Introduction to Risks Risk is the

potential for
deviation from an
Enterprise Risk is a expected result.
process performed by
the board,
management and
other personnel, and
applied in a strategy
setting across the Credit Risk is the
Operational Risk is
the risk of direct or
firm. It is intended to risk of loss resulting indirect loss resulting
identify potential risks from failure of from inadequate or
obligors or failed internal
that could impact the counterparties to processes, people,
firm. honor payments. Market Risk is the
risk of adverse
and systems or from
external events.
movement in
market factors, such
as asset prices,
foreign exchange or
interest rates.
Measuring Different Types of Risk

Known Knowns Known Unknowns Unknown Unknowns

are risks that are: are risks or information are risks that are
• Well known that you know about, outside the scope of
• Identified and but you are uncertain as most scenarios
• Measured to when the risk will because they are
manifest itself random events

Risk Management strives to:

• Identify risks
• Assess and Monitor risks
• Manage risks within tolerance
• Communicate to decision-
makers when necessary
4
 Risk Is A Dynamic Process Risks are those things that, if
they manifest themselves,
could preclude a business from
Identify meeting its objectives.
Known Risks

Identify the root cause Assess the likelihood of the

of a risk and its Determine
Root Cause
Probability & risk manifesting itself & its
subsequent causal Analysis
Impact potential impact
factors

• Some risks are Management decides what

Unknowable (Random Accept,
Event & Crisis
Pursue or risks to Accept, Pursue or
Events) Management
Avoid Avoid
• Establish protocols to
manage Known and
Unknown Risks Risk • Limits Thresholds Triggers
Monitoring
• Emerging & Strategic Risks
Introduction
• Market Risk Management is the process of using market data and
statistical measures to identify, assess, measure and manage risk to
create economic value.
• The goal is not to minimize risk – it is to take intelligent risks, based on
analysis of data.
• Risk should be evaluated on a forward-looking basis.
Measuring Market Risk (1/3)
• Risk management begins with mechanisms that measure risk.
• The expected profit of an investment should outweigh its assumed risk,
so there is a tradeoff between risk and return that must be weighed.
• The graph on the next page shows both a normal and lognormal
distribution, which are often used for modeling financial products.
• The vertical axis represents frequency (relative probability) of a
gain/loss. The horizontal axis represents the size of the gain/loss.
• Mean is the average return, and it is the mid-point of the curve.
• Standard Deviation, also referred to as volatility, measures the dispersion around
the mean.
• Value at Risk would be a percentile within the distribution.
Lognormal vs Normal Distribution
0.7

0.6 Lognormal
Normal
0.5

0.4

0.3

0.2

0.1

-4 -3 -2 -1 0 1 2 3 4 5 6
 Measuring Market Risk (2/3)

The Normal Probability of

X
Distribution Cases in portions
of the curve
Probability

Type equation here.

Value

-1.98σ 1.98σ
95% of values

-2.58σ 2.58σ
=0.0013 99% of values
=0.0013
=0.0013 =0.0214 =0.1359 =0.3413 =0.3413 =0.1359 =0.0214
Standard Deviations from the Mean
-4σ -3σ -2σ -1σ 0 +3σ +2σ +3σ +4σ

Cumulative % 0.1% 2.3% 15.9% 50% 84.1% 97.7% 99.9%

Z Scores -4.0 -3.0 -2.0 -1.0 0 +1.0 +2.0 +3.0 +4.

0
Comparing t-distributions to z-distributions
Lower
Peak

Sample
Fatter Size = 12
“Tails”

-2 -1 𝛍=0 1 2
-1.96 1.96 More
95% Uncertainty
-2.201 2.201
95%
Measuring Market Risk (3/3)

• Often risk is measured against a benchmark.

• Absolute Risk is measured in terms of shortfall versus the initial
value of the investment or the investment in cash.
• Relative Risk is measured versus a benchmark index.

