Asset and Liability Management

Financial Risk and Regulation Series

Chapter 5
Other Non-trading Market Risk in the Banking Book
Chapter 5 Outline – Other Non-trading Market Risk in the Banking Book

‣ Credit Spread Risk

‣ Foreign Exchange Risk

‣ Investment Risk

‣ Pension Risk

‣ Other Risks

‣ Economic Capital

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Chapter 5 Focus

‣ Forms of market risk that is not traded, but nevertheless can have an impact on
profitability and/or regulatory and economic capital requirements

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Credit Spread Risk

Interest Rate Benchmark Credit Spread

Consumer Loan Pricing Fixed Fixed

SME Loan Pricing Floating (Prime/Base rate) Fixed

Corporate Loan Pricing (including FRNs) Floating (Euribor/SOFR/LIBOR) Fixed

Bond Pricing Fixed (Swaps/Govt. Bonds) Fixed

‣ When any of the above instruments are held in the trading book, the inherent risks are actively
managed. Interest rate risk may be hedged with interest rate swaps, for example, and credit
spread risk with credit default swaps.
‣ However, when the instruments are held elsewhere, say in the Treasury liquidity reserve portfolio
or in separately managed subsidiaries, this may not the case.
‣ This, then, gives rise to a separate non-trading market risk item, credit spread risk.

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Foreign Exchange Risk
‣ Managing the ALM processes of a separately capitalized foreign banking subsidiary will inevitably
require a local treasury to fund operations in local currency and as the business requires. However,
any funding structure other than “match funding” will likely introduce an element of forward
FX risk, when the assets and liabilities of the subsidiary are translated into the home currency
of the central group entity for end-of-year accounting and for risk reporting purposes. This is not
ideal, since banking profits typically originate in the “maturity transformation” process between
short-term deposits and longer term loans. Match funding neutralizes the possibility of profiting
from this process.
‣ In the end, much of the economic FX risk inherent in assets and debt liabilities of local subsidiaries
will be hedged, especially the more detailed transaction and translation FX risks. This leaves the
equity and retained earnings of the local entity un-hedged, which helps to optimize utilization of
local capital and compliance with local capital adequacy ratios.
‣ This type of FX risk is clearly not a trading related risk, so the effects of it will not show up on
intra-group or on external regulatory trading reports.
‣ It is, however, still reportable as a non-trading market risk.

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Investment Risk
‣ Non-trading investment risk is a broad category, but in most cases it covers investments
in equity only. While equity bought, sold, or hedged is ordinarily part of trading book
activity, there are a few cases where this risk is non-traded and is part of the banking
book.
‣ Strategic
• The list of franchise enhancing investments a bank can make is substantial. Such franchises can be built
from scratch or acquired. If acquired, the equity in that entity is not for sale and is held long-term for
strategic reasons.
• Equity compensation plans is another area which requires long-term, not-for-sale equity investment.

‣ Alternative
• A bank may purchase a block of flats or a shopping mall outright and proceed to rent out units with the
aim of generating operating profits and/or capital appreciation over a very long investment horizon from
the underlying property.
• Both venture capital (VC) and private equity (PE) investments are made with very long time horizons in
mind, five to seven years; the equivalent of a business cycle is typical. During this period of time the stock is
held by the bank as not-for-sale and a fair market value is often difficult to ascertain.
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Pension Risk

‣ With rising market yields, the value of future pay-outs in defined-benefit pension plans
will increase and the value of investment returns simultaneously decrease, giving rise to
a double loss: rising liabilities at the same time as falling asset values.
‣ When this happens, the pension fund sponsor, the bank employing the pension fund
member, will have to make up the shortfall.
‣ Defined-benefit plans can therefore be very risky for an employer, a risk that is not part
of the trading book, but more appropriately described as a non-trading market risk.
‣ The specific risk exposures for the bank are interest rate risk, inflation risk, credit spread
risk, equity risk and longevity (pension recipients living longer lives than projected) risk.

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Other Risks

‣ A principal guaranteed note, fund or deposit usually involves an option and a zero-coupon
bond.
‣ However, here the option is purchased for the difference between the customer invested
principal and the discount value of a zero-coupon bond. The discount depends on the
level of nominal yields and on time to maturity. When yields are low, maturity has to be
high to compensate the investor, which is one reason many banks still have this risk on
their books. If the option expires worthless, the customer has the principal from the zero
coupon bond that matures at par value. If, on the other hand, the option retains value at
expiry, the investor not only gets the invested principal back, but also some return.
‣ Initially, banks would be on the other side of these trades with their customers. Many
would later hedge their positions, but the risk persisted in the market and tended to
accumulate at banks with highly skilled market risk management teams.
‣ Regardless, this is a market risk, but there is no trading associated with it.

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Economic Capital

‣ Non-trading market risk consumes Economic

Capital at a bank. Economic Capital Usage by Non-trading Market Risk Type

‣ The table on the right shows the Economic (EUR million) Dec 31, 2017 Dec 31, 2016
Capital (EC) consumed by non-trading market
risks at Deutsche Bank (DB) during the 2017 Interest rate risk (IRRBB) 1,743 1,921
financial year.
Credit spread risk 722 1,419
‣ While the 33% drop in EC from 2016 to 2017
may seem impressive (more effective), it is 1,431 1,834
Equity and investment risk
largely a technical adjustment as a result of a
quantile change in DB’s model from 99.98% to Foreign exchange risk 1,509 2,485
99.90% confidence level. Without access to
the underlying model it is therefore difficult Pension risk 1,174 1,007
to say if there is a genuine reduction in
EC for this risk group at DB, if the EC Guaranteed funds risk 49 1,699
has remained largely the same, or if, in fact, it
has increased. Total non-trading market 6,628 10,365
risk portfolios

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Summary

‣ Non-traded market risk is present at most banks and in many different forms
‣ Whether:
• Credit spread risk in a treasury collateral pool
• Foreign exchange risk in a foreign banking subsidiary’s equity position
• Equity investment risk in franchise enhancing acquisitions
• Pension risk from the defined-benefit book
• Residual risk from selling guaranteed products or any other non-traded market risk

‣ Banks need to identify the risk, quantify it, monitor it, control and report it ̶ just as
with the traded market risk book.

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