing studies that measure such relationships are limited. Moreover, the literature has revealed several constraints in the Saudi Arabian corporate governance environment that exacerbate the challenge associated with regulatory set-up, compliance and the detection of any changes in corporate governance procedures. Considering the `great` importance of the insurance sector in the Saudi economy, and the important role of corporate governance in regulating the insurance business, the study proposes that policy makers and regulators develop policies and regulations that would ensure that firms implement appropriate risk management strategies to improve the performance of the insurance industry in Saudi Arabia. Finally, the policy makers should focus on strengthening Takaful insurance because it has much potential due to its risk-averse characteristics.
Keywords: financial performance; corporate governance; board of directors; board independence; audit committees
Central bank capital management
Paul Wessels, Head of Payment and Collateral Operations and Dirk Broeders, Senior Financial Risk Manager, De Nederlandsche Bank

This paper offers general guidelines for central bank capital management. Capital adequacy is important to be a credible, independent monetary authority over a medium-term horizon. Central banks, however, face several challenges in determining their capital adequacy. Firstly, the amount of capital only plays an auxiliary role in central banks' effectiveness given that they cannot default as long as they have the right to issue legal tender. Secondly, central banks face two types of financial risks: calculable risks from current exposures and latent risks from future exposures. These latent risks, in particular, are difficult to quantify because they stem from contingent policy measures such as quantitative easing and lending of last resort. It is argued that a central bank's target level of capital (1) can be calibrated with a confidence level that is lower than that used for commercial banks and (2) takes latent risks into account that are related to GDP or the size of the financial sector in the economy.
Keywords: capital; capital management; central banks; latent risks; risk management
Book review
The Principles of Banking, 2nd Edition by Moorad Choudhry
Reviewed by Krzysztof Jajuga, Wroclaw University of Economics and Business

Volume 16 Number 2

Editorial
Julie Kerry, Publisher
Practice papers
Pricing of climate transition risks across different financial markets
Dirk Broeders, Senior Financial Risk Manager, Bernd Schouten, Economist, Isabelle Tiems, Economist and Niek Verhoeven, Economist, De Nederlandsche Bank

As the global economy transitions towards net zero, it is conjectured that efficient financial markets reflect the risks involved with this transition. This hypothesis is empirically tested in this paper and signals are found of climate transition risk pricing in options, equity and bond markets, based on greenhouse gas emission levels. The analysis of recent developments in the option market suggests that investors perceive the oil and gas sector to have an elevated risk profile. In the equity and bond market for, particularly, the energy sector, investors appear to demand higher returns to compensate for a higher transition risk. In addition, it is found that the average maturity of newly issued bonds in the carbon intensive coal sector decreased, while the average maturity increased strongly in the renewables sector with low carbon emissions. The reduction of investors' long-term exposure to the coal sector signals concerns about its long-term viability, while the opposite is the case for the renewables sector. Nonetheless, it is not possible to conclude that climate risk pricing is consistent, as the statistical evidence is not overwhelming and not fully aligned across different markets. Furthermore, as climate indicators and emission data still contain important flaws, climate pricing based on these indicators could also be inadequate. Therefore, this paper aligns with the literature arguing that climate risk pricing is inconsistent and inadequate and that this is important for investors and risk managers to acknowledge. In addition, policymakers are urged to ensure that transition information, like emission data, is correct, timely and comparable to ensure its information value and usability.
Keywords: climate change; climate transition risks; equity market; bond market; option market
The impact of climate risk on the insurance industry: Recent developments and emerging risk mitigation approaches
Sonjai Kumar, Certified Fellow of the Institute of Risk Management and Purnima Rao, Associate Professor, Fortune Institute of International Business

