Filename

ERM in Banking

James LamPresident, James Lam & Associates

Sponsored by Casualty Actuarial Societyand Society of ActuariesJuly 28-30, 2003

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James Lam’s biography

Professional President, James Lam &

Associates Founder and President, ERisk Partner, Oliver, Wyman &

Company CRO, Fidelity Investments CRO, Capital Markets Services

Inc., a GE Capital company

Industry Activities 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 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

Recent Clients

The World Bank Salomon Smith Barney Allied Capital Risk Management Association First Data Corporation GMAC

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New book on ERM

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The business case for ERM

Lessons learned and best practices

ERM going forward – 10 Predictions

Discussion outline

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Risks and linkages

EventRisk

OperationalRisk

FinancialRisk

September 11 impact on operations

Loan document and credit loss severity

Kobe earthquake and Nikkei fall

Enterprise-Wide RisksFinancial Risks

MarketRisk

LiquidityRisk

CreditRisk

Credit Risk Associated with

Investments

Credit Risk Associated with Borrowers and

CounterpartiesFunding Liquidity

Asset Liquidity

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Key risk trends

EnterpriseRisk

Management

Corporate Disasters

• Enron• WorldCom• Tyco

IndustryInitiatives

• Treadway Report, US• Turnbull Report, UK• Dey Report, Canada

CorporatePrograms

• Banks• Asset Managers• Energy Forms• Corporations

RegulatoryActions

• Sarbanes-Oxley• SEC Initiatives• Basel II

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The Wheel of Misfortune

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Benefits of risk management

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

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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

CEOs face a challenging environment

Companies must identify, measure, and manage

the underlying sources of earnings volatility

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The business case for ERM

Lessons learned and best practices

ERM going forward – 10 Predictions

Discussion outline

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Establishing an ERM framework

2. Line Management

Business strategy alignment

3. Portfolio Management

Think and act like a “fund manager”

4. Risk TransferTransfer out

concentrated or inefficient risks

5. Risk Analytics

Develop advanced analytical tools

6. Data and Technology Resources

Integrate data and system capabilities

7. Stakeholders ManagementImprove risk transparency for key stakeholders

1. Corporate Governance

Establish top-down risk management

ERM Framework

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Enterprise-WideRisk Management

(Integration)

CreditRisk

Business &Operational

Risk

Now Year 1 Year 2 Year 3+

MarketRisk

Goal:Target State

Risk Management

Goal:Target State

Risk Management

Now

Year 1

Year 2

Year 3+

Credit policy

framework

established –

key credit

policies

approved

Market risk

methodologies

Operatio

nal

relia

bility

models and

business

objectives in

place

ER

Mco

nce

pt

intr

od

uce

d –

su

pp

ort

fro

m

bo

ard

an

d

man

agem

ent

Develop data modelsand systems capability

Automated reporting

Active portfolio management

Transactional process alignment Ad hoc reporting

Early warning

indicators

Align reporting

with policies Develop portfo

lio stress-te

sting

Establish market risk controls

Enhance framework

and policy

Dev

elop

risk

met

rics

and

repo

rting

Align insurance programs

Define fra

mework

and policy

Est

ablis

h or

gani

za-

tiona

l res

pons

ibilit

ies

Est

ablis

h C

RO

Def

ine

fram

ewor

k

and

polic

y

Alig

n w

ithst

rate

gy

Def

ine

risk

tole

ranc

e

App

ly e

cono

mic

cap

ital

as c

omm

on r

isk

unit Cre

ate

inte

grat

ed r

isk

repo

rt

and

succ

ess

mea

sure

s

Int

egra

te r

isk

man

agem

ent

into

bus

ines

s pr

oces

ses`

Dev

elop

str

ess-

test

ing

and

resp

onse

pla

n

Evo

lve

risk

cultu

re t

hrou

gh a

war

enes

s,tr

aini

ng a

nd in

cent

ives

Establish a vision and a roadmap

Unique workplans are developed for each deliverable milestone

Unique workplans are developed for each deliverable milestone

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Risk taxonomy (a common language)

