Filename
ERM in Banking
James LamPresident, James Lam & Associates
Sponsored by Casualty Actuarial Societyand Society of ActuariesJuly 28-30, 2003
Filename 2
James Lam’s biographyProfessional 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
Filename 3
New book on ERM
Filename 4
The business case for ERM
Lessons learned and best practices
ERM going forward – 10 Predictions
Discussion outline
Filename 5
Risks and linkages
EventRisk
OperationalRisk
FinancialRisk
September 11 impact on operations
Loan document and credit loss severity
Kobe earthquake and Nikkei fall
Enterprise-Wide RisksFinancial Risks
MarketRisk
LiquidityRisk
CreditRisk
Credit Risk Associated with
Investments
Credit Risk Associated with Borrowers and
CounterpartiesFunding Liquidity
Asset Liquidity
Filename 6
Key risk trends
EnterpriseRisk
Management
Corporate Disasters
• Enron• WorldCom• Tyco
IndustryInitiatives
• Treadway Report, US• Turnbull Report, UK• Dey Report, Canada
CorporatePrograms
• Banks• Asset Managers• Energy Forms• Corporations
RegulatoryActions
• Sarbanes-Oxley• SEC Initiatives• Basel II
Filename 7
The Wheel of Misfortune
Filename 8
Benefits of risk managementBenefit Company Actual Results
Market value improvement
Top money center bank Outperformed S&P 500 banks by 58%
Early warning of risks
Large investment bank Identified over 80% of future losses; risk limits cut by 1/3 prior to Russian crisis
Loss reduction Top asset management company
30% reduction in the overall loss ratio; up to 80% loss reduction at business units
Regulatory capital relief
Large commercial bank $1 billion regulatory capital relief, or about 8-10%
Insurance cost reduction
Large manufacturing company
20-25% reduction in annual insurance premium
Filename 9
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
CEOs face a challenging environment
Companies must identify, measure, and managethe underlying sources of earnings volatility
Filename 10
The business case for ERM
Lessons learned and best practices
ERM going forward – 10 Predictions
Discussion outline
Filename 11
Establishing an ERM framework
2. Line ManagementBusiness strategy
alignment
3. Portfolio Management
Think and act like a “fund manager”
4. Risk TransferTransfer out
concentrated or inefficient risks
5. Risk AnalyticsDevelop advanced
analytical tools
6. Data and Technology Resources
Integrate data and system capabilities
7. Stakeholders ManagementImprove risk transparency for key stakeholders
1. Corporate GovernanceEstablish top-down risk management
ERM Framework
Filename 12
Enterprise-WideRisk Management
(Integration)
CreditRisk
Business &Operational
Risk
Now Year 1 Year 2 Year 3+
MarketRisk
Goal:Target State
Risk Management
Now
Year 1
Year 2
Year 3+
Credit policy
framework
established –
key credit
policies approved
Market risk
methodologies
Operational
reliabilit
y
models and
business
objectives i
n
place
ERM
conc
ept
intr
oduc
ed –
su
ppor
t fro
m
boar
d an
d m
anag
emen
t
Develop data modelsand systems capability
Automated reporting
Active portfolio management
Transactional process alignment Ad hoc reporting
Early warning
indicators
Align reporting
with policies Develop portfo
lio stress-testing
Establish market risk controls
Enhance framework
and policy
Dev
elop r
isk m
etrics
and r
epor
ting
Align insurance programs
Define framework
and policy
Esta
blish
org
aniza
-
tiona
l res
pons
ibiliti
es
Esta
blish
CRO
Def
ine
fram
ewor
kan
d po
licy
Alig
n w
ithst
rate
gy
Def
ine
risk
tole
ranc
e
App
ly e
cono
mic
cap
ital
as c
omm
on ri
sk u
nit
Cre
ate
inte
grat
ed ri
sk re
port
and
succ
ess
mea
sure
s
Inte
grat
e ris
k m
anag
emen
tin
to b
usin
ess
proc
esse
s`
Dev
elop
stre
ss-te
stin
gan
d re
spon
se p
lan
Evo
lve
risk
cultu
re th
roug
h aw
aren
ess,
train
ing
and
ince
ntiv
es
Establish a vision and a roadmap
Unique workplans are developed for each deliverable milestone
Filename 13
Risk taxonomy (a common language)
RISK TYPEFINANCIAL / OPERATIONAL EVENT
Investment /Credit Market Operational Reputational Catastrophe
Loan Losses Interest Rates People
Systems
Processes
Employees
Clients
Investors
Analysts
Rating Agencies
Regulators
Press
Key Person
Investment Performance
Real Estate Terrorist Attacks
Liquidity-FundingLeverage
Fires/Other One-time Events
Capital Markets Accounting /Valuation Fraud