The present paper discusses the key emerging risks in the insurance industry due to the worsening of the global climate. First, the paper identifies the adverse impacts that have already taken place in the recent past in the insurance industry. Further, it discusses the various tools the industries utilise to manage their risks, such as underwriting, risk management and public disclosures. Finally, some key measures taken by the industry are discussed that include not providing insurance to polluting industries, tightening risk management governance and mandatory disclosures recommended by different insurance regulators.
Keywords: climate risk; insurance industry; underwriting; risk management; disclosure
The marginal impact of predicted climate risk scenarios on portfolio credit risk stress testing
Jonas de Oliveira Campino, Lead Strategic Risk Management Specialist, The Inter-American Development Bank

This paper adapts the methodology developed by de Oliveira Campino et al. (June 2021) to account for predicted climate risk shocks' impact on a sovereign portfolio's credit quality on a forward-looking basis and in probabilistic terms. In particular, the portfolio stress testing capability is enhanced by adjusting the severity of the credit shocks to account for climate risk-related events on an additive basis. The benefit to risk managers is that it allows understanding of the impact of climate risk in marginal terms in relation to the original credit shock. The recently created NGFS (the Network for Greening the Financial System) database makes this exercise possible. Moreover, the described approach translates the marginal impact of climate risk scenarios on the portfolio's credit risk stress testing into capital adequacy metrics dislocations, which facilitates communicating the marginal impact of climate risk scenarios as capital consumption amounts. The paper presents an overview of the underlying model, and the methodological approach developed to adapt the credit risk stress-testing capabilities to account for climate risk using the NGFS database. Moreover, it applies the methodology to a hypothetical sovereign loan portfolio and discusses the results. Over the period considered, the study finds that the transition aspect of climate risk has a more pronounced marginal impact on a sovereign portfolio's credit risk than the chronic physical aspect of climate risk. Moreover, the results indicate that as the world takes action to transition away from carbon, the credit risk of sovereign portfolios may be exacerbated, especially if there are delays and a lack of coordination across countries and sectors.
Keywords: climate risk; capital adequacy; sovereign risk; credit rating; stress testing; machine learning; LASSO; Monte Carlo simulation
Approaches for quantifying the financial impacts of reputational damage from climate change
Michael Grimwade, Managing Director, Operational Risk, ICBC Standard Bank Plc

Climate change is an existential threat to humanity. As such it has the potential to create uniquely severe reputational damage for financial institutions by significantly altering both their stakeholders' expectations and their perceptions of firms. Changes in the behaviours of the current (or future) providers of capital, funding and revenues to financial institutions would have the most direct and significant influences on the financial performance of firms. These impacts can be systematically assessed, through scenario analysis, by evaluating the effects in terms of the scale, financial sensitivity and duration of stakeholder responses. For prominent reputational risk events, the consequences may be simultaneously felt across five different financial impacts, although the responses of different stakeholders may vary. As there is uncertainty as to how stakeholders may respond, and a scarcity of climate change data, then non-climate change related reputational risk case studies are used in this paper to illustrate the scale and duration, where known, of the financial impacts. As with all forms of scenario analysis, the value obtained from these activities for climate change related reputational risks may ultimately arise as much from the greater understanding gained through the process, rather than the precision of the predictions. This paper sets out more systematic approaches for evaluating this reputational risk by detailing: the nature of reputational risk, including sources of negative stakeholder perceptions, and the differing abilities of stakeholders to act upon their negative perceptions by changing their behaviours; the nature of the risks posed by climate change, and how they may lead to reputational damage for financial institutions; and how these changed stakeholder behaviours/reputational damage may translate into five different categories of financial impacts, and how each may be assessed.
Keywords: climate change; reputational risk; financial impacts; scenario analysis
Research papers
ESG information integration into portfolio optimisation
Haoming Cao, Master of Mathematics degree student and Tony S. Wirjanto, Professor, University of Waterloo

