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Trading and Capital-Markets Activities Manual

Trading Activities: Market Risk  (Continue) 
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

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MARKET-RISK LIMITS 

Market-risk limits are one of the most fundamental controls over the risks inherent in an institution's trading activities. Banks should establish limits for market risk that relate to their risk measures and are consistent with maximum exposures authorized by their senior management and board of directors. These limits should be allocated to business units and individual traders and be clearly understood by all relevant parties. Internal controls should ensure that exceptions to limits are detected and adequately addressed by management. In practice, some limit systems include additional elements, such as stop-loss limits and trading guidelines, that may play an important role in controlling risk at the trader and business-unit level. Examiners should include these elements in their review of the limit system. Other institutions may have several levels of limits informally allocated by product or by staff. For example, policy guidelines may give head traders substantial discretion in allocating limits among staff. Some institutions that permit traders to take positions in multiple instruments may apply limits broadly across the organization, with sublevels of advisory limits when gross exposures exceed a given percentage, such as 75 percent, of overall levels. 

When analyzing an institution's limits, examiners should evaluate the size of limits against the institution's financial strength. The risks resulting from full utilization of an institution's limits should not compromise its safety and soundness. Examiners should also evaluate the percentage of limit use over time. Excessively large limits may circumvent normal reporting lines; an increase in activity or position may not be properly highlighted to senior management. Conversely, overly restrictive limits which are frequently exceeded may undermine the discipline of the limit structure in place. Finally, examiners should evaluate profitability along with position taking. Institutions should be able to explain abnormal daily profits or losses given the size of their positions. 

The following is a summary of limits frequently used by financial institutions: 

  • Limits on net and gross positions. Limits may be placed on gross positions, net positions, or both. Limits on gross positions restrict the size of a long or short position in a given instrument. Limits on net positions, on the other hand, attempt to recognize the natural offset of long and short positions. Institutions generally should employ both types of limits in their risk management. 
  • Maximum allowable loss (''stop-loss''). Limits may be established to avoid the accumulation of excessive losses in a position. Typically, if these limits are reached, a senior management response is required to hedge or liquidate a position. These limits are usually more restrictive than overall position limits. Typical stop-loss limits are retrospective and cover cumulative losses for a day, week, or month. 
  • Value-at-risk limits. Management may place limits on the extent to which the value of a portfolio is affected by changes in underlying risk factors. Limits can be specified as the maximum loss for a specified scenario (for example, a 100 basis point change in rates) or for scenarios defined at some specified confidence level derived from internal VAR measures (for example, 99 percent of possible occurrences over a one-day time horizon). Generally, measures of sensitivity are based on historical volatilities of risk. 
  • Maturity gap limits. These limits enable an institution to control the risk of adverse changes in rates for the periods designated in the institution's planning time horizon. Limits might range from stated absolute amounts for each time frame to weighted limits that emphasize increasing rate-movement exposure applicable to the relative distance into the future in which the gap appears. In addition, these limits should specify the maximum maturity of the specific instrument or combination of instruments. Typically, institutions employ maturity gap limits to control risks arising from nonparallel shifts in yield curves and forward curves. 
  • Limits on options positions. An institution should place unique limits on options positions to adequately control trading risks. Options limits should include limits which address exposures to small changes in the price of the underlying instrument (delta), rate of change in the price of the underlying instrument (gamma), changes in the volatility of the price of the underlying instrument (vega), changes in the option's time to expiration (theta), and changes in interest rates (rho). 
  • Limits for volatile or illiquid markets. Management may choose to limit trading in especially volatile markets, in which losses could accumulate quickly, or in illiquid markets, in which management may be forced to take a loss to close a position it cannot offset.

Market Risk 

Examination Objectives 

1. To evaluate the organizational structure of the market-risk-management function. 

2. To evaluate the adequacy of internal market risk-management policies and procedures for capital-markets and trading activities and to determine that actual operating practices reflect such policies. 

3. To identify the market risks of the institution. 

4. To determine if the institution's market-risk measurement system has been correctly implemented and adequately measures the institution's market risks. 