Economic Compliance Adversaries
Controlled Investments Competitors
Filename 14
Balance the hard and soft side of risk
Hard Side
• Measures and reporting
• Risk oversight committees
• Policies & procedures
• Risk assessments
• Risk limits
• Audit processes
• Systems
Soft Side
• Risk awareness
• People
• Skills
• Integrity
• Incentives
• Culture & values
• Trust & communication
Filename 15
Case study:
• New capital markets business
• Traders hired from foreign bank
• Aggressive business and growth targets
Background 2-Year ERM Program• Established risk policies and
systems
• Instilled risk culture
• Survived “Kidder” disaster
• Captured 25% market share with zero policy violations
• Recognized as best practice
Filename 16
Credit Risk Management
Expected Loss• Anticipated average loss rate• Cost of doing business, cover through
pricing and provisioning• EL = f(credit quality, collateral, structure)
Economic Capital• Covers catastrophic losses• Risk inherent in business, cover through
capital allocation and adequacy• EC = f(credit quality, collateral, structure,
industry sector, maturity, credit rating)
Catastrophic Loss Protection
Expected Loss (EL)
Average Loss Rate
Economic Capital (EC)
EconomicCapital
ExpectedLoss
Time
Loss
Rat
e ($
)
Frequent Low Losses
Infrequent Catastrophic
Losses
Filename 17
Market Risk Management
Nonlinear Products
Product BalanceMortgageDeposits
:
Value vs Rate-300bp
+300bp… …
Value
Rate
6 mo 30 yr10 yr
Structural Position
Cash Flow
Rate
Time
shift
twist
Change in Term Structure
– ILLUSTRATIVE –
– ILLUSTRATIVE –
Distribution
Change in value=
Simulation
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)
Step 4: Read EC from distribution of changes in AL values
9 bps
EC
Filename 18
Risk Metrics
Risk Event Log
Event Loss RootCauses
ControlsNeeded
Education
0%
20%
40%
60%
80%
100%
1995 1996 1997 1998
• New associates• Management• Business/Operational processes• Best practices• Lessons learned
Goal
MAP
Actual Loss Experience
85% Decline
Operational Risk Management
Filename 19
Economic capital as common currency
Credit RiskEarnings volatility due to variation in credit losses
Market RiskEarnings volatility due to market price movements
Operational RiskEarnings volatility due to changes in operating economics (e.g. volume, margins or costs) or one-off events
Credit Risk
MarketRisk
OperationalRisk
Probability
Change in Value
Enterprise-wide Risk
Filename 20
Expenses
-
Revenue
Equity
-
Losses
M&A
New Business
Risk Management by Silos (5, 6)
Value creation through ERM
4. Risk oversight costs5. Insurance/hedging expense
6. Credit, market operational write-offs
7. Capital management8. Risk transparency
9. New business development
10. M&A/Diversification strategy
1. Risk-based pricing2. Target customer selection3. Relationship management
Risk Management Impact
Integrated risk management (4–7)
Growth
ROE
Shareholder Value
Enterprise risk management (1-10)
Filename 21
Calculate ROE Calculate Pricing
Exposure $100 mm $100 mmMargin 2.50%Revenue $2.5 mm $2.2 mmRisk Losses <0.5 mm> <0.5 mm>Expense <1.0 mm> <1.0 mm>
Pre-Tax Net Income $1.0 mm $0.7 mmTax <0.4 mm> <0.3 mm>
Net Income $0.6 mm $0.4 mmEconomic Capital $2.0 mm $2.0 mmRAROC 20%
Measuring profitability and pricing
2.20%
30%
Filename 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 Economic Capital
Ceded RAROC =
Rationalized risk transfer
Common Cost/Benefit FrameworkDifferent Structures
Derivatives
Structured Finance
Insurance
Filename 23
Case study:
• $1 trillion of assets under management
• Private company
• Decentralized business culture
Background 3-Year ERM Program• 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
Filename 24
The business case for ERM
Lessons learned and best practices
ERM going forward – 10 Predictions
Discussion outline
Filename 25
1. ERM will become the industry standard
2. CROs prevalent in risk-intensive companies
3. Audit committees will evolve into risk committees
4. Economic capital in; VaR out
5. Risk transfer executed at enterprise level
6. Advanced technologies key to advancement
7. A measurement standard will emerge for operational risk
8. Mark-to-market accounting becomes standard
9. Risk becomes part of corporate and college programs
10.Salary gap among risk professionals continues to widen
Ten Predictions