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ERM in Banking

ERM in Banking. James Lam President, James Lam & Associates. Sponsored by Casualty Actuarial Society and Society of Actuaries July 28-30, 2003. James Lam’s biography. Professional President, James Lam & Associates Founder and President, ERisk Partner, Oliver, Wyman & Company

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ERM in Banking

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  1. ERM in Banking James Lam President, James Lam & Associates Sponsored by Casualty Actuarial Society and Society of Actuaries July 28-30, 2003

  2. James Lam’s biography Professional • President, James Lam & Associates • Founder and President, ERisk • Partner, Oliver, Wyman & Company • CRO, Fidelity Investments • CRO, Capital Markets Services Inc., a GE Capital company Industry Activities • PRMIA Blue Ribbon Panel Member • GARP 1997 Financial Risk Manager of the Year • Published over 50 articles and book chapters • Quoted in Wall Street Journal, Financial Times, and CFO Magazine Academic • Adjunct Professor of Finance, Babson College • Lectured at Harvard Business School as the subject of a HBS case study • MBA, UCLA School of Business • BBA, Baruch College Recent Clients • The World Bank • Salomon Smith Barney • Allied Capital • Risk Management Association • First Data Corporation • GMAC

  3. New book on ERM

  4. Discussion outline • The business case for ERM • Lessons learned and best practices • ERM going forward – 10 Predictions

  5. Financial Risks Credit Risk Associated with Investments Kobe earthquake and Nikkei fall MarketRisk Asset Liquidity CreditRisk LiquidityRisk Credit Risk Associated with Borrowers and Counterparties Loan document and credit loss severity Funding Liquidity September 11 impact on operations Risks and linkages Enterprise-Wide Risks FinancialRisk EventRisk OperationalRisk

  6. Enron • WorldCom • Tyco Corporate Disasters • Banks • Asset Managers • Energy Forms • Corporations CorporatePrograms RegulatoryActions • Sarbanes-Oxley • SEC Initiatives • Basel II • Treadway Report, US • Turnbull Report, UK • Dey Report, Canada IndustryInitiatives Key risk trends EnterpriseRiskManagement

  7. The Wheel of Misfortune

  8. Benefits of risk management

  9. Companies must identify, measure, and manage the underlying sources of earnings volatility CEOs face a challenging environment • Pressure on sales and earnings • Unforgiving stock market • SEC crackdown on "earnings management" • New legislative, regulatory, and accounting requirements • More demanding boards and outside analysts

  10. Discussion outline • The business case for ERM • Lessons learned and best practices • ERM going forward – 10 Predictions

  11. 1. Corporate Governance Establish top-down risk management 3. Portfolio Management 4. Risk Transfer 2. Line Management Transfer out concentrated or inefficient risks Business strategy alignment Think and act like a “fund manager” 6. Data and Technology Resources 5. Risk Analytics Develop advanced analytical tools Integrate data and system capabilities 7. Stakeholders Management Improve risk transparency for key stakeholders Establishing an ERM framework ERM Framework

  12. Goal:Target State Risk Management Year 1 Year 2 Year 3+ Now Develop data modelsand systems capability Early warningindicators Credit policy framework established – key credit policies approved Automated reporting Active portfolio management Ad hoc reporting CreditRisk Transactional process alignment Establish market risk controls Develop portfolio stress-testing Enhance frameworkand policy Year 3+ Align insurance programs Align reportingwith policies Develop stress-testingand response plan Integrate risk managementinto business processes` Create integrated risk reportand success measures Market risk methodologies Establish organiza-tional responsibilities Evolve risk culture through awareness,training and incentives Year 2 Define framework and policy Develop risk metricsand reporting MarketRisk Operational reliability models and business objectives in place Establish CRO Apply economic capitalas common risk unit Define frameworkand policy Define risktolerance Align withstrategy Year 1 ERMconcept introduced – support from board and management Business & OperationalRisk Now Enterprise-WideRisk Management(Integration) Establish a vision and a roadmap Unique workplans are developed for each deliverable milestone

  13. Risk taxonomy (a common language)

  14. Hard Side Soft Side • Measures and reporting • Risk oversight committees • Policies & procedures • Risk assessments • Risk limits • Audit processes • Systems • Risk awareness • People • Skills • Integrity • Incentives • Culture & values • Trust & communication Balance the hard and soft side of risk