5. To determine how the institution measures non-standard products such as exotic options, structured financings, and certain mortgage-backed securities. 

6. To determine if senior management and the board of directors of the financial institution understand the potential market exposures of the capital-markets and trading activities of the institution. 

7. To ensure that business-level management has formulated contingency plans for illiquid market conditions. 

8. To review management information systems for comprehensive coverage of market risks. 

9. To assess the effectiveness of the global risk-management system and determine if it can evaluate market, liquidity, credit, operational, and legal risks and that management at the highest level is aware of the institution's global exposure. 

10. To recommend corrective action when policies, procedures, practices, internal controls, or management information systems are found to be deficient.

Market Risk 

Examination Procedures 

These procedures list processes and activities that may be reviewed during a full-scope examination. The examiner-in-charge will establish the general scope of examination and work with the examination staff to tailor specific areas for review as circumstances warrant. As part of this process, the examiner reviewing a function or product will analyze and evaluate internal audit comments and previous examination work papers to assist in designing the scope of examination. In addition, after a general review of a particular area to be examined, the examiner should use these procedures, to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge that determines which procedures are warranted in examining any particular activity. 

1. Review the market-risk-management organization. 

a. Check that the institution has a market risk-management function with separate reporting lines from traders and marketers. 
b. Determine if market-risk-control personnel have sufficient credibility in the financial institution to question traders' and marketers' decisions. 
c. Determine if market-risk management is involved in new-product discussions. 

2. Identify the institution's capital-markets and trading activities and the related balance sheet and off-balance-sheet instruments. Obtain copies of all risk-management reports prepared by the institution. 

a Define the use and purpose of the institution's capital-markets products. 
b. Define the institution's range, scope, and size of risk exposures. Determine the products in which the institution makes markets. Determine the hedging instruments used to hedge these products. 
c. Evaluate market-risk-control personnel's demonstrated knowledge of the products traded by the financial institution and their understanding of current and potential exposures. 

3. Obtain and evaluate the adequacy of risk-management policies and procedures for capital-markets and trading activities. 
a. Review market-risk policies, procedures, and limits. Determine whether the risk-measurement model and methodology adequately address all identified market risks and are appropriate for the institution's activities. 
b. Review contingency market-risk plans for adequacy. 
c. Check that limits are in place for market exposures before transacting a deal. If the financial institution relies on one-off approvals, check that the approval process is well documented. 
d. Review accounting and revaluation policies and procedures. Determine that revaluation procedures are appropriate. 

4. Determine the credit rating and market acceptance of the financial institution as a counterparty in the markets. 

5. Obtain all management information analyzing market risk. 
a. Determine the comprehensiveness, accuracy, and integrity of analysis. 
b. Review valuation and simulation methods in place. 
c. Review stress tests, analyzing changes in market conditions. 
d. Determine whether the management information reports accurately reflect risks and that reports are provided to the appropriate level of management. 

6. Determine if any recent market disruptions have affected the institution's trading activities. If so, determine the institution's market response. 

7. Establish that the financial institution is following its internal policies and procedures. Determine whether the established limits adequately control the range of market risks. Determine whether management is aware of limit excesses and takes appropriate action when necessary. 

8. Determine whether the institution has established an effective audit trail that summarizes exposures and management approvals with the appropriate frequency. 

9. Determine whether management considered the full range of exposures when establishing capital-at-risk exposures. 
a. Determine if the financial institution established capital-at-risk limits which address both normal and distressed market conditions.
b. Determine if senior management and the board of directors are advised of market-risk exposures in times of market disruption and under normal market conditions. 

10. Determine that business managers have developed contingency plans which outline actions to be taken in times of market disruption to minimize losses as well as the potential damage to the institution's market-making reputation. 

11. Based on information provided, determine the institution's exposure from dynamic hedging strategies during times of market disruption. 

12. Recommend corrective action when policies, procedures, practices, internal controls, and management information systems are found to be deficient.

Market Risk 

Internal Control Questionnaire 

Review the market-risk-management organization. 
a. Does the institution have a market-risk-management function with separate reporting lines from traders and marketers? 
b. Do market-risk-control personnel have sufficient credibility in the financial institution to question traders' and marketers' decisions? 
c. Is market-risk management involved in new-product discussions in the financial institution? 

