HSBC Bank Middle East Ltd

1
HSBC Bank Middle East Ltd
Basel 2 Market Risk
30 NOVEMBER 2008
JOHN C PERRY For Palestine Banking Conference
2
Forward-looking statements

• This presentation and subsequent discussion may
  contain certain forward-looking statements with
  respect to the financial condition, results of
  operations and business of the Group.
• Such forward-looking statements represent the
  Groups expectations or beliefs concerning future
  events and involve known and unknown risks and
  uncertainty that could cause actual results,
  performance or events to differ materially from
  those expressed or implied in such statements.

3
Contents

• Where is Market Risk?
• Market Risk
• Counterparty Credit Risk
• Securities Financing Transactions
• Internal Model Method (IMM)
• Position Risk Requirement
• General Risk
• Specific Risk
• Interest Rates, Equities, Commodities and Foreign
  Exchange
• Value at Risk (VaR)
• Developments in the Basel Market Risk framework
• Incremental Risk Capital (IRC) charge
• Discussion Planning for the unexpected !

4
Managing Risks Comfort zones

• The general tendency is one of optimism regarding
  the future.
• This leads to many misconceptions regarding risk
  especially when considering the probability (the
  likelihood) that an event will happen
• History does not crawl, it jumps
• The past is rarely a guide to the future,
  especially when one looks further into the past.
• Looking backwards with benefit of hindsight. The
  tendency is to explain an unforeseen event with
  the phrase. It happened because. This is a
  contradiction!
• The delusion of statistics
• The Gaussian bell curve (Carl Fredrich Gauss)
  assumes a normal distribution.
• Extreme events (Black Swans) do happenand
  more frequently than you imagine
• Quotations
• Harold McMillan - the greatest challenge -
  Events dear boy Events
• Harold Wilson - I am an optimist but an
  optimist who carries a raincoat

5
Market Risk Pillar 1, 2 and 3 implications
Risk that movements in rates and prices will move
causing the losses to be incurred on the open
positions
P1
P2
P3
Managed Risks
Managed Risks
Credit
Operational
Includes Legal
Market
Asset Liability Management
Pension Fund
Pension
Insurance business
Insurance
Other Business Risks
Strategic Risk
Market Risk has many widespread impacts. Not only
in the Trading Book !
6
Market Risk- Counterparty Credit Risk-
Securities Financing Transactions- Internal
Model Method (IMM)
7
Exposure at Default (EaD) - OTC DerivativesMark
to Market Method (M t M). It combines values
derived from the current mark to market,
predicted M t M and collateral to calculate an EaD
Netting Agreement
No Netting Agreement
EaD (floor)
Balance Sheet Value
Add-On (future)
Funded
Positive Mark to Market
Negative Mark to Market

(Zero)




Non-Funded
IRS lt 1 Year
0
x
Variable NGR (max 1.0)
x

(0.4)

Product and Maturity
0.5 to 15
x
Product and Maturity
Own est
x
?

• Short-dated FEX deals up to and including spot
  are excluded
• Collateral taking into haircuts is permitted to
  reduce the EaD

Collateral (CSA)
8
EaD - OTC Derivatives - Conversion FactorsAdd On
Factors are applied to the contract values to
provide an estimate of the future possible
adverse change in the mark to market
Credit Conversion Factors for OTC Derivatives
Residual Maturity
Equity
Precious Metals
Other Commodities
lt 1 Yr
6.0
7.0
10.0
gt 1-5 Yrs
8.0
7.0
12.0
gt 5 Yrs
10.0
8.0
15.0
Credit Conversion Factors for Credit Derivatives
- Trading Book
Product Type
Qualifying Reference
Protection Buyer / Return Receiver
Protection Seller / Return Seller
Protection Seller - Other
Y
5.0
5.0
0.0
Credit Default Swap
N
10.0
10.0
0.0
Y
5.0
5.0
-
Total Return Swap
N
10.0
10.0
-
How appropriate are these in a volatile world or
even pegged currencies ?
9
Standardised IRB
Securities Financing Transactions (EaD)Many
approaches to choose from
Master Netting Agreement Internal Models Approach
(VAR)
Counterparty Credit Risk Internal Model Method
(EEPE)
Financial Collateral
Simple Method
Comprehensive Method
Approaches
Supervisory
Own Estimates
Balance Sheet Value
Master Netting Agreement

• E balance sheet value of exposure
• C market value of collateral
• Eva the volatility-adjusted exposure
  amount
• Cvam the volatility-adjusted value of the
  collateral (including adjustments appropriate for
  the collateral, currency mismatch and maturity
  mismatch)
• ?(E) the sum of all Es under the agreement
• ?(C) the sum of all Cs under the agreement
• Hsec the volatility adjustment appropriate
  to a particular type of security
• Efx the net position (positive or
  negative) in a given currency other than the
  settlement currency of the agreement
• Hfx the volatility adjustment appropriate
  for currency mismatch
• VAR output of the internal model estimates of
  the potential change in value of the unsecured
  exposure amount
• a 1.4 or any higher amount specified
  in the firm's CCR internal model method
  permission (if permitted may use its own
  estimates of a, subject to a floor of 1.2)
• Effective EPE (?k1min(1 year maturity ))
  ((Effective EEtk)(dtk))

