College of Administrative and Financial Sciences
Risk Management (FIN301)
Deadline for students: (22/04/2022@ 23:59)
Course Name: Risk Management
Course Code: FIN301
Student’s ID Number:
Academic Year: 1443/1444 H, Second Semester
For Instructor’s Use only
Instructor’s Name: Dr. Mohammad Athar Ali
Students’ Grade: /5
Level of Marks: High/Middle/Low
Instructions – PLEASE READ THEM CAREFULLY
❖ This assignment is an individual assignment.
❖ The Assignment must be submitted only in WORD format via the allocated
❖ Assignments submitted through email will not be accepted.
❖ Students are advised to make their work clear and well presented. This also
includes filling in your information on the cover page.
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❖ Late submitted assignments will NOT be entertained.
❖ Avoid plagiarism; the work should be in your own words; copying from
students or other resources without proper referencing will result in ZERO
marks. No exceptions.
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Submissions without this cover page will NOT be accepted.
Q1: Briefly explain three key goals of Asset/Liability Management (ALM)? (1.5 Marks)
Q2: Discuss four Purposes of the Internal Risk Rating System (IIRS)? (2 Marks)
Q3) What is the difference between default and bankruptcy? (1.5 Marks)
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MICHEL CROUHY, DAN GALAI, ROBERT MARK
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I ntroduction to the Second Edition:
Reforming Risk Management for the Post-Crisis Era
1. Risk Management: A Helicopter View
1.1 Typology of Risk Exposures
2. Corporate Risk Management: A Primer
3. Banks and Their Regulators:
The Post-Crisis Regulatory Framework
3.1 Basel I
3.2 The 1996 Market Risk Amendment
3.3 Basel II and Minimum Capital Requirements for Credit Risk
3.4 Basel 2.5: Enhancements to the Basel II Framework
3.5 Contingent Convertible Bonds
4. Corporate Governance and Risk Management
5. A User-Friendly Guide to the Theory of Risk and Return
6. Interest Rate Risk and Hedging with Derivative Instruments
7. Measuring Market Risk: Value-at-Risk,
Expected Shortfall, and Similar Metrics
8. Asset/Liability Management
9. Credit Scoring and Retail Credit Risk Management
10. Commercial Credit Risk and the Rating
of Individual Credits
10.1 Definitions of Key Financial Ratios
vi • Contents
11. Quantitative Approaches to Credit
Portfolio Risk and Credit Modeling
11.1 The Basic Idea of the Reduced Form Model
12. The Credit Transfer Markets—and Their Implications
12.1 Why the Rating of CDOs by
Rating Agencies Was Misleading
13. Counterparty Credit Risk: CVA, DVA, and FVA
14. Operational Risk
15. Model Risk
16. Stress Testing and Scenario Analysis
16.1 The 2013 Dodd-Frank Severely Adverse Scenarios
17. Risk Capital Attribution and
Risk-Adjusted Performance Measurement
Epilogue: Trends in Risk Management
The world changed after the global financial crisis of 2007–2009, and the
change was especially dramatic for banks. The second edition of this book
is therefore very welcome and helps to clarify both the implications of
the crisis for risk management and the far-reaching process of regulatory
change that will come into full force over the next few years.
Banks are reforming their risk management processes, but the challenge goes much deeper. Banks must rethink their business models and
even question the reason for their existence. Do they exist to take proprietary risks (on or off their balance sheet) or to provide a focused set of
services and skills to their customers and business partners?
At Natixis, our business adopts the latter model. We have recently
completed an aggressive push to adapt to post-crisis regulatory constraints,
end our proprietary activities, reduce our risk profile, and refocus on
our three core businesses: wholesale banking, investment solutions, and
specialized financial services.
The far higher capital costs under Basel III are likely to shift many
other banks toward a more service-based business model with less risk
retained. The new regulations are also obliging banks to change their funding strategies—e.g., by making use of new funding tools in addition to
reformed approaches to securitization and traditional funding avenues.
This change of philosophy may mean developing trusted partnerships
with different kinds of financial institutions, such as insurance companies
and pension funds, that can absorb the risks that banks no longer wish to
carry on their balance sheets—a process that Natixis has already begun.
As banks change their approach, they must also take a fresh look at
their corporate governance. The crisis showed that banks had been driven
viii • Foreword
by too simplistic a notion of growth and short-term profitability. Going
forward, firms must build a wider and longer-term view of stakeholder
interests—e.g., by defining long-term risk appetites explicitly and connecting these securely to strategic and operational decisions. Ensuring the
right kind of growth will require many of the best-practice mechanisms of
corporate governance discussed in this book.
