INTELLIGENT RISK knowledge for the PRMIA community
April, 2014 ©2014 - All Rights Reserved Professional Risk Managers’ International Association
PROFESSIONAL RISK MANAGERS` INTERNATIONAL ASSOCIATION EDITORIAL BOARD
INSIDE THIS ISSUE
EXECUTIVE EDITOR Justin McCarthy editor@prmia.org
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Introduction - Letter from the Editor
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Letter from Faruk Patel, Chair PRMIA Board
PRODUCTION EDITOR Andy Condurache andy.condurache@prmia.org
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Inverview with PRMIA Executive Director, Kevin Cuff
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Financial Stability Board Response & Comment
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UK Banking Standards Review - PRMIA Comment
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PRMIA CRO Summit - NYC - Mark Abbott
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CRO Summit Dinner Keynote Address - Clifford Rossi
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Sponsored Article - Enterprise Risk Quantification
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PRMIA Survey - Julian Fisher
ACADEMIC PARTNER PROFILE
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London Chapter Profile
Andy Condurache andy.condurache@prmia.org
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UCC University Chapter Event
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Ease the Pain, without Sacrificing Return: Next Generational Risk Management by Frank Schmielewski
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Economic Capital - David O’Neill
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PRMC Case Study Competition
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iRisk Guidelines
REGULAR FEATURES VISIONS OF RISK PRODUCER AND EDITOR
Bob Mark treasurer@prmia.org
CHAPTER REPORT
Beth Fossum beth.fossum@prmia.org
SPECIAL THANKS
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Intelligent Risk - April, 2014
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letter from the editor
Justin McCarthy It is with great pleasure and enthusiasm that I write this opening to PRMIA’s first Intelligent Risk magazine of 2014. Already, this year is shaping up to be an important year for PRMIA with the announcement of a new Membership Model. Additionally, PRMIA has inaugurated one of our first EMEA University Chapters, submitted a significant response to a Financial Stability Board paper and responded to the UK Banking Standards Review. This is reflected in this edition of Intelligent Risk magazine with content including: • An update in the letter from the chair of our global board of directors, Faruk Patel, about the membership model and all available benefits to Sustaining Members of PRMIA • A n interview from earlier this year, when I met PRMIA’s Executive Director, Kevin Cuff, in London. Kevin brings years of member-focused association experience to PRMIA, which is a great insight into how the membership model is being augmented for our members, who have recently surpassed 92,000 in number • T he submission PRMIA made to the Financial Stability Board on their recent paper on Risk Culture. This was done in conjunction with
PRMIA’s Blue Ribbon Panel and shows how PRMIA is becoming a thought leader and voice for the risk management community. Moreover, we include the submission made to Sir Richard Lambert on the ongoing British Banking Standards Review; and, • A note from the recent PRMIA CRO Summit in New York and how it relates to our ongoing C-Suite initiative. In 2014, we plan to expand these kinds of “C-Suite” events to London and Asia. Furthermore, we have reopened application to this renewed executive membership level. I invite you to visit http:// www.prmia.org/c-suite-membership for more information.
In addition to these PRMIA focused items, we have included some excellent thought leadership articles on risk management, which all practitioners will find interest in. These are: “Ease the Pain, Without Sacrificing Return: Next Generational Risk Management” by Frank Schmielewski, “Banking Economic Capital: Driving Business Value?” by Daniel O’Neill and an excellent article on Enterprise Risk Quantification from our issue sponsors Ernst & Young. I hope you will enjoy reading this issue as much as the iRisk team and I have enjoyed preparing it. Please continue to read this resource, as we advance PRMIA and our risk management community through the year 2014 and onwards.
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letter from the chair
Faruk Patel Dear PRMIA Volunteers and Members, Over the course of the next several iRisk editions of this “Letter from the Chair”, I want to share the many tremendous initiatives that your Association’s Board of Directors and Committees have been involved in such as C-Suite events, PRM (updated) certification and training, advocacy, industry collaboration, etc. For the immediate future, there remains a single and determined focus of the organization and its leadership: Membership. We say the word all the time here at PRMIA as we strive to define, promote and support our Membership. But, as a PRMIA Member, what does that word really mean to you? You may define membership through the particular ways that you interact with PRMIA. Do you live near a local chapter and attend thought leadership events? Do you attend training courses and webinars? Do you access online resources like white papers, blogs and presentations? Are you pursuing the PRM certification? PRMIA is fortunate to have members who value networking in the community of risk professionals that PRMIA’s events help to foster and members who appreciate access to thought leaders,
education, CPE credits, and original content. Our members see value in professional certification and in belonging to an organization whose very reputation as a meeting place of thought leaders enhances the reputation of those who belong. As a member-driven organization, your support of the offerings that you utilize is critical so that we can continue to provide you with the resources you value, the interactions that make a difference in your career development. If you are already a Sustaining or a Contributing member, thank you for your support. If you have not yet upgraded your membership, I invite you to consider upgrading today to access everything PRMIA has to offer.