• Estimating the distribution of future profits and losses is a

major part of the risk measurement process.
• Expected profit can be measured by calculating the expected return
proportional to the investment.
• Future profits and losses are much harder to estimate given
uncertainty.
Portfolio Construction (1/3)
• Portfolio construction combines expected return and risk, and the
choice of investment.
• Risk vs return is a tradeoff, and you would expect higher risk is
accompanied by higher return. Sharpe Ratio is the ratio of the average
rate of return in excess of the risk-free rate to the absolute risk.
• The Sharpe Ratio adjusts return based on total risk measured in
absolute terms.
• Asset Allocation is the process of deciding how to construct a portfolio
across all asset classes.
• Correlation Coefficient measures the extent to which two asset classes
are related to each other. It is scaled between -1 and +1, with -1
representing perfect negative correlation and +1 perfect positive
correlation.
Portfolio Construction (2/3)
• Sharpe Ratio for Portfolio i

Ri = average return on Portfolio i RFR = risk-free rate of return

σi = the standard deviation of the rate of return for Portfolio i
• All assets are assumed to have a normal distribution thus the
distribution of the portfolio returns can be summarized by the Mean
and Variance.
• An Efficient Portfolio represents the portfolio mix that has the best risk
and return characteristics.
Portfolio Construction (3/3)

Efficient Frontier
14.00%

12.00% F
D E
C
10.00%
Expected Return E(R)

B A
8.00%

6.00%
Minimum Variance Portfolio

4.00%

2.00%

0.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%

Standard Deviation σ
Portfolio Construction: Minimizing Volatility

100%

Portfolio Standard Deviation

80%
Diversifiable Market Risk
Total Risk = Risk +
(systematic)
(unsystematic
60% )

40% Portfolio of
U.S. Stocks
26%
Total
20% Risk Systematic
Risk

1 10 20 30 40 50

Number of Stocks
Capital Asset Pricing Model (CAPM)
• CAPM provides a formula that calculates • Calculating E(Return): A
the Expected Return of a security based on portfolio has an Expected
its risk and the Market Risk Premium (MRP) Return of 8%, Volatility of 20%,
and Beta of 0.5. The Risk-Free
• E(Return) = Risk Free Rate + Beta x MRP Rate is 5% and the Market
• MRP = Market E(Return) - Risk Free Rate Expected Return is 10%. What
is the E(Return)?
• Beta measures the risk arising from
exposure to general market E(R) = Risk-Free Rate + Beta x MRP
movements. The market itself has a beta
E(R) = 5% + 0.5(10% - 5%)
of 1.
E(R) = 7.5%
• Alpha gauges the performance of an
investment against a market index or Note: The Market Risk Premium is the net
benchmark that is considered to represent difference between the Market Expected Return
of 10% and the Risk-Free Rate of 5%.
the market’s movement-as-a-whole.
Capital Market Theory
15%
Efficient Frontier of All
Risky Securities
Market Portfolio
Tesla
= Efficient Portfolio

GE
Capital
10%
Expected Return

Disney
Market
Line McDonald’s
GM
Merck
Exxon Mobil
Campbell Soup
Anheuser-Busch
5%
Edison
International
Risk-Free
Investment

0%
0% 5% 10% 15% 20% 25% 30% 35% 40%

Volatility (Standard Deviation)

Capital Market Theory

market

market
Introduction
• Credit Risk is measured by the cost of replacing cash flows if the
counterparty or obligor (borrower) defaults.
• Credit Risk and Market Risk have in many ways converged because of
the introduction of new products (securitized products like mortgage-
backed securities, credit default swaps…)
• These products allow credit risk to be quantified like market risk and sold to
investors moved off a firm’s balance sheet.

