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Apollo Bank and Mercury Bank are commercial banking institutions considering a merger. The head of Apollo's risk committee, Alan Armstrong, is meeting with Mercury's CEO, Neil Shephard, to discuss risk management practices for their respective firms and for the prospective merged firm.Shephard shares Mercury's risk management philosophy: "We think risk management is an ongoing process. We follow a conservative management style, and in all of our businesses, our risk policy is to adjust risk levels so that risk exposures remain within certain ranges. Our risk governance entails a firmwide, enterprise risk management approach where risk factors are considered both in isolation and in relation to each other."Shephard continues with a discussion of the portfolio's sources of risk: "For example, our investment portfolio includes publicly traded large-cap and small-cap domestic stocks and global bonds. Our bonds are denominated in various currencies and have both fixed and floating rates. We use over-the-counter derivatives to hedge risks related to interest rates, foreign currency, adverse security price movements, and payment default."Shephard asks Armstrong to describe how Apollo manages credit exposure related to its over-the-counter derivatives activity. Armstrong makes the following comments:Comment 1: Swap, option, and forward payments are netted. Each of these derivatives has bilateral credit risk.Comment 2: Market value updates received from counterparties are used to measure credit risk.Comment 3: Cross-default provisions are negotiated into all agreements to reduce credit risk.Shephard turns his attention to the loan portfolio. He asks Armstrong, "To which industries does Apollo have substantial loan exposure?" Armstrong indicates Apollo has three industry-specific lending units and shows him the data contained in Exhibit 1. Armstrong then states, "At Apollo, in addition to VAR, we use an additional risk measure that is an extension of VAR. This supplemental metric provides a measure of our expected loss in excess of VAR."Armstrong concludes the discussion by commenting, "Ultimately, our success as a merged company will depend, in part, on measuring the total amount of risk we are taking. Within our risk management framework, we can use scenario analysis to estimate total losses under normal market conditions and then stress our models to estimate total losses under extreme market conditions. |
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