Building a Modern Risk Management Department Seminar

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Building a Modern Risk Management Department Seminar. Financial Services Volunteer Corps (FSVC) January 19 – 22, 2009 Tripoli, Libya. Day One. Period 9:50 to 11:00 AM. Setting the Stage: Principles of Bank Risk Management. Core Objectives of Risk Management.
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Building a Modern Risk Management Department SeminarFinancial Services Volunteer Corps (FSVC)January 19 – 22, 2009Tripoli, LibyaDay OnePeriod 9:50 to 11:00 AMSetting the Stage: Principles of Bank Risk ManagementCore Objectives of Risk Management
  • Maintenance of solvency: constrain losses to within acceptable levels at all points through the economic cycle
  • Ensure risks are transparent and well understood, both internally and externally (owners must understand the risks they are investing in; government/regulators should understand important and systemic risks)
  • Ensure risks taken are consistent with organizational capability and risk appetite
  • Risk Management as a source of competitive advantage
  • The “Vicious Cycle” of RiskTake Uneconomic RisksDrive Growth AggressivelyIncur Large LossesClamp Down on Lending/Risk TakingLose Market Share/ProfitsForego Economic RisksSome principles about banking and riskSince the future is uncertain, you can’t generate returnswithout taking risk:
  • Capital and expenses come first, and are certain – revenues come later (and are uncertain)
  • You can’t divorce the level of risk from the expected level of return: the higher the desired return, the more risk you must be willing to take
  • Half the time you can expect the mean return or more, and half the time the mean return or less
  • Diversification is necessary to lower the average total risk
  • Some principles about banking and risk (Cont.)
  • That said, banks need to be low-risk:
  • Society relies on the effective functioning of the banking system
  • The system is based on confidence and trust
  • The main source of funding in most countries is customer deposits
  • Banks are the main mechanism for domestic and international payments
  • Banks are the main vehicle for storing non-real estate wealth
  • In many countries banks raise most of the country’s external debt…
  • … hence the importance of reputation and confidence
  • Reputation follows behavior; thus need to build and sustain trustSome principles about banking and risk (Cont.)There is a finite limit to the level of risk a commercial bank can take
  • Fundamentally businesses depend on their ability to fund themselves and generate cash
  • Companies go bust when they run out of cash. They run out of cash when they are not viable economically, or lose confidence
  • Failure usually happens when you get the basics wrong, not the subtleties
  • The amount of risk that is acceptable is fundamentally determined by the need to raise funding (and, where applicable, to preserve credit ratings)
  • Banking is a cyclical business:
  • Leveraged to the economic cycle
  • High financial leverage
  • High operating leverage – fixed costs often approximate 50% of revenues
  • Average margins on assets and liabilities are often very low so financial risk tolerance must also be low, so high confidence levels are used in risk measurement
  • Some principles about banking and risk (Cont.)
  • To be successful banks must remain successful and viable at every point on the economic cycle.
  • If you take all the opportunities on the way up…
  • You get all the losses on the way down!
  • Some principles about banking and risk (Cont.)
  • Fundamentally the level of risk is determined by:
  • the decision to be in a business,
  • the extent to which you participate,
  • the capability and culture of the organization, and
  • the quality of the people you put in charge of the business
  • This governs 80% of the outcome
  • The balance is in how this is executed
  • Note: Culture is a dominant factor in risk outcomes, including incentives
  • Strong leadership from the top on risk matters is essential to ensure a strong “risk culture”
  • Components of an Effective Risk Management Process
  • Governance
  • Risk Identification
  • Risk Measurement
  • Risk Management: Policy and Process
  • Risk Reporting
  • Policy and Process Compliance (Internal Audit; Legal / External Audit; Regulatory Compliance; Supervisory Examinations; etc)
  • Some principles about banking and risk (Cont.)
  • History shows that banks periodically get it materially wrong (eg early 1990’s in USA, UK, Australia; Currently in the U.S., Europe and globally)
  • Until recently, advances in risk management (especially credit risk) have borne fruit
  • e.g. very few bank failures in the USA, UK and Europe during the economic downturn of 2001 - 2002
  • But the current crisis has brought a lot of bank failures. Have the recent advances in risk management bred complacency, misguided quantification and modelling, or did they encourage inappropriate risk appetites?
