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World Bank Risk Management Seminar Corporate Governance and ERM: A Framework for Integrating Risk and Performance Management May 21, 2004 Presented by: Richard C. Reynolds, PwC Partner. PricewaterhouseCoopers LLP. Agenda. Overview of Enterprise-wide Risk Management

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slide1

World Bank Risk Management SeminarCorporate Governance and ERM:A Framework for Integrating Risk and Performance ManagementMay 21, 2004Presented by: Richard C. Reynolds, PwC Partner

PricewaterhouseCoopers LLP

agenda
Agenda
  • Overview of Enterprise-wide Risk Management
  • Designing and Implementing an ERM Framework and Organization Structure
  • Impact of International Financial Reporting Standards on ERM
overview of coso erm framework
Overview of COSO ERM Framework

Framework

Application

Guidance

  • COSO ERM project launched in 2001 (PwC Authored)
  • Builds on COSO Internal Control Framework (PwC Authored)
  • Consists of conceptual framework and application guidance
why erm is important
Why ERM is Important
  • Underlying principles:
    • Every entity, whether for-profit or not, exists to realize value for its stakeholders.
    • Value is created, preserved, or eroded by management decisions in all activities, from strategy setting to operating the enterprise day-to-day.
  • ERM supports value creation by enabling management to:
    • Deal effectively with potential future events that create uncertainty.
    • Respond in a manner that reduces the likelihood of downside outcomes and increases the upside.
enhancing management capabilities
Enhancing Management Capabilities
  • Enterprise risk management provides enhanced capabilities to:
    • Align risk appetite and strategy
    • Link growth, risk and return
    • Enhance risk response decisions
    • Minimize operational surprises and losses
    • Identify and manage cross-enterprise risks
    • Provide integrated responses to multiple risks
    • Seize Opportunities
    • Rationalize capital
framework components
Framework Components

The Framework Has Eight Interrelated Components

the coso erm framework lays the foundation for organizations to advance erm
Improving shareholder value

Improving/maintaining credit rating

Economic capital savings

Improved risk management strategy

Closer working relationship between Finance & Risk functions

Alignment of individual’s compensation to risk-sensitive behaviour

Improved MI in other related areas

Cost reduction through organisational realignment and/or process improvement

The COSO ERM Framework lays the foundation for organizations to advance ERM.

Opportunities

Ensure market understands risk adjusted performance

Set value targets to satisfy investor and analyst expectations in line with well articulated risk appetite

Strategyselection

Investor andcredit rating agency

communication

Capitalallocation

Value and risk

managementprinciples

RewardSchemes

Performancereporting

Set performance measures to drive creation

Link executive remuneration to value creation to align management and shareholder interests

slide8
Leading organizations have many building blocks in place. The challenge is in creating seamless connectivity top to bottom.

SVA / Risk Adjusted

Performance Measurement

  • Link risk adjusted performance measurement to shareholder value and planning processes
  • Align performance measures with desired behavior
  • Rebalance, hedge the portfolio (capital optimization)
  • Correlation, VaR, marginal contribution

Active PM

  • Manage concentrations through limits
  • Establish allowances (capital preservation)

Portfolio Risk

Traditional PM

  • Portfolio reporting and analysis
  • Aggregation of exposure (notional & risk adjusted)
  • Analysis of Loss & default experience
  • Data management / MIS

Portfolio Risk Identification

Linking the Building Blocks

  • Relationship profitability analysis
  • Risk adjusted pricing (value creation - MTM / RAROC)
  • Structuring individual transactions
  • Allocation of limits to clients / products

Transactional risk management

Transaction Risk

  • Risk Assessment
  • Risk Modeling
  • Pricing Analysis
  • Client, Industry and Market information

Transactional risk identification

Data Management

  • Data acquisition, maintenance and distribution
slide9
However, beyond financial risks, executives have a much different view as to what are the most significant risks.

