Transcript (A) Enterprise Risk Management: A Closer Look at the Issues

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Enterprise Risk Management- A closer look at the
issues
Mr. Ravi Varadachari
November 18, 2008
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The following is intended to outline our general
product direction. It is intended for information
purposes only, and may not be incorporated into any
contract. It is not a commitment to deliver any
material, code, or functionality, and should not be
relied upon in making purchasing decisions.
The development, release, and timing of any
features or functionality described for Oracle’s
products remains at the sole discretion of Oracle.
Agenda
• ERM defined
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• Goals of ERM
• ERM Framework
• ERM implementation
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Enterprise Risk Management
Economic Risk
• Market risk
• Credit risk
Societal Risk
Financial Risk
• Operational risk
• Liquidity risk
• Interest rate risk
Technological Risk
•ALM
Geopolitical Risk
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• Concentration risk
• Financial
institutions
are
exposed to a variety of risks
like financial risk, economic
risk, geo-political risk and
societal risk.
• Traditionally, the focus has
been on understanding and
managing the financial risk.
• Enterprise Risk Management
is a mechanism to have a
holistic view of all the risks
that a financial institution is
exposed to at the right level
of granularity.
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Global risks
Economic
• Oil price shock/energy
supply interruptions
• US economy
• Chinese economic
hard landing
• Fiscal crises caused
by demographic shift
• Blow up in asset
prices/excessive
indebtedness
Financial
• Market risk
• Credit risk
•Operations risk
•Liquidity risk
•Interest rate risk
•Concentration risk
Societal
• Pandemics
• Infectious diseases in the
developing world
• Chronic disease in the
developed world
• Liability regimes
Geopolitical
• International
terrorism
•
Proliferation
of
weapons
of
mass
destruction
• Civil wars and failed
and failing states
• Retrenchment from
globalization
• Middle East instability
Technological
• Breakdown of critical
information infrastructure
• Emergence of risks
associated
with
nanotechnology
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External stakeholders
Internal stakeholders
-Rating agencies
-Investors
-Employees
-Strategic partners
Regulatory
Management
- Align risk with
- Sarbanes Oxley
strategy
ERM
Internal
External
ERM- key drivers
Board and Audit
Committee
Legislature
-Understand risk profile
Other
- Basel II
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Other
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Agenda
• ERM defined
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• Goals of ERM
• ERM Framework
• ERM implementation
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The goals of ERM
Establish
sustainable
competitive
advantage
• Integrate with business planning and value
management processes
• Avoid missing key risks and losing vital opportunities
• Optimize balance between capital preservation and
growth/profit-generation
• Minimize risk averse behavior
Manage
risk at lower
cost
• Develop cost-effective risk strategies and solutions
• Eliminate redundant or unnecessary risk controls
• Support more informed/proactive risk management
decisions aligned with business objectives/strategies
Support
Business
decisions
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• Link to enterprise performance, measurement and
monitoring
• Reduce volatility and prevent surprises
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Estimate the “Right” amount of capital
Capital depends on various factors including:
 Exposure to type of asset class - corporate, bank, sovereign and the
like
 Country of incorporation of the exposures
 Credit ratings/Credit Score
 Term of exposure – short term or long term
 Collateral
 Policy, processes and systems for risk management
ERM and Capital can impact growth
ambitions and funding cost
 Impact on Growth:
 Asset growth would require additional capital
 Additional capital required depends on growth in “risk weights”
and not just asset growth
 Cost of Funds:
 Lower wholesale deposit rates for banks that demonstrate good risk
management systems and adequate capital
 No substantial impact on retail deposit rates
and also profitability …
Capital
10
10
10
10
Borrowings
90
100
110
120
Total assets
100
110
120
130
Average cost of
borrowings
4%
4%
4%
4%
Average yield on
loans
7%
7%
7%
7%
Average costs
1%
1%
1%
1%
Interest Income
7.0
7.7
8.4
9.1
Interest
Expenses
3.6
4.0
4.4
4.8
Other Expenses
1.0
1.1
1.2
1.3
Net Income
2.4
2.6
2.8
3.0
Return on Equity
24%
26%
28%
30%
Agenda
• ERM defined
<Insert Picture Here>
• Goals of ERM
• ERM Framework
• ERM implementation
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Key to effective Enterprise Risk
Management
• How Do We Address ERM?