• However, credit still requires constructing the distribution of Default

Probabilities, Loss Given Default, and of Credit Exposures, all of
which contribute to credit losses and should be measured in a portfolio
context.
Pre-Settlement and Settlement Risk
• Pre-Settlement Risk is the risk of loss due to a counterparty’s failure to
perform on an obligation during the life of the transaction.
• Pre-Settlement Risk exists for long time periods as it is the life of the transaction
from start to settlement.
• Settlement Risk arises from the exchange of cash flows and is short-
term in comparison.
• The risk is due to the timing of cash outflow versus inflow and the risk heightens
especially due to different time zones.
• Failure to honor payments can be from default, liquidity constraints or
operational issues.
 Managing Settlement Risk (1/2)
A trade can be classified in 5 categories:

Revocable Irrevocable Uncertain Settled Failed

• When the • After the • After the • After the • After is has been
institution can payment has payment from counterparty established that
still cancel the been sent and the other party is payment has the counterparty
transfer without before payment due but before it been received. has not made the
counterparty from the other is received. payment.
consent. party is due.

Settlement Risk arises in Irrevocable and Uncertain categories.

Managing Settlement Risk (2/2)
• Real-time gross settlement systems strive to reduce the time interval
between the time an institution can no longer stop a payment and the
receipt of the funds from the counterparty.
• Settlement Risk can also be managed by netting agreements.
• Bilateral netting is when two banks settle based on the net balance
outstanding rather than the notional balance.
• Multilateral netting systems (also called continuous-linked settlements)
are where payments are netted for a group of banks that belong to the
system
Pre-Settlement Risk
• This is a discrete state,
either the counterparty
Pre-Settlement Risk is is or is not in default.
Default
the traditional credit risk • The probability of
default needs to be
and is driven by three estimated.
variables.
• This is the economic
Credit claim on the
counterparty and also
Exposure called Exposure At
Default.

• This is the fractional

Loss loss due to a default.
• For example, if a firm
Given has a recovery rate of
Default 20% the Loss Given
Default is 80%.
Credit Risk Components
Will an asset What proportion
become a of the value of a
defaulted asset? defaulted asset
will we lose?

Probability Loss Given

of Default Default
(PD) (LGD)

Exposure
at Default Maturity
(EAD)
What is the
The effective
expected value
remaining
of the defaulted
term of a
asset at the
credit facility.
time of default?
Overview of Credit Risk (1/2)
• Expected Loss is the sum of the values of all probable losses, with
each multiplied by the probability of that loss occurring. For bank
loans, expected loss is shown as the Loan Loss Reserve on
the balance sheet.
• Unexpected Loss is the loss over and above Expected Loss. It is
calculated as a number of standard deviations from the mean at a
certain confidence interval. Also referred to as Credit Value at
Risk.
• The extension of credit has an embedded short option position
because the borrower has the option to default. This embedded
option causes lower credit quality borrowers to have higher
interest rates.
Overview of Credit Risk (2/2)

• Expected Loss (EL) is calculated as:

EL = PD x LGV x Exposure at Default

• Exposure at Default is the total value a bank is exposed to when a loan

defaults.
• Economic Capital is the amount of capital, assessed on a risk-adjusted
basis, that a firm needs to ensure solvency in a worst-case scenario.
Potential Credit Losses
Measurement of Credit Risk
Estimation of Credit Risk has evolved over the years:
1. Notional amounts simply add up simple exposures. This approach completely
ignores the probability of default.
2. Risk-Weighted amounts add up exposures with a basic adjustment for risk. Risk-
weighting was introduced by the Basel Committee in 1988, and it provided a rough
risk weighting by asset class that was multiplied by the notional amount. This
ignored the differences in credit risk of various counterparties because it was
based on asset class.
3. Notional amounts combined with credit ratings, adding up exposures adjusted for
default probabilities.
4. Internal portfolio credit models, integrate all dimensions of credit risk. Basel II
allows banks to set their internal or external credit ratings, providing a more refined
measure of credit risk.
5. The dispersion in credit losses depends on the correlation between default events.
The expected credit loss depends on default probabilities, but the higher the
default correlation, the higher the unexpected credit loss.
Comparing Credit and Market Risk

Some aspects of Credit and Market Risk have converged but key
differences remain.

