Rethinking Risk Management

1
RethinkingRisk Management

• Where to now?

2
Presentation toPRMIA, Dublin BranchDr. Brian
OKellyPrincipal, QED EquityAdjunct Professor
of Finance, Dublin City UniversityAcademic
Director, M.Sc. in Investment, Treasury Banking
3
Overview

• Background
• The trouble with banking
• Risk management and models
• Accountants, regulators, rating agencies and
  other culprits!
• Defining a new role for risk management

4
Overview

• Background
• The trouble with banking
• Risk management and models
• Accountants, regulators, rating agencies and
  other culprits!
• Defining a new role for risk management

5
Destined to Fail?

• Owners of capital will stimulate the working
  class to buy more and more of expensive goods,
  houses and technology, pushing them to take more
  and more expensive credits, until their debt
  becomes unbearable. The unpaid debt will lead to
  bankruptcy of banks, which will have to be
  nationalised, and the State will have to take the
  road which will eventually lead to communism.
• Karl Marx
• Das Kapital, 1867
• Capitalism has not failed. We have failed
  capitalism.
• Bernard-Henri Lévy

6
Why did it happen?

• This confidence, taken for granted in
  well-functioning financial systems, has been lost
  in the present crisis in substantial part due to
  its recent complexity and opacity,weak credit
  standards, mis-judged maturity mismatches, wildly
  excessive use of leverage on and off-balance
  sheet, gaps in regulatory oversight, accounting
  and risk management practices that exaggerated
  cycles, a flawed system of credit ratings and
  weakness of governance.
• G30 report, Washington, January 2009

7
Cause of Crisis Turner Review

• Growth of financial sector
• Increasing leverage - in many forms
• Changing forms of maturity transformation
• Misplaced reliance on sophisticated maths
• Hard-wired pro-cyclicality

8
Unresolved Tension

• The story that I have to tell is marked all the
  way through by a persistent tension between those
  who assert that the best decisions are based on
  quantification and numbers, determined by the
  patterns of the past, and those who base their
  decisions on more subjective degrees of belief
  about the uncertain future. This is a controversy
  that has never been resolved.
• Against The Gods The Remarkable Story Of Risk
• Peter L. Bernstein

9
Subjective or Quantitative?

• Those who understand well the financial questions
  that need answering ? are often not
  quantitatively proficient ? As for the quants,
  they love nothing more than having to tackle
  technically difficult problems ? Not only will
  the pleasure in solving the puzzle be greater,
  but ? the quants indispensability to the firm
  will be further confirmed.
• So, it is not surprising after all that the quant
  suggesting that a simpler, less quantitative
  approach should be used to solve a problem is
  only slightly less rare than a turkey voting for
  Christmas.
• Plight of the Fortune TellersRiccardo Rebonato,
  2007

10
Déjà vu? A U.K. experience

• The clearing banks could now compete more easily,
  but remained trapped by a culture of controls and
  ceilings. Loan applications had to pass slowly
  through a web of bureaucracy. This did not fit
  well into a climate of frenzied wheeler-dealing.
• Fringe banks, in contrast, had close
  relationships with property speculators and were
  prepared to make almost instant decisions.
  Interest rates were high, and perhaps the levels
  of security were weak, but what did that matter
  when property values were climbing at 30 per cent
  a year? In any property bubble, lending appears
  to create its own security cautious bankers win
  no business.
• UKs Secondary Banking Crisis, Grumpy Old
  BankersBarry Riley, 2009

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Unintended Consequences

• In most fields, the evolution of engineering,
  reduces risk. We learn from our successes and
  failures and ? end up with safer ? buildings and
  cars. ?
• This does not seem to be the case for engineering
  in the financial markets. The results of
  financial engineering the increasing
  sophistication of the markets, the complexity and
  the speed with which market events unfold and
  propagate seem to be taking us in the wrong
  direction. These breakdowns come about not in
  spite of our efforts at improving market design,
  but because of them its origins are in what we
  would generally call progress.
• A Demon of Our Own DesignRichard Bookstaber,
  2008

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Risk Measurement or Management?