On behalf of the PRMIA Board of Directors (listed below), I remain humbled to serve as your Chair. Please continue to support the Association that supports you and your career.
Faruk Patel Chair
On behalf of the Board of Directors: Justin McCarthy Robert Mark Oscar McCarthy Dominik Dersch
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Vice Chair Treasurer Secretary EMEA
Wilson Fyffe Saurabh Mathur Ken Radigan Robert Reitano
APAC APAC Global Americas
letter from the chair
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executive director inverview
with Justin McCarthy
Kevin M. Cuff PRMIA’s new Executive Director is in search of a sustainable and credible industry voice in a crowded field. Kevin Cuff was named PRMIA’s Executive Director on July 1, 2013. Recently, PRMIA’s Vice-Chair and iRisk Editor-in-chief, Justin McCarthy sat down with Kevin to discuss the current state of the Association, his vision for the future and the overall reform of the financial services industry and the potential power of PRMIA in helping to shape the future of risk management. Justin
You come to PRMIA with a long resume of experience in Association management in banking and lending. What do you think are the major current issues before PRMIA that might help shape the future of its members and the future of risk management?
Kevin
As an Association, our ability to identify the core diversified principles surrounding PRMIA’s integration into the global risk community. Our focus on those few key values and our ability to translate them into membership investment through thought leadership contribution and a sustainable membership dues investment will enhance our overall standing throughout the world.
Justin
If you had to identify 5 primary objectives before the Association, what do you think they would be and how critical is the Association’s management (strategically and operationally) of those issues for its future?
Kevin
Certification: creating a progressive designation to support the practicing risk management professional. Content: Managing accreditation and continuing education as a component to membership and professional development. PRMIA will be your one-stop shop for all risk management informational content. Community: PRMIA as the meeting place for the risk management professional including all of your Chapter relations. Advocacy: PRMIA as an integrated risk management professional partner representing the very best industry standards of practice. PRMIA ~ Your voice for Risk Management. Sustainability: PRMIA’s identification with its 92,000 members in such a way to invite a modest dues investment for the good of the industry. Our ability to identify with our members will create huge opportunities.
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Justin
Where is PRMIA going to be in 5 - 10 years?
Kevin
I believe that if we get a moderate membership investment in the above 5 principles, then we will be allowed to establish a satisfactory business model that will provide a tremendous reinvestment in all of the above including Chapter development, organization of quality events, and further growing our network more aggressively in all pockets of the world.
Justin
Recently, PRMIA has been dramatically more visible by way of offering organized public comment before regulatory bodies or industry oversight organizations such as the Financial Stability Board and the new Banking Standards Review Board in the UK. What has prompted this new initiative? Is this really the best public position for the Association’s 90,000 plus members?
Kevin
PRMIA has been given very much through the power of Association (92,000 members strong and counting), and thus, some contribution is expected. We have a great opportunity to serve as the voice of the industry. This can be extremely valuable to our members, corporate partners, regulators, other Association partners, etc. in helping to shape the industry in this regulatory reform environment. I hope that our members can identify how extraordinarily powerful and important this kind of advocacy can be.
Justin
What can you tell us about Kevin Cuff, the person? What makes you tick when you are not thinking about PRMIA?
Kevin
Both my wife and I were competitive student athletes many, many years ago!! All of the better qualities of my personal and professional development (teamwork, coordination, organization, respect, tenacity, competitive spirit), I have learned from this tremendous opportunity and collective experiences that have remained the building blocks of my entire life. If we can pass along a fraction of those experiences to our 10-year-old daughter (also a tremendous student athlete), then I think I may have actually gotten something right in my life!!
Learn more about Kevin’s specific background through his LinkedIn page: click here
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FSB response
Kevin Cuff & PRMIA BRP The Blue Ribbon Panel serves as a resource to the organization by advising leadership and staff on risk management best practices and trends and actively promoting the organization and its goals by building connections at the highest levels in the industry. This committee is responsible for discussing and drafting, for general distribution, official PRMIA positions on risk-related issues.
January 31, 2014 Mark Carney, Chairman - Financial Stability Board, and Secretariat, Financial Stability Board Bank for International Settlements Centralbahnplatz 2 CH-4002 Basel, Switzerland Via email: fsb@bis.org Re: Comments on Consultative Document “Increasing the Intensity and Effectiveness of Supervision Guidance on Supervisory Interaction with Financial Institutions on Risk Culture” (http://www.financialstabilityboard.org/publications/c_131118.pdf) Dear Chairman Carney and Secretariat to the Financial Stability Board: On behalf of the Blue Ribbon Advisory Panel of the Professional Risk Managers’ International Association (PRMIA) we are pleased to provide comments on the Financial Stability Board’s (FSB’s) consultative document issued on November 18, 2013 and its subsequent guidance of December 23, 2013 “Guidance on Supervisory Interaction with Financial Institutions on Risk Culture - Questions for Public Consultation.” (PRMIA’s Blue Ribbon Advisory Panel is made up of a cross-section of senior risk professionals. Although their collective opinion has been greatly debated and appropriately vetted, it should not be accepted as the confirmed consensus of the Association’s 90,000 members.) Today, financial businesses interact in a global ecosystem where interconnections across sovereign jurisdictions provide an enormity of differing risk regimes in order to comply. To model and monitor this behavior will require cooperation by supervisors in the application of subjective judgments of good vs. bad behavior, or risky vs. appropriate behavior. Even judging the “tone-at-the-top” set by boards and their management has characteristics of subjectivity, requiring supervisors’ judgments.