A growing number of investors in recent years has focused on environmental, social and governance (ESG) factors in carrying out investment activities and the COVID-19 pandemic has only driven such trends of ESG investing at an accelerated rate. Many studies have examined the relationship between ESG scores and corporate financial performance, along with the effectiveness of ESG portfolios. This paper discusses various approaches to incorporate ESG factors into a portfolio optimisation and critically compares and contrasts the efficacy of these approaches on the Dow Jones Industrial Average constituents. It finds that thematic investing appears to be the best performer. In addition, it is also found that there is no evidence that ESG portfolios underperform the market.
Keywords: ESG; portfolio optimisation; best-in-class selection; thematic investing; ESG integration; Dow Jones Industrial Average; hybrid strategies; Sustainalytics
The estimation of Value-at-Risk using a non-parametric approach
Amir Olfat, PhD Student of Statistics and Farzad Eskandari, Professor of Statistics, Allameh Tabataba’i University

This paper is concerned with estimating the risk measure, Value-at-Risk (VaR), without considering the usual hypothesis used in parametric methods. A non-parametric method is used to fit severity and frequency loss distributions in collective risk models. In addition, an optimum bandwidth is estimated. The model is then applied to insurance claims data from a particular insurance company. As a result of the new model, the outcomes show better accuracy, for both light-tailed and heavy-tailed distributions.
Keywords: risk management; non-parametric models; VaR; cross-validation; kernel function
Estimating Value-at-Risk and expected shortfall of metal commodities: Application of GARCH-EVT method
Maaz Khan, COMSATS University Islamabad, Mrestyal Khan, Lecturer and Muhammad Irfan, Associate Professor and Deputy Dean, Balochistan University of Information Technology, Engineering and Management Sciences

The metal markets have become extremely competitive and highly volatile due to financial globalisation. Therefore, in this study, the Value-at-Risk (VaR) and expected shortfall (ES) are estimated for the metal markets. A two-stage dynamic extreme value theory (EVT) method has been adopted along with the GARCH (1, 1) model to identify the pre-specified threshold for the metal market by using high-frequency returns data of 15-minute intervals ranging from 1st January, 2018 to 24th September, 2021, which provides accurate information about metal market volatility and tail distribution. Moreover, the empirical findings confirm the presence of a high level of volatility persistence in the metal market, especially in the financial returns of gold. Furthermore, silver metal returns exhibit the highest VaR compared to other metals in the market. The empirical results could assist financial investors and portfolio managers to minimise and control the potential risk in the market.
Keywords: Value-at-Risk; extreme value theory; GARCH; metal market

Volume 16 Number 1

Editorial
Eduardo Canabarro, Independent Financial Economist
Opinion/Comment
Determining environmental and social risk rating in a multilateral development bank
Cristiane Ronza, Lead Specialist of Environmental and Social Risk Management and Stefanie Brackmann, Lead Specialist of Environmental and Social Risk Management, Inter-American Development Bank

The Inter-American Development Bank (IDB) is committed to managing environmental and social risks in all banking operations. To meet this commitment, the IDB applies a risk-based approach to environmental and social management for project development and execution to prioritise its interventions. The purpose of this paper is to describe the key concepts involved in determining the environmental and social risk rating of IDB operations and its value to the bank’s overall risk management framework.
Keywords: environmental and social risk management, impact assessment, ESG risk management, ESG portfolio management, ESG integration, engagement, environmental and social policy
Practice papers
Should investors rely on central bank asset purchases to backstop markets?
Colin Ellis, Professor of Finance, Hult International Business School

During the global financial crisis, central banks in advanced economies cut policy rates to near zero, and then provided further stimulus via balance sheet expansion. In many instances this took the form of quantitative easing — central banks creating new money with which to purchase securities. With years of quantitative easing behind us, and aggressive measures from central banks during the COVID-19 pandemic, should investors now expect central banks to backstop financial markets? This paper examines asset purchases from the twin perspectives of monetary and financial stability, and argues that investors should not expect central banks to always come to their rescue.
Keywords: central banks; quantitative easing; financial stability; moral hazard
Failure of strategic risk management in a life insurance company in India
Sonjai Kumar, Certified Risk Management Professional, IRM and Purnima Rao, Associate Professor, Fortune Institute of International Business