Non-Financial Risks

Financial Risks

Reputational Risk 53%

Regulatory Risk 28%

Operational Risk 24%

Political/external risk 11%

Credit Risk 34%

Market Risk 23%

How important are the following risks to your institution’s financial services business? (percentage of respondents rating each risk as the biggest their organization faces)

  • Source: Economic Intelligence Unit and PricewaterhouseCoopers survey of 160 senior financial executives
leading organizations are moving towards an integrated approach to governance risk and compliance
Leading organizations are moving towards an integrated approach to governance, risk and compliance.

Governance

Determining

Objectives

and Knowing

We Are Executing Appropriately

Enterprise Risk Management

Identifying Risks That May Affect Our Ability to Achieve Objectives

And Determining How to Respond

Compliance

Executing as Expected To Support Achievement of All Objectives

slide11
They are also implementing frameworks that deliver integrated profitability and risk information for decision making…

Best Practice Methodologies for Managing business functions

Achieving operational excellence

Market

Op.

Cost

Credit

Revenue

Profitability

Risk

Business Unit Level

Customer Level

Product Level

Legal Entity Level

Organizational Level

Risk-adjusted Performance

Shareholder Value Drivers

Enabling consistent business management

Integrated Planning

Cycle

Tactical, operational

and strategic

decision support

Achieving Strategic Excellence

Shareholder Value Creation

and support forward looking analysis for strategic planning
…and support forward looking analysis for strategic planning.

Scenario analysis

Earnings Sensitivity

Complexity Modeling

Market

Op.

Cost

Credit

Revenue

Profitability

Risk

Business Unit Level

Product Level

Customer Level

Legal Entity Level

Organizational Level

Risk-adjusted Performance

Shareholder Value Drivers

Impact on future earnings and Shareholder Value

slide13

Risk measures are aligned with both control objectives and value creation targets to provide management a dynamic view of current financial results and risks to the strategic plan.

Types of Measures:

Value Metrics– financial and non-financial measures that demonstrate value creation for investment community

Value

Metrics

Focus:

Strategy

Dashboard

Corporate Dashboard – provide management with insight into actions that need to be taken to achieve strategy

Key Risk Indicators*

Leading/Risk Indicators – identify systemic issues or causal factors related to strategy; and they are tactical and predictive

Key Risk Indicators

Leading Indicators

(Proactive)

Escalation Triggers – are reported after a predetermined trigger is tripped, they are designed to facilitate management intervention prior to day-to-day risks manifesting beyond an expected or acceptable tolerance.

Escalation Criteria

(Reactive)

Focus:

Steady

State

Lagging Indicators

Lagging Measures– are after the fact

Transactions and Data

* PwC defines key risk indicators as measures that can be collected atANY time during the period as required by management

slide14

Strategic risk management focuses on balancing capital optimization with capital preservation.

Transaction

Relationship

Line of Business

Portfolio

Enterprise

Capital Optimization

Analyze

Structure

Measure

Monitor

Report

Capital Preservation

Too often, the pendulum swings; towards lax controls and overly aggressive risk taking in good times, and overly restrictive controls and risk aversion in bad times.

slide15

We have utilized the following framework with several leading financial institutions to gain better role clarity, particularly around the integration of strategic, financial and risk management planning.

Validate/refine strategy

Business

Cycle

Business Strategy

and Planning

Business Process

and Execution

Evaluation

  • Business mission and strategy
  • Value proposition and risk appetite
  • Organization and governance
  • Business planning and budgeting processes
  • Capital allocation and balance sheet management
  • Business and individual performance objectives
  • Risk policies and procedures
  • Risk measurement methodologies
  • Risk-based pricing and customer profitability
  • Risk aggregation and reporting
  • Active portfolio and balance sheet management strategies
  • Value drivers
  • Internal reporting
  • Performance measures
  • External disclosure

Procedures

Analysis

Limits

Key

Controls

Capital

Policy

Reporting

Re-allocate capital/limits

Risk Management Systems Infrastructure

erm is a key enabler of value creation and preservation
ERM is a key enabler of value creation and preservation

Value

Risk

Trust

Transparency

Performance

Reputation

Brand

Value is created, preserved, or eroded by management decisions, from strategy setting to operating the enterprise day-to-day.

agenda1
Agenda
  • Overview of Enterprise-wide Risk Management
  • Designing and Implementing an ERM Framework and Organization Structure
  • Impact of International Financial Reporting Standards on ERM
slide18

A thorough understanding of your business objectives is critical to designing an infrastructure that meets your specific needs and fits within your culture and environment.