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Given such subjectivity across many jurisdictional boundaries, what we, as risk professionals, have to offer is a direction toward a quantitative floor for boards and their management from which to allow supervisors to make consistent judgments. Here we take the FSB’s lead in tying risk culture to risk appetite by suggesting a quantitative approach to risk appetite setting, and ultimately, tying those risk metrics to the enterprise risk management systems and framework of financial institutions. In taking this approach, the Blue Ribbon Advisory Panel is hereby providing our perspective and observations based upon our collective experiences. Understanding a company’s risk taking and risk mitigating conduct is a result of each individual’s own behavior that collectively empowers group behavior, we will suggest what we term Key Risk Culture Indicators (KRCIs) for benchmarking such behavior. The views of risk professionals about risk culture and its measurement exist between two extremes: measureable KRCIs can be identified, and a review of conduct and practices is insufficient to get complete insight into culture. If supervisors desire to assess risk culture as a part of their responsibilities, then there is concern amongst practitioners about the qualifications of supervisors to interpret any quantification of such culture deficiencies. There is also no mention of what a supervisor might do with this information. A better understanding of the intended uses of the review of risk culture would be very helpful in forming our comments. If supervisors don’t understand how to use this review, then a “check-the-box” regulatory classification for risk culture would probably not be a helpful outcome. The evaluation of company’s risk culture should be an iterative process since both the company’s and regulators’ understanding of risk culture evolves. A sound risk culture might appropriately be different for different financial institutions. Nevertheless, how this variance among corporate risk cultures is to be interpreted by supervisors should be somewhat consistent. Some are skeptical that an accurate risk culture assessment can be made after conversations with the board and senior management and whether the institution’s risk culture supports adherence to an agreed risk appetite. We agree with the starting point of the four principles of risk culture offered in the FSB’s Risk Paper and offer additional perspectives on more fully incorporating risk appetite into risk culture. A review of practices may be insufficient to achieve an appropriate insight into a firm’s risk culture. The process of determining a firm’s risk appetite is an outward sign of the risk culture, but there may be many desirable risk cultures and not just one sound risk culture as suggested by the paper. In fact, the best risk culture may not be the “sound” or the “unsound” cultures that are inferred in the paper. Our response is divided into a section on “Foundational Elements of a Sound Risk Culture” that recognizes the variability of cultures and the importance and linkages of risk governance, risk appetite and compensation. We also recognize that governance processes should be designed to support discernment of the changing business and economic environment to the adaptation of risk management practices. This can be accomplished by changing the underlying risk analytics of the risk appetite framework. In this section, we articulate and support a movement from a subjective evaluation to a more objective measurement of risk culture in order to achieve the FSB objective of “formally assessing risk culture at financial institutions.”
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We are mindful that we can still differentiate cultures without risk measures, especially if we live inside of an organization. Furthermore, introducing measures of risk culture does not ensure that we will gravitate toward a strong risk culture over time. Nevertheless, we believe it is useful to articulate support of a more objective measurement. This section is followed by the response to the “Questions for Public Consultation” dated 23 December 2013, where the four indicators of good risk culture put forward by the FSB are further expanded upon. The responses encourage development of Key Risk Culture Indicators (KRCIs) as measures of risk culture for each of the main key indicators described by the FSB: • Tone from the top (4 subcategories) • Accountability (3 subcategories) • Effective Challenges (2 subcategories) • Incentives (2 subcategories), and In addition, we comment on other potential measures such as ethics, integrity, transparency, communication, adaptive or dynamic risk appetite, in addition to others. We believe that if a risk culture is successfully integrated into the fabric of a financial institution, then this will lead to a risk adjusted corporate culture that will benefit the entire financial ecosystem and, in turn, lead to stabilizing the global economy. However, it will take time, probably a generation, to indoctrinate staff to the new order of risk-adjusted performance and incentives, both within supervisor ranks and at financial institutions. We look forward to developing a comprehensive relationship with the Financial Stability Board, seeking to become a cooperative collaborator and confidential liaison in representing the risk profession. As part of our education and accreditation mission, PRMIA has issued its global Professional Risk Manager (PRM™) certification to individual practitioners and regulators throughout the world. We will continue this effort while embracing new ideas about risk culture into the curriculum. Respectfully submitted, Blue Ribbon Advisory Panel* (BRP) of the Professional Risk Managers’ International Association (PRMIA)
Kevin M. Cuff Executive Director, PRMIA
For the complete response click here
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Blue Ribbon Advisory Panel Members, PRMIA Mark C. Abbott Dr. Michel Crouhy Dr. Daniel Galai Allan D. Grody Edward Hida Dr. Colin Lawrence
Dr. Robert M. Mark Leslie Rahl Dr. Anurag Saksena Raj Singh Dr. Thomas C. Wilson