The crisis also showed that banks need to pay more than lip service
to the concept of enterprise risk management. They must improve their
understanding of how a wide range of risks—credit, market, liquidity,
operational, reputation, and more—can interact with and exacerbate
each other in a bank’s portfolios and business models when the financial
system is under strain.
In turn, this requires the development of new risk management
methodologies and bankwide infrastructures—for example, in the area
of macroeconomic stress testing. One of the accomplishments of this book
is that it helps set out these new methodologies and explains their strengths
and also their limitations. The authors believe that financial institutions
must not rely on any single risk measure, new or old. Risk measurement
and management methodologies are there to help decision makers, not to
supply simplistic answers.
It is critical that institutions (as well as regulators) develop a better
understanding of the interconnected nature of the global financial system.
As this book explains in its various chapters, systemic risks, counterparty
interconnections, liquidity risks, credit risks, and market risks all feed on
one another in a crisis. Understanding how risks concentrate during good
times and then spread through systemic interconnections during bad times
needs to become part of the philosophy of bank risk management. Without
this understanding, it is difficult for financial institutions to resist activities
that boost growth and profitability in the short term, but that may create
unsustainable levels of risk in the longer term.
The global economy is trying to find a path toward sustainable growth
at the same time that developed nations have begun to unwind the unprecedented support given to economies and banking systems during the
crisis years. This will give rise to many challenges as well as opportunities.
Natixis plays a frontline role in financing the real economy, but we know
that this must be built on solid risk-managed foundations.
Foreword • ix
In this sense, the book supports the business philosophy we are
developing at Natixis. We believe that long-term success comes to institutions and economies that can deliver growth while managing downside
risks through both improved risk management and the careful selection of
fundamental business models.
Chief Executive Officer of Natixis
September 13, 2013
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I think that the concept of the Crouhy, Galai, and Mark book, The Essen-
tials of Risk Management, Second Edition, is brilliant. In my career as an
academic and in investment management, I found that there is too large
a separation between the technocrats who build risk-management models
and systems and those who should be using them. In addition, the model
builders seem to me to be too far from economics, understanding what
risk management can and cannot do and how to structure the risk management problem. Crouhy, Galai, and Mark bridge that gap. They bring the
academic research together with applications and implementation. If riskmanagement model builders come to appreciate the economics underlying
the models, they would be better prepared to build risk-management tools
that have real value for banks and other entities. And, as the authors bring
up time and again, board members of corporations must also become as
familiar with the models and their underlying economics to ask the correct
Risk management is often described as being an independent activity of the firm, different from generating returns. Most macro and micro
models in economics start from a framework of certainty and add an error
term, a risk term to represent uncertainty. When describing predicted
actions that arise from these models, the error or uncertainty term disappears because the modelers assume that it’s best to take expectations as
their best guess as to future outcomes.
In both cases, however, this is incorrect. Risk management is part
of an optimization program, the tradeoffs between risk and return. As
described in the book, the three tools of risk management are (a) reserves,
(b) diversification, and (c) insurance. With greater reserves against adverse
xii • Foreword
outcomes, the risk of the firm or the bank is reduced. Greater reserves,
however, imply lower returns. And, the dynamics of the reserve need to be
known. For example, if a bank needs capital or liquidity reserves to shield
it against shock, is the reserve static or can it be used, and how is it to be
used at time of shock? If it is a reserve that must always be at a static level,
it is not a reserve at all. These are important optimization and planning
questions under uncertainty. With more diversification, the bank reduces
idiosyncratic risks and retains systematic risks, which it might also transfer
to the market.
Diversification has benefits. But, if a bank earns profits because its
clients want particular services such as mortgages, it might want to concentrate and make money by taking on additional idiosyncratic risk, for
it is not possible to diversify away all risks and still earn abnormal profits.
The bank must respond to its client’s demands and, as a result, take on
idiosyncratic risks. The same is true of insurance. Unlike car insurance,
wherein, say, the value of the car is knowable over the year, and the amount
of the insurance is easy to ascertain, as the book describes, the bank might
not know how much insurance is necessary and when it might need the
insurance. Nor does it know the dynamics of the insurance plan as prices
change in the market.