Item Market Risk Credit Risk

Source of risk Market risk only Default risk, recovery risk,
market risk
Distributions Mainly symmetrical, could Skewed to the left
have fat tails
Time horizon Short term Long term
Aggregation Trading unit Whole firm versus
counterparty/borrower
Legal issues None High
Introduction
• Operational Risk is often called non-financial risk, but an operational
risk event can result in both financial loss and reputational risk.
• Operational Risk is difficult to identify and control because it:
• Is Embedded in organizations
• Exists within instruments
• Is Impacted by external events and prone to random events
Operational Risk Framework
Organizational
Three Lines
Risk Internal Control
of
Governance and Framework
Defense Model
Policy

Risk & Control

Loss Events Key Risk
Self-
Management Indicators
Assessment

Scenario Risk Appetite Risk Culture &

Analysis Framework Risk Behaviors
Portfolio of Operational Risk
• Operational Risk is often mistakenly
thought of as risk in operations, but as Business
Merger Resiliency
the diagram shows Operational Risk is
Risk
much more expansive. Advisory Sales
Risk Practices
• Operations are a significant contributor Model
to Operational Risk, but the nature of Risk
Product
Operational Risk requires a modified Fraud
approach when compared to Market Operations Liability
and Credit Risk: Regulatory Climate
• Market and Credit Risk are Discrimination Risk
Legal Change
generally based on discrete
decisions that a firm elects either to Risk
Project
take or not. Management
Cyber
• Operational Risk is found within the Risk
firm itself (people, processes,
systems) and its
environment (external events).
Operational Risk Classifications
Specific Risk Type Definition
Transaction Processing Risk of loss/gain arising from failed internal processes related to processing
transactions.
Technology Risk associated with the use of systems and technology, including availability,
security, disaster recovery, and projects.
Dependency/Third Risk associated with the use of third-party service providers.
Party
Legal and Regulatory Risk associated with compliance with laws, regulations and policies.

Human Capital Risk associated with the possibility of unexpected losses/gains arising from the
actions and inactions of people.
Financial Reporting and Risk of loss from failed financial controls impacting either posting to the general
Recording ledger, financial reporting, or the firm’s ability to meet its obligations.
Business Resiliency Risk associated with operational and systems readiness to support and service
products, systems, and clients. Risk of loss/gain due to business disruption.
Physical Security Risk of loss arising from failed internal controls intended to protect physical assets.

Fraud Risk associated with intentional misconduct and can be internal or external.
Operational Risk
requires multiple Loss/Gain Data Capture
measurement tools: (Backward Looking)
Root cause analysis of losses
and gains to determine
reasons for breakdown.

Reporting/Analysis and Key Risk Indicator (KRI)

Governance Monitoring (Forward
• Deliver risk analysis Looking)
to influence decision Analysis of leading, lagging
making.
and performance indicators
• Active role in the
to identify trends and soft
governance spots.
structure.

Risk/Control
Assessments (Cultural)
• Management assessment
of its own control
environment.
• Overall assessment
framework that accounts
for all forms of
assessment.
Overview
• Enterprise Risk Management was introduced in 2004 when the
Committee of Sponsored Organizations (COSO) issued its Enterprise
Risk Management – Integrated Framework.
• COSO defined Enterprise Risk Management as a process performed by
the Board, management and other personnel, and applied in a strategic
setting across the firm.
• Enterprise Risk Management is intended to have a portfolio view of
risk that provides a holistic perspective of the organization and seeks
to understand the impact all risks faced by the firm.
Enterprise Risk Management

Culture and Risk Governance

Enterprise Risk Management Strategic Risk Framework
Emerging Risk Framework
Reputation Risk Framework

