Barclays Bank plc very kindly agreed to provide information on how a major global bank actually manages its risk. Barclays is a long-established British bank, headquartered in London but with major global operations. By tier 1 capital, it is the fourth largest UK bank, and ranks 14th in the world, according to the July 2003 edition of The Banker. Figure below shows the way Barclays organises its risk management. Essentially, risk is managed along two lines, by type of risk and by different business units. Four directors, each in charge of a certain type of risk (e.g. credit risk, market risk) report to a group risk director, as do three directors in charge of functional support, such as regulatory compliance. Seven ‘‘business risk’’ directors also report to the group risk director. One business unit is their investment banking arm, Barclays Capital, others include Barclaycard, Business Banking and Barclays Private Clients.
Barclays classifies risk into four categories: credit, market, non-financial and other risk.
Credit Risk is defined as the risk that customers will not repay their obligations, and is divided into retail and wholesale risk.
Market Risk is the risk of loss due to changes in the level or volatility of market rates or prices such as interest rates, foreign exchange rates, equity prices and commodity prices. It is incurred as a result of both trading and non-trading activities.
Non-financial Risk consists of operational risk, using the Basel definition and business risk, defined as the potential to incur a loss because of an unexpected decline in revenue, which cannot be offset by a corresponding decrease in costs.
Other risk includes risks arising from all other sources, such as property, equipment, associates (e.g. risk linked to joint ventures), and so on. Given the diversity of risks in this category, there is no further discussion of it in this section.
Barclays divides market risk into trading risk and retail market risk. Trading risk is primarily incurred by Barclays Capital and Treasury operations – used to support customer services, such as the sale or purchase of foreign currencies. DVaR, or daily value at risk of the exposure, is the central measure used in Treasury operations and at Barclays Capital.
Trading market risk is evaluated through a multiple of the DVaR (e.g. DVaR times some multiple). The same method is employed for Treasury operations but with a higher multiple.
Barclays Bank plc: How Risk Management is Organised.
Retail market risk arises from imperfect hedges against customer products, either due to the unexpected customer behaviour or losses arising from residual unhedged positions. It applies to all fixed rate, capped rate or index-linked products, across all business units, except for Barclays Capital. There are three categories. Prepayment risk – the risk that customer repayments or withdrawals are unexpected. Recruitment risk – the risk that the bank fails to sell the expected amount of a fixed rate product (e.g. bond), usually due to an adverse movement in market rates. In this event, the bank has to adjust the hedge, by buying/selling interest rate swaps. It can affect the expected cost of funds. Finally, residual unhedged risk – occurs if the actual hedge positions differ from the hedge positions determined by the hedge models that are used. Again, the risk is estimated based on a multiple of the DVaR of the exposure.
Wholesale Credit Risk is the risk of losses arising from default by awholesale counterparty. Though Barclays uses both Creditmetrics and KMV Portfolio Manager. The KMV model, now based on five years of experience, is used to assess wholesale credit risk. The KMV model has been discussed at length. At Barclays, KMV Portfolio Manager is used to compute the capital which should be set aside for each individual exposure, then aggregated over the business unit to provide the overall capital allocation for that unit.
Retail Credit Risk employs two methodologies. For the ‘‘base level’’ methodology, it is assumed that the factors affecting the probability of borrower default are factors specific to a borrower (e.g. age, occupation) and the influence of the state of the macroeconomy on the retail sector. The correlation between the systematic and factor-specific variables is also taken into account. This framework was chosen because it is consistent with the KMV model (used to assess wholesale credit risk) and with the approaches recommended by Basel 2. It is also relatively easy to use because it is based on straightforward formulae. The second methodology for retail credit risk is known as the advanced approach, and is applied to Barclaycard. Here, Monte Carlo techniques are used to estimate a loss distribution. To reduce concentrations of retail credit risk, Barclays uses securitisation (transferring assets off-balance sheet), credit derivatives and insurance.
Barclays manages operational risk beginning with the assumption that OR consists of two independent stochastic components, frequency of loss and severity of loss.
Four variables are used to model operational risk:
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