  • Risk Management FrameworkThe Risk Management and Control Framework defines the key elements necessary for effective risk management & controlOrganization and Culture
  • Organizational structure
  • Accountability
  • Authority levels
  • Staffing and capability
  • Ethics and integrity
  • Risk Management philosophy & culture
  • Risk limits
  • Objective Setting
  • Strategic planning and budgeting process
  • Measurability and alignment of objectives
  • Communication and understanding of objectives
  • Monitoring
  • Business performance monitoring
  • Risk measurement and analysis
  • Management control self-assessment
  • Independent evaluations
  • Risk Assessment ProcessInformation and Communication
  • Self-assessment planning
  • Risk (event) identification
  • Risk assessment
  • Risk response
  • Ongoing Control Activities
  • Information infrastructure
  • Common reporting metrics
  • Information reports
  • Communication channels and methodologies
  • Business process controls
  • IT controls
  • Physical controls
  • Control documents – policies, procedures, standards and guides
  • Five criteria define excellence in risk management
  • Business areas take ownership, and risk management is an ingrained, actively managed process
  • External stakeholder expectations are met
  • We operate in a no-surprise environment
  • Each type of risk, and risk experience in the aggregate, is within our risk appetite
  • We know where we are
  • Risk PhilosophyRisk philosophy guides development and action
  • Governance
  • Board Awareness – of risks and related strategies
  • Senior Management Accountability – for risks in their respective areas, within policy
  • Independent Risk Management – apart from the business areas and Audit
  • Decision-Making
  • Business Plan Integration – of risks and required mitigation strategies
  • Cost/Benefit Analysis – for consideration of alternate risk strategies and/or risk acceptance
  • Risk Philosophy (cont.)
  • Infrastructure
  • Explicit Capital Charge – to measure risk exposure and create incentives
  • Self-Assessment Performed by Each Business/Functional Area – following enterprise methodology
  • Loss Data – collected, quantified and reported by all business areas
  • Formalized Policies & Governance – document policies, procedures, and guidelines
  • Culture
  • Explicit Risk Performance Goals – define an acceptable level of risk appetite and performance measures
  • Transparency and Openness – sharing and reporting of risk exposures, weaknesses and events
  • Governance ElementsFramework consists of:
  • Board oversight & involvement
  • Organizational structure
  • Independence of each of three functions
  • MIS and reporting
  • Culture
  • Risk Management Framework – Summary
  • A sound governance structure is essential for establishing an appropriate framework and implementing effective risk management
  • Banks have flexibility in creating organization structures so long as the required elements – and independence – are incorporated
  • The governance process should continuously monitor existing risk measurement and management processes (risk architecture) and development and implementation of a framework for newer risk types using sound project management and oversight methodologies
  • BoardBoard Risk&/or Audit CommitteeCEO etc.Internal AuditBusiness HeadChief Risk Official“Independent Risk”ManagementLine of BusinessRisk Management“Independence” HierarchyConstituenciesRating AgenciesCapital MarketsDebt & Equity MarketsOther StakeholdersOwnersRGovernmentBoard of DirectorsExternal AuditRegulatory SupervisionInternal Audit“Independent Risk Management”Business Risk ManagementThe Current CrisisFactors
  • Flawed risk decisions
  • Statistical
  • Judgmental
  • Extreme leverage
  • Mismatched book: Short finances long
  • Mismatched book:
  • Off-balance sheet assets & liabilities were actually on balance sheet liabilities
  • Sold risk participations circled back to seller upon default
  • Weak due-diligence (trust, but verify)
  • Lax regulation / Complacent regulation
  • Poor rating-agency performance
  • Moral hazards
  • Misguided macro-economics
  • Risk types misunderstood so not analyzed or analyzed by wrong skill sets
  • Is it a Financial Crisis or an Economic Crisis – or both?Libya
  • Small participant in the global economy
  • Vulnerable to oil price volatility (a significant factor in the global economy and in the current crisis)
  • But …
  • “Libyan Energy Fund to acquire minority stake in Italy's Eni and might push for representation on Eni’s board” (WSJ 12/8/08)
  • “Libyan Investment Authority has agreed to buy a large office building in the City of London” (FT – 12/10/08)
  • As Libya becomes more externally focused (and if it becomes more welcoming of internal investment and travel) it will become more subject to the global economy.
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