Where Do We Go From Here? Penny Cagan Managing Director

Where Do We Go From Here?

Penny CaganManaging Director

© 2008 Algorithmics Incorporated. All rights reserved.

Where We Have Come From


2008: A year of great volatility

March 2008: Bear Stearns is acquired by JP Morgan in a transaction orchestrated by the US government

July 2008: US Federal government seizes IndyMac (largest thrift to fail in US history)

Sept. 7, 2008: US government takes over Freddie Mac and Fannie Mae

Sept. 14, 2008: Bank of America announces it will acquire Merrill Lynch

Sept 15, 2008: Lehman Brothers files for bankruptcy

Pieter Bruegel the Elder, The Fall of the Rebel Angels


2008: A Year of Great Volatility

Sept. 16, 2008: US government announces $85 billion emergency aid package for AIG

Sept. 18, 2008: Federal Reserve and central banks in Asia and Europe pump up to $180 billion into money markets. US Congress considers $700 billion facility to buy bad debt from banks.

Sept. 19, 2008: US government announces that it will insure all money market funds. The SEC bans short selling of shares in 799 financial stocks.

Sept. 22, 2008: Goldman Sachs and Morgan Stanley announce they have requested a change in their status to Bank Holding Companies, regulated by Federal Reserve

Pieter Bruegel the Elder, Landscape with the Fall of Icarus


Where Risk Lies

Underwriting of new loans: Credit Risk (loan quality) & OpRisk (documentation, background check, integrity of loan process)

Securitization: Reputation & OpRisk (mis-selling, valuation, investor issues) & Liquidity Risk (cash shortages)

Investor: Credit, Market & OpRisk (mark-to-market issues, what are securitized loans worth when they are sold in volatile markets, will the investment pay off, what’s under the hood of structured products)

Market Reactions: Market Risk, OpRisk (increased volatility leads to behavior that can increase oprisk, such as unauthorized trades, questionable valuations, processing issues), Credit Risk (bankruptcies can occur if investors, issuers and packagers can not raise funds.)


Events by Trigger

Source: Algo FIRST


Events by Trigger

Source: Algo FIRST


“At any given time there exists an inventory of undiscovered embezzlement in - or more

precisely not in - the country's business and banks. This

inventory - it should be called the bezzle. It also varies in size with

the business cycle."

from “The Great Crash: 1929” by John Kenneth Galbraith.

The Bezzle


Procylicality of Fraud & Market Practice Issues

Supply of fraud is correlated with supply of credit Access to credit allows for the continuance of both fraud

and gray-matter market practice issues Corporations push the boundaries when credit is available

in terms of compensation, disclosure, client relationships, profit taking and financial reporting

Enron, Worldcom, and Madoff frauds initiated during bubble and uncovered during retraction

The absence of credit during a downturn results in uncovering of frauds


CBOE Volatility Index,1990-2008, vs. events in the FIRST database

Source: CBOE, Bloomberg and FIRST

Vix

Daily C

losin

g P

rices

Kidder Peabody/J. Jett $350m UAT

Codelco $170m UAT

Barings $1.3 billionUAT

BankBoston$73m fraud

WGZ $230m UAT Enron$2.2 billion

fraud

AIB Allfirst$691m UAT

Hamilton Bank$130m fraud

December 2008:Bernard Madoff

$50 billionPonzi Scheme

SocGen $7.2bUAT

Calyon $247mUAT


Bernard Lawrence "Bernie" Madoff (born April 29, 1938 ) is an American businessman and former chairman of the NASDAQ stock exchange. He founded the Wall Street firm Bernard L. Madoff Investment Securities LLC in 1960 and was its chairman until December 11, 2008, when he was charged with perpetrating what may be the largest investor fraud ever committed by a single person.

A Gallery of Rogues: Bernard Madoff and Robert Stanford

• Robert Alan Stanford, charged with running $9.2 billion investment fraud

• Sold $8 billion of Certificates of Deposit through Stanford International Bank, based in Antigua

• Promised double-digit returns over the past 15 years• Bank claimed $51 billion in deposits and assets under

management, with more than 70,000 clients in 140 countries

• Possible money laundering charges pending


Largest Losses from Credit Crisis

Source: Algo FIRST

Organization Name Sum of Loss Amount Percentage

American International Group Inc. 96,278,000,000 27.85%

Citigroup Inc. 63,400,000,000 18.34%

Bank of America Corporation 55,038,000,000 15.92%

UBS AG 48,400,000,000 14.00%

Wells Fargo & Co. 8,617,925,000 2.49%

Morgan Stanley & Company 3,700,000,000 1.07%

Goldman Sachs Group, Inc., The 3,060,000,000 0.89%

JPMorgan Chase & Co 1,600,000,000 0.46%

Top 8 Total 280,093,925,000 81.02%

Others 65,634,029,280 18.98%

Grand Total 345,727,954,280 100.00%


Product Types Behind Subprime losses

Source: Algo FIRST


The Opportunity: OpRisk at the Core of the Solution

We will see a fundamental re-design of risk management:

Operational Risk provides the governing framework

IN: Integrated. Consistent. Actionable. Non-deterministic.

OUT: Silos, automatic models, compliance running on auto-pilot

Categorizations have become meaningless!

