COUPLING OF MARKET RISK, CREDIT RISK, AND LIQUIDITY RISK

Rabinder K. KoulManaging Director and Head of Risk ServicesGateway Partners

INTRODUCTION

Gateway Partners is a Registered InvestmentAdvisor (RIA) dedicated to providing our clientswith best-in-class risk management solutions.Gateway Partners has the expertise to identify,measure and manage market, credit, liquidity,operational, and regulatory risk at the executivelevel of numerous large financial Institutions. Thistranslates into first class solutions for our clients.We have the unique expertise to address theissues of traceability of regulatory informationprovided to regulators and to provide end-to-endtransparency on regulatory reports.

INTERACTION OF MARKET ANDCREDIT RISK & LIQUIDITY RISK

1. What is Market Risk

2. What is Credit Risk

3. Interaction between Market and Credit Risk

4. Liquidity Risk

5. Funding Risk

WHAT IS MARKET RISK

Market risk is the loss in a financial institution’sportfolio due to the price and volatility in financialmarkets. The level change and volatility are alsoresponsible for the upside of the assets in theportfolio. This is reflected by the change in level andthe volatility in markets given below.

TRADITIONAL MARKETRISK DRIVERS

Equity Markets1. Equity price and price changes2. Equity volatility

Interest Rate LIBOR and Swap Markets1. Interest rate level change2. Basis risk3. Interest rate volatility

Governmental Funding Rate Markets1. OIS funding

Treasury Markets1. Short term treasury rates2. Long term treasury rates

FX Risk:

1. Spot rate levels

2. Spot rate volatility

3. Forward rates

4. Forward rate volatility

Commodity Risk

1. Price risk

2. Volatility risk

TRADITIONAL MARKETRISK DRIVERS

Credit Products

1. Rate risk

2. Spread risk

Mortgage Loan Markets

1. Swap rates

2. Current coupon rates

3. Commitment spreads

4. Prepayment risk

TRADITIONAL MARKETRISK DRIVERS

Commercial Loan Market Risk

1. Commercial loan rates risk

2. Commercial loan spread risk

Credit Card Markets

1. Credit card spread risk

TRADITIONAL MARKETRISK DRIVERS

CREDIT RISK

Credit risk is the possibility of loss of principalamount in credit and debt markets due tochanges in the credit ratings of the borrower orpossibility of the default by the obligor and thechanges in the recovery rates along with cost ofrecovery.

CREDIT RISK

Drivers of credit risk include:

• Rating Migration Risk

• Default Risk

• Recovery Rate Risk

However, default risk and recovery rate information ishidden in the credit spread of the counterparty.

TRADITIONAL CREDIT RISK

Credit Products1. Spread risk2. Rating based spreads3. Credit Spread = Probability of Default x Loss Given

DefaultMortgage Loan Markets

1. Default riskCommercial Loan Market Risk

1. Commercial loan refinancing risk2. Commercial loan write off risk3. Default risk

Credit Card Markets1. Default risk

INTERACTION BETWEENMARKET AND CREDIT RISK

• Historically, market and credit risks have been treatedseparately as if these risk are independent of each other.This has been primarily because of practical considerations.

• These risks are measured and managed separately, as is themeasurement of economic and risk capital. The two aresimply added together to arrive at the combined result.

• However, the economic factors which drive market risk arealso the drivers of credit risk as we have partially seen inprevious enumeration of these risks. The coupling betweenthe two is much more intimate, and in fact can havecompounding effects on each other.

• The distinction between the two has further been blurredby credit risk transfer markets and mark-to-marketaccounting of certain held to maturity banking bookpositions.

• The recent financial crisis has shown us the strongcoupling and compounding effects between marketand credit risk that create large losses in institutionalportfolios. It has also shown how the loss of liquiditycan act as a coupler between market and credit risk.

• As we have seen, market and credit risk is separated byidentifying credit risk with the default or ratingmigration of a counterparty. Market risk on the otherhand can be seen as the fluctuation of asset prices as afunction of market factors as enumerated previously(e.g., commodity prices, exchange rate of interestrates, etc.). This fluctuation of asset prices gives rise tothe riskiness of the asset, thus, the change in theprobability of default.

INTERACTION BETWEENMARKET AND CREDIT RISK

Some empirical studies in Europe have shown that shocks to short terminterest rates have a larger effect on a firm’s default when its credit riskmodel accounts for the feedback of these shocks in credit models.

Example of Market and Credit Risk Coupling

• Adjustable Rate Loans: Adjustable rate loans have coupons thatchange as interest rates change. If we assume that a loan does notdefault, the bank has no market risk as that risk has been passedon to the borrowers. If the credit risk is computed separately fromthe market risk, then we keep the interest rate fixed at the currentlevel. However, this calculation misses the impact of interactionbetween the market and credit risks. For example, if theprobability of default increases with an increase in interest rates,we will be underestimating the actual probability of default.Therefore, the sum of market and credit risk is underestimated.

INTERACTION BETWEENMARKET AND CREDIT RISK

Example of Market and Credit Risk Coupling

• Carry trades and foreign currency loans: Consider a tradewhere one borrows funds in a low interest rate currency andlends the funds at a higher interest rate currency. If the lowinterest rate currency lender computes the market andcredit risk separately, the market risk is computed byassuming that borrower is not going to default, in which caseonly market risk is left. That is because of the fluctuation ofcurrent FX and interest rates. To measure credit riskseparately from market risk, we assume that interest ratesand the FX rates are not changing. Then credit risk does notdepend on these factors. However, if the probability ofdefault depends upon whether the trade is profitable, thenthe total risk computed is underestimated.

INTERACTION BETWEENMARKET AND CREDIT RISK

Example of Market and Credit Risk Coupling

• Matching long and short positions in OTC derivatives: Suppose abank buys OTC derivatives from one counterparty and sells thesame OTC derivatives to another counterparty. In such a situation,the bank is market risk neutral. Suppose the market value of theOTC derivatives does not change in the market. In case of defaultby counterparty, its deliverable can be purchased at the sameprice. Hence, there is no credit risk. However, if the value of thederivative changes, and one counterparty defaults at the sametime, the change in market value and default together generate aloss for the bank. During the Russian crisis in 1998, this mechanismcreated losses in foreign currency forwards when westerncountries held USD/ruble forwards with Russian banks withopposite positions with western customers.

INTERACTION BETWEENMARKET AND CREDIT RISK

LIQUIDITY RISK

• Liquidity risk is the risk arising through the liquidityin asset markets due to outstanding volume, andthe demand in the markets for the asset class.

• It also includes the availability of a firms’ cashliquidity so that routine market activities cancontinue, like servicing margin, etc.

LIQUIDITY RISK

What is Market Liquidity?• A market is liquid if the transactions of the asset in the market

can take place easily and rapidly without significantly moving themarket value of the asset.

• Depth of the market in a particular asset class that measures thesize of assets can be transacted without making additionalavailability of the asset class difficult. It also depends upon thenumber of participants in the market, hence, price transparency.

• It depends upon the effect on bid-ask spread of the asset pricewhen the asset of a particular size is transacted.

• The rapidity of the transaction in an asset refers to the speedand ease in which the transaction takes place so that the marketreturns to normal as quickly as possible.

• Dependence of market liquidity upon the funding liquidity.

FUNDING RISK

Funding risk is the risk arising due to fundingthe market activity of borrowing assets andservicing these assets in response to thechanging price of these assets.