Crisis Sentiment Index Q4 2014 CRO Opinion

Copyright, 2013, The Governance Fund Advisors, LLC All Rights Reservedthe DCRO

Directors and Chief Risk Officers Group

Leaders in risk governance and value creation.

An updated assessment of globalfinancial and economic risk by chief risk

officers, board members, and c-suiteexecutives

Fourth Quarter 2014

The Crisis Sentiment Index

Copyright, 2014, The Governance Fund Advisors, LLC All Rights Reserved

Copyright, 2014The Governance Fund Advisors, LLC

All Rights Reserved

[email protected]+1-507-301-3149


The Crisis Sentiment Index (CSI)

On a quarterly basis, an assessment of globaland local risk conditions by members of theDirectors and Chief Risk Officers group (theDCRO), provides the data that drives theCrisis Sentiment Index (CSI).

For the fourth quarter of 2014, the CSIindicates that these board members, chief riskofficers, and other c-level executives remaincautious about global and local risk.

While there is some variation betweenregional assessments, with more optimismfound in the Asia/Pacific region and the mostpessimism found in the Middle East, overallsentiment can best be characterized as onethat reflects respondents who are looking forsome significant event to trigger anothercrisis. Or, perhaps more accurately stated,

there is a sense that if there is a trigger event,the world has an ample supply of issues thatcould cause swift and severe market andeconomic reactions.

This sentiment was revealed most clearly inthe CSI-Fear sub-index, where the readingwas on the upper edge of the crisis zone.

CSI-Credit, on the other hand, is suggestiveof an environment where credit is generallymore available and even nearing normalconditions. Individual comments suggestthat credit availability is often at a high priceand may be restricted by segment orborrower. However, this sub-index is closeenough to normal to be having little negativeimpact on the overall CSI reading.

Hot spots of concern includeRussia/Ukraine/Balkans, the Middle East inparticular, regions where ISIS is active, theEuropean, Chinese, and Japanese economies,and the high level of fear that is perceived.

Detailed comments from respondents arefound in the full report. Should you have anyquestions, please dont hesitate to contactme.

David R. Koenig

The survey was conducted between MondayNovember 3, 2014 and Thursday November6, 2014. Survey participants, 214 in total,typically hold the titles of Chief Risk Officer /Heads of Risk Management (57%), BoardDirector (28%) or other C-Level title (15%).Respondents come from 50 countries - 47%from the Americas, 37% from EMEA and16% from the Asia-Pacific region.

Executive Summary


Governors and managers of risk are charged,in one regard, with undersstanding risk andits potential impact on decision-making. Fearforces both inaction and over-reaction.Recently experienced risks cause people tosee risk everywhere. Further, since peopleoften cannot see what they have neverexperienced before, when an unseen risk isrealized it has a substantial impact onbehavior going forward.

It is this context in which mostenterprises have been operatingsince 2008. Six years on fromthe crisis that led to the GreatRecession, respondents to theCrisis Sentiment Index (CSI)survey see much about which toworry, often citing the potentialfor significant financial andeconomic disruption if a triggerevent is realized. Manypotential triggers for instabilitylurk at the edges of the financialsystem, [with] no clarity as towhen something might gocritical, said a Board Memberfrom North America, echoingthe comments of many.

According to respondents, there are itemswhich make our time of risk assessment farfrom normal and caution is, therefore, due.One North American C-level Executivedescribes the current environment as being

akin to driving a car at 90 miles-per-hour,with a broken headlight, leaky gas tank, andthe kids fighting in the back seat. Hecontinued, It feels incendiary and it onlytakes a spark to connect all the factors andlead to [a highly consequential] accident.

Likewise, a C-Suite Executive in NorthAmerica notes, general risk conditions arebeing affected by factors we were not used toconsidering as priorities in the past and the

adaption to this newenvironment is taking time.

But, the charge of riskgovernors, as well, is to helptheir organizations to make thebest use of risk capital, even indifficult times. So, the questionto be asked and answered is,are caution and preservationpresently the best use of scarcerisk capital?

The Crisis Sentiment Index forQ4 2014 remains in a regionadvising caution, but the storydoesnt end there.

The graphic at the top of this page shows themost common words used in comments leftby respondents a larger font is suggestiveof a greater frequency of appearance. Wordsrelated to the 2008 financial crisis and itsimpact continue to dominate comments.

