Managing Risks in Financial Services: Case Study

Market Risk – Diagnosis of the market risk management framework regarding Basel/Capital Adequacy Directive (amendment of 1998) requirements for a major Luxembourg bank

The Issue

In 1998 the market risk amendment to the Capital Adequacy Directive (98/31/EC), known in the market as CAD II became part of EU legislation. This allows the recognition, by local regulators, of internal Value at Risk models to calculate regulatory capital, if quantitative and qualitative criteria are met.

Having implemented a Value at Risk engine for its own internal risk management, a major Luxembourg bank decided to use this model for capital requirement calculations as well. The precondition for the endeavour was the prior authorisation by the CSSF.

In this context, the bank asked for PwCs’ assistance to perform a diagnosis to:

• Assess the market risk management framework regarding CAD II requirements
• Independently evaluate the Value at Risk model
• Assist in the remediation of the framework and the model corresponding to the results of the previous steps

Our Approach

Our diagnosis consisted in a gap analysis of CAD II requirements and best practice observations on the one hand, and the current market risk management framework of the bank on the other hand.
The scope of the diagnosis included a review of the qualitative and quantitative policies, procedures and controls of the bank, its market risk function and other functions involved in the application for model recognition.

The Outcome

Our expertise and knowledge of best practice standards in market risk management gained from other successful experiences within our International network enabled us to quickly identify major areas of improvement and set up recommendations. We then designed an action plan to implement the required changes and become CAD II compliant.
 
Based on our action plan, the bank improved its market risk management framework significantly and obtained from the CSSF the authorisation to use its internal value at risk model to calculate its capital requirement for market risk.