• There are more fundamental problems with current
  financial risk management. These are to be found
  in its focus on measuring risk and its scant
  attention to how we should reach decisions based
  on this information. Ultimately, managing risk is
  about making decisions under uncertainty.
• Riccardo Rebonato, 2007, op. cit.

13
Risk Management in a Crisis

• When it comes to risk management during market
  crises, the usual economic linkages and
  historical market relationships do not matter.
  Rather, what matters is who owns what, and who is
  under pressure to liquidate. These dynamics are
  not part of institutions risk management models.
  So, the very time risk measurement is most
  critical, the models fail to deliver.
• Richard Bookstaber, op. cit.

14
Death of Expertise?

• The use of a growing array of derivatives and the
  related application of more-sophisticated
  approaches to measuring and managing risk are key
  factors underpinning the greater resilience of
  our largest financial institutions which was so
  evident during the credit cycle of 2001-02 and
  which seems to have persisted.
• Because risks can be unbundled, individual
  financial instruments can now be analysed in
  terms of their common underlying risk factors,
  and risks can be managed on a portfolio basis.
• Risk Transfer and Financial StabilityAlan
  Greenspan, Federal Reserve Bank of Chicagos41st
  Annual Conference on Bank Structure, May 5, 2005

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Death of Expertise? contd.

• The crisis will leave many casualties.
  Particularly hard hit will be much of todays
  financial risk-valuation system, significant
  parts of which failed under stress.
• Those of us who look to the self-interest of
  lending institutions to protect shareholder
  equity have to be in a state of shocked
  disbelief.
• But I hope that one of the casualties will not be
  reliance on counterparty surveillance, and more
  generally financial self-regulation, as the
  fundamental balance mechanism for global finance.
• We will never have a perfect model of riskAlan
  Greenspan, Financial Times, 16/Mar/08

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Casualties of the Crisis

• Fatalities
• Efficient markets hypothesis
• Copula approach, correlation traders
• 100 LTV
• 6 times LTI
• Masters of the Universe
• SIV, CPDO, CDO2
• Seriously Wounded
• Value-at-Risk
• Securitisation

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Flawed Assumptions Turner Review

• Market prices are good indicators of rationally
  evaluated economic value
• Securitised credit increases allocative
  efficiency and financial stability
• The risk characteristics of financial markets can
  be inferred from mathematical analysis,
  delivering robust quantitative measures of credit
  risk
• Market discipline can be used as an effective
  tool in constraining harmful risk-taking.
• Financial innovation is beneficial since
  competition would winnow out innovations that did
  not add value

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Was it Inevitable?

• Stunning as such crises are, we tend to see them
  as inevitable. The markets are risky, after all,
  and we enter at our own peril. We take comfort in
  ascribing the potential for fantastic losses to
  the forces of nature and unavoidable economic
  uncertainty.
• But that is not the case. More often than not,
  crises arent the result of sudden economic
  downturns or natural disasters. Virtually all
  mishaps ? had their roots in the complex
  structure of the financial markets themselves.
• Richard Bookstaber, op. cit.

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Overview

• Background
• The trouble with banking
• Risk management and models
• Accountants, regulators, rating agencies and
  other culprits!
• Defining a new role for risk management

20
The Trouble with Banking

• Fundamental instability
• Not self-correcting when equilibrium disturbed
• Prone to destruction
• Totally reliant on trust
• Once lost, cannot be retrieved
• Whether you think a bank is sound, or otherwise,
  youre usually right!
• self-fulfilling prophesy

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The Trouble with Banking contd.