10
OTC Derivatives and Securities Financing
Transactions (IMM)The Internal Model Method
(IMM) is an approach to calculate an Effective
Expected Positive Exposure value.
Four steps
Exposure
Effective Expected Exposure (EEE)- non-reducing
EE profile
3.
Effective EPE (EEPE)- time weighted average of
Effective Expected Exposure over the first year
(Then multiplied by alpha (1.4))
?
4.
Expected Positive Exposure (EPE)- average of
Expected Exposure profile for 1 year can not be
used, because it does not take into account the
rollover of short dated contracts
2.
Expected Exposure (EE)- average exposure
profile produced (from the Monte Carlo
simulation) having set negative values to zero
taking into account the collateral agreement
1.
?
Profile shown represents a stylised Interest Rate
Swap portfolio where there is a positive mark to
market on trade date. The portfolio has no
collateral offset and matures in 15 months time
Residual Time (years)
Note A lower alpha of 1.2 is permitted subject
to regulatory approval
11
Market Risk- General and Specific Risk
12
UK FSA BIPRU section 7(Annexes I, III, IV and V
of the EU Capital Adequacy Directive.)
Position Risk Requirement (PRR) General Risk (GR)
Specific Risk (SR)

• Interest rate, General Specific Risk for debt
  security)
• Equity General Specific
• Commodity, (covering both Banking and Trading
  Book)
• Foreign Currency (including Gold, Spot, Forwards,
  Options, Futures and CFD)
• Collective Investment Undertakings
• Securities Underwriting
• Credit Derivatives. (Total Return Swaps (TRS)
  Credit Linked Notes (CLNs)
• General Specific Risk.

13
General Specific Risk
General Risk The risk of a price change in
an investment owing to a change in the

• Interest rates,
• Commodity prices,
• Foreign currencies,
• Options,
• Collective Investment Undertaking valuations
• Valuation of Equity positions that relate to
• Broad equity-market movement unrelated to any
  specific attributes of individual securities
• Basic interest rate for equity derivatives

Specific Risk This covers both the impacts of
Interest Rates and Equity Prices

• Unique risk that is due to the individual nature
  of an asset and can potentially be diversified.
• The risk of a price change in an investment due
  to factors related to its issuer or, in the case
  of a derivative, the issuer of the underlying
  investment

14
Interest Rates General Risk
4 approaches

• Simplified maturity method Regulatory
  prescriptive (Maturity Bands)
• Maturity method Regulatory prescriptive (Zones
  and Bands)
• Duration method Regulatory prescriptive
• Value at Risk Model specific with regulatory
  guidelines

Simplified maturity method

• Weights individual net positions to reflect their
  price sensitivity to changes in interest rates.
• Weights are related to the coupon and the
  residual maturity of the instrument (or the next
  interest rate re-fix date for floating rate
  items) (less than or more than 3 for gt 1 year)
• The sum of each individual net position (long or
  short) multiplied by the appropriate PRA.
• Net positions to the appropriate maturity bands
• residual maturity in the case of fixed-rate
  instruments
• the period until the interest rate is next set in
  the case of instruments on which the interest
  rate is variable before final maturity.

15
Interest Rates Specific Risk Standardised
Approach
Asset Class

• Notes
• qualifying issuers ( investment grade to
  conform with Banking Book definitions)
• Specific Charge for hedged positions using credit
  derivatives

16
Equity Risk
3 approaches

• Simplified Regulatory prescriptive
• Standard Regulatory prescriptive
• Value at Risk Model specific with regulatory
  guidelines

• Market value of the net position (ignoring the
  sign) multiplied by the appropriate PRA

Simplified

• General move in a country's equity market.
• No offset between different country portfolios
• Limited offset between different country
  portfolios. (Only country portfolios for
  countries which are full members of the OECD,
  Hong Kong or Singapore are included)
• Specific move in an individual equity's price
  changing relative to that country's equity
  market.

Standard

• Notes
• converted into the firm's base currency at
  current spot foreign currency rates
• A firm does not have to use the same method for
  all equities

17
Commodity Risk
4 approaches

• Simplified Regulatory prescriptive
• Maturity ladder Regulatory prescriptive
• Extended maturity ladder Regulatory prescriptive
  
• Value at Risk Model specific with regulatory
  guidelines

Simplified

• 15 of the net position multiplied by the spot
  price for the commodity
• 3 of the gross position (long plus short,
  ignoring the sign) multiplied by the spot price
  for the commodity
• A firm must use the same approach for a
  particular commodity
• But need not use the same approach for all
  commodities.
• If A short position to which applies
  falls due before a long position
• Then A firm must also guard against the risk of
  a shortage of liquidity which may exist in some
  markets.