That is why risk management is integrated into an optimization system where there always are tradeoffs between risk and return. To ignore
risk considerations is inappropriate; to concentrate on risk is inappropriate. The boards of banks or corporations are responsible to understand and
challenge the optimization problem. Likewise, modelers must also understand the economic tradeoffs. Prior to the financial crisis of 2008, many
banks organized their risk management activities in line and not circle
form. That is, the risk department was separate and below the production
department. The risk management systems of the future must be designed
such that the optimization problem is the center focus. This involves deciding on the level of capital employed not only for working capital, or physical investment capital, or human capital but also the amount of risk capital in deciding on the profitability of various business lines and how they
coordinate with each other.
Risk management involves measurement and model building. This
book provides us with a description of many of the problems in building
Foreword • xiii
models and in providing the inputs to the models. But, once the senior
management and the modelers understand the issues, they will change
their focus and address the modeling and measurement issues. For example, there are three major problems in the model building/data provision
or calibration of the model framework: (1) using historical data to calibrate
the model, (2) assuming the spatial relationships will remain unchanged,
such as how particular assets are grouped together into clusters or how
clusters move together, and, (3) assuming that once the model is built and
calibrated that others don’t reverse engineer the model and its calibration
and game against those using the model. There are myriad examples and
applications of each of these, or these in combination with each other in
this book. For example, the rating agencies used historical data to calibrate the likelihood of declines in housing price such that homeowners
would default on their mortgages. Unfortunately they used too short a time
period and assumed incorrectly that the best prediction of the future would
be provided from these short-period data inputs. They also assumed that
homeowners default on their mortgages randomly, while ignoring the possibility that the independent clusters of possible mortgage defaults that
they assumed existed would become one cluster during a crisis such as
the 2008 financial crisis. Moreover, once they provided their ratings on
complicated mortgage structured products, market participants reverse
engineered how they rated mortgage products and gamed against them by
putting lower and lower quality mortgages into structures to pass just the
ratings level that they wanted to attain. These three lessons are pervasive
in risk management and are illustrated brilliantly in one form or the other
over and over again in this book.
There are decisions that should be made, in part, proactively and decisions that should be made, in part, reactively. Risk management includes
an understanding of how to plan to respond to changes in the opportunity
set and to changes in the costs of adjusting assets and to financing activities. There is a value in planning for uncertainty. Ignoring risk might supply large short-term profits but at the expense of survivorship of the business, for not setting aside sufficient risk capital threatens survivorship of
the business. And understanding includes evaluating the returns and risks
of embedded and explicit options.
xiv • Foreword
All risk management systems require a careful combination of academic modeling and research with practical applications. Academic
research highlighted in this book has made a major contribution to
risk management techniques. Practice must be aware of the underlying
assumptions of these models and in what situations they apply or don’t
apply and adjust them accordingly. Practical applications include understanding data issues in providing inputs to these risk models and in
calibrating them consistent with underlying economics. The 2008 crisis
highlighted once again the importance of risk management. I believe that
all board members must become as conversant in risk management as in
return generation. That will become a prerequisite for board participation.
This book highlights the importance of these issues.
Myron S. Scholes, Frank E. Buck Professor of Finance, Emeritus, Stanford
University Graduate School of Business; 1997 recipient of the Nobel Prize
INTRODUCTION TO THE
MANAGEMENT FOR THE
Half a dozen years and more have passed since the start of the global
financial crisis of 2007–2009,1 and even the European sovereign debt crisis
of 2010 is fading into history. In neither case can we be sure that the crises are fully resolved, and their aftershocks and ramifications continue to
shape our world. However, enough time may have elapsed for us to absorb
the main lessons of the crisis years and to begin to understand the implications of the still unfolding reforms of the world’s financial industries.
In this new edition of The Essentials of Risk Management, we have
revisited each chapter in light of what has been learned from risk management failures during the crisis years, and in this Introduction we pick out
key trends in risk management since we published the first edition in 2006.
However, we have also tried to prevent the book as a whole from
becoming too dominated by the extraordinary events of 2007–2009 and
the immediate succeeding years. Some of the lessons learned in those years
were lessons that earlier crises had already taught risk managers, and that
Throughout this book, we’ve used the phrase “financial crisis of 2007–2009” to define, reasonably precisely, the banking and financial system crisis of that period. Others choose to
use the term “global financial crisis,” or GFC.
xvi • Introduction to the Second Edition
were covered in some detail in the first edition of the book—even if some
firms found it hard to put them into practice. The crisis years also spawned
a series of fundamental reforms of the regulation of financial institutions,
and one thing we can be sure of in risk management is that major structural change creates new business environments, which in turn transform
business behavior and risk.