FSB response
banking standards review
Kevin Cuff & BSR WG on behalf of BRP March 7, 2014 Sir Richard Lambert Banking Standards Review 60 Gresham Street, 1st Floor London, EC2V 7BB UK info@bankingstandardsreview.org.uk Dear Sir Richard, On behalf of the Blue Ribbon Advisory Panel of the Professional Risk Managers’ International Association (PRMIA) we are pleased to provide comments on the consultation paper ‘Banking Standards Review’1 (the ‘Paper’) issued in February 2014. We support your goal to form a new organization in the UK to act as an independent champion for better banking standards that will contribute to a measurable and continuous improvement in both the conduct and the culture of banks doing business in the UK. We offer the comments that follow and the responses to the 19 questions in the Appendix in the spirit of potential collaborations between our organization and yours. We hope that the proposed new organization will be successful and function as an incentive for other countries to follow its example in the new banking environment we are transitioning toward. The conditions for fostering improved standards of conduct in banks at this point in time are not ideal, although most needed. Challenges will be significant. The combination of rapidly advancing technology, the advent of derivative contracts to provide more sophisticated forms of risk intermediation and the emergence of complex trading and investment structures has produced a global banking system characterized by high degrees of interconnectedness and complexity. These are the circumstances that became the breeding ground for a new form of risk - the contagion of ‘systemic risk’ - that ultimately provided the conditions that triggered the financial crisis. One of the short-term regulatory responses to the crisis was Basel 2.5 and Basel III2 which included the mandate for banks to enhance the quality of their capital and liquidity reserves. The aim was to increase banks’ capacity to buffer unexpected losses and introduce mechanisms to reduce ‘model risk in capital
1 / ‘Banking Standards Review’ - Consultation Paper, Sir Richard Lambert, February 2014 2 / ‘Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems’, Bank for International Settlements, December 2010, and Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, Bank for International Settlements, December 2010
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adequacy calculations. Basel III also introduced an accounting based leverage ratio. Following the crisis the Basel Committee has also issued a number of papers that gave recognition to the shortcomings of internal models as a basis for determining capital adequacy and provided alternative methods3. The longer-term response of both the Basel Committee and the Financial Stability Board (FSB) has placed emphasis on the implementation of more robust risk management frameworks and infrastructures. Five recent papers are worthy of particular mention in this regard. • Basel Committee - Principles for effective risk data aggregation and risk reporting • Basel Committee - The regulatory framework: balancing risk sensitivity, simplicity and comparability • FSB - Principles for an effective risk appetite framework • FSB - A Global Legal Entity Identifier for Financial Markets • FSB - Supervisory interaction with financial institutions on risk culture (which the Blue Ribbon Advisory Panel of PRMIA recently responded to)4. We highlight these papers as we believe they provide the road map to a future global banking system and regulatory regime that will provide the conditions that are more conducive to the development and nurturing of the new banking standards proposed in the Paper. However, the realization by banks and regulators of these frameworks and infrastructures represents a significant challenge. For example, the Basel Committee expects that Global – Systemically Important Banks (G-SIBs) will have implemented the risk data aggregation and risk reporting principles referred to above by 2016. In a recent progress review the Basel Committee reported5:
‘‘
“All banks indicated that they are making efforts towards closing all significant gaps by the 2016 deadline, but in some cases the expected compliance dates set by some banks seem to be overly optimistic. More importantly, 10 banks, 33% of the population (30 G-SIBs), mentioned that they currently expect to not fully comply with at least one principle by the deadline. Some of these banks noted that the reason is large, ongoing, multi-year, in-flight IT and data-related projects.”
We further observe that the Basel Committee’s aspiration to achieve a more effective balancing of risk sensitivity, simplicity and comparability in the regulatory framework is vitally important. In all likelihood it will take many years before a reconfigured and effectively functioning framework will emerge to correspond with this ambition.
3 / For example, Fundamental Review of the Trading Book, consultation by the Basel Committee on Banking Supervision, Bank for International Settlements, May 2012 4 / Comments on the Consultative Document “Increasing the Intensity and Effectiveness of Supervision - Guidance on Supervisory Interaction with Financial Institutions on Risk Culture”, PRMIA, January 2014, accessed on 5/3/2014 at https://www.financialstabilityboard.org/publications/c_140206t.pdf 5 / Progress in Adopting the Principles for Effective Risk Data Aggregation and Risk Reporting, Bank for International Settlements, December 2013
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We also note that the above five initiatives are interdependent. For example, an effective risk appetite framework is dependent on the ability to aggregate risk data that have been appropriately controlled against accounting records; the ability to aggregate data is dependent upon the ability to do so on the standardized and consistent identification of counterparties; the development of a positive risk culture is dependent on the implementation of an effective risk appetite framework; and none of this will be possible if we do not achieve a greater degree of simplicity and comparability in the regulatory framework.
