20240429 Calibre April 2024 Investor Presentation.pdf
Cap markets news jun2000
1. FEDERAL RESERVE BANK
OF CHICAGO
CAP IT.AL
Going! Going! Gone!
(Then again, maybe not)
T
he pricing and hedging of fixed-
income securities has become
infinitely more complex since the
on the run"' U .S. Treasury curve,
apparently decoupled from the funda-
mentals of economics and interest rate
theory, has begun to trade in a world of
it's own. Relative to that, market strategists
have opined on causes for the recent yield
curve inversion. Bulls rationalize a lack of
supply sparked by the Treasury
Department's buyback plans, shaky
equity markets, and a fully discounted
Federal Reserve monetary policy while
bears hang on to fundamentals and
contrarian technical indicators.
Through it all, the spectators to this
battle are beginning to question
whether Treasury securities can continue
to serve as a risk-free benchmark and
hedging tool for the fixed-income markets.
The role ofa benchmark is to act as an
indicator against which other related
segments of the financial markets can
determine relative value. In terms of
determining the value of interest rates
across a maturity spectrum, US Treasury
securities ("Treasuries") have been (as far
back as the current generation of traders
and money managers can remember)
the benchmark or the base interest rate
continuum. The prominent characteristics
of Treasuries that have afforded them
benchmark status are volume (in terms of
dollars outstanding), liquidity and,
because they are backed by the full faith
and credit ofthe US government, effectively
no credit risk. Additionally, the large size
of any single issue and a program of
MARKETS NEWS
regular borrowing with pre-announced
market dates have enhanced their bench-
mark status. Recently a number offactors,
directly related to those characteristics
that had previously supported Treasury
securities' benchmark status, have acted
to undermined their standing as a pricing
vehicle for other fixed income securities.
The Treasury Department announced
a suite ofchanges to its debt issuance and
buyback strategy, beginning with the
February refunding, that will affect the
supply ofTreasuries going forward. Large
budget surpluses are making it increas-
ingly difficult for the Treasury to manage
the average maturity of the debt while
maintaining auction liquidity. The
revised refunding announcement, as well
as statements from various officials, have
led the markets to believe that the
Treasury is preparing the market to let the
30-year benchmark bond go; whether
this becomes reality or not is currently
being debated, but perception is
nonetheless influencing market reaction.
June 2000
That perception of scarcity is one of the
factors causing Treasuries to trade more
like commodities, where prices increase
in anticipation of greater scarcity rather
than as an indicator of fundamentals in
interest rate movements.
Additional complications to the liquidity
of the 30-year bond result from changes
in the private debt issuance markets and
the trading patterns of the 30-year issue.
Private sector borrowing in the debt market
has increased significantly, and underwriters'
need for a hedging vehicle has increased
demand for Treasuries. What's more, the
placing and unwinding of large hedges
creates technical pressures that increase
volatility and further distort the prices of
these securities. Dealers who provide
liquidity by taking risk positions have
been very hesitant to short the Treasury
market since the emerging market crisis
in the autumn of 1998, a situation that
clearly revealed the frailties of this market
as an all-purpose hedging vehicle.
Additional liquidity was destroyed when
Capital Markets News is published quarterly by the Capital Markets Group of the
Supervision and Regulation Department. Its primary intention is to further
examiners' understanding of topical issues pertaining to derivatives and other
capital markets subjects. Articles are not intended as exhaustive commentaries of
the subject matter; rather, they are summaries meant to convey a basic under-
standing of the issue and to serve as a foundation for further analysis. Readers
who would like further information on any of the articles may contact the author
directly. For additional copies of back issues of the newsletter, please contact
Joe Cilia at 312-322-2368.
Any opinions expressed are the authors' alone and do not necessarily reflect
the views ofthe Federal Reserve Bank ofChicago or the Federal Reserve System.
2. CA p ITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Going! Going! Gone! continued
the same market crisis reduced the number
ofproprietary trading desks that supported
market liquidity. The "riskless" status of
Treasuries also makes them the investment
of choice in a "flight to quality" hedge
against the equity market. This link has
caused unpredictable volatility and price
distortions, further prompting a cautious
stance on the part of dealers who would
normally be liquidity providers. All told,
these volatility and price distortions,
especially in the long end of the Treasury
curve, have called into question whether
the 30-year is an appropriate, risk-free
benchmark against which fixed-income
issuers should price their debt.