• Maturity transformation
• Greatest social good
• Greatest business weakness
• However, I have pledged to you, the rating
  agencies and myself to always run Berkshire
  with more than ample cash. We never want to count
  on the kindness of strangers in order to meet
  tomorrows obligations. When forced to choose, I
  will not trade even a nights sleep for the
  chance of extra profits.
• Warren Buffetts Shareholder Letter,
• February 27, 2009

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The Trouble with Banking contd.

• Limited upside, immense downside
• Portfolio of short puts
• Default option
• Pre-payment (call) option
• Requires extremely large portfolio to diversify
  (1,000)
• Correlated risks
• Concentration
• 30-40 stocks create diversified portfolio
  (Statman, JFQA, September, 1987)
• Portfolio of long calls

23
Liquidity Black Holes (after Persaud)

• Everyone using the same computer models
• All financial institutions being regulated in the
  same way
• The herd mentality
• Wrong way risk induces forced selling

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Overview

• Background
• The trouble with banking
• Risk management and models
• Accountants, regulators, rating agencies and
  other culprits!
• Defining a new role for risk management

25
Model Risk

• Ignorance is preferable to error and he is less
  remote from the truth who believes nothing than
  he who believes what is wrong.
• Thomas Jefferson, 1781

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Model Risk contd.

• There is ? considerable danger in applying the
  method of exact science to problems ? of
  political economy the grace and logical accuracy
  of the mathematical procedure are apt to so
  fascinate the descriptive scientist that he seeks
  for ? explanations which fit his mathematical
  reasoning and this without first ascertaining
  whether the basis of his hypothesis is as broad ?
  as the theory to which the theory is to be
  applied.
• Karl Pearson, 1889

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Model Demise

• We are seeing things that were 25-standard
  deviation events, several days in a row
• David Viniar, Chief Financial Officer, Goldman
  SachsLimitations of Computer Models, Financial
  Times, 14-Aug-07

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Merton on Models

• Im not defending complex structures, Im just
  saying to you thats not anywhere near the
  answer, or even the main answer, in my view. If
  you have housing come down, as it did as an
  underlying asset youre going to have those
  effects in the most vanilla of securities. Any
  virtue can become a vice when taken to its
  extreme. Only a crazy person would have a
  mathematical model just running -- (and) you go
  off fishing.
• Observations on the Science of Finance in the
  Practice of FinanceRobert C. Merton, MIT, Mar 5
  , 2009

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de Laroisière on Models

• The use by sophisticated banks of internal risk
  models for trading and banking book exposures has
  been another fundamental problem. These models
  were often not properly understood by board
  members (even though the Basel 2 rules increased
  the demands on boards to understand the risk
  management of the institutions). Whilst the
  models may pass the test for normal conditions,
  they were clearly based on too short statistical
  horizons and this proved inadequate for the
  recent exceptional circumstances.

30
VaR in the Dock Turner Review

• The increasing scale and complexity of the
  securitised credit market was obvious to
  individual participants, to regulators and to
  academic observers. But the predominant
  assumption was that increased complexity had been
  matched by the evolution of mathematically
  sophisticated and effective techniques for
  measuring and managing the resulting risks.
  Central to many of the techniques was the concept
  of Value-at-Risk (VAR), enabling inferences about
  forward-looking risk to be drawn from the
  observation of past patterns of price movement.

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VaR in the Dock contd.

• The very complexity of the mathematics used to
  measure and manage risk, moreover, made it
  increasingly difficult for top management and
  boards to assess and exercise judgement over the
  risks being taken. Mathematical sophistication
  ended up not containing risk, but providing false
  assurance that other prima facie indicators of
  increasing risk (e.g. rapid credit extension and
  balance sheet growth) could be safely ignored.

32
Risk Management Failures de L.

• Fundamental failures in the assessment of risk,
  both by financial firms and by those who
  regulated and supervised them
• a misunderstanding of the interaction between
  credit and liquidity
• failure to verify fully the leverage of
  institutions
• Resulting in an overestimation of the ability of
  financial firms as a whole to manage their risks,
  and a corresponding underestimation of the
  capital they should hold.
• Faulty risk management has played a key role in
  the run-up to the current crisis. International
  firm supervisors should therefore pay greater
  attention to banks' internal risk management
  practices and insist on proper stress tests.