‘‘
PRMIA’s Blue Ribbon Advisory Panel commented on the FSB’s risk culture consultation paper6 referred to above and concluded:
“We believe that if a risk culture is successfully integrated into the fabric of a financial institution, then this will lead to a risk adjusted corporate culture that will benefit the entire financial ecosystem and, in turn, lead to stabilizing the global economy. However, it will take time, probably a generation, to indoctrinate staff to the new order of risk-adjusted performance and incentives, both within supervisor ranks and at financial institutions.” Implicit in this conclusion is the need for a greater degree of alignment among regulatory capital, economic capital and accounting capital. This alignment will encourage the further deployment of risk adjusted performance measurement systems that will in turn act as a stimulus for improved compensation structures and banking practices. Our belief is that major improvements in standards of practice, culture and behavior in banks will not occur without integration of global practices across financial institutions The new organization needs to be planned for in conjunction with a fundamental reengineering of the global banking system as discussed above and that is already underway. Banking Standards Review Working Group of the Blue Ribbon Advisory Panel of the Professional Risk Managers’ International Association, Inc.
Respectfully submited, Kevin M. Cuff Executive Director, PRMIA The Banking Standards Review Working Group of the Blue Ribbon Panel is grateful to Peter J. Hughes of Financial InterGroup and Leeds University (UK) for his insightful and valuable contributions (leadership) in the preparation of this document. For the complete response click here
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banking standards review
PRMIA CRO Summit – NYC - November, 2013 Summary by Mark C. Abbott, PRM, Managing Director, Guardian Life and member of PRMIA’s Blue Ribbon Advisory Panel, Global Council, and New York Chapter Steering Committee The PRMIA Fall CRO Summit Dinner at the Harmonie Club in New York City on Wednesday, November 20th started with a networking reception with 33 chief risk officers and senior risk leaders followed by dinner and a keynote dinner address by Clifford Rossi, Ph.D., Executive-in-Residence and Professorof-the-Practice, Department of Finance, Robert H. Smith School of Business. Dr. Rossi had nearly 25 years of experience in banking and government, having held senior executive roles in business or risk management at several of the largest financial services companies including Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae as well as starting his career at the U.S. Treasury’s Office of Domestic Finance and then the Office of Thrift Supervision. Cliff’s remarks provided an introspective review of the state of risk management five years after the crisis through the following questions:
• How has risk governance evolved (or not) since that time? What are desirable traits of effective risk culture? Do board and/or senior management’s backing and authority increase the success of the risk management function within an organization?
• Have we struck the right balance between quantitative and qualitative assessment of risk and where is that balance achieved?
• Are we better now at assessing emerging risk than before the crisis? Has regulation helped or hindered the process? Lessons from the liquidity crisis.
• What are the opportunities and challenges for risk management? • How will derivatives exchanges impact risk transfer under the new regulatory regime? Will U.S. and Europe volumes continue to decline while volumes rise in Asia?
• What are the potential implications from the recent bank and hedge fund settlements? Both the dinner and summit were made possible by the generous support of our sponsor Ernst&Young. 45 CROs and senior risk leaders attended the PRMIA Fall 2013 CRO Summit Thursday morning, November 21, 2013 at the Roof Dining Room of The Yale Club of New York City. Marc Saidenberg, Principal, Financial Services Advisory, Ernst & Young provided welcoming remarks and Mark C. Abbott, PRM, Managing Director, Guardian Life reminded participants that discussions were under Chatham House Rule. A presentation of Ernst & Young and IIF’s Annual Survey of CROs titled “Remaking Financial Services Risk Management Five Years After the Crisis” and a facilitated discussion were led by Peter Davis, Partner, Financial Services Advisory, Ernst & Young LLP. 014
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An update on the Risk Management Standards of Practice from Justin McCarthy, Management, Governance Risk and Compliance Centre & Co-Regional Director of PRMIA Ireland included a summary of the Standards of Practice Working Group’s (SOPWG) efforts. The SOPWG is collecting and reviewing other organization’s standards efforts such as the actuarial profession’s ERM SOPs, the DCRO’s Risk Director Standards, and regulatory and supervisory works. Risk Conscious Culture was discussed by Leslie Rahl, Managing Partner, Capital Market Risk Advisors. Justin relayed that PRIMA’s Risk Management Standards of Practice Working Group is considering the following four questions: • What risk management standards are desirable and achievable at a group level. For example at board, management committees, in a risk management unit or for a business unit? • S hould or can similar risk management standards be adopted across professions and industries. For example risk in banking and insurance? • A re professional risk management Standards of Practice (SoP) desired at the individual level or across an organisation? • I f so, how do risk management SoP at the individual level compare and contrast with risk management standards at a group level? The working group believes that Standards of Practice for Risk Managers should be created and propagated across the risk management profession in industries such as banking, insurance and money management. The group is researching, collecting and assessing existing professional standards. PRMIA will work to benefit from the lead of other industries and industry professional bodies such as the CFA Institute and actuarial associations in their establishment of Standards of Practice. The purpose of the related working group has been to define risk management Standards of Practice, agree on their structure, build a prototype & related templates and then develop a process to manage the creation of these SoPs. Justin proposed extending techniques such as key risk indicators (KRIs) used in operational risk should be developed and applied in other areas such as Ethics and Energy. There was an engaged discussion involving most participants. While most participants supported the effort as important for the risk management profession, one senior practitioner made a pointed challenge that they did not consider risk management a profession, but rather termed it an activity. The best person to negotiate a work out or analyze the risk of the work out is the person who made the original loan and not someone who comes in fresh. You need someone who is willing to challenge the status quo in a constructive fashion. The person that you want is the one who has the will to go into their boss’ office and voice that the risk of what we are running is inappropriate or we are not being rewarded for the amount of risk we own or there’s an unidentified risk. He or she essentially has to risk their job a bit, every time. This practitioner also believed that attestation was a dead concept and that there would be absolutely no support for people to sign off. Unlike a CFO who has accounting experience with big four audit and consulting support, the CPA credential and FASB guidance for a common set of standards with a welldeveloped yardstick for evaluating financial statements.