Alternate Benchmarks?
Government sponsored enterprises or
GSEs, specifically Fannie Mae and
Freddie Mac, have been quick to establish
themselves as the alternate benchmark by
increasing the size and regularity of their
debt issuance. While their actions may
address two prominent attributes of a
benchmark, volume and liquidity, at the
same time they introduce credit risk.
Fannie Mae came to market with "bench-
mark notes" in 19982
and Freddie Mac
quickly followed in 1999 with their issue
known as "reference notes".' Both GSE's
tout such attractive features as outstanding
supply, auction size, and regularity in their
attempt to replace the potential vacuum
being created in Treasuries. Skeptics
nonetheless question whether the GSE's
would truly be able to support the
issuance size necessary to be a benchmark
within the confines of their charters.
Chartered to support the mortgage markets,
it would be interesting to see how much
debt could be sustained by the entities in an
economic downturn that reduces mortgage
lending.' In terms ofcredit risk, what was
initially thought to be a viable alternative
for the risk free component of Treasuries
has been put to question with Treasury
Undersecretary Gensler's recent proposal
that government credit lines to the agencies be
reduced. Away from GSEs, comparable
corporate issues' ("corporates") are
another alternative that may be considered
as a benchmark for both corporate hedging
and pricing. Thirty years ago the corporate
bond market functioned without Treasury
benchmarks, and corporates were used to
hedge other corporates. Nonetheless,
liquidity constraints remain a concern for
this type ofhedge, and using corporates as
a pricing benchmark for other corporates
could introduce a new element of credit
induced volatility into the mix.
Credit markets have been built around
and out of the Treasury market, and
removing its inner structure will create a
variety ofvacuums and some dislocations.
The risk profile of the entire market will
increase, which in turn means greater
susceptibility all around during economic
downturns or in the face of unforeseen
events. While the market has adjusted to
other benchmarks and hedging vehicles
such as LIBOR6
along the short end ofthe
yield curve, it has had difficulty finding a
suitable substitute in the long end. As a
hedging vehicle, bond desks have been
utilizing swaps' to a large extent for at least
the last 12 months or so. However both
swaps and agencies, as they now stand, are
far from ideal substitutes for Treasury
bonds.
Although the supply of on-the-run
Treasury issues is certainly a factor in the
trading pattern of this sector, it is by no
means clear that it is the only or even
predominant component affecting its
performance. As painful as the trading
distortions resulting from the other elements
noted may be, the market will ultimately
sort them out. The supply-induced
2
portion of the Treasury market should be
carefully evaluated as an independent factor
to determine its actual effect. It is important
to remember that the advantage of US
sovereign debt as a benchmark is its risk
free component, and if the supply of
Treasuries is the overriding component
affecting the current yield curve inversion
and price volatility, the market will form
an agreement on appropriate substitutes,
bearing this fact in mind. Even if a deal
is officially priced off one benchmark, its
performance will be determined, by and
large, by its relationship with a variety of
markets.
-Donna M. Zagorski
'The "on-the-run" issue is the most recently auc-
tioned issue.
'Durfey, Steve, "There's a New Benchmark (Note)
in Town", Capital Markets News, March 1998, Federal
Reserve Bank ofChicago
3
Peterson, Michael, ''We're Dedicated Followers
of Fashion", Euromoney, February 2000, Issue 370, P.
60,
4
Baum, Caroline, "Public or Private?", Bloomberg
Commentary, March 23, 2000.
5
Clow, Robert, "The new national debt" ,
Instit11tio11a/ Investor 102 34, no.1 Qan.2000)
6
London Interbank Offered Rate
7
The large demand for this hedging vehicle has
produced its own demand distortions in the Svaps
market.
3. OpTech 2000
T
he annual FIA sponsored
OpTech conference offers a
forum for US futures exchanges,
FCMs, and industry vendors to come
together and exchange information on
new developments in the technology
and operations areas. The two-day
conference, held this past April in New
York, dealt with a number ofinformative
issues and prompted some valuable
debates.