RISK TYPE

FINANCIAL / OPERATIONAL EVENT

Investment /Credit

Market Operational Reputational Catastrophe

Loan LossesInterest Rates People

Systems

Processes

Employees

Clients

Investors

Analysts

Rating Agencies

Regulators

Press

Key Person

Investment Performance

Real Estate

Terrorist Attacks

Liquidity-FundingLeverage

Fires/Other One-time Events

Capital MarketsAccounting /

ValuationFraud

Economic Compliance Adversaries

Controlled Investments Competitors

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Balance the hard and soft side of risk

Hard Side

• Measures and reporting

• Risk oversight committees

• Policies & procedures

• Risk assessments

• Risk limits

• Audit processes

• Systems

Soft Side

• Risk awareness

• People

• Skills

• Integrity

• Incentives

• Culture & values

• Trust & communication

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Case study:

• New capital markets business

• Traders hired from foreign bank

• Aggressive business and growth targets

Background 2-Year ERM Program• Established risk policies and

systems

• Instilled risk culture

• Survived “Kidder” disaster

• Captured 25% market share with zero policy violations

• Recognized as best practice

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Credit Risk Management

Expected Loss• Anticipated average loss rate• Cost of doing business, cover through

pricing and provisioning• EL = f(credit quality, collateral, structure)

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)

Catastrophic Loss Protection

Expected Loss (EL)

Average Loss Rate

Economic Capital (EC)

EconomicCapital

ExpectedLoss

Time

Lo

ss R

ate

($)

Frequent Low Losses

Infrequent Catastrophic

Losses

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Market Risk Management

Nonlinear Products

Product BalanceMortgageDeposits

:

Value vs Rate-300bp

+300bp… …

Value

Rate

6 mo 30 yr10 yr

Structural Position

Cash Flow

Rate

Time

shift

twist

Change in Term Structure

– ILLUSTRATIVE –

– ILLUSTRATIVE –

Distribution

Change in value=

Simulation

Step 1: Analyze sensitivity of asset and liability value to changes in interest rates

Step 2: Simulate changes in term structure of interest rates

Step 3: Recalculate value of assets and liabilities (repeatedly)

Step 4: Read EC from distribution of changes in AL values

9 bps

EC

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Risk Metrics

Risk Event Log

Event LossRoot

CausesControlsNeeded

Education

0%

20%

40%

60%

80%

100%

1995 1996 1997 1998

• New associates• Management• Business/Operational processes• Best practices• Lessons learned

Goal

MAP

Actual Loss Experience

85% Decline

Operational Risk Management

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Economic capital as common currency

Credit RiskEarnings volatility due to variation in credit losses

Market RiskEarnings volatility due to market price movements

Operational RiskEarnings volatility due to changes in operating economics (e.g. volume, margins or costs) or one-off events

Credit Risk

MarketRisk

OperationalRisk

Probability

Change in Value

Enterprise-wide Risk

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Expenses

-

Revenue

Equity

-

Losses

M&A

New Business

Risk Management by Silos (5, 6)

Value creation through ERM

4. Risk oversight costs5. Insurance/hedging expense

6. Credit, market operational write-offs

7. Capital management8. Risk transparency

9. New business development

10. M&A/Diversification strategy

1. Risk-based pricing2. Target customer selection3. Relationship management

Risk Management Impact

Integrated risk management (4–7)

Growth

ROE

Shareholder Value

Enterprise risk management (1-10)

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Calculate ROE Calculate Pricing

Exposure $100 mm $100 mm

Margin 2.50%

Revenue $2.5 mm $2.2 mm

Risk Losses <0.5 mm> <0.5 mm>

Expense <1.0 mm> <1.0 mm>

Pre-Tax Net Income $1.0 mm $0.7 mm

Tax <0.4 mm> <0.3 mm>

Net Income $0.6 mm $0.4 mm

Economic Capital $2.0 mm $2.0 mm

RAROC 20%

Measuring profitability and pricing

2.20%

30%

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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

Return

Economic CapitalCeded RAROC =

Rationalized risk transfer

Common Cost/Benefit FrameworkDifferent Structures

Derivatives

Structured Finance

Insurance

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Case study:

• $1 trillion of assets under management

• Private company

• Decentralized business culture

Background 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

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The business case for ERM

Lessons learned and best practices

ERM going forward – 10 Predictions

Discussion outline

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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

Ten Predictions

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James Lam’s contact information

Phone: 781-772-1961

Email: jameslam@comcast.com

Thank you