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PRMIA CRO Summit
Another participant said if we are going to have standards or a guild or a group of risk management professionals, there has to be the ability like with doctors, lawyers or actuaries to kick them out of the profession. Otherwise there are no teeth. There was general debate about membership qualifications and how standards needed to be well established before any governance board and reviews for disciplinary process or possible sanctions that might be imposed should be considered. Another practitioner cautioned as not confuse the issue of attestation with the entirely different concept of risk management as a profession. After the meeting an attendee pointed out that for insurers’ Own Risk Solvency Assessment someone will have to attest to the ORSA. There was mention made about the legal entity identifiers (LEIs). We don’t have much closure thus far and in addition, with all the mergers in the past, many larger institutions haven’t really reconciled internally their LEIs. The regulators put a lot of emphasis on the ability to drill down with granularity and see position level exposures or sector level exposures based on the new Form PF for hedge funds. For some reason they believe this is a talisman and that will provide them insight. Patricia C. Mosser, Deputy Director for Research and Analysis, Office of Financial Research, U.S. Department of Treasury, provided an update on the Office of Financial Research (OFR). While only in her position at the OFR for a few weeks, she was already totally engaged with OFR Director Richard Lerner and others. The OFR 2013 Annual Report was being prepared for release and Patricia provided some insights into their mission, current functional organization, data and technology implementation and plans for 2014 and beyond. The Office of Financial Research activities include: • Analyzing threats to financial stability - developing the framework, tools and metrics to assess and monitor vulnerabilities and threats to financial stability. • Conducting research on financial stability - using network analysis and agent based modeling techniques to model interconnectedness; evaluate macro prudential tools (e.g. stress tests), studies of financial disruptions and contagion, assessments of risks associate with financial entities; analysis of policy tools and responses. • Identifying gaps in financial data and helping to fill them - promoting data integrity, accuracy, and transparency for the benefit of market participants, regulators, and research communities. • P romoting data standards - collaborating with policymakers and industry to establish global and national data standards, e.g., for global legal entity identifier (LEI) and data hierarchies. Richard Bookstaber, Research Principal, Office of Financial Research, U.S. Department of Treasury discussed “Using Agent-Based Models for Analyzing Threats to Financial Stability.” Rick Bookstaber compared the markets to a giant traffic jam with such tremendous interaction and dependencies amongst all the actors that modeling requires considerable drill down and rich granularity in order to truly understand how tightly the markets are interrelated. In financial markets the actors are in different positions just like they are in different positions in a traffic jam and they have different alternatives as far as what they can do. It’s work in progress and definitely not a one-size-fits-all. 016
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The Liquidity and Funding Risk discussion was led by Marc Saidenberg, Principal, Financial Services Advisory, Ernst & Young LLP and Christopher Stavrakos, CFA, Managing Director, Head of Cash Investment Strategy and Risk Management, BlackRock. They reflected on how changes in market structure and regulatory directives are impacting current market liquidity and behaviour in a future crisis. Kevin Cuff, Executive Director, PRMIA and Mark C. Abbott, PRM, Managing Director, Guardian Life led the final “Risk Around the Table” discussion. Regulatory risk disclosure such as in the SEC’s Form PF versus providing it for client use was a topic. A hedge fund practitioner wrestled with whether to provide Form PF to their clients or not, and if provided, should it be redacted or should the whole submission be provided with supplemental commentary? No client had requested Form PF and they already provide robust disclosure and monthly statement to clients. They don’t use the data on Form PF themselves as they believe it’s an inappropriate measurement of the risk and in some sense they think it’s a bit misleading. Another concern was that regulators were not appropriately distinguishing the risk that a bank should take from the risk that an insurance company should take or the risk that a money manager or mutual fund should take. Despite existing state insurance regulation, one major insurer practitioner indicated that federal regulators seemed concerned that a large amount of an insurer’s liabilities could simply walk out the door in the space of five days, which indicates a lack of understanding of the basic insurance model. Several attendees were concerned that centralized clearing was essentially our mutualizing the risk contained in the market and that essentially is concentrating that risk. Certainly no one knows where the next crisis is going to originate from but centralized clearing parties potentially could be the locus of that new crisis. Dan Rodriguez, Managing Director and CRO of Systematic Market Making Group at Credit-Suisse & CoRegional Director PRMIA New York provided the closing remarks and thanked EY for their generous support and the participants for excellent discussions at the CRO Summit and appreciation for the varied views expressed around SOP and other topics.
