The purpose of this seminar is to give you a good understanding of methods for measuring and controlling aggregate risks in financial institutions and to discuss how these methodologies can be integrated into an economic capital allocation process.
We start with a brief review of recent trends within financial risk management. We trace the progression of risk-management techniques, from "duration management" via ALM to Enterprise-wide Risk Management. We explain why risk integration, increased competition and stakeholder pressures have lead to the need for a more proactive approach to risk management and a more efficient usage of risk capital.
We look at the two prevailing approaches to measuring and managing risks: the "silo" approach, and the ERM, or fully integrated, approach to risk management. We explain how risks are measured at the individual and at the aggregate levels using "Value-at-Risk" and other measures and how these measures translate into regulatory (Basel) and economic capital charges.
Our main focus will be on the use of "Economic Capital" as the foundation for risk management in modern financial institutions. We define the concept of "economic capital", and we explain in depth a number of approaches to calculating the amount of capital required to maintain a certain solvency level. The use of economic capital is in the very core of good risk management and is an important component of the ICAAP (Internal Capital Adequacy Assessment Process) of Basel II.
Further, we explore how, through the process of capital allocation, an institution can control risk-taking on an ex-ante basis and how this "capital-at-risk" is used as the basis for risk-adjusted performance evaluation. We explain how to manage risks in order to guarantee that firm-wide exposure is consistent with shareholders' risk preferences, how to define limits for individual risk units, and how top management can evaluate performance on a risk-return basis (RAROC).
Finally, we discuss some practical issues related to the implementation of a risk capital allocation system, including the choice risk-centre architecture, the degree of risk specialization, and the type of capital allocation process and its degree of centralization-decentralization.
