Measuring & Managing Risks at Financial Conglomerates: Case of Hua Nan Financial Holdings Company

1. Measuring & Managing Risks at Financial Conglomerates:Case of Hua Nan Financial Holdings Company Speaker: Jim H.J. Liu, EVP Head of Risk Management Division, HNFHC Dec. 31, 2003 “It’s the best of times and it’s the worst of times.”

2. Table of Contents (1) Risk vs. Return Tradeoff (2) Scope of Risk Taking (3) How Do We Approach the Task of Integrated Risk Management at Hua Nan? (4) Implementation of Basel II and Risk Management in Taiwan (5) Concluding Remarks

3. (1) Risk vs. Return Tradeoff • At last the Efficiency Frontier is also at play in financial services industry • A financial institution (FI) is paid to take risks • Risk is more than just a defensive mechanism; it is also a source of a FI’s competitive advantage • Know Thyself: Risk-Adjusted Rate of Return (or RAROC) and Economic Value Added (or EVA)

4. (1) Risk vs. Return Tradeoff • RAROC is defined as returns divided by risks • Cash is the King: EVA • EVA = EP = Accounting profits – Capital charge = AP – Allocated risk capital × Weighted-average rates of return • Risk capital is determined by risks

5. (2) Scope of Risk Taking • Across business units: commercial bank, brokerage, property and casualty insurance (P&C), investment management, bills finance, venture capital, investment management consulting, insurance brokerage, futures trading, life insurance, AMC.

6. (2) Scope of Risk Taking • Across geographic areas: inside or outside of Taiwan. • Across the nature of risks: Market risk, credit risk, operational risk, liquidity risk, legal risk, reputational risk. • A unifying risk measure: Value at Risk • Expected loss (EL) as against unexpected loss (UL)

7. (3) How Do We Approach the Task of Integrated Risk Management at Hua Nan? • EP = AP – Risk Capital × WACC ---> FTP, ABC, ALM / Capital allocation according to risk types (market risk, credit risk, and operational risk, etc.) / Profitability Analysis (PA) • Oracle’s OFSA system, FTP, PA, ALM

8. (3) How Do We Approach the Task of Integrated Risk Management at Hua Nan? • Capital allocation scheme will be rolled out as part of Basel II implementation • Current state of market risk measurement and management • Current state of credit risk measurement and management • Current state of operational risk measurement and management

9. (4) Implementation of Basel II and Risk Management in Taiwan • Internal Rating-Based Model (IRB), especially the Advanced version, though strongly encouraged by BOMA, is probably too much of a task to ask of our FHCs • Too complicated even for the USA FIs

10. (4) Implementation of Basel II and Risk Management in Taiwan • Our reservations 1. Non-existence of many basic tools and data 2. Administrative guidance aplenty, unsatisfactory state of corporate governance and inadequate organizational structure for banks

11. (4) Implementation of Basel II and Risk Management in Taiwan 3. Qualified and experienced risk professionals (especially risk managers) in serious shortage • Supervisory review and market discipline

12. (5) Concluding Remarks • Building risk management framework will be a multi-year efforts • It will transform banking industry as is currently perceived. • It will make financial services industry much modern and stronger • Will contribute to more M&As • Consumers of financial services will benefit