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Understanding and Managing Risks
In a Volatile Environment
Prepared for: Delaware Bankers Association
Thursday, January 22, 2009
University & Whist Club | Wilmington, DE
Agenda
• Quick Introductions – Our Qualifications• Overview of Current Environment – Setting
the Stage• The Challenges & Opportunities• Final Conclusion & Possible Next Steps• Open Q&A
Quick Introductions – Our Qualifications
Richard P. Eckman
Richard P. Eckman is a partner in the Wilmington office of Pepper Hamilton LLP. He is a finance and transactional lawyer and chairs the firm’s Financial Services Practice Group. Mr. Eckman’s transactional practice focuses on representing financial institutions, corporations and other entities in complex financing transactions, including mergers and acquisitions, asset securitizations and other lending and venture transactions.
Mr. Eckman was one of the drafters of Delaware’s landmark Financial Center Development Act that attracted over 25 financial institutions to Delaware, many of whom he represents. He was chairman of the Commercial Law Section of the Delaware Bar Association from 1989-1991 and of its Banking Law Committee from 1984-1992. He has been counsel to the Bank of Delaware, now PNC Bank; was a founder of and vice president and general counsel for The Chase Manhattan Bank (USA), N.A.; and was a director and secretary of FCC National Bank, headquartered in Wilmington.
Mr. Eckman is a fellow in and former regent of the American College of Consumer Financial Services Lawyers and a member of the Lawyers Committee of the Consumer Bankers Association. He is also an adjunct professor at the Villanova University School of Law where he teaches financial institution law. He is active in and held leadership positions on the Consumer Financial Services Committee of the Business Law Section of the American Bar Association and currently serves as editor-in-chief of its e-newsletter. Mr. Eckman was a founder and president of the Delaware Entrepreneurs’ Forum. Mr. Eckman is also a member of the Editorial Board of the Journal of Payment Systems Law.
Richard P. Eckman302.777.6560 – Direct302.421.8390 – Fax [email protected]
Mr. McTaggart started his legal career in the Legal Division of the Board of Governors of the Federal Reserve System and is now is a partner in the Washington, D.C., office of Pepper Hamilton LLP. He focuses his practice on bank and financial services regulatory matters. He also has significant experience handling transactional, enforcement and legislative matters for financial services clients. Earlier in his career, Mr. McTaggart served as the Delaware State Bank Commissioner (1994-1999) and as counsel to the U.S. Senate Banking Committee (1991-1994).
Mr. McTaggart has represented financial services companies, foreign banks, investor groups, bank trade associations, investment firms and retailers in connection with issues such as Internet banking, state and federal financial regulation, government-sponsored enterprise matters, and privacy and data safeguard issues. Mr. McTaggart also has represented clients before the federal bank regulatory agencies, including the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision and the Board of Governors of the Federal Reserve System, as well as various state banking departments across the country.
As the Delaware State Bank Commissioner, Mr. McTaggart supervised and set policy for retail banks, trust companies, wholesale banks, credit card banks, saving banks, mortgage companies and other financial services companies with operations in Delaware and across the nation. He also was responsible for administering escheat laws and the bank franchise tax applicable to all financial institutions operating in Delaware.
Timothy R. McTaggart202.220.1210 – Direct202.220.1665 – Fax [email protected]
Timothy R. McTaggart
Mr. Noring is a Managing Director in the Finance and Accounting practice in the Washington DC office. He leads NCI’s Financial Risk Management Advisory Practice, which includes the Internal Audit Services, Sarbanes Oxley Services, Financial Risk Management, Credit Risk Management, Model Risk Management, and Servicing Operations Risk Groups.
Mr. Noring has extensive experience in capital markets operations, mortgage banking, securitization transactions, derivative risk management operations, auto finance, best practice environments surrounding financial instrument accounting, fair value measurements and allowance for loan loss methodologies.
Mr. Noring has over 21 years of professional services experience and is a former partner at PricewaterhouseCoopers where he spent 18 years serving large multinational financial services clients. Prior to joining Navigant Consulting, he was Senior Vice President of Finance at Fannie Mae, responsible for financial reporting, tax and the business unit controller’s function as well as leading key restatement efforts.
Mr. Noring joined Navigant Consulting in June 2006 and since then has lead three significant restatement projects involving a major multi-family real estate finance company, a leading auto lender, and a government sponsored agricultural mortgage guarantor. Key restatement issues involve FIN 45(R), FAS 133, FAS 140 as well as other financial instrument and real estate accounting pronouncements.
Most recently, Mr. Noring has led a detailed servicing operations review at a top 10 mortgage servicer on behalf of the trustee for the entity’s private label securitizations. In addition to covering all servicing functions, the review placed extra emphasis on the servicer’s loss mitigation and loan modification activities.