Environment

Environment

Environment

Environment

Infrastructure

Infrastructure

Process

Process

Strategy

Strategy

Business Missionand Strategy

Validation/

Validation/

Reassessment

Reassessment

Risk Strategy

Value Proposition

Risk Appetite

Risk

Risk

Risk

Risk

Value

Value

Measurement

Measurement

Assessment

Assessment

Operations

Operations

Awareness

Awareness

Evaluation

Evaluation

and Control

and Control

and Action

and Action

Organization

Organization

Limits &

Limits &

Methodologies

Methodologies

Systems

Systems

Data

Data

Policies

Policies

Reporting

Reporting

& People

& People

Controls

Controls

Communi

Communi-

-

-

Performance

Performance

Culture

Culture

Training

Training

Rewards

Rewards

cations

cations

Measures

Measures

Enterprise-wide Risk Management Framework

the starting point is to define a clear mission statement for the corporate risk manager
The starting point is to define a clear mission statement for the Corporate Risk Manager.

Key themes in a Mission Statement of the Corporate Risk Manager

  • Protect the franchise
  • Avoid surprises, no unexpected losses
  • Acknowledge the sources of earnings volatility
  • Facilitate risk taking
  • Support efficiency of capital usage and performance evaluation processes
  • Mold the risk culture
    • Partner with the business
    • Build a risk management network
  • Report v. manage
  • Devolve risk management from the corporate level into the business units
slide20
The mission must balance the risk management objectives and the complexity of the risks assumed by the organization.

E

I

D

L

B

C

J

K

F

G

H

A

M

Your Company????

Risk Management Styles

  • Strategic:
  • Assist in molding views of regulators
  • Frequent global stress testing to analyze potential impacts of market events
  • Risk Management partners with the business in decision-making
  • True understanding of positions and risks
  • Development and analysis of risk-adjusted returns
  • Control Focused:
  • Respond to requests by regulators
  • Quarterly stress testing at the desk or business unit level (to meet regulatory requirements)
  • Risk Management performs a purely limit monitoring role
  • Monitoring of positions and risks against limits

Strategic

Risk Management Style

Control Focused

Simple

Complex

Risk Profile

slide21
The next step is to define the overall approach for corporate risk management. Below is an illustration of a risk management framework.

Risk ControlFramework

Limits

  • The allocation of capital to the business units:
  • signifies approval of the business plan
  • serves as an overall limit on risk taking activities
  • provides a benchmark for required returns

Capital

  • Risk management policies and procedures:
  • define and set the standards for Client risk taking activities
  • set parameters for permissible risk taking
  • clearly define roles, responsibilities and accountabilities

Procedures

Re-allocate capital/limits

Policy

  • An effective risk and performance reporting framework:
  • provides timely feedback to evaluate the business strategy
  • effectively communicates risk, elevates awareness and promotes consistency and transparency
  • ensures monitoring of policy compliance

Analysis

Reporting

slide22

Integrating risk into the strategic planning and budgeting process is also key. Annual business plans form a contract with shareholders for the management of capital and required returns.

Annual Business and Risk Management Planning Process

Business Units

Formulate

  • Annual Business Plan
  • Strategy
  • Product and service offerings
  • Capital budget
  • Forecasted absolute and risk adjusted returns
  • Key risks and limits
  • Infrastructure weaknesses and action plans
  • Other information

Shareholders

Total Return

Financial Control

Assist

Capital

Corporate Risk Management

Approve

slide23

ERM reports should clearly articulate the nature of the business, including key risks, profitability, the risk-reward relationship and the impact of external events.