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PRMIA CRO Summit
PRMIA CRO Summit Dinner Keynote
Clifford Rossi, Ph.D five years after the crisis: an introspective look at risk management Thank you Mark for that introduction and to PRMIA and EY for inviting me to speak to this group this evening. Some of you have heard me refer to myself as a recovering CRO masquerading as an academic these days. Given my track record as a sort of accidental Forrest Gump of the banking business at some of the more notable institutions associated with the crisis, I suppose my remarks can be thought of in the context of lessons learned the hard way. In the years following my departure from my last CRO role at Citigroup, I have spent a lot of time teaching, writing and thinking about our profession, particularly with some distance now between us from those dark days of 2008. What I would like to do here is to take stock of where risk management has evolved over the last 5 years, with emphasis on three areas that will shape the direction of the profession going forward; namely risk governance, the effectiveness of regulation to facilitate prudent risk-taking behavior and building the talent base and infrastructure for sustainable risk management in the future. No matter how much is invested in human capital,
Read complete keynote address here
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data, analytics and other risk infrastructure, a necessary and sufficient condition for effective risk management is a culture and governance process that cultivates a risk mindset that is pervasive throughout the organization. In other words, companies that are risk leaders have an intangible quality about them that cannot be forced upon them by regulation. When people ask me what it was like to be a risk manager in the years preceding the crash, I tell them that it reminds me of a Super Bowl ad that appeared a few years back. In the ad, there were a number of monkeys sitting around a board room table with a party in full swing, monkeys were smoking cigars, burning money, having a great time since sales were going through the roof. The only human in the ad looks at the chart and tells them that sales are actually falling at which point the party immediately comes to a halt. Then the head monkey goes over and turns the chart back the other direction at which point the party recommences. I tell people that my life as a risk manager was much like the human in that ad. So where does that leave us?
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enterprise risk quantification
by David Wicklund, Chad Runchey & Rick Marx overview Insurance is a risk-taking business. Risk managers must ensure that the risks taken are intentional and understood, as well as aligned to the organization’s objectives. This can be achieved only through a welldesigned risk management framework, with effective governance and high-quality risk information. To provide management with the information it needs, risks should be quantified through various lenses, at aggregate and more granular levels. This article focuses on risk quantification at an enterprise level. We will discuss three important risk quantification topics: economic capital, stress testing and assetliability management. Each area provides management with different information needed to influence capital management, investment and other business decisions, and require coordinating information across the enterprise. We will provide background on some of the factors driving risk management enhancements across the industry and the limitations of common industry approaches. Then we will discuss the purpose, key methodology decisions and practical challenges for each of the three enterprise risk quantification topics.
drivers Across the insurance industry, companies are enhancing risk management practices as they recognize both risk management’s importance and increased regulatory focus. As the 2008 financial crisis unfolded, financial institution losses emerged in ways companies had not anticipated. Two risk quantification realities quickly became apparent to management and regulators alike. First, many companies did not have a framework in place to evaluate enterprise-level risk exposure to adverse environments. And second, many did not have the infrastructure in place to perform timely risk analysis. Regulation of insurance companies with a US presence varies based on the size and complexity of an organization and location of the parent company. With the emerging regulatory developments, most companies will soon fit into one of the following categories: 1. US parent, not systemically important, no bank ownership — Legal entities are regulated by state regulators or local foreign regulators; group disclosures to state regulators.