Operational risk is the driver for change


Largest Bank Failures

Source: Algo FIRST

Organization Name Loss Amount Percentage

Kaupthing hf 28,200,000,000 24.64%

Glitnir Bank 23,400,000,000 20.45%

Landsbanki Ãslands hf. 15,900,000,000 13.90%

Indymac Bancorp Inc 9,400,000,000 8.21%

BankUnited FSB, Coral Gables, Florida 4,900,000,000 4.28%

Wachovia 4,500,000,000 3.93%

Guaranty Bank, Austin, TX 3,000,000,000 2.62%

Colonial Bank, Montgomery, Alabama 2,800,000,000 2.45%

Franklin Bank, S.S.B., Houston, Texas 1,500,000,000 1.31%

Downey Financial Corp. 1,400,000,000 1.22%

Top 10 Total 95,000,000,000 83.02%

Others 19,429,024,512 16.98%

Grand Total 114,429,024,512 100.00%


Control Failings Behind Bank Failures

Source: Algo FIRST


Product Types Behind Bank Failures


Where We Came From: Five Deadly Sins

1. Lack of care for stakeholders

2. Automatic approach

3. Unknowns ignored

4. Silos accepted

5. Risk and return managed separately Domenico di Michelino, La commedia illumina Firenze


1. Lack of Care for Stakeholders

Short-term earnings culture threatened shareholder value

Failure to put clients’ interests first

Fiduciary duties became secondary

Compensation

Community Role

Pieter Bruegel the Elder, The Fall of the Rebel Angels


Perfecting standard models

2. Automatic Approach

Firms that experienced more significant problems tended to apply a mechanical risk management approach.

Senior Supervisors Group (2008)

The tendency to overly formalize arcane aspects of an analysis often detracts from the bigger picture.

Corrigan Report (2008)

Pieter Bruegel the Elder, Parable of the Blind


3. Unknowns ignored

Pieter Bruegel the Elder, The Adoration of Kings

Methodology can convey a false sense of precision

All models use assumptions and assumptions can have a material impact on the model outcomes. However, most models do not specifically acknowledge what assumptions they are making.

Federal Reserve Bank of New York (2008)


4. Silos Accepted

The existence of organizational silos appeared to be detrimental to performance during the turmoil. Business areas [made] decisions in isolation and in ignorance of other area’s insights.


Pieter Bruegel the Elder, The Tower of Babel


5. Risk and Reward Separated

Pursuing returns without managing risk

Firms that recorded relatively larger unexpected losses tended to champion the expansion of risk without commensurate focus on controls.


Pieter Bruegel the Elder, Gluttony


Where We Can Go From Here: Five Virtues

1. Focus on the Stakeholders

2. Acknowledge uncertainty transparently

3. Imagine and Challenge assumptions

4. Manage risk at the enterprise level

5. Manage risk and return proactively Pieter Bruegel the Elder, Fortitude


1. Focus on the Stakeholders

Develop a culture of risk governance

Risk management must rely heavily on judgment, communication and coordination. This culture of governance will help to break down the silo mentality.

It [requires] rigorous and continuous attention at the highest levels.


Pieter Bruegel the Elder, Justice


2. Acknowledge Uncertainty

Risk is more than a single number

[We] must recognize the limitations of mathematical models.


Managers at better performing firms relied on a wide range of measures of risk.

Senior Supervisor Group (2008)

Pieter Bruegel the Elder, Prudence


3. Imagine. Challenge Assumptions

Firms [must] think creatively about how stress tests can be conducted.


Firms that tended to avoid significant challenges assessed risk positions drawing on different underlying assumptions.


Discover the Unknown, Don’t Perfect the Known


4. Manage Risk at the Enterprise Level

Dismantle silos

Firms that understood quickly the risk they faced relied on information from many parts of their businesses.

Better performing firms were able to integrate their measures of market risk and counterparty risk across businesses.

Senior Supervisors Group (2008) Institute of International Finance (2008)

Pieter Bruegel the Elder, The Tower of Babel


5. Manage Risk (and Return) Pro-actively

The need for speed

[Firms] must have the capacity to monitor risk concentrations as well as exposures to institutional counterparties in a matter of hours and provide effective and coherent reports to senior management.



The Next Wave: A Prediction

Black Swans will happen There will be more risk-related regulation:

Recent G20 and BIS actions are just a start

Comprehensive and active ERM is “back”

Assumptions, models and results will become context specific

Client-centric financial innovation is here to stay

Pieter Bruegel the Elder, The Battle about Money


The Next Wave: A Hope

Think!

Imagine. Explore what you don’t know

Challenge your assumptions

Communicate, don’t “report”

Use sound judgment

Risk management = Decision making under uncertainty Pieter Bruegel the Elder, Hope


Where do we go from here

OpRisk Best Practices is part of the solution Manage risk on a firm-wide basis and overcome silos

Integrate risk identification, risk and self assessments, monitoring and testing of controls within the enterprise-wide risk framework

Look at all material risks together, and not be limited to market, credit, liquidity and operational risk

Understand assumptions and what happens if assumptions fail

Integrate scenario approaches within overall framework

Lobby to change an organization’s culture

Supplement quantitative tools with qualitative judgment


Thank you for your time

For further information contact:

Penny CaganManaging Director

[email protected]

Documents

Where Do We Go From Here? Penny Cagan Managing Director