US Exchange Leaders'
The conference opened with a high
level session as exchange leaders from
the CME, NYBOT, and NYMEX
discussed recent strategic initiatives.
The CME and NYMEX have made
progress in their plans to change their
ownership and governance structure,
and have filed with the SEC to convert
to for-profit corporations. In re-assessing
the clearing house function based on
these changes taking place, exchanges
who view the clearinghouse as a strategic
asset are trying to leverage off those
operations that have proven successful
to both OTC products and the B2B
markets. They have plans to expand the
range of acceptable margin to OTC
commodities positions and, prompted
by new international developments, are
re-evaluating the existing model of
separate clearing for the cash market
and derivatives.
Although FCMs feel threatened by
the e-commerce revolution, the
exchange leaders reinforced the notion
that exchanges rely on the FCMs to
distribute their products, and reiterated
that the FCM relationship and clearing
function is a critical business feature of
the futures industry. The exchanges
have taken new initiatives aimed at a
more cost-effective structure; on the
operational side, one ofthese initiatives
is straight-through-processing, which
will offer a seamless routine from trade
entry,to clearing, eliminating human
intervention and providing cost effective
trade processing.
Online Customers
Two sessions were devoted to legal
and operational issues of online cus-
tomers. Many questions arose, but
answers often fell short of providing
satisfactory, direct, or comprehensive
solutions, highlighting the difficulties
the futures industry faces in devising a
comprehensive legal and regulatory
framework in the New Economy.
There was overwhelming consensus
that electronic trading will soon be the
predominant trading venue in the US,
analogous to the European model that
swiftly shifted to the electronic platform.
Online trading facilitates more partici-
pation, increases liquidity, and affords a
sufficient audit trail. It is, ofcourse, not
free ofchallenges, and the CFTC is still
in the process of devising a workable
framework to address the tremendous
changes and opportunities brought
about by technology.2
On the retail side, the futures industry
has yet to experience the same level of
direct online access witnessed in the
stock-trading arena. Single stock
futures may turn out to be the catalyst
for retail participation and the emergence
of a new trading behavior as already
experienced in the securities markets,
where participants trade four times as
frequently online as not. Clients already
demand real-time connectivity, and the
prospect of increased participation
makes it all the more necessary for systems
to be scalable and redundant to cope
with failure. Such direct access to
exchanges might disintermediate
FCMs. For example, online systems
can easily integrate middle office
management capabilities and provide a
direct (and in the future real-time) basis
for cash funding, functions that were
traditionally fulfilled by FCMs.
Inevitably, FCMs will need to focus on
value-added services to retain their
client base. They must cater more deci-
sively to the needs of their customers,
who increasingly demand real-time
connectivity, more transparency in
models used, and uniformity in reporting
across different brokers. A current trend
3
among FCMs is for differentiation
through research. To that end, FCMs
could continue to add value in the
credit decision making process, as
credit screening systems integrated into
online trading are only capable ofdiscrim-
inating rather than making judgement
calls.
Reliance on access, security, and
privacy are issues that the industry is
only beginning to address given the
persistence of open outcry among
exchanges in the US. Discussions
focused on speculation as to why cases
where online trading was the primary
issue against FCMs or exchanges have
been conspicuously absent within the
legal system. Given that within the
futures industry, electronic trading is
exchange-driven, reasons might be
attributed to the clarity oflimitation of
liability rules ofthe exchanges reinforced
by the CFTC posture that there would
be no medium-based exceptions in ·
enforcement action. 3
In the future,
more jurisdictional issues are expected
to arise, especially with regard to the
transnational aspects of electronic sys-
tems. In general, cyberspace law is not
expected to differ significantly from
current futures, securities and contract
law, and the consensus felt that as long
as cyberspace law is in the making,
FCMs should seek liability protection
through disclosure.
E-Clearing
E-clearing, leveraging off of new
and existing technologies, has two key
aspects: an adequate and scalable network
and accurate on-time delivery ofdata in
a standardized format. Exchanges have
developed and support protocols for
data and message transmission, with
some standardization already evident,
and have adopted set rules and policy
while they rely on industry vendors to
provide the networks. Clearinghouses
have made a strong commitment to
e-clearing, convinced that through the
use of technology neither location nor
physical proximity to the trading floor is
an issue, while at the same time recogniz-
4. CA P I T A L MA R K E T S N E W S - - - - - - - - - - - - - - - - - - - - - - - -
OpTech 2000 continued
ing that redundant systems and disaster
recovery plans have become more critical
than ever. Clearinghouses look to their
clearing firms for the necessary investments
in technology to make e-clearing possible,
with ongoing productive dialogue
between FCMs and exchanges an important
initiative at this juncture.