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Risk Management Failures de L. contd.

• The extreme complexity of structured financial
  products, sometimes involving several layers of
  CDOs, made proper risk assessment challenging for
  even the most sophisticated in the market.
• Moreover, model-based risk assessments
  underestimated the exposure to common shocks and
  tail risks and thereby the overall risk exposure.
• Stress-testing too often was based on mild or
  even wrong assumptions. Clearly, no bank expected
  a total freezing of the inter-bank or commercial
  paper markets.

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Overview

• Background
• The trouble with banking
• Risk management and models
• Accountants, regulators, rating agencies and
  other culprits!
• Defining a new role for risk management

35
Accountants Exacerbate Crisis

• Regarding the issue of pro-cylicality, as a
  matter of principle, the accounting system should
  be neutral and not be allowed to change business
  models which it has been doing in the past by
  "incentivising" banks to act short term. The
  public good of financial stability must be
  embedded in accounting standard setting. This
  would be facilitated if the regulatory community
  would have a permanent seat in the IASB
• Accounting standards should not bias business
  models, promote pro-cyclical behaviour or
  discourage long-term investment
• de Laroisière

36
Remuneration Structures - Turner

• The crisis has launched a debate on remuneration
  in the financial services industry. There are two
  dimensions to this problem one is the often
  excessive level of remuneration in the financial
  sector the other one is the structure of this
  remuneration, notably the fact that they induce
  too high risk-taking and encourage short-termism
  to the detriment of long-term performance.
• Social-political dissatisfaction has tended
  recently to focus, for understandable reasons, on
  the former. However, it is primarily the latter
  issue which has had an adverse impact on risk
  management and has thereby contributed to the
  crisis. It is therefore on the structure of
  remuneration that policy-makers should
  concentrate reforms going forward.

37
Credit Rating Agency Errors

• The major underestimation by Credit Rating
  Agencies of the credit default risks of
  instruments collateralised by sub-prime mortgages
  resulted largely from flaws in their rating
  methodologies. The lack of sufficient historical
  data relating to the US sub-prime market, the
  underestimation of correlations in the defaults
  that would occur during a downturn and the
  inability to take into account the severe
  weakening of underwriting standards by certain
  originators have contributed to poor rating
  performances of structured products between 2004
  and 2007.
• de Laroisière

38
Mark-to-Market

• Has a role, but a limited one
• Measure counterparty risk exposure
• Measure values in a trading book
• Often used inappropriately
• Front-loading profits which have yet to emerge
• They may not emerge, are subject to operational
  risk, counterparty risk
• Inappropriate incentives
• Marking liabilities
• Unable to buy back at these prices
• Creating hollow profits

39
Mark-to-Market contd.

• The adage that a bird in the hand is worth two in
  the bush is now old hat. A conservative
  accountant counts the bags at the end of the
  shoot and a less conservative one registers the
  number of birds as they fall from the sky. But
  the modern accountant not only eats what he kills
  but also takes credit for the expected cull as
  soon as the hunters guns are primed.
• John Kay, Financial Times, 14-Oct-08

40
Portfolio Modelling

• The probabilities of large losses are measured
  very imprecisely ? as a consequence, companies
  should rely less on estimates of such
  probabilities and pay more attention to the
  implications of large losses for their survival.
• Greater use of scenario planning could allow
  institutions to do a better job of anticipating
  the likely consequences of low-probability
  outcomes and developing effective responses to
  them.
• Risk Management Failures What are they and when
  do they happen,René Stulz, Journal of Applied
  Corporate Finance, Fall 2008

41
Procyclicality

• Ratings, triggers, margins, haircuts
• Accounting
• Mark-to-market of securities
• Disallowance of general provision in banking book
• Regulatory
• Basel II capital requirements
• Despite the through the cycle rating requirement