Paul A. Norig, CPA703.734.5912 – Direct703.734.5970 – Fax [email protected]
Paul A. Noring, CPA
Overview of Current Environment –Setting the Stage
Despite the implemenation of new methodologies, modeling techniques and supporting technologies, significant “long tail” events continue to take the industry by surprise
The Risk Management Challenge
Risk Tolerance
Risk
Appetit
e
Ton
e
at th
e
Top
Regulatory Oversight Managemen
t Experti
se
Tech
. Fra
mew
or
k
Risk Modeling
Limitations
Risk Modeling
Limitations Resource Hiring &
Investments
Constraints
Resource Hiring &
Investments
Constraints
Increased Complexity in Products & Services
Increased Complexity in Products & Services
Revenues & Earnings Pressures
Revenues & Earnings Pressures
Governance Governance & &
Risk Risk CultureCulture
Governance Governance & &
Risk Risk CultureCulture
Organizational Roles &
Responsibilities
Misaligned Performance & Compensation
Plans
Willingness to accept risk in the normal
course
Willingness to pursue risk for reasonable
returns
Level of influence exerted by Oversight
groups
Understanding complex transaction
risks
Systems capabilities & constraints
Articulated & demonstrated
Commitment & Ethics
The environmental factors surrounding the execution of Risk Management activities can significantly impact the overall effectiveness of such efforts
In order to survive and thrive in this environment, FSO’s must proactively respond & adapt to the new business reality
Pursue revenue generation opportunities
WHAT CAN AND SHOULD WE DO?
Assess & balance resource needs
Assess & mitigate embedded risks Ensure the
integrity of Governance & Controls framework
Mitigating Risk In a Volatile
Environment Seek out & implement process efficiencies
It is incumbent upon Executive Management to pursue all opportunities to preserve franchise value in times of extraordinary pressures
» Confirm that all controls are in place and effective» Mitigate credit losses to the extent possible» Improve processes to support expense containment» Continue to drive revenues in a risk appropriate manner
The Challenges & Opportunities
Credit Risk
Arises from the potential that a borrower or counterparty will fail to perform under the contractual terms of an obligation.
Mitigating Risk In a Volatile
Environment
- Underwriting
- Off balance sheet exposures (guarantees / SPV's and SIV's / commitments)
- Covenant and Collateral Protection
- Portfolio Correlation / Concentration
- Continuous Risk Rating / Risk Mitigation
- Transparent Risk Analytics / Reporting
- Stress Testing
- Reserving
- Workout / recovery
Market Risk
The risk to a financial institution's condition resulting from adverse movements in market rates or prices, such as interest rates foreign exchange rates, or equity / prices. - Proprietary Trading Desks and Strategies
- Investment & Liquidity Portfolio (realized versus unrealized)
- Derivative and FX dealing (matched book versus market making activities)
- Securitization Residuals (subordinated tranches and MSRs)
- Principal Investing
- Collateral values
- Refinancing options (ties into credit risk
Operational Risk
Arises for the potential that inadequate information systems, operational problems, breaches in internal controls, fraud or unforeseen catastrophes will result in unexpected losses.
- Fraud / Unauthorized Activities
- Accounting Processes (trade capture / payments / reconciliations)
- Financial Restatements
- Merger Integration
- Unauthorized access to data
- Business Continuity / Disaster Recovery
- New Product Approval (ties into all risk categories)
Other Key Risk Categories
Liquidity Arises from the potential inability to meet obligations when due because of inadequate funding or an inability to liquidate assets, or in cases where exposures cannot be unwound or offset without significantly lowering market prices because of inadequate market depth or market disruptions.
Legal
Arises from the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or conditions of a banking organization
Reputational Arises from the potential that negative publicity regarding an institution's business practices whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.
Enterprise Risk Management (“ERM”) is focused on the minimization of earnings volatility, and effective implementation is considered a critical element in value creation
"…a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives."