Frank Perrone of Deutsche Bank
Futures offered a perspective on e-clearing
from the FCM side. The FCMs expect
e-clearing to enhance risk management,
reduce costs, handle more volume, and
improve regulatory compliance. A difficulty
for FCMs lies in the fact that every
exchange solves clearing problems in a
different way. Standardization is imperative
and there is, therefore, a need for clearinghouses
to take a broad perspective on embracing
standards and to move towards centraliza-
tion in an effort to facilitate global clearing.
It is also anticipated that the CBOT-
Eurex alliance will provide a glpbal
clearing vision for derivatives and equities.
Cash Management
Global cash management and collateral
optimization are critical components of
the FCM business, and will become
increasingly important as electronic trading
facilitates transnational transactions.
Ronald Metcoff ofJP Morgan Futures
provided a useful overview of margin
accepted as collateral by international
futures exchanges. Constructing a collateral
matrix for initial and variation margin,
which tabulates accepted forms ofmargin
(cash in different currencies or securities)
by international exchanges and indicates
basis point spreads and haircuts, can help
organize information and facilitate cash
management decisions. Tim Doar of the
CME presented cash management initiatives
on the part ofCME. Clearing firm capital
and operating efficiencies, liquidity,
settlement characteristics, and custody
implications are the collateral philosophy
tenets ofthe CME. Following the success
of the IEF program,' the CME is con-
templating a similar program to allow
investment in the full range of Reg 1.255
securities with appropriate diversification,
credit, and concentration standards. The
benefits of such a managed portfolio
approach will result in a simplified
operational and risk environment from the
firm's prospective (the firm will simply deal
in cash). The exchange will offer professional
portfolio management with the benefits
ofsecurity analysis and screening, diversi-
fication ofrisk, and enhanced rate ofreturn.
Concluding Issues
The conference concluded with two
sessions on new initiatives and emerging
issues. Amidst a booming economy and
an emphasis on dot-com companies, the
exchanges have experienced considerable
employee turnover and retention issues in
the technology area, and have dealt with
the problem by resorting to outsourcing
and a shifting emphasis on consulting.
The exchanges themselves are increasingly
embracing the Internet as a public network;
Melba Cubillos and Asad Gilani of
NYMEX provided an overview of the
NYMEX migration from the current
batch-based data transmission environment
to a straight-through processing model of
real.:.time connectivity over the Internet
utilizing virtual private tunnel architecture.
Unlike what the name might imply,
the OpTech 2000 conference steered
away from technical terms and focused
decisively on recent trends and strategy.
Participants have accepted the impact that
technology has had in changing the face
ofthe industry as evidenced by the drastic
and decisive shift in Europe from pit to
screen-based trading. Exchanges have
resolved to use the Internet as a public
route network _in their plans to replace
current batch-based data transmission
with real-time connectivity. Although
retail participation in the futures market
has not yet reached the level witnessed in
the stock market, more involvement at
the retail level is anticipated. Electronic
trading and new technology will
empower the individual, and the industry
will need to meet a whole new array of
operational, compliance, security, privacy,
and risk management challenges. While,
for the time being, disclosure can shield
FCMs from legal liability, at the same
time technology offers new opportunities
for the exchanges, which are determined
to leverage off their proven expertise in
clearing to expand their services to other
products in the OTC and the B2B markets.
-Gloria Ikosi
4
The panel was .
. comprised of Ma k
President and CEO N r D. Fichte!
. . • ew York Board ofT •
E. Oliff, Vice Chairman B rade,Jarnes
, oard ofDire
Mercantile Exchan ctors, Chicago
. ge, and Daniel R.
