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Session I Motivation / Need for Risk Management / Lessons from Financial Disasters

Session I Motivation / Need for Risk Management / Lessons from Financial Disasters. Dr. Peter Kandl March 19, 2007. Objectives. Comprehend the need for risk management Understand topology of risks Lessons learned from case studies. The need for risk management. Why risk management?

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Session I Motivation / Need for Risk Management / Lessons from Financial Disasters

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  1. Session IMotivation / Need for Risk Management / Lessons from Financial Disasters Dr. Peter Kandl March 19, 2007

  2. Objectives • Comprehend the need for risk management • Understand topology of risks • Lessons learned from case studies

  3. The need for risk management • Why risk management? • Every business is about managing risks • What is risk management? • Process, by which various exposures are identified, measured, controlled and if deemed to high, mitigated • What is exactly risk? • Negative deviation of a planned (expected) outcome • Volatility of unexpected outcomes • ...

  4. Business risk • The risk that corporations are willingly to assume to create competitive advantage and shareholder value • Pertains to particular product market, in which a firm operates • Includes technological innovations, product design, marketing activities • Judicious exposure to business risk is a core competency of all business activity

  5. Non-business risk • Other risk, over which firm has no control • Includes strategic (environmental) risk • Results from fundamental shifts in economy or political environment • Difficult to hedge (diversification across business lines and different countries)

  6. Financial risk • Risk to incur losses in financial markets • due to e.g. interest rate movements, equity market downturns, ... • Exposure to financial risk • should be optimised carefully and • is part of a business strategy • Allocation of resources to managing business risks („core competence“) • Primarily function of financial institution is managing financial risk actively • Assume, intermediate or advise on financial risks • Is part of their core activity (“products”)

  7. Sources of risk • Human-created • Business cycles, inflation, changes in government policies, wars • Natural phenomena (disasters) • Earthquakes, hurricanes, flooding • Long-term economic growth • Technological innovations

  8. How to live with risks? • Risk and willingness to take risks are essential to the growth of our economy • Finance / insurance industry create markets to share risks • Financial markets cannot protect against all risks • “Safety nets” can be thought as service provision of government (forced participation of individuals), where markets fail to take and share the risks

  9. Financial Industry - Banks Retail Asset Management / Private Banking Banks Payment system Securities houses / Investment banks

  10. Financial Industry - Insurance Life Insurance Non-Life Reinsurance

  11. Types of financial risks – market risk • Arises from movements in the level or volatility of market prices • Directional risk relates to movements of direction of financial variables (stock prices, interest rates, exchange rates, commodity prices) • Non-directional risks relates to non-linear exposures or exposures to hedged positions or to volatilities • Second-order or quadratic exposures (options) • Basis risk (hedged positions) • Volatility risk (actual or implied) • Controlling: Limits on exposures

  12. Types of financial risks – credit risk • Counterparties unwilling or unable to fulfil contractual obligation • Effect is measured by the cost of replacing cash flows in the event of default, encompasses • Exposure (amount at risk) • Recovery rate (proportion paid back to the lender) • More general: • Potential loss in the mark-to-market value due to a credit event (change in the counterparty’s ability to perform its obligation

  13. Credit risk (cont‘) • Sovereign risk: • Impose foreign-exchange controls (impossibility for counterparties to honour their obligation) • Settlement risk: • One counterparty makes payment whereas other defaults (Herstatt Bank)

  14. Credit risk (cont’) • Credit exposures of traditional instruments (bonds, loans): • Face value • Credit risk of derivatives (e.g. swaps): • Involves detailed analysis of market risk interacting with credit risk (exposure changes with time) • Controlling • Limits on Notionals, Credit lines • Limits on current and potential exposures • Credit enhancement features (e.g. collateral of marking to market)

  15. Liquidity risk • Asset liquidity: transaction cannot be conducted at prevailing market prices due to the size of the position relative to normal trading lots • Funding liquidity (cash flow risk): inability to meet payments obligations. Interacts with asset liquidity risk if portfolio contains illiquid assets that must be sold at less than market value. • Controlling: • Asset liquidity: setting limits on certain markets or products and by means of diversification • Funding risk: proper planning on cash flow needs (limits on cash flow gaps) and early consideration of how new funds can be raised