One of the curses of risk management is that it perennially tries to
micromanage the last crisis rather than applying the first principles of risk
management to forestall the next—a trap we have tried to avoid.
We hope this book contributes to the attempt to strengthen the overall framework of risk management by encouraging the right mix of theoretical expertise, knowledge of recent and past events, and curiosity about
what might be driving risk trends today.
The financial crisis that started in the summer of 2007 was the culmination of an exceptional boom in credit growth and leverage in the
financial system that had been building since the previous credit crisis in
2001–2002, stimulated by an accommodative monetary policy. The boom
was fed by an extended period of benign economic and financial conditions,
including low real interest rates and abundant liquidity, which encouraged
borrowers, investors, and intermediaries to increase their exposure in
terms of risk and leverage. The boom years were also marked by a wave of
financial innovations related to securitization, which expanded the capacity of the financial system to generate credit assets but outpaced its capacity
to manage the associated risks.2
The crisis uncovered major fault lines in business practices and market dynamics: failures of risk management and poorly aligned compensation
systems in financial institutions, failures of transparency and disclosure, and
many more. In the years following the crisis, many areas of weakness have
begun to be addressed through regulation and from the very top of financial
institutions (the board of directors and the management committee) down
to business line practices, including the misalignment of incentives between
the business and its shareholders, bondholders, and investors. Below, we
Securitization and structured credit products are discussed in Chapter 12.
Introduction to the Second Edition • xvii
summarize some of the major problem areas uncovered by the global financial crisis; the rest of the book addresses these issues in more detail.
Governance and Risk Culture
Risk management has many different components, but the essence of what
went wrong in the run-up to the 2007–2009 financial crisis had more to do
with the lack of solid corporate governance structures for risk management
than with the technical deficiencies of risk measurement and stress testing.
In the boom period, risk management was marginalized in many financial
institutions. The focus on deal flow, business volume, earnings, and compensation schemes drove firms increasingly to treat risk management as a
source of information, not as an integral part of business decision making.
Decisions were taken on risk positions without the debate that needed to
happen. To some degree, this is a matter of risk culture, but it also has to do
with governance structures inside organizations:
• The role of the board must be strengthened. Strengthening board
oversight of risk does not diminish the fundamental responsibility of management for the risk management process. Instead, it
should make sure that risk management receives some enhanced
attention in terms of oversight and, hopefully, a longer-term and
wider perspective. Chapter 4 on corporate governance elaborates
on the role and obligations of the board.
• Risk officers must be re-empowered. Some firms distinguish between
a “risk control” function, responsible for quantitative measures,
and a “risk management” function, which has a more strategic focus.
Either way, it is no longer appropriate for risk management to be only
an “after the fact” monitoring function. It needs to be included in
the development of the firm’s strategy and business model. Chief risk
officers (CROs) should not be just risk managers but also proactive
risk strategists. With the strength of regulators and an angry public
behind them, risk managers presently wield some clout. The trick
will be to make sure this lasts in periods of recovery (or growing corporate frustration with unexciting returns). Chapter 4 elaborates on
the role of the CRO in a best-practice institution.
xviii • Introduction to the Second Edition
Inadequate Execution of the Originate-to-Distribute
One common view is that the crisis was caused by the originate-todistribute (OTD) model of securitization, through which lower quality
loans were transformed into highly rated securities. To some extent, this
characterization is unfortunately true.
The OTD model of securitization reduced incentives for the originator of the loan to monitor the creditworthiness of the borrower,
because the originator had little or no skin in the game. In the securitization food chain for U.S. mortgages, intermediaries in the chain made
fees while transferring credit into an investment product with such an
opaque structure that even the most sophisticated investors had no real
idea what they were holding.
Although the pre-crisis OTD model of securitization, and its lack
of checks and balances, was clearly an important factor, the huge losses
that affected banks, especially investment banks, mainly occurred because
financial institutions did not follow the business model of securitization.
Rather than acting as intermediaries by transferring the risk from mortgage lenders to capital market investors, these institutions themselves took
on the role of investors. Chapter 12 elaborates on this issue.