This paper discusses the importance of strategic risk management in avoiding an adverse effect on performance in the life insurance sector if long-term risks are ignored. The case considered here is the rise and subsequent fall of a life insurance company in India. The company initiated the sales and distribution of products in collaboration with banks (Bancassurance) but ignored the market momentum of the emerging distribution trend and did not change its distribution strategy. As a result, the company, which played a pioneering role in establishing the Bancassurance model, is now performing poorly, being at the bottom of the ladder on new business premium income.
Keywords: strategy; risk management; strategic risk management; life insurance; Bancassurance; sales and distribution
Research papers
What can we learn about repurchase programmes and systemic risk? Evidence from US banks during financial turmoil
Foued Hamouda, Assistant Professor, Higher Institute of Management of Tunis GEF2A-Lab, and Higher Institute of Management of Gabès

This paper contributes to the debate on systemic risk by measuring and comparing systemic risk and interconnectedness when banks repurchase shares during financial turmoil. It assesses the extent to which buyback programmes within banks contribute to systemic risk, relying on several measures of systemic risk and connectedness in a sample of 112 US banks during both a tranquil and an unstable period. Empirical results reveal remarkable increases in systemic risk in repurchasing banks compared to non-repurchasing banks and they are more exposed to it in difficult periods such as the European debt crisis and COVID-19. Banks that repurchased shares strengthened indirect links during systemic events and are potentially riskier. The results also classify and rank banks in terms of systemic risk involvement and connectedness and contribute to the identification of systematically important banks.
Keywords: financial crisis; systemic risk; bank networks; interconnectedness; buyback programmes; COVID-19
A coherent economic framework to model correlations between PD, LGD and EaD, and its applications in EaD modelling and IFRS-9
Peter Miu, Professor of Finance, DeGroote School of Business, McMaster University and Bogie Ozdemir, Co-Founder, RiskVision

This paper proposes an economic framework recognising EaD as a stochastic variable and capturing the PD–LGD, PD–EaD and LGD–EaD correlations. It explains how these correlations can be estimated from historical data, and how PD, LGD and EaD can then be simulated in determining credit VaR. The framework allows credit losses to be more accurately captured, both in terms of the expected credit losses (ECL under IFRS-9 and CECL) and the unexpected tail events in measuring Credit VaR. The framework quantifies the potential underestimation of the tail risk in Credit VaR and the IFRS-9 ECL if the full correlation structure is not captured. By explicitly modelling EaD in a correlated fashion with PD and LGD, lenders can understand and model the increase in funding requirements during downturns. Application in back-testing IFRS-9 ECL is discussed and supplemented by a numerical example.
Keywords: ESG; risk management; climate risk; credit risk; liquidity risk; operational risk; regulatory risk
Assessing risks in international investments using hesitant fuzzy linguistic term sets
Ayfer Basar, Visiting Lecturer, Özyeğin University

The world economy, global markets and competition for international investments have undergone great change in recent years. Changes in the economy of a society affect many countries as a result of international commerce and agreements with other countries. This has given rise to many risks that governments have to deal with; hence, the importance of risk management has increased for all countries, especially in the finance sector. Global economics means that financial institutions need to make decisions about investment in other countries (eg opening a new bank branch or a participation company), so they need to measure the financial risks of candidate countries in fuzzy conditions. This study presents a novel method to meet that need. First, the most common financial risks are determined by means of a literature survey and consulting expert opinion. Secondly, the relative weight of each main and sub-risk is determined by expert opinion and hesitant fuzzy linguistic term sets (HFLTS). These weights are used to measure the financial risks of 30 countries to select the best four and the results are approved by the experts. Finally, the proposed method is implemented to aid the investment decision of a large financial institution. This paper proposes a new method to assess financial risks in fuzzy conditions.
Keywords: financial institutions; investment decisions; risk management; hesitant fuzzy linguistic term sets; case study