  16. Operational risk • Arises from human and technological errors or accidents • Includes fraud, management failure and inadequate procedures and controls • Can lead to market and credit risk • Model risk: model used to value positions is flawed • Protection / Controlling: • Redundancies of systems • Clear separation of responsibilities with strong internal controls • Regular contingency planning and testing

  17. Legal risk • Arises when a transaction proves unenforceable in law • Related to credit risk (counterparties may find legal grounds for invalidating transaction) • Controlling: • Policies developed by institution‘s legal counsel in consultation with risk managers and senior management • Ensure that agreements with counterparties can be enforced before any transaction

  18. Integrated risk management • Market-based methodologies are extended to measure integrated market and credit risk • Measurement of operational risk by actuarial methods (developed by the insurance industry), focus on distribution of losses from historical experience • Goal: measure all financial risk on a integrated basis

  19. Digression Risk Map for Insurers Total risk Underwriting risk Market risk Credit risk Operational risk Non-Life specific underwriting risks Interest rate risk Issuer Default Legal risk Premium risk Compliance risk Equity risk Reserve risk Reinsurer Default Life specific underwriting risks Model risk Foreign Exchange risk Longevity risk Parameter uncertainty risk Spread risk Morbidity risk (disability, illness) Business risk Liquidity risk Mortality risk Expense risk Lapse risk

  20. Valuation and risk management

  21. Large historical losses • Dec 2001: Enron ($31.2bn) ROGUE MANAGERS / FRAUD • CEO Kenneth Lay, CFO Andrew Fastow and other top executives inflated revenues and dissimulated losses with creative accounting while making fortunes from allocating themselves fat bonuses and from selling their shares. • Jun 1996: Sumimoto ($2,6bn) ROGUE TRADER / FRAUD • Unreported losses over 3 years of copper trader Yasuo Hamanaka • Feb 1995: Barings ($1,6bn) ROGUE TRADER / FRAUD • Unreported losses over 2 years of Nick Leeson led to bankruptcy • July 1995: Daiwa ($1,1bn) ROGUE TRADER / FRAUD • Toshihide Iguchi, at Daiwa Bank in New York, fiddled with confirmations to sell off securities owned by clients. Unreported losses over 11 years by rogue trader led to insolvency.

  22. Large historical losses (cont'd) • Sep 1996: Deutsche Morgan Grenfell ($720m) • Fund manager breaches guidelines; IMPROPER PRACTICES Deutsche Bank compensates investors. • Feb 2002: Allied Irish Bank ($750m) ROGUE TRADER / FRAUD • FX trader John Rusnak accumulated losses on the spot and forward $/¥ market, hiding them by recording fake options offsetting his exposure. For liquidity, he wrote deep in-the-money options without recording them. • Jan 2004: National Australia Bank (US$277m) ROGUE TRADERS • Four traders masked the losses they had incurred since Oct03 on huge positions on the AUD with the help of fictitious trades.

  23. Lessons from recent losses • Losses attributed to derivatives grew sharply in the past 15 years • Incidents caused by a combination of exposures to several risk types and some “stressed factors” (catalyst) • In some instances lack of derivatives increase risks or funding costs (can be used for hedging purposes) • Losses attributed to derivatives • Orange County: Reverse repos (Loss: 1,810 million $) • Metallgesellschaft: Oil futures (Loss: 1,340 million $) • Barings (U.K.): Stock index futures (1,330 million $)

  24. Case studies Risk factors in losses

  25. Exercise / Homework • Write a summary report (audit report) of one past incident (2-3 pages) • Describe the business of the company in short • Describe the culture, sophistication of controls and environmental factors (corporate policy, ethical aspects) that the company was operating in • Describe the risk types that the company was exposed to at the time of the break-down • Explain, why the incident happened, what the ultimate cause was and if early warning signals (could) have been observed • Explain, what type of controls broke down, were breached or were not in place • Deadline: Monday, 21 May 2007

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