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Middle Office review: Sample middle office gap analysis report

Middle Office Gap Analysis Review Report: Executive Summary

At the beginning of this assignment we were given a three-item mandate

  1. Validate the results and assumptions of reports currently generated by the Middle Office function with respect to the Central Bank requirements
  2. Identify gaps and areas of improvements with respect to Central Bank, Basel II and international risk management best practices
  3. Identify gaps in the current middle office reports and processes that would need to be filled in for derivative products licensing.


This report presents the results of our analysis and assessment.

Our initial assessment indicated that the client had introduced organizational changes to upgrade existing risk management setup and comply with Central Bank risk management guidelines. Two initiatives under these changes included the creation of a middle office function to focus on market risk and a firm wide risk function to focus on risk at the enterprise level. A Financial Institution function already existed for approval and review of lines to treasury counter parties and an active credit committee for reviewing and approving lending decisions. There is an internal control system in place which involves segregation of duties/responsibilities, dual signatures/authority levels, confirmation process, call recording system, subsidiary ledger balancing etc. For staff guidance the Treasury Manual is available and systems/procedures defined are implemented.

From Basel II perspective there is a fair amount of work that needs to be done for the advanced approaches on Market, Credit and Operational Risk Management. For basic and standardized (Risk Weighted) approaches, the market risk component is already in place, whereas for operational risk calculations a simple spread sheet will suffice. State of readiness for the credit risk function was not assessed as part of this report.

On the financial risk management side the primary focus has been on calculating and reporting liquidity exposure via price and maturity gaps (as per Central Bank requirements), calculation of mark to market (MTM) for money market and equity securities and reporting transaction summary reports to head office. With Foreign Exchange positions because of limited trading exposure only Net Open Positions and Gaps (as per Central Bank definition) are calculated and reported. A limit structure is in place for risk within and across markets and sectors but is driven by regulatory limits linked to bank capital. Work in progress includes Value at Risk for Capital Market and FX and the possibility of exploring additional risk reports.

Given treasury priorities and structure at the time of the study the largest price risk component in the trading book that required daily mark to market is in equities proprietary trading. The total limit assigned to capital market exposure is Rupees (500) hundred million, which was 1% the size of the balance sheet, but 15.9% of Net Assets and 136% of pre tax income for the six month period ending June 30th, 2005. The bank also carried approximately 240 Million Rupees worth of exposure to Government Bonds in the Available for Sale category. Foreign Exchange (FX) limits as assigned by Central Bank is 200 Million Rupees but daily FX exposure averages out to approximately 60 Million Rupees per day. Ignoring accounting categories and daily mark to market requirements, the largest interest sensitive and price risk exposure component lies with x Billions of PIB’s carried in the Held To Maturity category on account of the accrual book. This portfolio is marked to market on a daily basis but information circulation at this point is limited to senior management.

A few observations can be derived from the above comments.

  1. First, even though trading limits exposure are negligible compared to overall balance sheet footprint, they represents a reasonable percentage of Net Assets and a substantial portion of pre tax income. The comparison of balance sheet exposures to net assets and income heads is one way of assessing vulnerability of bottom line numbers to unexpected trading and market losses.
  2. Second, core exposure when considering the trading book lies in equities and money market investments with limited price risk exposure to foreign exchange.
  3. Third, core exposure at the balance sheet level lies within the accrual book (x) billion of Government bonds. Even though for regulatory and accounting reporting purposes the instruments and securities in the HTM category are not marked to market or subject to market risk capital requirements, for internal bank management and reporting all market sensitive assets should be evaluated and monitored on the same basis as the trading portfolio.
  4. Fourth, rather than regulatory drivers determining limits and allowable exposures, an internal assessment of the risk reward ratio, capital requirements, strategic direction, income, net asset coverage and market environment should form the basis for the limit setting and review exercise. Outside of regulatory and organizational issues within derivative markets opportunities for transaction miss pricing exist in financial, credit & operational risk aspects and it is important to take a broader, scalable and more multi-dimensional view if newer product areas need to be explored.

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The financial risk management setup at Client Bank is in a state of flux and meets a number of Central Bank driven risk management requirements. Additional risk reports are also being investigated and setup. We have made a number of suggestions on inclusion of summary statistics in Mark to Market and ALCO reports as well as the usage of market based assumptions for calculation of Price and Maturity Gap reports.

