Market risk

Market risk is the risk of loss arising from movements in market variables, including observable variables such as interest rates, exchange rates and equity market indices, and others which may be only indirectly observable such as volatilities and correlations. The risk of price movements on securities and other obligations in tradable form, resulting from general credit and country risk factors and events specific to individual issuers, is also considered market risk.

We report our market risk exposure as Value at Risk (“VaR), which is explained on page 71, but we also apply a range of other measures and controls which are described in the sections below.

Sources of market risk

Market risk is incurred primarily through our trading activities, but also arises in some of our non-trading businesses.

Trading

Trading activities are centered in the Investment Bank, and include market-making, facilitation of client business and proprietary position taking. We are active in the cash and derivative markets for fixed income, equities, interest rate products, foreign exchange, energy and, to a lesser extent, precious metals. In 2005 we began to trade derivatives on base metals and soft commodities.

In our fixed income business we carry extensive inventory in support of market-making and client facilitation. Although inventory levels vary and the portfolio is well diversified, the credit spread exposure (a component of interest rate risk) from these positions is generally the largest contributor to VaR.

Exposure to movements in the level and shape of yield curves arises in all our activities but predominantly in the rates, FX and cash and collateral trading businesses. Our exposure to directional interest rate movements is not generally large, but it varies depending on our view of the markets. It is often these variations that drive changes in the level of Investment Bank VaR, although the impact of any switch depends on the composition of the portfolio at the time.

Equity risk is the other major contributor to Investment Bank market risk. We generally carry exposure to all major and a number of smaller equity markets, the other significant component of equity VaR being proprietary positions taken, for example, to capture arbitrage opportunities or price movements resulting from mergers and acquisitions. These positions can be relatively large and can cause significant fluctuations in the level of market risk.

We run positions in foreign exchange, and in precious metals and energy (which are reported in the risk type “other) but their contribution to overall market risk exposure is generally relatively small. Base metals and derivatives on soft commodities are not yet included in VaR but the exposure from this business is not material.

Outside the Investment Bank, in Global Asset Management, the seed money invested by our alternative and quantitative investments platform in their funds in the start up phase contributes modestly to our reported market risk exposure. There is only very limited trading activity, in support of client business, in our Wealth Management operations.

Non-trading

Our Treasury department (part of Corporate Center) assumes market risk as a result of its balance sheet and capital management responsibilities. Interest rate risk arises from the funding of non-business items such as property and investments, from the investment of our equity, and from long-term interest rate risk transferred from other Business Groups. These are described in more detail on pages 76 to 77.

Other market risks from non-trading activities, mainly interest rate risk, arise in all Business Groups but they are not significant.

We also hold equity financial investments outside our trading activities. The majority are unlisted, and their fair values tend to be driven mainly by factors specific to the individual companies rather than movements in equity markets which have only a limited impact. For this reason, and because they are not generally liquid, they are controlled outside the market risk framework. Our private equity investments make up the largest portfolio, but they are being run down. There is a comprehensive control, monitoring and reporting process around this portfolio and the positions are included in our overall Earnings-at-Risk measure.

Risk control

There is a Chief Risk Officer (CRO) in each Business Group and a designated CRO for Treasury. The CROs report functionally to the Group CRO and are responsible for the independent control of market risk. They and their teams ensure that all market risks are identified, establish the necessary controls and limits, monitor positions and exposures, and ensure the complete capture of market risk in risk measurement and reporting systems. An important element of the CRO’s role is the assessment of market risk in new businesses and products and in structured transactions.

The CRO organization in the Investment Bank provides market risk measurement and reporting support to all Business Groups and is responsible for the development and ongoing enhancement of market risk measures, in particular the VaR model.

Market risk authority is vested in the Chairman’s Office and the GEB and from there is delegated ad personam to the Group CRO and market risk officers in the Business Groups. Authorities apply to measurement methodologies and portfolio limits and to individual positions and transactions where specific approval is required.

We apply market risk measures, limits and controls at the portfolio level, and we apply concentration limits and other controls, where necessary, to individual risk types, to particular books and to specific exposures. The portfolio risk measures are common to all market risks, but concentration limits and other controls are tailored to the nature of the activities and the risks they create. Such measures therefore differ significantly between, for example, the Investment Bank, where the risks are most varied and complex, and Group Treasury which carries material market risk but in a limited range of risk types and not generally in complex instruments.