42
Procyclicality
43
Overview

• Background
• The trouble with banking
• Risk management and models
• Accountants, regulators, rating agencies and
  other culprits!
• Defining a new role for risk management

44
Turner Recommendations

• Increase quantity and quality of capital
• Focus on Core Tier 1
• Increase by 40
• Increase trading book capital (x 3)
• Employ through-the-cycle ratings
• Create counter-cyclical capital buffers
• Offset pro-cyclicality in published accounts
• Introduce gross leverage backstop
• Intensify liquidity regulation

45
de Laroisière Recommendations

• The Group sees the need for a fundamental review
  of the Basel 2 rules. The Basel Committee of
  Banking Supervisors should therefore be invited
  to urgently amend the rules with a view to
• - gradually increase minimum capital
  requirements
• - reduce pro-cyclicality, by e.g. encouraging
  dynamic provisioning or capital buffers
• - introduce stricter rules for off-balance sheet
  items
• - tighten norms on liquidity management and
• - strengthen the rules for banks internal
  control and risk management, notably by
  reinforcing the "fit and proper" criteria for
  management and board members.
• Furthermore, it is essential that rules are
  complemented by more reliance on judgement.

46
Turner on Regulation

• But I would emphasise the surprising support that
  several writers offer for some kind of return to
  Glass-Steagall call it narrow banking, or
  utility banking, it clearly has an appeal. My own
  view, is that any institution which benefits from
  the umbrella of regulation must be regulatable
  which means it must not be too big to regulate,
  too complex to regulate, or too interconnected to
  regulate.

47
Regulation in Future de L.

• Future rules will have to be better complemented
  by more reliance on judgement, instead of being
  exclusively based on internal risk models.
  Supervisors, board members and managers should
  understand fully new financial products and the
  nature and extent of the risks that are being
  taken stress testing should be undertaken
  without undue constraints professional due
  diligence should be put right at the centre of
  their daily work.

48
Need for Capital de L.

• The crisis has shown that there should be more
  capital, and more high quality capital, in the
  banking system, over and above the present
  regulatory minimum levels. Banks should hold more
  capital, especially in good times, not only to
  cover idiosyncratic risks but also to incorporate
  the broader macro-prudential risks. The goal
  should be to increase minimum requirements. This
  should be done gradually in order to avoid
  pro-cyclical drawbacks and an aggravation of the
  present credit crunch.

49
Dynamic Provisioning de L.

• The general principle should be to slow down the
  inherent tendency to build up risk-taking and
  over-extension in times of high growth in demand
  for credit and expanding bank profits. In this
  respect, the "dynamic provisioning" introduced by
  the Bank of Spain appears as a practical way of
  dealing with this issue building up
  counter-cyclical buffers, which rise during
  expansions and allow them under certain
  circumstances to be drawn down in recessions.
  This would be facilitated if fiscal authorities
  would treat reserves taken against future
  expected losses in a sensible way. Another method
  would be to move capital requirements in a
  similar anti-cyclical way.

50
Leaning into the Wind de L.

• The crisis has revealed the strong pro-cyclical
  impact of the current regulatory framework,
  stemming in particular from the interaction of
  risk-sensitive capital requirements and the
  application of the mark-to-market principle in
  distressed market conditions. Instead of having a
  dampening effect, the rules have amplified market
  trends upwards and downwards - both in the
  banking and insurance sectors.
• Important that banks, as is the present rule,
  effectively assess risks using "through the
  cycle" approaches which would reduce the
  pro-cyclicality of the present measurement of
  probability of losses and default

51
Role of Risk Management

• The risk managers job is to take away the
  champagne just as the party is getting going
• Towards a new regulatory agenda to reduce
  risk and improve risk management to improve
  systemic shock absorbers to weaken pro-cyclical
  amplifiers to strengthen transparency and to
  get the incentives in financial markets right.
• de Larosière Report