Market Risk Framework Credit Risk Framework Operational Risk Framework

Market Risk Policies Credit Risk Policies Operational Risk Policies

Implementing Procedures Implementing Procedures Implementing Procedures

 Rapidly Changing Business Environment
ECONOMIC/3RD PARTY RISKS
FACING NEW LAUNCH NON-
COMPETITION TRADITIONAL PRODUCTS OPERATIONAL RISK

CHANGING CUSTOMER
DISRUPTIVE
INTERACTIONS
BUSINESS DATA PRIVACY RISK
MODELS
SHORTER CUSTOMER
ATTENTION SPAN REPUTATIONAL RISK
ORGANIZATION NEW MODES OF
INTERACTION CYBER SECURITY RISKS
TECHNOLOGY
ADVANCEMENT
KEEPING PACE WITH
TECHNOLOGY STRATEGIC RISKS
CONSTANT
REGULATORY CHANGING POLITICAL
CHANGE ENVIRONMENT GEOPOLITICAL RISK
EMERGING
REGULATIONS COMPLIANCE RISK
The Growing Scale of ERM
TRADITIONAL EMERGING

INTER-
IMPACT LIKELIHOOD VELOCITY
RELATIONSHIP

Increasing Larger number of News spreads Multi-dimensional

Interdependencies potential Points of fast, Bad News Even business models lead
between Economies Failure due to Faster in a to latent relational
and Businesses increasing hyperconnected en influences
business touch vironment
LEADS TO pointsTO
LEADS LEADS TO LEADS TO
Larger Impact From Higher Frequency of Certain Risk Event Unpredictability in
Similar Risk Events Similar Risk Events Impact To Catapult terms of impact and
than in the past than in the past Exponentially frequency

*Reference. The Power of Four, KPMG (2016).

The Financial System

Source: Mishkin, F., The Economics of Money, Banking and FinancialMarkets

Money and Capital Markets
Money Market Instruments
• US Treasury Bills
• Negotiable Bank Certificates of Deposit
• Commercial Paper
• Bankers Acceptances
• Repurchase Agreements
• Federal Funds
• Eurodollars
Money and Capital Markets
Capital Market Instruments
• Corporate Stocks
• Residential, Commercial, and Farm Mortgages
• Corporate Bonds
• US Government Securities (Intermediate and Long-Term)
• State and Local Government (Municipal) Bonds
• US Government Agency Bonds
• Bank Commercial and Consumer Loans
US Regulatory Structures
• Dual Banking System
• National or state charters for depository institutions
• National Currency Act (1863) / National Bank Act (1864)
• Homeowners Loan Act (1933) - chartering of federal savings associations
• Various state banking laws
• Separation of Banking and Commerce
• Bank and thrift holding companies are subject to restrictions on activities
• Bank Holding Company Act (1956)
• Functional Regulation
• Gramm-Leach Bliley Act (1999)
• Affiliates of banks subject to regulation based upon function (i.e. broker-dealer,
insurance)
• Dodd-Frank (Wall Street Reform and Consumer Protection) Act (2010) grants
Federal Reserve Board increased authority to examine bank holding companies
and non-bank subsidiaries
Protection of Depositors and Consumers
• Federal deposit insurance for deposit accounts at
depository institutions
• Banking Act (1933)
• Coverage of $250,000 per depositor (subject to certain aggregation
rules) made permanent by Dodd-Frank Act and retroactive to 01/08
• Dodd-Frank Act established the Consumer Financial Protection
Bureau (CFPB) within the Federal Reserve System
• CFPB assumed “consumer financial protection functions” previously
performed by the federal banking agencies (FRB, OCC, FDIC, NCUA),
as well as HUD and the FTCCFPB has rulemaking authority for all
depository institutions and supervision/examination authority for large
depository institutions and affiliates, as well as most non-depository
institutions
 Federal Regulators
Prudential Bank Securities and Other Regulators of Coordinating Forum
Regulators Derivatives Financial Activities
Regulators