• Risk measurement and management
• Regulatory capital
• Economic capital
• Risk based pricing and compensation
• Stress testing
• Internal controls and mechanisms
• Strategy
• Governance
• Organization structure
• Processes, Policies and Procedures
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The “Risk Management” Value Chain
Capital
Allocation
Capital estimation
commensurate
with risk
Risk Based
Pricing
Pricing takes into
account capital
charge apart from
expenses
Risk
Management
Collateral,
Guarantees,
Covenants
Risk
Identification
•Identification of
risks and Go - No
Go Decision
Stage I
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Source: i-flex study
based on various
surveys
Stage II
Stage III
Stage IV
Regulatory, Economic and Book Capital
 Regulatory
regulator
Capital : Capital that banks are required to hold by their
 “The amount of capital a bank must have to stay in business”
 Under the Basel II framework – computed based on a prescriptive formula
for credit risk
 Economic Capital : Capital that is required commensurate with the risk
profile of the bank
 “The amount of capital a bank should have”
 Various models to estimate economic capital - stochastic view
 Endeavor is to use it for business decisions
 Book Capital : Capital that a prudent bank would choose to hold
 “The amount of capital a bank that a bank has on its book”
 Economic book value – different from accounting concept of book value
 Concept of risk appetite
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The meaning of capital- different when
perceived in the context of risk management
Regulatory Capital : Capital that banks are
required to hold by their regulator
“The amount of capital a bank must have”
=
Economic Capital : Capital that a prudent
bank would choose to hold –
commensurate with the risk of the bank
To maintain
Capital Adequacy Ratio =
Capital/ Risk Weighted
Assets >= 8%
Capital depends on the risk
profile of the bank’s portfolio
“The amount of capital a bank should have”
Regulators are now trying to align regulatory capital with
economic capital…
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The “Stochastic” Representation
Probability
Distribution
Worst
Expected
Best
Risk
Worst
Expected
Best
Market
Price%
0% or Bid/Ask
Price%
Credit
Unexpected Loss%
Average Loss%
0 Loss%
Operational
Unexpected Error%
Average Error%
0 Error%
SET LIMITS
Economic Capital for Credit Risk
EC = Coverage against “unexpected” losses at
desired confidence level
Probability of Loss
ECONOMIC
CAPITAL
Expected
Loss
Unexpected
Loss
Mean
Typically 99.96%
to 99.98%
denoting risk
appetite
Confidence Level
Amount of Loss ($)
ERM frameworks- A global perspective
• UK - The Combined Code (2003) and Turnbull (2005)
• US – Committee of Sponsoring Organizations (COSO) ERM (2004)
• Australia/New Zealand 4360 Standard on Risk Management 1999, 2004
• South Africa– King II Report (2002)
• Federation of European Risk Management Association (FERMA) (2004)
• Basel II (2004)
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The COSO ERM framework
•The eight components of the
framework are interrelated.
Monitoring
Information and
communication
Internal
environment
Objective
setting
ERM
Framework
Control
activities
Event
identification
Risk
response
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Risk
assessment
•It considers activities at all
levels of the organization.
•The objectives can be viewed
in the context of four
categories•Strategic
•Operations
•Reporting
•Compliance
•A strong system of internal
control
is
essential
to
effective
enterprise
risk
management.
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Agenda
• ERM defined
<Insert Picture Here>
• Goals of ERM
• ERM Framework
• ERM implementation
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A structured approach to ERM implementation
• A thorough understanding of the
organization’s current approach to
risk management is the first step in
migrating to ERM.
An as-is analysis
Establishing the value proposition
Core Banking
implementation
Develop a model
Pilot the model
Review/revise the road map
• The next step is the establishment
of the value proposition of ERM in
the context of the organization. It
should cover the financial and
business advantages that the
organization draws from this revised
approach to risk management.
