ERM in Banking James Lam President, James Lam & Associates Sponsored by Casualty Actuarial Society and Society of Actuaries July 28-30, 2003 Filename.
Download ReportTranscript ERM in Banking James Lam President, James Lam & Associates Sponsored by Casualty Actuarial Society and Society of Actuaries July 28-30, 2003 Filename.
ERM in Banking James Lam President, James Lam & Associates Sponsored by Casualty Actuarial Society and Society of Actuaries July 28-30, 2003 Filename James Lam’s biography Filename Professional Industry Activities President, James Lam & Associates Founder and President, ERisk Partner, Oliver, Wyman & Company CRO, Fidelity Investments CRO, Capital Markets Services Inc., a GE Capital company PRMIA Blue Ribbon Panel Member GARP 1997 Financial Risk Manager of the Year Published over 50 articles and book chapters Quoted in Wall Street Journal, Financial Times, and CFO Magazine Academic Recent Clients Adjunct Professor of Finance, Babson College Lectured at Harvard Business School as the subject of a HBS case study MBA, UCLA School of Business BBA, Baruch College The World Bank Salomon Smith Barney Allied Capital Risk Management Association First Data Corporation GMAC 1 New book on ERM Filename 2 Discussion outline The business case for ERM Lessons learned and best practices ERM going forward – 10 Predictions Filename 3 Risks and linkages Enterprise-Wide Risks Financial Risks Kobe earthquake and Nikkei fall Financial Risk Event Risk Operational Risk Market Risk Liquidity Risk Funding Liquidity September 11 impact on operations Filename Credit Risk Associated with Investments Asset Liquidity Credit Risk Credit Risk Associated with Borrowers and Counterparties Loan document and credit loss severity 4 Key risk trends • Enron Corporate • WorldCom Disasters • Tyco • Banks • Asset Managers • Energy Forms • Corporations Corporate Programs Enterprise Risk Management Regulatory Actions • Sarbanes-Oxley • SEC Initiatives • Basel II • Treadway Report, US • Turnbull Report, UK • Dey Report, Canada Filename Industry Initiatives 5 The Wheel of Misfortune Filename 6 Benefits of risk management Filename Benefit Company Actual Results Market value improvement Top money center bank Outperformed S&P 500 banks by 58% Early warning of risks Large investment bank Identified over 80% of future losses; risk limits cut by 1/3 prior to Russian crisis Loss reduction Top asset management company 30% reduction in the overall loss ratio; up to 80% loss reduction at business units Regulatory capital relief Large commercial bank $1 billion regulatory capital relief, or about 8-10% Insurance cost reduction Large manufacturing company 20-25% reduction in annual insurance premium 7 CEOs face a challenging environment Pressure on sales and earnings Unforgiving stock market SEC crackdown on "earnings management" New legislative, regulatory, and accounting requirements More demanding boards and outside analysts Companies must identify, measure, and manage the underlying sources of earnings volatility Filename 8 Discussion outline The business case for ERM Lessons learned and best practices ERM going forward – 10 Predictions Filename 9 Establishing an ERM framework ERM Framework 1. Corporate Governance Establish top-down risk management 2. Line Management Business strategy alignment 3. Portfolio Management Think and act like a “fund manager” 5. Risk Analytics Develop advanced analytical tools 4. Risk Transfer Transfer out concentrated or inefficient risks 6. Data and Technology Resources Integrate data and system capabilities 7. Stakeholders Management Improve risk transparency for key stakeholders Filename 10 Establish a vision and a roadmap Now Year 1 Year 2 Develop data models and systems capability Year 3+ Goal: Target State Risk Management Evolve risk culture through awareness, training and incentives Credit Risk Market Risk Year 3+ Year 2 Year 1 Unique workplans are developed for each deliverable milestone Business & Operational Risk Now Enterprise-Wide Risk Management (Integration) Filename 11 Risk taxonomy (a common language) RISK TYPE FINANCIAL / OPERATIONAL EVENT Investment / Credit Market Operational Reputational Loan Losses Interest Rates People Employees Investment Performance Real Estate Systems Clients Processes Liquidity-Funding Leverage Catastrophe Key Person Terrorist Attacks Investors Analysts Fires/Other One-time Events Rating Agencies Capital Markets Accounting / Valuation Economic Compliance Controlled Investments Filename Regulators Fraud Press Adversaries Competitors 12 Balance the hard and soft side of risk Hard Side Filename Soft Side • Measures and reporting • Risk awareness • Risk oversight committees • People • Policies & procedures • Skills • Risk assessments • Integrity • Risk limits • Incentives • Audit processes • Culture & values • Systems • Trust & communication 13 Case study: Background 2-Year ERM Program • New capital markets business • Established risk policies and systems • Traders hired from foreign bank • Instilled risk culture • Aggressive business and growth targets • Captured 25% market share with zero policy violations • Survived “Kidder” disaster • Recognized as best practice Filename 14 Loss Rate ($) Credit Risk Management Infrequent Catastrophic Losses Economic Capital (EC) Economic Capital Catastrophic Loss Protection Expected Loss (EL) Frequent Low Losses Expected Loss Average Loss Rate Time Expected Loss • Anticipated average loss rate • Cost of doing business, cover through pricing and provisioning • EL = f(credit quality, collateral, structure) Filename Economic Capital • Covers catastrophic losses • Risk inherent in business, cover through capital allocation and adequacy • EC = f(credit quality, collateral, structure, industry sector, maturity, credit rating) 15 Market Risk Management Step 1: Analyze sensitivity of asset and liability value to changes in interest rates Step 2: Simulate changes in term structure of interest rates Change in Term Structure Rate Value Step 3: Recalculate value of assets and liabilities (repeatedly) twist = shift Change in value Rate Time Cash Flow Structural Position Nonlinear Products Product Balance Mortgage Deposits : 6 mo 10 yr Simulation Value vs Rate -300 bp … … +300 bp Distribution 30 yr 9 bps Step 4: Read EC from distribution of changes in AL values Filename EC 16 Operational Risk Management Education • • • • • New associates Management Business/Operational processes Best practices Lessons learned Loss Root Causes 100% 80% Risk Event Log Event Actual Loss Experience Controls Needed 85% Decline 60% 40% 20% Risk Metrics 0% Goal 1995 1996 1997 1998 MAP Filename 17 Economic capital as common currency Credit Risk Earnings volatility due to variation in credit losses Credit Risk Market Risk Operational Risk Market Risk Earnings volatility due to market price movements Enterprise-wide Risk Operational Risk Earnings volatility due to changes in operating economics (e.g. volume, margins or costs) or one-off events Probability Change in Value Filename 18 Value creation through ERM Risk Management Impact Revenue Expenses ROE 1. Risk-based pricing 2. Target customer selection 3. Relationship management 4. Risk oversight costs 5. Insurance/hedging expense Losses Shareholder Value Equity New Business 6. Credit, market operational write-offs 7. Capital management 8. Risk transparency 9. New business development Growth M&A Risk Management by Silos (5, 6) Filename Integrated risk management (4–7) 10. M&A/Diversification strategy Enterprise risk management (1-10) 19 Measuring profitability and pricing Calculate ROE Exposure $100 mm $100 mm Margin 2.50% 2.20% Revenue $2.5 mm $2.2 mm Risk Losses <0.5 mm> <0.5 mm> Expense <1.0 mm> <1.0 mm> $1.0 mm $0.7 mm <0.4 mm> <0.3 mm> Net Income $0.6 mm $0.4 mm Economic Capital $2.0 mm $2.0 mm RAROC 30% 20% Pre-Tax Net Income Tax Filename Calculate Pricing 20 Rationalized risk transfer Different Structures Common Cost/Benefit Framework Return Ceded RAROC = Derivatives Return – Pay cashflows or insurance premium – Include transaction and ongoing management costs – Reduce Economic Capital ‘benefit’ Economic Capital – Reduce Economic Capital held for risk – Increase Economic Capital counterparty exposure – Increase operating risk Economic Capital Structured Finance Insurance Filename Economic Capital 21 Case study: Background • $1 trillion of assets under management • Private company • Decentralized business culture Filename 3-Year ERM Program • Organized Global Risk Forum • Implemented annual Global Risk Review • Built loss/event tracking system • Developed ERM framework • Implemented intranet-based Global Risk MIS • Experienced 30% reduction in loss ratio 22 Discussion outline The business case for ERM Lessons learned and best practices ERM going forward – 10 Predictions Filename 23 Ten Predictions 1. ERM will become the industry standard 2. CROs prevalent in risk-intensive companies 3. Audit committees will evolve into risk committees 4. Economic capital in; VaR out 5. Risk transfer executed at enterprise level 6. Advanced technologies key to advancement 7. A measurement standard will emerge for operational risk 8. Mark-to-market accounting becomes standard 9. Risk becomes part of corporate and college programs 10. Salary gap among risk professionals continues to widen Filename 24 Thank you James Lam’s contact information Phone: 781-772-1961 Email: [email protected] Filename 25