  • RISK REPORTING OBJECTIVES:
  • Do we acknowledge, understand and articulate our risks clearly, accurately and comprehensively?
  • Are these risks aligned with our stated risk appetite and strategy?
  • Are we being adequately compensated for these risks?
  • Are we overly reliant on any revenue, risk or other concentrations that could adversely impact the quality or sustainability of earnings?
  • What is the quality and sustainability of our earnings stream?
  • What is the impact of the current and potential external environment on our business?
slide24
An effective ERM reporting framework should address the daily, monthly and quarterly objectives of the target risk management audience.

Enterprise-Wide Risk Reporting Framework

  • Risk Reporting Objectives:
  • Heighten Awareness and Transparency of ALL Risks
  • Include Quantitative and Qualitative Information
  • Promote Shareholder Value Creation

Daily Risk Summaries

Monthly Risk Packages

Quarterly Risk Package

  • Key Objectives:
  • Identify risk issues that require immediate attention and potential management action by reviewing:
    • limit excesses
    • risk concentrations
    • P&L changes
    • market/credit/operational risk events
  • Target Audience:
  • Business, Line and Risk Managers
  • Contents:
  • Detailed market risk
  • Selected credit, liquidity, valuation and operational risk metrics and issues
  • P&L attribution analysis
  • Scope:
  • Desk level
  • Key Objectives:
  • Reaffirm risk appetite, business propositions and boundaries by assessing:
    • risk profile
    • performance
    • internal and external business environment and risk implications
  • Target Audience:
  • Senior Management
  • Contents:
  • Summary market risk
  • Detailed credit, liquidity, valuation and operational risk
  • Trend analyses
  • Business and market outlook
  • Scope:
  • Business units globally
  • Key Objectives:
  • Promote shareholder value creation by evaluating:
    • capital/resource allocation decisions
    • earnings reliability and sustainability
    • short and long term business opportunities and their risks
  • Target Audience:
  • Executive Management
  • Contents:
  • Summary of all business and customer risks
  • Risk-adjusted performance measurement
  • Trend analyses
  • Business and market outlook
  • Status of key initiatives
  • Scope:
  • Global Markets consolidated
an illustration
An Illustration….

$MM

Economic Capital

Marginal Capital

Revenue Quality

Return on Economic Capital

Revenue/Expense

2002

Last 12 m

2002

Last 12 m

2002

Last 12 m

2002

YTD

Commercial

90.6

66.0

22.4

25.4

3.0

4.6

263%

459%

2.5

Personal

147.0

156.7

130.5

134.6

1.3

1.3

115%

149%

2.5

Life and Annuities

49.1

46.2

33.7

34.8

4.9

5.1

506%

549%

3.3

Investments

60.8

63.4

35.1

20.6

1.9

1.6

111%

93%

1.7

Banking

63.1

94.5

(20.5)

8.3

0.5

0.9

40%

110%

2.0

Treasury

30.7

17.3

7.7

(0.5)

0.3

0.4

21%

40%

2.0

International

298.4

306.1

249.3

268.8

(0.0)

0.1

0%

24%

2.0

TOTAL

458.3

491.9

458.3

491.9

1.9

1.9

138%

181%

2.0

Economic Capital represents capital needs based on monthly revenue volatility of each business. The higher the volatility of a business’ revenues the higher the economic capital required for the business (annualized monthly revenue volatility x 2.33).

Marginal Capital represents the relative contribution of each business to the total capital of the Fixed Income business. It takes into account diversification/correlation effects across businesses (2.33* 12-month Revenue volatility *Correlation).

Revenue Quality is the ratio between average monthly revenue and monthly revenue volatility. It provides an assessment of the quality and sustainability of earnings over time. The higher the ratio, the better the quality of earnings.