• Adopting a robust model that can
be customized to meet the
requirements of the organization with
minimum change requirements.
• Running a pilot and proving the
concept
before
a
full-scale
implementation allows for refinement
of the program if needed.
•Review and revise the road map for
transition to steady-state.
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ERM implementation impediments
Operational:
-Inadequate tools and
systems for statistical
analysis.
-Lack of adequate
decision support
mechanisms.
Strategic:
-ERM objectives nor
aligned to corporate
objectives.
-Inadequate
conceptualization of
ERM model.
Implementation
impediments
People:
-Insufficient
commitment from top
management.
- Challenges of change
management.
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Changing Landscape of Risk
• Financial Crisis Experienced by Banks/Financial Institutions
• Increase in “Rare Events”
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Key Events that Shaped Regulation …
Banking Crisis of 1929
Conflict of Interest
•Conflict of Interest
Bank Herstatt Failure
Credit Risk
•Deposit Guarantee
Institutions
S&L Crisis
ALM/ Market Risk
•Credit Risk
•Market Risk
Barings/LTCM Collapse
Operational Risk
Orange County
Operational Risk
Enron/WorldCom
Financial Statement Accuracy Risk
Proctor & Gamble Derivative Loss
Strategy Risk
•Operational Risk
•Regulatory Risk
•Financial Statement
Accuracy Risk
•Reputation Risk
•Strategy Risk
The current financial crisis
16th Mar ’08- Bear Stearns
17th Sept ’08- AIG
•Bear Stearns gets acquired for $2 a
share by JP Morgan Chase in a fire sale
avoiding bankruptcy.
•The US Federal Reserve loans $85 billion
to American International Group (AIG) to
avoid bankruptcy
7th Sept ’08- Fannie Mae & Freddie Mac
•Federal takeover of Fannie Mae and
Freddie Mac was based on a growing
concern about the liquidity of the firms
• These two companies back-up nearly
half the country’s mortgages.
15th Sept ’08- Lehman Brothers
•Liquidity crisis forced Lehman
Brothers to file for bankruptcy
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25th Sept ’08- Washington Mutual
•Liquidity crisis due to a 10-day bank run
forced the OTS (Office of Thrift and
Supervision) to place the bank under FDIC.
•The banking assets were sold to J P Morgan
Chase.
29th Sept ’08- Wachovia Bank
•Wachovia Bank was acquired by Wells
Fargo
• The bank was invested heavily in
adjustable-rate-mortgages and faced
severe losses.
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The Global Story …
14th Sept ’07- Northern Rock Bank, UK
•UKs fifth largest mortgage lender
sought financial support from the Bank
of England. The bank was taken into
state ownership/nationalized
•This was on account of the global credit
crunch triggered by the sub-prime
mortgage crisis in the US.
18th Sept ’08- HBOS, UK
•HBOS was taken over by Lloyds
Bank TSB.
• The share prices suffered heavy
fluctuations on account of short selling
and rumors of a credit crunch.
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29th Sept ’08- Bradford & Bingley, UK
•The share prices of the bank fell on
account of the credit crunch.
•The bank was nationalized and the
Spanish bank Group Santander
acquired all the savings bank assets.
29th Sept ’08- Fortis Bank, Belgium
•The bank was partially nationalized
by the European Central Bank
• The share prices fell dramatically on
account of rumors of insolvency.
•Can be attributed to the sub-prime
mortgage crisis in the US
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The Black Swam Phenomenon
“No amount of observations of white swans can allow the inference
that all swans are white, but the observation of a single black swan
is sufficient to refute that conclusion.”
What is a Black Swam?
•It is an Event
•Hard to predict based on historical data
•After the event – many people saw it coming
Stress testing models must assume black swan events to ensure greater
predictive power.
The London “Millennium Bridge”
Incident
Source: http://www.urban75.org/london/
The London “Millennium Bridge”
Incident
London Bridge – Architect Lord Norman Foster
Source: http://www.urban75.org/london/
Thank you
Mr. Ravi Varadachari
Practice Leader – Risk Management & Compliance
[email protected]
+1 917 502 9480
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