Office of the Comptroller Securities and Exchange Federal Housing Finance Financial Stability
of the Currency (OCC) Commission (SEC) Agency (FHFA) Oversight Council (FSOC)
Federal Deposit Commodities Futures Consumer Financial Federal Financial
Insurance Corporation Trading Commission Protection Bureau (CFPB) Institutions Examinations
(FDIC) (CFTC) Council (FFIEC)
National Credit Union President’s Working
Administration (NCUA) Group on Capital Markets
(PWG)
Federal Reserve Board
(FRB, or the Fed)
 UK Regulatory Structures
Figure 1: The New Regulatory Structure
HM Treasury and Parliament
FPC
Bank of England Financial Policy (Committee)
FCA accountable
85 directly to HM Treasury
and Parliament
Powers of
Subsidiary direction & recommendation
in relation to financial stability
PRA Cooperation & coordination FCA
Subsidiary of the Veto Ongoing legal
bank of England entity of the FSA

Prudential Conduct Prudential and conduct

regulation regulation regulation

Dual-regulated firms
(deposit takers, insurers & significant All other
investment firms) regulated firms
UK Regulatory Structures
• Financial Conduct Authority (FCA):
• Operational objectives - consumer protection, integrity of UK financial system,
promoting competition in interests of consumers
• Prudential Regulation Authority (PRA):
• Promote safety and soundness of systemically important firms, including insurers, and
ensuring policyholders are protected in the event of failure
• Financial Policy Committee (FPC):
• Committee within the Bank of England responsible for identifying emerging risks
to the financial system and providing strategic direction for the entire regulatory
regime
• FPC has the power to use “macro-prudential tools” to counteract systemic risk.
Tools could include leverage limits on banks or enforcing particular capital
requirements for specific asset classes
EU Regulatory Structures
European System of Financial Supervision (ESFS), network of national
and EU supervisors, created by EU, January 1, 2011.

European System of
87
Financial Supervision
Micro- Macro-
prudential prudential
supervision oversight

Joint Committee Micro- European Systemic Risk Board

prudential
European European Central
European European information Bank (ECB) National Supervisors
Insurance and
Banking Occupational Securities and
Authority Markets National central
Pensions
(EBA) Authority banks
Authority
(EIOPA) (ESMA) European Chairman of the
Supervisory Economic and
Early risk Authorities (ESAs) Financial Committee
National National National warning and (ECOFIN)
Banking Insurance Securities European
supervisor Commission (EC)
Supervisors Supervisors Supervisors recommendation
EU Regulatory Structures
• European Systemic Risk Board (ESRB)
• Independent body responsible for the macro-prudential oversight of the EU
financial system.
• ESRBs day-to-day business entrusted to the European Central Bank
• European Supervisory Authorities (ESAs)
• European Banking Authority (EBA)
• European Securities and Markets Authority (ESMA)
• European Insurance and Occupational Pensions Authority (EIOPA)
• Joint Committee of the ESA’s
• Deals with “cross-sectoral” issues
• EU Member State national supervisors (28), carry out day-to-day supervision of
financial institutions
What is Scenario Analysis?
“…a systematic process of obtaining expert opinions from business
managers and risk management experts to derive reasoned
assessments of the likelihood and loss impact of plausible high-severity
operational losses” - Advanced Capital Adequacy Framework (Published
in the Federal Register, December 7, 2007).

