RBS 2012 Annual Report Download - page 246

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Business review Risk and balance sheet management continued
Market risk: Risk measurement continued
Risk appetite*
The Executive Risk Forum (ERF) approves the quantitative market risk
appetite for trading and non-trading activities. The Global Head of Market
& Insurance Risk, under delegated authority from the ERF, sets and
populates a limit framework, which is cascaded down through legal entity,
division, business and desk level market risk limits.
At the Group level, the risk appetite is expressed in the form of a
combination of VaR, SVaR, sensitivity and stress testing limits.
A daily report summarises the Group’s market risk exposures against the
agreed limits. This daily report is sent to the Head of Restructuring &
Risk, Global Head of Market & Insurance Risk, divisional Chief Risk
Officers and appropriate divisional market risk managers.
Legal entities, divisions and lower levels in the business also have an
appropriate market risk framework of controls and limits in place to cover
all material market risk exposures.
The specific market risk metrics that are appropriate for controlling the
positions of a desk will be more granular than the Group level limits and
tailored to the particular division and business.
The market risk control framework has been enhanced further during
2012 with the implementation of SVaR and portfolio gap risk limits. The
portfolio gap risk takes into consideration the possibility of the joint
occurrence of losses across different gap risk products.
In line with the overall business strategy to reduce risk exposures, the
Group’s market risk limits were adjusted down during 2012. The majority
of the Group’s market risk exposure were in the Markets, International
Banking and Non-Core divisions and Group Treasury. The Group is also
exposed to market risk through interest rate risk and foreign exchange
risk on its non-trading activities in the retail and commercial businesses.
These aspects are discussed in more detail in Non-traded interest rate
risk on page 153 and Structural foreign currency exposures on page 155.
In 2012, a market risk economic capital model was developed. It is
planned to use this model for performance measurement within Markets
and to assess the risks of the group from a consolidated economic
perspective. The results of the model will be consolidated with other risk
types and reported during 2013. The model calculates the market and
default risk in the trading book using an extended historic simulation
approach with multiple liquidity horizons (differentiated by portfolio and
asset class). The results are annualised to be consistent with the other
Group economic capital models.
Risk models*
Risk models are developed both within divisional units and by Group
functions. Risk models are also subject to independent review and sign-
off to the same standard as pricing models. Meetings are held with the
FSA every quarter to discuss the traded market risk, including changes in
models, management, back-testing results, risks not included in the VaR
framework and other model performance statistics.
VaR - is a technique that produces estimates of the potential change in
the market value of a portfolio over a specified time horizon at a given
confidence level. For internal risk management purposes, the Group’s
VaR assumes a time horizon of one trading day and a confidence level of
99%. The Group's VaR model is based on a historical simulation model,
utilising data from the previous two years.
The VaR model has been approved by the FSA to calculate regulatory
capital for the trading book for those legal entities under its jurisdiction.
These legal entities are The Royal Bank of Scotland plc; National
Westminster Bank Plc; RBS Financial Products Inc; and RBS Securities
Inc. Regulatory VaR differs from the internal VaR as it is based on a ten-
day holding period. The approval covers general market risk in interest
rate, foreign exchange, equity and specified commodity products and
specific risk in interest rate and equity products.
The VaR model is an important market risk measurement and control
tool. It is used for determining a significant component of the market risk
capital and, as such, it is regularly assessed. The main approach
employed to asses the ongoing model performance is back-testing, which
counts the number of days when a loss (as defined by the FSA) exceeds
the corresponding daily VaR estimate, measured at a 99% confidence
level. The FSA categorises a VaR model as green, amber or red. A green
model status is consistent with a good working model and is achieved for
models that have four or fewer back-testing exceptions in a 12-month
period. For the Group’s trading book, a green model status was
maintained throughout 2012.
The Group’s VaR should be interpreted in light of the limitations of the
methodology used, as follows:
x Historical simulation VaR may not provide the best estimate of future
market movements. It can only provide a forecast of portfolio losses
based on events that occurred in the two-year time series. Therefore,
events that are more severe than those in the historical data series
are not represented.
x The use of a 99% confidence level does not reflect the extent of
potential losses beyond that percentile.
x The use of a one-day time horizon will not fully capture the profit and
loss implications of positions that cannot be liquidated or hedged
within one day.
x The Group computes the VaR of trading portfolios at the close of
business. Positions may change substantially during the course of
the trading day and, if so, intra-day profit and losses will be incurred.
These limitations mean that the Group cannot guarantee that losses will
not exceed the VaR.
*unaudited