Poor Underwriting Standards
The OTD model generated a huge demand for loans to feed the securitization machine, and this in itself contributed to a lowering of underwriting
standards. But benign macroeconomic conditions and low default rates
also gave rise to complacency and an erosion of sound practices in the
world’s financial industries. Across a range of credit segments, business
volumes grew much more quickly than investment in the supporting infrastructure of controls and documentation. The demand for high-yielding
assets encouraged a loosening of credit standards and, particularly in the
U.S. subprime mortgage market, not just lax but fraudulent practices proliferated from late 2004. Chapter 9 elaborates further on the issue of retail
Introduction to the Second Edition • xix
Shortcomings in Firms’ Risk Management Practices
The crisis highlighted the risk of model error when making risk assessments. The risk control/risk management function must become more
transparent about the limitations of risk metrics and models used to make
important decisions in the firm. Models are powerful tools, but they necessarily involve simplifications and assumptions; they must be approached
critically and with a heavy dash of expert judgment. When risk metrics,
models, and ratings become ends in themselves, they become obstacles
to true risk identification. This applies also to the post-crisis rash of new
models and risk assessment procedures. Chapter 15 analyzes the problems
associated with model risk.
• Stress testing and scenario analysis. Stress testing, discussed in
Chapter 16, is now a formal requirement of Basel III and the
Dodd-Frank Act and has become a much more prominent part
of the risk manager’s toolkit. Properly applied, stress testing is a
critical diagnostic and risk identification tool, but it can be counterproductive if it becomes too mechanical or consumes resources
unproductively. It is important to approach stress testing as one
aspect of a multifaceted risk analysis program. In particular, stress
testing must be carefully designed to gauge the business strengths
and weaknesses of each individual firm; it cannot follow a “one size
fits all” approach. Firms need to ensure that stress testing methodologies and policies are consistently applied throughout the firm,
take into account multiple risk factors, and adequately deal with
correlations between risk factors. Results must have a meaningful
impact on business decisions.
• Concentration risk. Firms need to improve their firmwide management of concentration risks, embracing not only large risks
from individual borrowers but also concentrations in sectors, geographic regions, economic factors, counterparties, and financial
guarantors. For example, a concentrated exposure to one (exotic)
product can give rise to major losses during a market shock if
liquidity dries up and it becomes impossible to rebalance a hedging position in a timely fashion.
xx • Introduction to the Second Edition
• Counterparty credit risk. The subprime crisis highlighted several
shortcomings of over-the-counter (OTC) trading in credit derivatives, most notably the treatment of counterparty credit risk. The
primary issue is that collateral and margin requirements are set
bilaterally in OTC trading and do not take account of the risk
imposed on the rest of the system (e.g., as experienced following the failures of Lehman Brothers and the quasi-bankruptcies
of Bear Stearns, AIG, and others). Counterparty credit risk is
discussed in Chapter 13.
Overreliance on Misleading Ratings from Rating
Credit rating agencies were at the center of the 2007–2009 crisis, as many
investors had relied on their ratings to assess the risk of mortgage bonds,
asset-backed commercial paper issued by structured investment vehicles, and
the monolines that insured municipal bonds and structured credit products.
Money market funds are restricted to investing in AAA-rated
assets, while pension funds and municipalities are restricted to investing in investment-grade assets.3 In the low interest rate environment of
the period before the crisis, many of these conservative investors invested
in assets that were complex and contained exposure to subprime assets,
mainly because these instruments were given an investment-grade rating or higher while promising a yield above that of traditional assets, such
as corporate and Treasury bonds, with an equivalent rating. Chapter 10
discusses ratings and the controversial role of the rating agencies.
Poor Investor Due Diligence
Many investors placed excessive reliance on credit ratings, neither questioning the methodologies of the credit rating agencies nor fully understanding the risk characteristics of rated products. Also, many investors
Most of the US$2.5 trillion sitting in money market funds is traditionally invested in such
assets as U.S. Treasury bills, certificates of deposit, and short-term commercial debt.
Introduction to the Second Edition • xxi
erroneously took comfort from the belief that insurance companies conducted a thorough investigation into the assets they insured.4
Going forward, institutional investors will have to upgrade their risk
infrastructure in order to assess risk independently of external rating agencies. If institutions are not willing or able to do this, they should probably
refrain from investing in complex structured products.
For U.S. retail investors who lack the knowledge and the tools to
evaluate and make decisions about financial products, the Dodd-Frank
Act creates the Bureau of Consumer Financial Protection (BCFP) as an
independent bureau within the Federal Reserve System. However, it is
by no m