• Examining and evaluating possible future events

• Scenarios may be possible but unlikely
• Need not be derived from historical events
• History can provide a great starting point
Purpose for Scenario Analysis
• Preparedness for unexpected events
• Identification of key risk exposures, especially emerging
risks
• Explore potential extreme events
• Mitigating risk of failure
Scenario Example - Historical

• Global financial crisis: frozen credit markets initiate stock

selloff across Asia and Europe continuing into US trading
hours on 9/29/08
• Greatest cumulative two-week SPX decline of 28.7% since
1990, observed during 9/29/08 - 10/10/08
• Corresponding observed day-over-day VIX changes during
9/29/08 - 10/10/08
• Historical VIX levels during 9/29 – 10/10/08
Scenario Example - Hypothetical
• Geopolitical developments over the weekend result in three
consecutive days of sharp SPX moves that trigger two levels of
market circuit breakers (7%, 13%)
• The market triggers a 7% circuit breaker. After the market
reopens, the SPX quickly falls to the second circuit breaker
level at 13%. Markets reopen after the pause and rebounds but
closes on the lows of the day.
• SPX reverses 15% to the upside on the third day
• VIX level increases 45%, 60% and closes at 55% on the third
day
What is Stress Testing?
“…is a projection of the financial
condition of a firm or economy Stress Tests Stress
under a specific set of severely Severe Stress Tests/Scenarios
relevant for risk
adverse conditions…” management and
regulation
- Stress Testing and Scenario Analysis

Severity
(International Actuarial Association, July 2013)
Scenarios

• One or multiple risk factors

Low Stress
• Simple or complex scenarios
Single risk, Complexity Multiple risks,
• Extreme but plausible likelihood single time interactions, time
period periods
Purpose of Stress Testing

• Inform risk appetite framework

• Allows management to set appropriate risk policies
• Ensure risk exposure does not exceed capital/liquidity
availability
• Ensure firm can survive an extreme event
• Identify magnitude of tail risks
Stress Testing Considerations
• Scenario Generation
• Identification of risk drivers
• Data availability and quality
• Modeling capability
• Stress test calculation
• Results aggregation and reporting
Example Stress Tests
• Beta-weighted 20% SPX shock
• Multi-day market crash
• Individual security/sector stress
• Inter-disciplinary risk event (market + credit + operational)
 Timeline: Negative Interest Rates & Declining Real
Rates
• The graph to the right shows that
real rates have been declining for
about 700 years, and negative real
rates have occurred previously.
• In 2014 the European Central Bank
(ECB) set the Deposit Rate Facility
below zero. This was the first time
that negative rates were used to
stimulate an economy.
 Timeline: Negative Interest Rates & Declining Real
Rates
• The Bank of Japan (BoJ) moved to a
zero-interest rate policy in 1999
and since 2016 its key rate has
been negative.
• Negative interest rates continue to
be experienced and present
challenges especially around
pricing and managing risk of
derivative instruments and bonds;
most models and systems assume
a non-negative rate.
Monetary Policy and Negative Interest Rates
• Negative interest rates are used
by central banks to stimulate the
economy by incentivizing both
borrowing and lending.
• Theoretically negative rates are a
disincentive to hold bank deposits
and an incentive to borrow.
• BoJ has been fighting deflation for
about 20 years and European
inflation has remained low despite
negative rates.

118
Negative Interest Rates: Mixed Results
• Opinions on the impact of negative rates are divided, and the use of
negative rates remains one of the more controversial tools for central
banks.
• Consequences of negative rates:
• Lenders expect a return based on the risk of the borrower and they expect to a
return on interest bearing assets.
• Negative rates could cause bank runs due to negative yielding savings deposits.
• Behavioral changes could mitigate the stimulative impact of negative rates.

119
Global Pandemic, Economic Growth, and Interest
Rates
• White papers begin to be published on behavioral changes that have
the potential to impact growth going forward.
o In Longer-Run Economic Consequences of Pandemics
(https://www.frbsf.org/economic-research/files/wp2020-09.pdf),
Oscar Jorda, Sanjay Singh, and Alan Taylor determined that
pandemics depress economic growth for several decades following
the pandemic.
o In Scarring Body and Mind: The Long-Term Belief – Scarring Effects
of COVID-19
(https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3588480),
Julian Kozlowski, Laura Veldkamp, and Venky Venkateswaran took
the position that the coronavirus could leave economic scars.