Chairman, New York M . appapon,
ercannle Excha
M . Hersch , Senior M . nge. Ronald
anagmg o·
Stearns & Co., Inc. was th Irector, Bear,
2 e moderator
The CFTC Staff For .
ce report on th N
Regulatory Framework w I e ew
as re eased in F b
2000. The report presents a com . e ruary
prehens1ve set of
recommended changes to the re
. . gulatory struct
administered by th C ure
e FTC. See
http:// www.cftc.gov/opa/regulato f,
3
" ry ramework.ru!f
The Internet - Testing the limits fgl b0 o al reg-
ulation." Remarks byJohn Tull (with h .
t e assistance of
Andrea Corcoran) at the Swiss Commodi" FL1es, utures
and Options Association Meeting in B k•urgenstoc
September, 1996. See www cftc g /
1'· ._ov opa
speeches/tull-16.html. The first enforcement
proceedings brought by the CFTC based exclusively
on Internet activities date back to 1996 and were in
connection with the offer of advisory services to
Internet subscribers by a firm without CTA registration.
The CFTC has subsequently filed several actions
alleging fraudulent Internet promotion ofcommodiry
trading systems and issued a consumer advisory
against fraudulent Internet promoters this spring. In
March, the Commission brought its first action to
address "spamming;• the use of mass marketing via
e-mail to defraud retail customers.
4
Under the IEF program, performancebond cash
and settlement funds which participating clearing
firms deposit with the Clearing House are pooled and
invested in US Treasury securities and in reverse
repurchase agreements collateralized by Treasuries.
5 The regulation of the Commodity Exchange
Act which restricts the range ofinScrtllllents in which
FCMs and clearing houses may invest cuStOmer funds.
5. -
The Interest Rate Risk Focus Report'
Introduction and Overview
The Interest Rate Risk Focus Report
(Focus Report) uses quarterly Call
Report data reported by banks to measure
their interest rate risk (IRR) exposure.
The report was created by staff at the
Board of Governors to enhance off-site
analysis of financial institutions and to
support examiners charged with determining
the scope ofthe IRR portion ofcommercial
bank examinations. This article presents
an outline of the financial information
presented in the Focus Report and
explains the Federal Reserve Economic
Value Model (EVM), the engine that
generates the risk statistics contained in
the report.' The statistics produced by the
EVM are a unique feature of the Focus
Report. While all of the financial data in
the Focus Report is available from other
sources (the benefit of the Focus Report
is having it all in one place), the results of
the Economic Value Model are not available
anywhere else. The risk statistics generated
by the Economic Value Model highlight
the degree to which a bank's capital is
exposed to IRR
Data Sources and Important Caveats
IRR related data from various sources
(primarily the Call Report) are forged
into a single report, providing a readily
available and comprehensive analysis of
IRR. Statistics in the Focus Report have
been calculated in exactly the same way as
information contained in other reports
used by bank supervisors-the Uniform
Bank Performance Report (UBPR), for
example. As always, the integrity of the
data, ratios, and analysis provided within
the Focus Report are dependent upon
the accuracy ofthe Call Report submitted
by the bank. The meaningfulness and
accuracy of conclusions drawn from the
report are particularly vulnerable to
misreporting ofasset maturities as well as
management's ability to identify and
report structured securities-both key
parts of the Economic Value Model.
An important consideration is that the
Focus Report does not contain information
on how the institution manages its risk.
For example, the economic value calculation
does not incorporate any hedging positions
that the bank might use to decrease or
increase risk. Therefore, the report is best
used in conjunction with other sources
that may supplement or supersede its
analysis, including management's internal
risk reports, monthly board reports, policies
and procedures, findings from previous
reports of examination, or other relevant
information provided by the institution.
The economic value calculations
included in the Focus Report should be
used only as a broad indicator of risk,
although comparisons with banks' own
risk reports have shown the Focus
Report's Economic Value Model to be
remarkably accurate.
Structure ofthe Focus Report
Each page ofthe Focus Report provides
ratios and statistics for the subject bank
and compares those results with the
bank's UBPR peer group. The report
covers the latest period for which Call
Report data are available, the prior quarter,
and the year ago period.