2. Identify the institution's capital-markets and trading activities and the related balance sheet and off-balance-sheet instruments and obtain copies of all risk-management reports prepared. 
a. Do summaries identify all the institution's capital-markets products? 
b. Define the role that the institution takes for the range of capital-markets products. Determine the hedging instruments used to hedge these products. Is the institution an end-user, dealer, market maker? In what products? 
c. Do market-risk-control personnel demonstrate knowledge of the products traded by the financial institution? Do they understand the current and potential exposures to the institution? 

3. Does the institution have comprehensive, written risk-management policies and procedures for capital-markets and trading activities? 
a. Have limits been approved by the board of directors? 
b. Have policies, procedures, and limits been reviewed and re-approved within the last year? 
c. Are market-risk policies, procedures, and limits clearly defined? 
d. Are the limits appropriate for the institution and the level of capital-markets and trading activity? 
e. Do the limits adequately distinguish between trades used to manage the institution's asset-liability mismatch position and discretionary trading activity? 
f. Are there contingency market-risk plans? 
g. Are there appropriate accounting and revaluation policies and procedures? 
h. Do the policies authorize the use of appropriate hedging instruments? 
i. Do the policies address the use of dynamic hedging strategies? 
j. Do the policies establish market-risk limits which consider bid/ask spreads for the full range of products in normal markets? 
k. Do the policies provide an explanation of the board of directors' and senior management's philosophy regarding illiquid markets? 
l. Do the policies establish market-risk limits which consider bid/ask spreads in distressed markets? How do the policies reflect liquidity concerns? 
m. Are limits in place for market exposures before transacting a deal? If the financial institution relies on one-off approvals, is the approval process well documented? 

4. If the financial institution has recently experienced a ratings downgrade, ascertain the impact of the credit-rating downgrade. What has been the market response to the financial institution as a counterparty in the markets? Have instances in which the institution provides collateral to its counterparties significantly increased? 

5. Obtain all management information analyzing market risk. 
a. Is management information comprehensive and accurate, and is the analysis sound? 
b. Are the simulation assumptions for a normal market scenario reasonable? 
c. Are stress tests analyzing changes in market condition appropriate? Are the market assumptions reasonable? 
d. Do management information reports accurately reflect risks? Are reports provided to the appropriate level of management? 

6. If there have been any recent market disruptions affecting the institution's trading activities, what has been the institution's market response? 

7. Is the financial institution following its internal policies and procedures? Do the established limits adequately control the range of market risks? Are the limits appropriate for the institution's level of activity? Is management aware of limit excesses? Does management take appropriate action when necessary? 

8. Has the institution established an effective audit trail that summarizes exposures and management approvals with the appropriate frequency? Are risk-management, revaluations, and close-out valuation reserves subject to audit? 

9. Has management considered possible market disruptions when establishing capital-at-risk exposures? 
a. Has the financial institution established capital-at-risk limits which address both normal and distressed market conditions? Are these limits aggregated on a global basis? 
b. Are senior management and the board of directors advised of market-risk exposures in illiquid markets? 

10. Have business managers developed contingency plans which outline actions to be taken to minimize losses as well as to minimize the potential damage to the institution's market-making reputation when market disruptions occur? Are management's activities in times of market disruptions prudent? 
a. Do opportunities for liquidation or unwinding of transactions exist? 
b. Is the depth (volume, size, number of market makers) of the market such that undue risk is not being taken? 
c. If executed on an exchange, is the open interest in the contract sufficient to ensure that management would be capable of hedging or closing out open positions in one-way directional markets? 
d. Can management execute transactions in large enough size to hedge and/or close out market-risk exposures without resulting in significant price adjustments? 

11. Has management determined the institution's exposure to dynamic hedging strategies during times of market disruption? 

12. Does the institution have a methodology for addressing difficult-to-value products or positions?

Continue to COUNTERPARTY CREDIT RISK AND PRE-SETTLEMENT RISK

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