With respect to requirements specified under r Authorized Derivative Dealer and Non Market Making Institution Licensing a number of gaps exist that have been identified in the ADD/NMI section of this report.

Structurally the Financial Risk Management function reports to the head of financial risk management and works very closely with Treasury and ALCO committee members. The Head of Treasury Risk Management reports directly to the President of the bank. The Central Bank’s guidelines and requirements for derivative licensing as well as best practices suggest that the reporting structure should be reviewed. Internationally risk committees and functions report directly to board level risk, management, executive or capital allocation committees. Additionally once the MO team has completed setting up data capturing, calculation and reporting infrastructure, the next evolutionary step would be to acquire the skill to play a more active product development, concept generation and capital optimization role.

We have also identified additional requirements for systems, documentation, process and manuals needed to comply with the market risk component of Basel II and Derivative licensing requirements. The conclusions below present the details of our analysis.


  1. The first step is the creation of the Board Firm Wide Risk Management Committee. Active Board level oversight is a key pillar of Basel risk management guidelines as well as Central Bank risk management framework. The Firm Wide risk management committee’s Client mandate is to provide Independent Risk Oversight (IRO) while delegating day to day management, execution, reporting and disclosures to Risk Committees and Executive Management. The individual risk committees operate within the policies and mandates developed by them and approved by the board. All major policy changes, decisions and actions are referred back to the board as well as informational and review reporting back to the board occurs on a regular (monthly initially and then weekly) basis.


  1. Outside of structural and system changes, gaps also exist with respect to reports and disclosures required by the Central Bank for NMI license. First among these is the calculation of daily MTM and daily counter party credit exposure monitoring for NMI’s. Even though the client has a limits and exposure monitoring process within the current in house and inter departmental functions no provision is available for calculating counter party credit exposure for a single derivative transaction, for all derivative transactions executed for a single counter party and for all counter parties for the total portfolio of outstanding derivative transactions entered into by the client. Technology and system development resources would need to be allocated to ensure compliance with the above requirements. The systems need to be in place and ready for review before Central Bank will entertain licensing applications and onsite reviews.


  1. On the product and domain knowledge front, an initial assessment of the middle office and treasury unit shows familiarity with products within the structured product desk. However outside of treasury, Internal Audit, Credit Risk, Financial Institution and BackOffice functions (though not assessed at this point) may require specialized training to increase their comfort level with products, applications, exposure measurement, exposure management and challenges associated with derivative transactions in the local market. Although some awareness of derivative products exist within market participants in general, each product line brings with it complexities that can only be appreciated with experience or training. Within the treasury and middle office unit refreshers in interest rate derivative pricing and currency options have already been taken and may be considered for non derivative desk traders and professionals also.


  1. Of the sixty plus financial institutions in our market only 3 banks have a derivative dealing license. Each of these institutions has inherited or invested significantly in the middle office and structured product desk function. When compared to these desks there is substantial effort that needs to be put in terms of mindset, resources, systems and processes before Client Bank is ready for ADD or NMI application. On the Basel II front, similar effort is required for advanced and internal models based approaches and there is enough time available (2 years) to accomplish milestone and goals required for these approaches. For basic and standardized approaches marginal work needs to be done in order to achieve compliance with Central Bank requirements as of 30th June 2006. When compared to a general risk management mindset, Client Bank is reasonably positioned in terms of systems, processes, documentation, resources and manuals. However this mindset is driven primarily by compliance and regulatory reporting requirements. The most difficult challenge that Client Bank (or for that matter any domestic bank) faces is changing this set of mindset and drivers to better reflect internal risk management and product development needs.


  1. Finally on the question of business case for derivative products. There are only two active areas of interest – Interest Rate products and Currency Options. Both products require specialized marketing and distribution units and a customer base that is interested and willing to pay for the protection derivative products provide. On the FX side an indicator for this interest is the number of forward cover requests and executed transactions. On the interest rate side, a similar indicator is the number of lending transactions that incorporate caps, floors or both on the lending rate. It would be worthwhile for Client Bank to evaluate both these indicators and strategies for increasing their level before making a decision about exploring derivative products.

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