Return on Economic Capital measures risk adjusted profitability across businesses. YTD return on capital represents YTD annualized revenue divided by last 12 months economic capital.

Revenue/Expense Ratio measures the degree of operational efficiency. These ratios were estimated based on 1997 financial performance.

Commercial

slide26

To implement ERM, a clear line between the responsibilities and accountabilities of the corporate risk manager and the business unit risk managers must be drawn.

Degree of Decentralization in Risk Management Approach

Business Unit Risk Managers

Corporate Risk Manager

Credit Cards

ConsumerLoans

Treasury

International

  • Set standards
    • Policies
    • Corporate data requirements
    • Reporting to business managers, senior management and the Board
    • Risk measurement
  • Aggregation of common risk factors across business lines
    • Scenario analysis / Stress testing
    • Limit Setting
  • Macro assessments of the risk profile and the drivers of change (Windows on Risk)
  • Capital allocation methodology, calculations and decisions
  • Support management of stakeholder relations
  • Risk identification
  • Communicate key risk factors
  • Risk aggregation by risk factor within the business line
  • Adhere to reporting and other standards
  • Proactive implementation of appropriate policies and procedures
  • Support decisions regarding new products, new businesses and new geographies
slide27

Some of our clients employ a decentralized approach that includes company-level standards, endorsed by the board, with business-specific delegations and accountabilities.

Board of Directors

  • Provides broad, independent oversight of Company activities
  • Endorses Company Risk Management Standards and acknowledges aggregate Group risk profile

BoD Audit Committee

  • Reviews unintended exposures/risks that result from control weaknesses, process fails or other shortcomings

BoD Risk Management Committee

  • Reviews risks consciously taken through business decisions and plans
  • Reviews the overall Company exposure/risk profile, risk appetite, and risk capacity
  • Reviews Company Risk Management Standards

Corporate Risk Management

  • Establishes Company Risk Management Standards
  • Approves broad Company risk parameters and limits; allocates risk limits to businesses
  • Approves business-specific risk management standards and practices and endorses the risk management culture embedded in those standards and practices
  • Maintains overall accountability and authority for the adequacy and appropriateness of all aspects of the Company risk management process

Business Risk Management

  • Establish business-specific risk management standards, policies and practices for the approval, measurement, reporting, monitoring, limiting and analysis of exposure/risk
  • Establish business-specific risk limits within allocated capital levels
  • Board of Directors
  • Audit Committee
  • Risk Committee

Office of the

Chairman

Corporate Risk Management

InvestmentRisk

Underwriting

Risk

Operat-ionalRisk

Asset/ Liability Risk

Risk

Capital

Business Risk Management

P&C

Life

International

Treasury

slide28

The business units are responsible for establishing a comprehensive risk organization within their businesses that interacts with other risk management and support groups.

Corporate Audit

To be defined

  • Market Risk
  • Credit Risk
  • Insurance Risk
  • Operational Risk
  • Country Risk

Business Units

Corporate Risk Management

Financial Control

Other Support Groups

Business

Operations

Global Risk Managers

To be defined

Operations & Technology

Business Unit Risk Managers

Legal and Compliance

Financial Control

Human Resources

Risk Architecture

Other Support Groups

Tax

Other

slide29

The business units, financial control, corporate risk and audit should have clearly defined, collaborative roles supported by appropriate infrastructure elements.