  15. Background 2-Year ERM Program • New capital markets business • Traders hired from foreign bank • Aggressive business and growth targets • Established risk policies and systems • Instilled risk culture • Survived “Kidder” disaster • Captured 25% market share with zero policy violations • Recognized as best practice Case study:

  16. Credit Risk Management Infrequent Catastrophic Losses Economic Capital (EC) Catastrophic Loss Protection Economic Capital Loss Rate ($) Expected Loss (EL) Average Loss Rate Expected Loss Frequent Low Losses Time Economic Capital Expected Loss • Anticipated average loss rate • Cost of doing business, cover through pricing and provisioning • EL = f(credit quality, collateral, structure) • Covers catastrophic losses • Risk inherent in business, cover through capital allocation and adequacy • EC = f(credit quality, collateral, structure, industry sector, maturity, credit rating)

  17. Change in Term Structure  Value Rate twist Change in value =  shift  Rate – ILLUSTRATIVE – Time Simulation Nonlinear Products Value vs Rate -300 bp +300 bp … … Product Balance Mortgage Distribution Deposits : – ILLUSTRATIVE – Market Risk Management Step 1: Analyze sensitivity of asset and liability value to changes in interest rates Step 2: Simulate changes in term structure of interest rates Step 3: Recalculate value of assets and liabilities (repeatedly)      Structural Position Cash Flow 6 mo 10 yr 30 yr 9 bps Step 4: Read EC from distribution of changes in AL values EC

  18. Operational Risk Management Education • New associates • Management • Business/Operational processes • Best practices • Lessons learned Actual Loss Experience Risk Event Log 85% Decline Root Controls Loss Event Causes Needed Risk Metrics Goal MAP

  19. Probability Change in Value Economic capital as common currency Credit Risk Market Risk Operational Risk • Credit Risk • Earnings volatility due to variation in credit losses • Market Risk • Earnings volatility due to market price movements • Operational Risk • Earnings volatility due to changes in operating economics (e.g. volume, margins or costs) or one-off events Enterprise-wide Risk

  20. Risk Management Impact • Risk-based pricing • Target customer selection • Relationship management  Revenue   - • Risk oversight costs • Insurance/hedging expense Expenses   ROE - Losses • Credit, market operational write-offs  Shareholder Value  • Capital management • Risk transparency  Equity  New Business • New business development  Growth M&A  • M&A/Diversification strategy • Risk Management by Silos (5, 6) • Integrated risk management (4–7) • Enterprise risk management (1-10) Value creation through ERM

  21. Measuring profitability and pricing Calculate ROE Calculate Pricing Exposure $100 mm $100 mm Margin 2.50% 2.20% Revenue $2.5 mm $2.2 mm Risk Losses <0.5 mm> <0.5 mm> Expense <1.0 mm> <1.0 mm> Pre-Tax Net Income $1.0 mm $0.7 mm Tax <0.4 mm> <0.3 mm> Net Income $0.6 mm $0.4 mm Economic Capital $2.0 mm $2.0 mm RAROC 30% 20%

  22.  Return • Pay cashflows or insurance premium • Include transaction and ongoing management costs • Reduce Economic Capital ‘benefit’ •  Economic Capital • Reduce Economic Capital held for risk • Increase Economic Capital counterparty exposure • Increase operating risk Economic Capital  Return Derivatives Ceded RAROC =  Economic Capital Structured Finance Insurance Rationalized risk transfer Common Cost/Benefit Framework Different Structures

  23. Background 3-Year ERM Program • $1 trillion of assets under management • Private company • Decentralized business culture • Organized Global Risk Forum • Implemented annual Global Risk Review • Built loss/event tracking system • Developed ERM framework • Implemented intranet-based Global Risk MIS • Experienced 30% reduction in loss ratio Case study:

  24. Discussion outline • The business case for ERM • Lessons learned and best practices • ERM going forward – 10 Predictions

  25. Ten Predictions • ERM will become the industry standard • CROs prevalent in risk-intensive companies • Audit committees will evolve into risk committees • Economic capital in; VaR out • Risk transfer executed at enterprise level • Advanced technologies key to advancement • A measurement standard will emerge for operational risk • Mark-to-market accounting becomes standard • Risk becomes part of corporate and college programs • Salary gap among risk professionals continues to widen

  26. Thank you James Lam’s contact information • Phone: 781-772-1961 • Email: jameslam@comcast.com

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