Crisis Sentiment Index Report


These are the risks most recently realized in alarge and surprising way. An analogy onemight consider is the emotion of steppinginto a street and coming within inches ofbeing run over by a speeding bus. The factthat you did not see the bus coming and thatits physical impact on you would likely havebeen fatal will make you more cautiouscrossing streets in the future - looking for thenext bus,even if thestreet neverhas busseson it. It ishumannature. Saida NorthAmericanC-LevelExecutive,thenormalbaselinenow isdifferentfrom wherewe wereprior to the Great Recession.

In essence, those affected by the 2008 crisisshould be expected to see busses, taxis, evendriverless cars, to watch out for. And they do.

A Board Member in the Asia/Pacific regionrefers to our present state as global,unstable, equilibrium. He cites, multiplegeopolitical standoffs, very weak economicactivity in Europe and Japan, and elevatedlevels of debt everywhere.

Europes sclerotic economic growth has beenwith us for some time now. Theocraticviolence, in the Middle East, Pakistan, andother regions seems to be of growingconcern, particularly in terms of the probablyof a global acceleration of engagement orexternal action of a significant magnitude.Not unlike the fear of global entanglement inthe Middle East, Russias new-found anddeep-rooted nationalism being expressed viaaggressive rhetorical and military means isseen as eerily reminiscent of Soviet days,

with counterweights to such hegemonylighter than warranted. Said one EuropeanBoard Member, Having concentratedactivity in the Russian market for better than30 years, I have never witnessed such amassive grassroots pulling together, andrealigning of economic, national and culturalinterests into what may truly become a verystrong united front based on conservative

political andeconomicprinciples.

But, Russia isnot the onlylarge politicalentitydeployingrhetorical andmilitaryweaponry.Chinashighlyaggressiveactions in theSouth ChinaSea suggest

that it, too, has ambitions which it feels areunlikely to be challenged with sufficientconviction or might. And, if they are, theimplications are abundant and unsettling.And, of course, there is the U.S., whichroutinely engages in extra-territorial actionsand announced an intention to expand trooppresence in Iraq, all the while continuing itsmilitary pivot to the Asia/Pacific region(see previous concern).

Lets throw-in, on top of these four verylarge issues, concern over the impact of assetbubbles created by quantitative easing,unstable emerging market economies,cybercrimes which are growing in magnitudeand one gets a world that can easily seempretty scary - certainly in potential.

So, it should come as no surprise that theCSI-Fear sub-index in this quartersassessment is lurking at the top of the crisisregion (see details below). This means thatboth inaction and over-reactions are likely tobe seen. Said a C-Suite Executive in the


Crisis Sentiment Index (CSI) vs. Stock Indices(S&P 500 and FTSE World Index, Normalized to Q3 2009)

S&P 500

FTSE World

Asia/Pacific Region, the velocity of risk ismore alarming than risk, per se.

So what are the counterfactuals to thisnarrative? Or, rather, is this narrative itselfcounterfactual?

Since two years ago, U.S. equity prices areup in the range of 50%. Global equity indicesare up roughly the same amount. Gold priceshave fallenby morethan 30%.U.S.residentialreal estateprices areup morethan 20%.Residentialreal estateprices inGreatBritain andGermanyare up morethan 10%.In China, New Zealand, Australia, SouthAfrica, the story on residential real estateprices is the same, with gains of 10-15%.

Even in Italy, Spain, France, and theNetherlands, the loss in residential real estatevalues is less than 10%, while equity priceshave increased.1

The CSI improved over this time frame aswell, even reaching a new high this quarter.But, this improvement is not in lock-step norin proportion to some financial and economicmeasures and that divergence may bereflecting the source of expectations thatsomething might ignite a panic.

A chart of U.S. and Global equity indicesplotted against the CSI shows a growingdivergence since the markets bottomed in

1 See an interactive guide to global real estateprices using the following link:http://www.economist.com/blogs/dailychart/2011/11/global-house-prices

early 2009. Is this the asset inflation thatrespondents cite as a byproduct ofquantitative easing (QE) and loose monetarypolicy? Or, are the governors of risk stilllooking for the next bus on their street? Weknow that busses exist. But, is our feardisproportionate to the real threat?

According to the Q2 2013 CSI report fromnearly 18 months ago:

The NextCrisis isComingtheme wascommonamongrespondents.