18
Foreign Exchange Risk
2 approaches

• Open Currency Position Regulatory prescriptive
• Value at Risk Model specific with regulatory
  guidelines

Open Currency Position

• Calculating the net position in each foreign
  currency
• converting each such net position into its base
  currency equivalent at current spot rates
• summing all short net positions and summing all
  long net positions calculated above (ignoring the
  sign)
• multiplying the sum of the absolutes of each open
  currency position and net gold position by 8

• Exclude
• Foreign currency assets which have been deducted
  in full from the firm's capital resources under
  the calculations under the capital resources
  table, or positions hedging these assets
• Positions that a firm has deliberately taken in
  order to hedge against the adverse effect of the
  exchange rate on the ratio of its capital
  resources to its capital resources requirement
• Transactions to the extent that they fully hedge
  net future foreign currency income or expenses
  which are known but not yet accrued.

19
Other Risks
Options

• Standard method PRR calculation for the relevant
  underlying position
• Hedging method (unavailable for Interest,
  Commodities and CIUs)

Collective Investment Undertakings (CIU)

• Look-through method
• Modified look-through method (unaware of
  underlying investments)

Securities underwriting

• Identify commitments to underwrite or
  sub-underwrite which give rise to an underwriting
  position
• Identify the time of initial commitment
• Calculate the net underwriting position, reduced
  net underwriting position or the net underwriting
  exposure.

Credit Default and Total Return Swaps (CDS / TRS)

• General and Specific Risk

20
Volatility in market rates is significantly
greater that the parameters

• 14NOV High Low (past 12months)
• Gold 747.50 1,004.30 639.60 / oz
• Silver 628.92 1,007.66 552.92 pence / ox
• Brent Crude 51.35 145.29 51.35 /
  barrel
• Reuters Commodities Index 1,980.74 3,053.35 1,956.
  64
• USD 3 mth interest rates 2.24 5.73
  2.24
• GBP / USD 1.4800 2.1100 1.4800
• EUR / USD 1.2700 1.6000 1.2700
• USD / JPY 96.81 119.64 93.16
• D J Industrials 8,497.31 14,198.10 8,378.95
• HSBC Ord FTSE 7.19 9.38 6.17
  (14Nov08 Mkt cap 87,032m)
• Overall World (MSCI) 46.6 down in 1 year

It is not surprising that most Banks adopt a VaR
approach !
Source Public data
21
RiskAre you in control of your own destiny?
Are there Unknown Unknowns? (Black Swans)
Murphys 1st law If something can go wrong, it
will !
Murphys comment on his first law I was an
optimist !
Black Swan event?
22
Market Risk- Value at Risk (VaR)
23
VaR (Value at Risk) Approach
The aim of the VaR model approach is

• To enable a firm with adequate risk management
  systems to be subject to a PRR requirement that
  is more closely aligned with the risks to which
  it is subject than the PRR requirements generated
  by the standard market risk PRR rules.
• An incentive to measure market risks as
  accurately and comprehensively as possible.
• Those responsible for managing market risk. Be
  aware of the assumptions and limitations of VaR
  model.
• A regulator will not normally grant a VaR model
  permission unless it is satisfied about the
  quality of
• the internal controls and risk management
  relating to the VaR model
• the VaR model standards
• stress testing and backtesting procedures
  relating to a VaR model
• Capital Charge
• 500 market moves based upon todays current
  positions
• 5th worst is taken as the VAR (99)
• Capital charge. A minimum of 3x the 10 day
  Value at Risk (VaR)

24
VaR (Value at Risk) Approach
VaR Model Approach Formula
59
i-0

• Where
• PRR Var is a firm's model PRR
• VaR t represents the previous day's value-at-risk
  figure
• VaR t-i represents the value-at-risk calculated
  for i business days earlier
• f is the multiplication factor and
• IDRC is the incremental default risk charge (if
  applicable).