The Focus summary page identifies
key IRR characteristics ofthe bank in terms
of earnings, asset/liability composition, and
economic value exposure. The summary
page also identifies whether the institution
appears on any IRR monitoring lists. On
page 1, the bank's major portfolios are
expressed as a percentage of assets and
placed in one ofthe six maturity/repricing
frequency time bands used in the Call
Report. Collateralized mortgage obligations
(CMOs)3 and mortgage derivatives are
reported in two time bands based on
weighted average life rather than final
maturity. Page 2 provides some detail on
balance sheet categories and product
complexity, which may in turn offer
insights on likely cash flow behavior. Page
3 details time deposits and borrowings by
stated contractual maturity or repricing
frequency. It reflects total interest bearing
liabilities and DDAs by type rather than
maturity, including insights regarding
nonmaturity deposits and the mix of
other funding.
Page 4 provides information on the
quality and stability of an institution's
net interest margins and other earnings
indicators. Page 5 presents the results of
the FRB economic value model in an
environment where interest rates have
risen 200bp. Page 5 also shows the potential
effect of an increase in interest rates on
5
the bank's capital adequacy. Page 6 details
the economic value model including
balances, risk-weights and resulting
estimated change in economic value for a
200 basis point shock, and shows the risk
weights applied to each balance sheet
grouping to generate the estimated
change in economic value under a
+200bp parallel shift in interest rates.
The Economic Hilue Model
The "net economic value" presented
in the Focus Report is the negative
change in market value of the bank's
assets offset by the positive change in the
market value ofthe bank's liabilities under
a +200 basis point parallel shift in interest
rates. This estimate is produced using
aggregated groups of similar balance sheet
items that are assumed to have similar
repricing characteristics; for example, all
mortgage related assets that
mature/reprice within 5 to 15 years or
nonamortizing loans that mature/ reprice
within 1 to 3 years. The use ofaggregation
is necessary because the EVM employs
data from published Call Reports, which
themselves aggregate individual balance
sheet items into broad categories and
repricing schedules.
The EVM uses proxy financial instru-
ments to calculate the change in economic
value.' The market sensitivity of each
proxy instrument is used as a " risk weight",
which is multiplied by the dollar amount
of the applicable balance sheet grouping.
Market data may suggest, for instance, that
for a 200 basis point increase in interest
rates, that proxy instrument would e.-q,erience
a decline in market value of 3.0%.
Therefore, the "risk weight" for that
grouping would be -3.0%. If a bank has
assets in this grouping totaling $10 million,
then the change in value would be $10
million x -3.0% or -$300,000.
Why does the EVM measure balance
sheet sensitivity only for increases in
interest rates? After all, wouldn't a 200
point decrease in rates cause interest rate
exposure as well? In general, banks fund
longer-term assets with shorter-term
liabilities. In a rising rate environment,
assets-because of their greater price
sensitivity-will change in value more
than liabilities, producing a net
negative impact.
6. CAPITAL MARKETS NEWS
The Interest Rate Risk Focus Report continued
The broad categories used in the
EVM are:
• 1-4 family mortgage products;
• CMOs, REMICs and strips
• Other amortizing assets;
• Nonamortizing assets;
• Nonmaturity deposits;
• CDs, time deposits and other
borrowings.
These categories are subdivided into
time bands that reflect the maturity or
repricing characteristics of the balance
sheet items:
• 0-3 months;
• 3-12 months;
• 1-3 years;
• 3-5 years;
• 5-15 years;
• over 15 years.
EVMCaveats
The EVM is a supervisory monitoring
tool intended to provide examiners with
a rough estimate of the interest rate risk
exposure of a financial institution. As
such, it is meant to be a starting point to
help Federal Reserve staffaddress potentially
significant interest rate exposures during
offsite monitoring and the examination
process. Examiners should not view the
EVM or its results as being the final word
in the level and source ofa bank's interest
rate risk. A bank's balance sheet sensitivity
may differ, perhaps materially, from the
level of risk suggested by the EVM. This
is most likely to occur when the actual
maturity and repricing characteristics
ofmortgage-related assets and nonmaturity
deposits differ from those used in the EVM.
Differences may also occur when
financial institutions use derivatives to
hedge interest rate exposure. The use of
interest rate derivatives is not captured
within the EVM. When banks successfully
use derivatives to hedge, the Net Change
in Economic Value statistic presented in
the Focus Report will not accurately
reflect the bank's interest rate sensitivity.