121
Global Pandemic, Economic Growth, and Interest
Rates (Cont.)
• There are several models used to forecast interest rates. Many of
these models are based on quantitative data but have the ability for a
qualitative adjustment.
• However, as we continue to experience increased central bank
intervention to the point where unconventional is now conventional
monetary policy, combined with the potential for behavioral changes
by global consumers as economies come out of Covid-19, it seems
reasonable to begin deploying scenario analysis and considering
operational risk when forecasting interest rates.

122
Global Pandemic, Economic Growth, and Interest
Rates (Cont.)
• An Operational Risk Event led to economic growth concerns, which led
to a Market Risk Event as assets priced lower, which led to Credit Risk
concerns, and Monetary and Fiscal stimulus and policies sought to
offset the negative economic impact of the pandemic, restore
confidence, and inject liquidity.
• COVID-19 has the potential to cause behavioral changes that impact
economic growth and interest rates going forward.

123
Operational Risk
• Operational Risk is about people, process, systems and
external events.
• External events can range from geo-political risk, to policies,
and behaviors.
• If external events impact interest rates, these events may
need to be taken into consideration when modeling or
forecasting interest rates.
• Bayesian networks can be used to model operational risk.
• The external environment needs to be evaluated to
determine potential threats or possible opportunities.
Operational Risk (Cont.)
• The internal environment also needs to be evaluated to
determine the strength of management, internal controls,
and the effectiveness of analysis and reporting.
• After the external and internal environments are assessed,
the net potential impact can be analyzed.
• A Bayesian network is a multi-variate statistical model that
can incorporate quantitative and qualitative inputs.
Bayesian Network Example Assess Strengths

Management
Expertise
Climate
Culture & Change
Risk Climate
Appetite Change
System of
Reporting & Internal Geo-Political
Analytics Controls Risk

Leadership Loss History

Disruptive
Technologies
New
Entrants
Strength of
Opportunitie
Risk &
Controls
s & Threats Assess
Employment Threats
Practices & External Business
Workplace Safety Fraud Disruption &
System Failure
Internal Execution,
Fraud Delivery &
Damage to
Process
Physical
Management
Assets
Operational Risk Event Clients,
Causation Categories Products &
Business
Practices
Stress Tests versus Scenario Analysis
Stress Testing “…is a projection of Scenario Analysis is “…a
the financial condition of a firm or systematic process of obtaining
economy under a specific set of expert opinions from business
severely adverse conditions…” managers and risk management
- Stress Testing and Scenario Analysis experts to derive reasoned
(International Actuarial Association, July assessments of the likelihood and
2013). loss impact of plausible high-
severity operational losses”
- Advanced Capital Adequacy Framework
(Published in the Federal Register, December
7, 2007).

127
Stress Tests versus Scenario Analysis (Cont.)
• They can be built from one or multiple • Scenario analysis is used to assess and
risk factors and can be simple of evaluate potential future events. They
complex depending on purpose of the are not necessarily derived from
stress test, the focus is on extreme but historical events although history can be
plausible events. The purpose of a a starting point when building a
stress test is to: scenario. Scenarios have the potential
§ Inform risk appetite framework. to be disruptive but may not be likely.
The purpose of a scenario analysis is to:
§ Allow management to set
appropriate risk policies. § Prepare for unexpected events.
§ Ensure risk exposure does not § Identify key risk exposures,
exceed capital and liquidity especially emerging risks.
availability. § Explore potential extreme events
§ Ensure the firm can survive an § Mitigate risk of solvency.
extreme event.
§ Identify magnitude of tail risks.
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Concluding Thoughts
• Central banks have become increasingly creative to combat
disinflation and provide economic stimulus.
• Governments have also provided unprecedented fiscal
stimulus, while also generating massive fiscal deficits.
• This intervention could distort market prices, and cause
anomalies in both asset prices and interest rates.
• External events need to be included when analyzing extreme
but plausible events to ensure firms are positioned to
operate in an increasingly volatile operating environment.