Formulate

Formulate

Manage

Manage

Validate

Request

Request

Formulate

Formulate

Reconcile

Review

Approve

Facilitate

Manage

Review

Request

Review

Review

Review

Produce

Review

Review

Facilitate

Formulate

Analyze

Approve

Approve

Analyze

Approve

Approve

Review

Review

Test

Test

Review

Review

Review

Test

Test

Test

Validate/refine strategy

Evaluate

Set Strategy

Budget/ Plan

Execute

Control

Business

Cycle

Business Units

Financial Control

Corporate Risk Management

Corporate Audit

Procedures

Analysis

Limits

Key

Controls

Capital

Policy

Reporting

Re-allocate capital/limits

Risk Management Infrastructure (O&T, HR, Legal, Compliance, Tax, other)

agenda2
Agenda
  • Overview of Enterprise-wide Risk Management
  • Designing and Implementing an ERM Framework and Organization Structure
  • Impact of International Financial Reporting Standards on ERM
why talk about ifrs
Why talk about IFRS?
  • Many non-US banks move to IFRS
  • Similar to US GAAP – often subtle yet important differences
  • No more avoiding of “difficult” accounting
    • Interest Method
    • Hedge Accounting
    • Impairment
  • Implementation: new accounting, systems, data requirements
ifrs and risk management
IFRS and Risk Management
  • Spotlight on transparency – more detailed analysis and disclosures on:
    • Concentrations of risk
    • Sensitivity of cash flows to risk scenarios and market variables
  • Failure to manage earnings and investment risks associated with IFRS could seriously undermine financial stability and credibility
  • IFRS will have an impact on credit, funding and liquidity risks
  • IFRS will have extra demands on data capture, modelling and other information systems
  • Complying with IFRS will be fraught with potentially costly pitfalls
  • A broader and more integrated approach to risk management could help companies to turn IFRS compliance into shareholder value
ifrs key aspects for banks
IFRS - Key Aspects for Banks

Expected IFRS impact – Relevant accounting issues

  • Financial statement presentation – Flows and disclosures
  • Fair value of financial instruments
  • Investment securities – Classification and transfers
  • Impairment (investments, loans, other assets)
  • Hedge Accounting
  • Provisions – Recognition criteria
  • Income and expense recognition – interest and commissions
  • Deferred taxes
  • Other complex issues?
impact of ias ifrs on consolidated financial statements
Impact of IAS/IFRS on consolidated financial statements

+

Financial Instruments

(IAS 39/ IAS 32)

Investments/ consolidation

(IAS 27/28, SIC 12)

Provisions

(IAS 37)

Financial Impact

Business Combination (IAS 22)

Impairment and intangibles (IAS 38/IAS 36)

Commissions (IAS 18)

Deferred taxes (IAS 12)

Financial statements and cash flow

(IAS 1, 30 et 7)

Segment Information

(IAS 14)

Property, plant and equipment

(IAS 16)

Employee Benefits

(IAS 19)

-

-

+

Complexity of implementation

expected ifrs impact business impacts
Expected IFRS Impact – Business impacts
  • Overall Business Impacts
  • Volatility of earnings
  • Difficulty in forecasting and budgeting
  • Product profitability/design
  • Regulatory compliance
  • Performance measurement and reporting
  • Tax planning strategies
  • Debt covenants
  • Share-based compensation plans
  • Transparency

+

Financial Impact

-

-

+

Complexity of implementation

top 15 implementation issues
Top 15 implementation issues
  • Shareholder and analyst understanding
  • Understanding and analysing impact on financial performance
  • Commitment and involvement at all levels of the organisation
  • Significant resources required
  • Underestimation of the amount of work involved
  • Costly and time consuming to embed into the organisation
  • Data availability and system requirements
  • Re-alignment of management information reporting / systems
  • Co-ordination with regulator reporting requirements
top 15 implementation issues1
Top 15 implementation issues
  • Training (“Knowledge transfer”) of management as well as finance functions in all locations
  • Regulatory environment continues to change
  • Risk management
  • Earnings management
  • IAS continues to evolve
  • Minimal expertise
slide38

This document is protected under the copyright laws of the United States and other countries as an unpublished work. The document contains information that is proprietary and confidential to PricewaterhouseCoopers LLP, which shall not be disclosed outside of the recipient's company or duplicated, used or disclosed, in whole or in part, by the recipient for any purpose other than to review the document. Any other use or disclosure, in whole or in part, of this information without the express written permission of PricewaterhouseCoopers LLP is prohibited.

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