Ifexaminers encounter situations where a
bank's internal IRR model exhibits
material differences from the results of
the EVM, they should check to see ifthe
bank is hedging and investigate the
reasonableness ofthe assumptions used in
the bank's internal model.
-Cheryl Sulima, CFA and Craig West,
Ph.D.
Operational Risk Management Issues
W
h_at e:pctly does operational
nsk rn~an? The core definition
reads aS' follows:
"Operational risk is the risk of direct
or indirect loss resulting from inade-
quate orfailed internal processes, peo-
ple, and systems, or from external
events."1
One school of thought states that
operational risk is anything that evades
traditional market and/or credit risk
definitions. A broader and more useful
definition would take into account th
tacit linkage between the trinity ofmarke:
credit, and operational risk. As borne ou~
by empirical evidence from the recent
~ussian debt crisis and accompanying
global contagion,' risks tend to converge
and blur during a systemic and widespread
market meltdown. As such, settlement,
collateral, and netting risks may not be
classified purely as operational risk, given
that they contain elements of more than
one risk,2
A more comprehensive definition
would also allow a subset of operational
risk management (ORM) to address the
component of model risk, given that
firms engaged in the use of non-vanilla
and· highly structured transactions
encounter ris_k of loss from inappropriate
use of modeling techniques.
Irrespective of its formal defi 't· ..
1
h m 100, 1t
i~ c ear t at ORM has been elevated to
e forefront ofrisk management initiatives
.or financial institutions, and is greatly
impacted by the following:
6
1
The Interest Rate Risk F
an examiner too[ A ocus Report is primarily
provided to bank · copy of the report should be
ers only in th
rate risk review a d h e context ofan interest
n s ould be ca full
the banker by an e . re Y explained to
. xanuner trained in its
circumstances should b use. Under no
a anker receive aF
for a bank other than hi /h ocus Report
2 s er own.
These issues are furth d .
. er eta1led in a publi .
entitled Interest Rate R•k F cation
IS ocus Report - A Us ' .
prepared by the Capital Mark . ersGuide
. . ets Umt. Copies of this
gmde are available upon request· 1. . ' p ease contact the
editor ofthis newsletter for m . r .
ore m1ormauon
3
For additional information O C II · .
n ° atenzed
Mortgage Obligations, see "Advanced CM .
OAnalyhcs
for Bank Examiners", a Product Summa
. . ry prepared by
the Fmanc1al Markets Unit of the F d Ie era Reserve
Bank ofChicago in May 1995.
4
For example, the proxy financi· I .a instrument
chosen for the grouping "1-4 family m rtgag 10 e oans
repricing in less than 3 months" is a 6.S% COFI
ARM.
• Basle Committee on Banking
Supervision3 - The Committee inter-
viewed roughly thirty large banks
from various member countnes on
ORM topics. The interviews reve~ed
. al . k 1u·ve to trading
that operaaon ns re a
. d b ' everal banks
activities was v1ewe ) s h. . . rressed t at
as high. A few mstttunons s
. k t confined to
operational ns was no . .
ffj
ctiv1ues but
typical back o ice a
ffi and essen-
enveloped the front O ice ' . s
. s operanon .
tially any facet of busmes . k.
' . thens ,n
The Committee, referencmg
h dealers 111aY
financial markets t at duct
. h ·tyorcon
exceed their aut on • ky
h' cal or ns
business in an unet 1
1 111ent
d the deveop
manner, has propose . 1 ·5k.uona n
of capital charges for opera
8. FEDERAL RESERVE BANK
OF CHICAGO
P.O. BOX834
CHICAGO, ILLINOIS 60690-0834
Rthm, Strvic, Rtq•tsttd
Publisher
Adrian D'Silva (312) 322-5904
Director, Capital Markets
Editors
Joe Cilia (312) 322-2368
Senior Capital Markets Analyst
Craig West (312) 322-2312
Senior Capital Markets Analyst
Capital Markets Group of
Supervision and Regulation
14th Floor
Federal Reserve Bank ofChicago
P.O. Box 834
Chicago, IL 60690-0834
PRESORTED
FIRST-CLASS MAIL
ZIP + 4 BARCODED
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CHICAGO, IL
PERMIT NO. 1942
