Data Warehousing and Business Intelligence

27 September 2015

Credit Risk and Market Risk

Filed under: Business Knowledge,Investment Banking — Vincent Rainardi @ 5:59 am
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Broadly speaking when we talk about risk in investment banking IT, it’s about 2 things: Credit Risk and Market Risk. Other financial risks are liquidity risks, operational risks, legal risks, but they don’t usually require a large IT systems to manage them.

Credit Risk

As a bank, credit is about lending money to companies to get interest. The companies are called obligors or counterparty. These obligors have obligation to pay us certain amount at certain times. The risk here is if those companies cannot pay us the amount they need to pay, when it’s due. This is called a default.

Credit risk is about 2 things: a) to manage the credit portfolio, b) to manage credit transactions. For a), the goal is to maximise the risk-adjusted return by maintaining the credit exposure of the whole portfolio within certain parameters. This is done using economic capital, correlation and hedging. These subjects are explained in these articles:

Economic Capital: http://www.ecb.int/pub/pdf/scpwps/ecbwp1041.pdf

Correlation: http://www.ecares.org/ecaresdocuments/seminars0809/castro.pdf

Things that a credit risk business analyst (BA) is expected to understand are: counterparty risk, CVA, Basel II & III, credit portfolio management, PD, LGD, EAD, Expected Loss, VAR, KMV, PFE, volatility, Economic Capital, RWA, Monte Carlo, correlation, ratings, credit derivative.

A credit risk data warehouse has the following functionalities:

  • Calculate Value At Risk and volatility of the credit portfolio every single day.
  • Produce regulatory reports such as Risk Weighted Assets, capital requirements, stress tests, and Potential Future Exposure.
  • Calculate portfolio risk measures such as Exposure At Default, Expected Positive Exposure, Credit Valuation Adjustment, counterparty risk.

Market Risk

Banks, insurance companies, pension funds and hedge funds all invest their cash in various things: shares, bonds, derivative, commodity, property, or in other companies. You intend to keep them for years. This is called investment portfolio, e.g. if you have £1 million to invest, you put 20% in bond, 50% in shares, etc.

Sometimes you don’t keep it for a long time. But only a few days, or even a few hours. This is called trading portfolio. Shares, FX, commodity, derivative, etc.

The value of your portfolio (be it investment or trading) can go up or down depending on 4 factors: the share prices, FX rates, interest rate and commodity prices. These 4 factors is called market risk, because the prices of these 4 factors are determined by the market (the buyer and the seller).

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