52
Role of Risk Management

• Identify and evaluate the risks faced by the
  firm,
• Communicate these risks to senior management and
  the board of directors
• Monitor and manage those risks in a way that
  ensures the firm bears only the risks to which
  its management and board want exposure
• Taking firms risk appetite as a given, assess
  the expected profitability of a proposed
  investment by evaluating how much capital is
  required to support it
• Risk Management Failures What are they and when
  do they happen, Journal of Applied Corporate
  Finance, Fall 2008 René Stulz

53
Back to First Principles

• Resurrect commonsense at the expense of
  algorithms. This is not a Luddite sentiment. The
  technique of risk assessment, pricing, etc., has
  improved enormously in recent years. But sitting
  down, looking out of the window and asking
  yourself as a banker or supervisor can this be
  right also has its place.
• This Time Its Different?, Grumpy Old
  BankersBrian Quinn

54
Bank Priorities

• Safety
• Profitability
• Growth
• In that order!
• We come from a culture where bigger is not
  better. You get bigger by being better, you dont
  get better by being bigger
• John Stumpf, Wells FargoFinancial Times, August
  24, 2008

55
What business are we in?

• Selling loans !
• No!
• Bankers are buyers, not sellers

56
The Nature of Banking

• You buy assets
• You sell liabilities
• Banks are in the buying business
• Marketing has a limited role
• Marketing mind-set is inappropriate
• The only business in which the front-line set the
  price
• Brian Ranson, Credit Risk Management
• Banks blow up when marketing mind-set prevails
• Dont congratulate me when I buy, congratulate
  me when I sell!
• Henry Kravis, KKR

57
Where have we failed?

• Taking large exposures to high-risk sectors
• Development property
• Take exposure only if pre-let to a strong
  covenant
• Hotels
• Pure asset-based lending
• No alternative use
• Take exposure to operating firm, or else none
  whatsoever

58
Where have we failed? contd.

• Measuring concentration risk
• None of the market models adequately measures the
  full economic cost of exposure concentrations
• The factor model approach (and especially the
  copula approach) do not capture the dynamic
  nature of the inter-relationships
• all correlations go to 1 in a downturn

59
What Risk should and shouldnt do

• What Risk Management shouldnt do
• go native
• be commercial
• Wheres the shareholder value added in blowing
  up?
• What should Risk Management do?
• Stand on the other side of the boat
• Ask difficult questions
• lean into the wind

60
Graph of Capital
61
Concept on Capital

• Current thinking sets capital as that required to
  achieve a desired default probability for senior
  debt
• But if capital is eroded, bank is unable to raise
  new debt
• In a crisis, the market demands higher
  capitalisation
• This occurs even as risk-weighted assets increase
  due to downgrades
• Bank default can result without ever incurring
  losses of this magnitude
• going concern vs gone concern - Turner
• What is currently regarded as capital is not
  available to absorb losses
• Need to provide for expected loss, not actual
  loss in good years
• Need more and higher-quality capital

62
Turner on Concept of Capital

• A gone concern approach in which what matters
  is the protection of senior creditors and
  depositors in the event of an individual bank
  failure within a stable overall system. From this
  perspective, any capital claim which is ranked
  subordinate to senior creditors will protect
  them subordinated debt as much as common equity.
• A going concern approach in which regulators
  and macroeconomic policymakers need to be
  concerned about the implications of bank capital
  structure for the behaviour of banks and the
  implications of that behaviour for the whole
  economy. From this perspective it is essential
  that capital is available to absorb losses
  without banks being under excessive pressure to
  constrain lending to the real economy and that
  banks are not so highly leveraged relative to
  common equity as to create incentives for
  excessive risk taking.

63
Role of the Board

• Define banks risk appetite
• often by reference to a desired credit rating
• at the heart of the banks strategy and how it
  creates value for its shareholders
• Weigh the benefits of increased risk-taking
  against the costs
• include the costs of financial distress