Respondentsto the CSIreport are anintelligent andsuccessful lot.Thats one ofthe greatbenefits of theinsight we

receive each quarter. So, this question ofwhether fear and its impact on decision-making is at play in keeping CSI at acautionary level is not intended as a questionof participants savvy. As is sampled on thenext page, the comments left by respondentsthis quarter were overwhelmingly focused onthe potential for something very bad tohappen if the right trigger is pressed. Rather,its simply a prudent question to ask in thenormal process of governing risk at any time.DCRO member perspectives should not betaken lightly, particularly when thoseperspectives come from so many differentgeographies, industries, and experiences.

Not all respondents are cautious. Six percentof members say that we are in normaltimes the highest percentage yet. Said oneBoard Member from North America, webelieve that risk is a good thing and a normalpart of business. It is not elevated ordiminished at this time. Risk exists in amanner that is consistent with a marketorientation.


Additional comments

[There is] plenty of dry tinder for anothereconomic event of some kind. BoardMember, North America

There will be a truly global crisis of globalscale in making.....[its only a] matter oftime. Board Member, Asia/Pacific

Rather than stabilising, there remainnumerous competing uncertainties that coulddrive markets in the wrong direction, andtherefore lead to business pressures andfailures. Chief Risk Officer, Europe

The low interest rate environment continuesto make shocks more likely as investors reachfor yield. Chief Risk Officer, NorthAmerica

The Ukraine situation looks like it shalldevolve again into an expanded and hotconflict shortly, and Kyiv will of necessityforce the energy question onto the EU lapagain. The US and the EU will have todecide whether to cut their political andeconomic losses and disengage with Kyiv, orenter into a further more seriously negativeeconomic self-flaggelation. That and otherinvolvements and positions within the EU arepotentially disunifying game changers. Board Member, Europe

Eurozone is moving towards a recession.Geopolitical risks are elevating in EasternEurope and the Middle East. NPLs [non-performing loans] are at high levels in southeuropean banks. Chief Risk Officer,Europe

The economy - particularly in the US - isstabilized, not fixed...The next crisis will bethe first one in which the Central Banks - thelenders of last resort and the last bulwarkagainst instability - will find themselves withtheir balance sheets full of assets ofquestionable quality. Board Member,Europe

Global accommodation and an activist Fedreduces the chance for a severe dowmturn. Chief Risk Officer, North America

Notwithstanding some of the marketfluctuations and sentiments - at the currenttime we are operating at BAU[business asusual]. Chief Risk Officer, NorthAmerica

Not convinced we ever came out of theCrisis. Certainly on the surface, someelements look sound but dig deeper and thinkwe will find a bit (or a lot) of decay Chief Risk Officer, North America

Faith in credit and trading technology andin the so-called central banks put bears aneerie resemblance to the faith incomputerized portfolio insurance just beforethe 1987 stock market crash. BoardMember, Europe

Cyber terrorism, especially the statesponsored one poses a major threat. We [donot] yet fully understand its destructivecapabilities as even a small nation can causeserious problems. Chief Risk Officer,Asia/Pacific

Cybersecurity is demanding adisproportionate share of attention andappears to be increasing. Chief RiskOfficer, North America

Operational risks are higher than everbefore, less understood and less quantified.This increases uncertainty. Chief RiskOfficer, North America

Cyber risk is the biggest concern to me as aboard member for three financial servicesfirms. Board Member, North America

There are many sources ofuncertaintyany trigger can result inextremely fast corrections with itsconsequences. Chief Risk Officer, NorthAmerica


The Availability of Credit

Our survey asks both credit providers and demanders of credit to tell usthe extent to which they agree that credit has been made more availablein the past three months.

This quarter, the CSI-Credit sub-index reached its highest level since thesurvey began, standing at the edge of normal conditions.

Three times as many credit providers reported that they had made creditmore available in the past quarter than those who reported restrictingcredit further. Additionally, roughly twice as many demanders of creditreported more favorable conditions being offered to them than those whofelt that credit availability had deteriorated.

There were some comments that credit, while availabile, was bothexpensive and limited. One North AmericanBoard Member reported, Access to credit,when offered by traditional players, has notimproved for small firms. However access tocredit from non-banks has improved.

Credit availability was also somewhatdependent upon region with local events orpolitical conditions dictating a restriction oflocal credit availability.