The equation (FSA BIPRU 7.10.113R) is the capital
requirement for the VaR approach

• For Specific risk, the changes have been as
  follows
• The specific risk surcharge (an additional value
  of 1.0 resulting in the 3.0 multiplier being
  increased to a 4.0 multiplier) has been replaced
  with an Incremental Default Risk Charge (IDRC)
  using a constant level risk assumption

There are many additional operational
requirements
25
VaR (Value at Risk) Specific Risk
VaR specific risk minimum requirements in
addition to the other requirements

• Explain the historical price variation in the
  portfolios concerned
• Capture concentration in terms of magnitude and
  changes of composition of the portfolios
  concerned.
• Be robust to an adverse environment.
• Capture name-related basis risk. That is the firm
  must be able to demonstrate that the VaR model is
  sensitive to material idiosyncratic differences
  between similar but not identical positions.
• Capture event risk
• Have an approach in place to capture, in the
  calculation of its capital requirements, the
  default risk of its trading book positions that
  is incremental to the default risk captured by
  the VaR measures as specified in this rule,
• Be able to demonstrate that the approach referred
  to above meets soundness standards comparable to
  the approach set out in The IRB approach, under
  the assumption of a constant level of risk, and
  adjusted where appropriate to reflect the impact
  of liquidity, concentrations, hedging and
  optionality.

Recent market turmoil has been a catalyst for
much regulatory soul-searching
26
Market Risk- Developments in the Basel Market
Risk framework- Incremental Risk Capital (IRC)
charge
27
Market Risk Framework Proposed Revisions by the
BCBS

• Capture not only defaults but a wider range of
  incremental risks in the Incremental Risk Capital
  charge (IRC)
• Perceived shortcomings in the current 99 10 day
  VaR, and proposals for a new trading book capital
  charge covering risks incremental to the market
  risk charge
• Comments by the industry on the proposals
• Overly ambitious implementation schedule
• Goes well beyond the current state of risk
  modelling at most banks
• VaR will continue to play an important role in
  Banks
• Double counting of Credit Spread and Equity Price
  risks for Regulatory Capital (fail Use Test)
• Simulation for a full year ignores the liquidity
  (incomparable to the Banking Book), creating a
  higher Trading Book capital charge and
  discouraging firms holding risks in a mark to
  market environment
• Using a constant level of risk assumption
  (appropriate for IDR) is a more challenging and
  ignores the difference between liquid and
  illiquid positions
• If as expected the IRC turns out to be a big
  component of the total regulatory capital charge,
  this will prevent convergence between regulatory
  and internal capital allocation

28
Market Risk Framework Proposals by the industry

• Higher regulatory capital number for the Trading
  Book
• Avoid creating perverse incentives, and thus
  encourage the right kind of behaviour
• Ensure an element of looking through the risk
  factors
• Avoid double counting of risks, thus ensuring
  that a risk process can be of use for internal
  purposes (passes the Basel 2 Use Test)
• VaR plus form of scaling factor(s)
• VaR stress testing and scenario analysis
• Other key messages and concerns expressed
• Implementation of models for structured products
  (given lack of through the cycle data)
• Interim treatment for re-securitisations
• A one year capital horizon and 99.90
• New liquidity horizon requirements
• Validation

• Notes
• The industry represented by ISDA, IIF, LIBA and
  ibfed
• Extracted from their letter dated 24th October
  2008 to BCBS

29
Conclusion - The key messages for managing risk
30
Key messages of the implications of managing risk

• Recognising that it means
• Stepping out of your comfort zone
• Embracing stress and scenario testing
• Ensuring that an effective governance process is
  in place
• Discharging responsibilities and adhering to
  policies
• To management and employees
• Do you know the risks in your business?
• Have the risks been communicated?
• Are the risks measured and managed by people, not
  by mathematical models?
• Is there a consistent and rigorous approach to
  managing risk?
• Does everyone understand that return is only half
  the equation and that decisions should be made
  only after considering both the risk and return
  to estimate the rewards?
• Is common sense being applied?

In conclusion minimise the unknown unknown
events... Stay in control of your destiny
31
Discussion
32
Biography of John C Perry, HSBC

• Joined HSBC in September 1975
• An International Manager since July 1977
• Muscat (Oman) Sub-Manager Branch
  Operations
• Hong Kong Group IT Systems Co-ordinator
• Riyadh (Saudi Arabia) Manager Operations and
  Area Operations
• Manager Office Automation
• Hong Kong Manager Group Treasury Systems
• Dubai (U.A.E) Financial Controller (U.A.E
  and Middle East)
• Milan (Italy) Chief Operating Finance
  Officer
• Sydney (Australia) Head of Treasury Services
  Compliance Officer
• Curitiba (Brazil) Head of Treasury Asset
  Management Services
• Toronto (Canada) Director, Chief Operating
  Chief Finance Officer
• (HSBC Securities (Canada) Inc.)
• New York Head of Finance - Global Markets
• London Group Project Manager - Basel 2 -
  Global Banking Markets
• Effective 01 December 2008
• Jersey (Channel Islands) Executive Director

33
Disclaimer

• The views expressed in this presentation should
  not be considered as representing the views of
  HSBC.
• This presentation has been produced to facilitate
  discussion and understanding of the Basel 2
  framework and in particular the approaches to
  Market Risk by attendees to the Palestine Banking
  Conference (Jericho) 30 November 2008 taking into
  account public statements