MeasurementMeasurementRisk Appetite / LimitsRisk Appetite / Limits ReportingReporting
CultureCulture
Structure & RolesStructure & RolesPrinciples & StandardsPrinciples & Standards
Integrated Financial Mgmt Systems
Risk Mgmt Tools
Data Mgmt Standards / Infrastructure
Infrastructure
MeasurementMeasurementRisk Appetite / LimitsRisk Appetite / Limits ReportingReporting
CultureCulture
Structure & RolesStructure & RolesPrinciples & StandardsPrinciples & Standards
Integrated Financial Mgmt Systems
Risk Mgmt Tools
Data Mgmt Standards / Infrastructure
Infrastructure
ERM Framework Components
A working definition for Enterprise Risk Management is ….……
An effective ERM framework: Reflects the risk culture of the
organization Is principles based, providing for
flexibility in execution Requires that Key Risk Metrics
(“KRMs”) be measured, reported & managed
Is based on a base level infrastructure that accommodates the harvesting & analysis of internal risk and financial data
The design of the risk governance framework is critical to the deployment of an effective enterprise wide risk & controls program
Board
Level
Govern
ance
Man
ag
em
ent
Com
mit
tees
Funct
ion
al
Gro
ups
LOB
s
Risk Appetite, Corp. Vision
& Corp. Ethics
Mission Statement, Risk Culture & Policy Setting
Limits & Guidelines
Development, Monitoring
&Tool Deployment
Execution
Market RiskMarket Risk
Credit RiskCredit Risk Loan Approval
Loan Approval
Asset/Liab Mgmt
Asset/Liab Mgmt
Ops Risk Ops Risk
AuditAudit
Credit ReviewCredit Review
Credit Risk Mgmt
Credit Risk Mgmt
Model Mgmt& Review
Model Mgmt& Review
Portfolio Mgmt
Portfolio Mgmt ComplianceCompliance Market
Risk MgmtMarket
Risk Mgmt
Ops Risk Mgmt
Ops Risk Mgmt
TreasuryTreasuryFinanceFinance Office of Gen Counsel
Office of Gen Counsel
Business Unit
Business Unit
Business Unit
Business Unit
Business Unit
Business Unit
Business Unit
Business Unit
Enterprise Risk MgmtEnterprise Risk Mgmt
ComplianceCompliance
Committee Charters Committee Membership Sub-Committee Structures Level of Delegation to Exec
Mgmt Required Reporting &
Communications to be Received
Committee Charters Defined Responsibilities Proper Reporting Lines Defined Scopes of Authority Committee Membership Sub-Committee Structures Level of Delegation to Mgmt Levels of Reporting &
Communications (up & down)
Appropriate Levels of Independence
Proper Reporting Lines Defined Scopes of
Responsibility Proper Goals & Incentives Appropriate Expertise/ Skill
Sets Tools that are Fit for Purpose Reporting & Communications Alignment of Business Goals
with Risk Strategies Tools that are Fit for Purpose
Board of DirectorsBoard of Directors
Risk Committee
Risk Committee
Risk Committee
Risk Committee
Risk Committee
Risk Committee
Risk Committee
Risk Committee
Internal Audit
Internal Audit
SOXSOX
Compliance Challenges Facing Financial Institutions
• Review the Scope and Depth of Your Compliance Program
• Do You have the Right People In Your Compliance Group?
• How Does Your Compliance Group Interact with Management?
• How Do They Interact with the Counsel?• What do the Regulators Say?
Hot Areas for Regulators
• Unfair and Deceptive Practices• Fair Lending• BSA/AML• Privacy/Data Breach
Third Party Relationships
• Need to Negotiate a Contract that Regulators will Love
• Treat Third Parties as Part of Your Company
• Audit Rights - Most Important• Reporting• Penalties and Remedies
How to Avoid Costly Litigation
• Effective Compliance Programs Limit Litigation
• Get Lawyers Involved Early• Use Arbitration Clauses• Try to Resolve Disputes Using Mediation• Hire Good Lawyers to Represent You
Final Conclusion & Possible Next Steps
Current Pressing Events
Mitigating Risk In a Volatile
Environment
- CAPITAL!!!
- Credit * Allowance for Loan Loss Provisioning * Portfolio Stress Testing * Risk Analytics / Reporting * Covenant / Collateral Protection * Workouts
- Securities / Derivatives * Valuation of Financial Instruments * Impact of credit spreads on matched books * Impairment
- Loan Modification Programs
- Government Bad Asset Purchase Programs
Need for Change
•Organizations can no longer afford to allow risk oversight practices to operate in their respective silos•Internal as well as external forces are driving the need for change •Management must determine the most effective approach to overcome any obstacles
It is Management’s fiduciary & ethical responsibility to ensure that the governance & risk management framework is sufficiently robust and effective for the levels of risk being undertaken
Drivers of Change: Excessive credit & investment losses
Heightened emphasis on risk mitigation
Increased complexity in products & services
New regulatory requirements
Internal cost reduction initiatives
Internal limitations on hiring & investment
Next Steps …………
Identify areas having potential opportunities for improvement ……..…...
Popularize this approach with business owners & decision makers ..…....
Identify & address any internal impediments to success ………………….
Perform a high level assessment of potential benefits & costs ………..
Develop a road map & prioritize efforts …………………..…………………
Mobilize ………………………………….……….…….……………………….
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Open Q&A