Meanwhile, one Chief Risk Officer in theAsia/Pacific region indicated some cautionabout the frothiness of lending activities,My company is an investor and we have become more cautious regarding credit basedinvestments in recent months.

The Degree of Fear Present

Each survey period we ask whether fear is growing among marketprofessionals and the public.

As noted in the main report, CSI-Fear during the fourth quarter of 2014is at a level bordering on crisis.

More than two-and-one-half times as many respondents feel that fear isgrowing among market professionals and the public versus those whofelt an improvement in this metric had been observed. Some of thissentiment seems related to the dry tinder concern expressed inresponses to the main survey question. A Board Member in theCentral/South American region noted, The problem at I see is thatemotional reactions [in] our days have an immediate impact on thefinancial world. He continued, I feel time is no longer a favorable

Leading Indicators

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CSI - Credit

Normal Conditions


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CSI - Fear

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value! If someone gets nerves, the fair value goes [down] in a fraction of time, faster that the re-evaluation of fact rather than fiction!

Similarly, one North American seniorexecutive said, The external environment,particularly the economic and politicalenvironment, remains volatile and uncertain.Due to the high degree of connectivitybetween geographical regions and industrysectors, risks can spread very quickly.

On a balancing note, a Board Member in theAsia/Pacific region said, I think theperception of fear always seems to begrowing but in reality there is little to fear forthe overwhelming majority of individuals and companies globally.


New to this quarters CSI survey is a further analysis of regional and local conditions. Where asufficient number of responses have been received (presently, North America, Europe,Asia/Pacific, and the Middle East), their assessment of regional conditions is presented below. Inaddition, where there is a difference in perception of global conditions, based on region, welikewise highlight that data.

Finally, where respondents have left comments about specific countries, these are presented. Pleasenote that these are anecdotal reports shared by individual DCRO members for the benefit of othermembers. The opinions of other members from the same region or country may differ.

Regional Crisis Conditions

As the chart on the left shows, CSI respondents in the Asia/Pacificregion were the least pessimistic in terms of their assessment oflocal risk conditions. While the reading on CSI-Asia/Pacific is stillon the edge of the caution zone, data there suggest a morefavorable view on risk than in any of the other regions.

Notable is the local view of respondents from the Middle East asdata from their perspective is suggestive of a higher level ofcaution than other areas. Said one Board Member in the MiddleEast, the Middle East is in turmoil with Saudi Arabia facing risksit is not used to handling and an unnatural Shia/Sunni divide isthreatening stability across the whole arc from northern India toMorocco. Another Chief Risk Officer in the Middle East notes,Asset prices in the Middle East are inflated and it is a matter of

time before the bubble will burst.

Country-specific comments include:

Australia Domestic Australian economy is going through a low interest rate, low growthenvironment with rising housing prices. These factors could combine to result in an elevated levelof risk across the economy in the longer term. Chief Risk Officer

Australia Australian Government in total denial re climate change is actually putting the futurestrength of our economy at risk with their blind faith in coal exports. China and India are reducingin this area and developing alternatives. Board Member

China/Hong Kong Massive uncertainty in Hong Kong and the reaction of the government. Board Member

India Indian economy is showing signs of improvement. Foreign investment inflows on the up.Stocks are up. Overall positive sentiment. Chief Risk Officer

India New Government has been formed : Stable, strong willed political class hence manythings are falling in place. The fear of economic failure is receding, and that is directly seen in theway stock markets have climbed to all time high. Chief Risk Officer

New Zealand New Zealand has weathered the storm well and has not been as heavily impactedas Australia by the slowdown in volume demand for primary commodities from China. Interest

Regional Assessments


rates are relatively high and the greatest threat is probably a potential policy error by an overlyhawkish central bank. Chief Risk Officer

Germany There is a growing risk for organizations who export a lot (as [do] most of theGerman big and mid-sized corporations) into crisis areas like near east or Russia. BoardMember

Greece Although some Greek macro fundamentals are improving the high unemployment rate(c. 26%) poses a threat to social cohesion. Greek banks have passed the ECB stress test but theNPL [non-performing loans] amount in the system is still enormous (c. 35% of total gross loans)and threatens sustainable economic growth. Increased geopolitical risks in the south east Europe& Middle East as well as political uncertainty in Greece (Presidential elections in February)complement the picture. Chief Risk Officer

Russia Russian economy is in tough condition which is worsened by the political factors. Chief Risk Officer

Russia Russia for all intents and purposes does not view the Ukraine and sanctions matterthrough 'western' eyes or assumptions. They will carry on until they prevail whatever the sanctionsor other direct action costs. The Russian view on the street and from the Kremlin is by and largeidentical, with the added energy of feeling they are "in the right" against a russo-phobic world. Board Member

U.K. General risk conditions are relatively stable. However, the recent call for additional fundsfrom the EU in particular has heightened the risks of a UK exit, with the political risks increasing.This could drive more uncertainty for businesses, in particular those that rely on exports. ChiefRisk Officer

South Africa Geopolitics is having a great influence on SA. The political environment hastransformed the country into democracy but a major price of capitalism is being paid. Governanceis poor in both public and private sector. Skills are a great problem and smart people are leavingthe country. SA is seen as a hub for African business for international players but business isbecoming too expensive. Chief Risk Officer

Brazil In Brazil we are facing decreasing levels of GDP (approaching recession), highinflation, primary deficit [year-to-date] and growing trading account deficit. If you add this toincreasing peceived credit risk in local banks, you will see that 2015 will be a challenging year. Chief Risk Officer

Canada Canada's energy dependent economy together with deflationary trends, rapidlyescalating real estate values, sluggish growth and home grown terrorist activities generallycontribute to this pessimistic outlook. Board Member

Mexico Mexicos risk is increasing given recent developments and lack of ability for thegovernment to manage them.... Board Member

Mexico Being based in Mexico nowadays, the actions of the organized crime and drug cartelshas been deteriorating the overall safety in the environment and is already raising obstacles to thereceipt of new investments for the country to be able to materialize all the structural reforms thathave been discussed and approved by parliament throughout this year. Delays in the execution ofrelated actions will deepen the reduction of economic activity even further [from] the slow motionspeed it has had for the first 3 quarters of 2014, with the consequent trouble on employment rates,consumption, overall growth of the economy. C-Suite Executive


The CSI is trending higher, but remains in an area suggesting caution. That improving trend,though, mimics the reaction one might expect as time decays the fear of seeing busses like thatwhich came charging through in 2008. Asset prices, particularly equities, are marching ahead at afaster pace. Either this reflects QE-driven asset inflation, as many suggest, or a more sanguine viewof risk, especially in relation to alternative investment opportunities.

Whichever the case, the successful governance of risk continues to be of high value.

Our next assessment will take place during the first quarter of 2015. In the event of a majordisruption in the markets before then, we will conduct an interim assessment. In the meantime, weencourage you to discuss this report and your localized experiences online via the Directors andChief Risk Officers Group discussion board.

Conclusion


Appendix

Questions in the Survey include the following:

1. Thinking broadly, which statement below best characterizes the level of risk, globally?

We are in what I would characterize as "normal times" - general risk conditions are notelevated

General risk conditions are not "normal," but, they are also not at a critical level or one ofgreat concern

General risk conditions are elevated and there is a good chance that they will be risingfurther soon

General risk conditions are high and I am planning our risk management activities for acontinuation of high risk levels for the foreseeable future

General risk conditions are very high I am expecting that they may become worse fromhere

2. Regarding risks in the country where you live, which of the following statements best describesyour sentiment?

General risk conditions in my country are "normal." We are comfortable with theenvironment in which we operate.

General risk conditions in my country are elevated. But, they have improved over the pastthree months.

General risk conditions in my country are elevated. But, they are stable compared to threemonths ago.

General risk conditions in my country are elevated and are likely to worsen in the comingthree months.

General risk conditions in my country are very high, causing organizations to operatedefensively

3. My company is a credit provider and we have been expanding our offering of credit to customersover the last quarter (Strongly Agree, Agree, Neutral, Disagree, Strongly Disagree)

4. My company is a user of credit and we have experienced an improvement in the availability ofcredit to us over the last few weeks (Strongly Agree, Agree, Neutral, Disagree, Strongly Disagree)


Contact:

David R. KoenigChief Executive OfficerThe Governance Fund

email) [email protected]) +1-507-301-3149

fax) +1-480-247-4773

LinkedIn) www.linkedin.com/in/davidrkoenig/Twitter) davidrkoenig

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