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2. US parent, systemically important or bank ownership — Group is regulated by the Federal Reserve; legal entities are regulated by state regulators or local foreign regulators; group disclosures to state regulators 3. European parent — Group is regulated per Solvency II; legal entities are regulated by state regulators or local foreign regulators; group disclosures to state regulators Companies in each category are experiencing an increased regulatory emphasis on risk management, with different regulators introducing various requirements, some of which are similar. For instance, the US insurance regulators will soon require that companies produce an Own Risk and Solvency Assessment (ORSA) report. To comply, US companies must provide their internal view on group-required capital and a prospective view of required and available capital in normal and stressed environments. Companies deemed systemically important financial institutions (SIFIs) by the Financial Stability Oversight Council (FSOC) or that own a bank will be subject to the Federal Reserve’s Internal Capital Analysis and Assessment Process (ICAAP), for which a robust enterprise stress-testing framework is a key component. Finally, companies with European parents are preparing for Solvency II enterprise risk reporting, including economic capital, stress testing and capital projections. Companies in the first group are subject to less rigorous and prescriptive requirements than those in the others, though additional factors may influence them. The US ORSA will provide insurance regulators with a new window into risk management practices and quantification methods, and ensure that risk management topics are on Board of Directors’ agendas. What Boards or US regulators will do with this information is not yet known, but it’s preferable for companies to show regulators that they are on the leading side of industry risk management practices. Companies with more rigorous regulatory requirements — SIFIs and European subsidiaries — will redefine leading practices and place pressure on the rest of the industry.
limitations of existing approaches Measuring risk exposure is hardly a new concept for insurers, though common industry approaches have limitations. Insurers often manage capital needs with frameworks based on US risk-based capital (RBC) or rating agency benchmarks, quantify individual risks in silos with widely varying techniques, and lack the ability to aggregate risks across businesses or project full future balance sheets in adverse conditions. State regulators designed RBC to provide early warning of financial trouble, but companies have often relied on it beyond its intended use, employing it as a primary capital adequacy measure. A company’s position on RBC — and rating agency capital, which aligns closely to RBC — is a very real constraint, but it does not necessarily lend itself to understanding the company’s specific risks. RBC is built on a US statutory balance sheet, which is book-value-based and may show losses slowly over time. It also has known
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missing risks (e.g., longevity, operational) and is not tailored to the risks facing specific organizations. Finally, since it is applied at the insurance legal-entity level, risks taken by non-insurance entities (including the holding company) are not captured. Additional, more economic risk exposure measurement techniques are also utilized but are often considered in risk silos (e.g., credit risk exposure), resulting in varying quantification approaches and levels of rigor. Limits are often applied for some risks and not others, and the individual risk quantification approaches are not linked to the overall company risk appetite. An emerging leading practice is to produce a forward-looking projection of a company’s balance sheet for various adverse scenarios under various accounting lenses (statutory, GAAP/IFRS, and/or economic). Although the value in the exercise is appreciated, few companies have robust stress-testing frameworks, and current capabilities have shortcomings. Projecting stochastically calculated balances, determining assumptions under stressed conditions and aggregating for the enterprise are some current challenges, resulting in slow turnaround times and use of shortcut methods that compromise accuracy.
emerging enterprise risk quantification approaches Economic capital Management must understand the organization’s overall risk and whether taking that risk provides an adequate return. Capital frameworks measure exposure across quantifiable risks. Economic capital models can align with the organization’s specific risks and objectives, provide a consistent view on the capital required to support those risks, and help inform management about risk and return trade-offs. Economic capital is commonly understood to utilize a value-at- risk measure on the potential loss of market value balance sheet surplus. While a popular application — and the Solvency II definition — economic capital need not be constrained to this interpretation. Regardless of the precise methodology, any economic capital framework seeks to determine how much capital should be held to support the actual risks the company faces. The capital definition should be aligned to a company’s risk appetite definition and its unique objectives. Some key, and interrelated, methodology decisions are as follows: • Valuation framework: Commonly economic capital frameworks utilize observable market variables to value assets and liabilities. Alternatively, an economic balance sheet can be defined with a discounted cash flow approach using current, but not necessarily market-consistent, assumptions. Because of their book value principles, GAAP and statutory balance sheets do not capture risk if required capital is quantified in terms of short-term losses. 022
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enterprise risk quantification
• Time horizon: Most commonly economic capital is defined by the potential loss over a one-year horizon, where the market value at each point in time reflects the full tail of the liabilities and the applicable risk margins. A run-off approach is sometimes used that could focus on how cash flow or surplus emerges over a long- term projection, but companies typically prefer the simplicity of a short-term approach. The time horizon should be linked to the valuation framework. For example, a market-consistent valuation framework is commonly used with a short-term horizon, where a statutory-based framework may be utilized with a long-term run-off approach. • Risk measure and confidence level: Regardless of the balance sheet and time horizon, a company must decide to what part of the tail it plans to measure exposure. While 99.5% value at risk is common, different confidence levels and risk measures (e.g., CTE98) could also be considered, depending on the valuation framework. Ultimately, the risk metric and confidence level should align to the unique objectives of each organization.
Once a methodology is agreed upon, implementing the approach presents challenges: • Management buy-in: Building senior management understanding and buy-in is often the greatest challenge with economic capital. An economic capital model is only as useful as the management actions it influences. To make it more than a theoretical exercise, economic capital’s value must be demonstrated to management, and sometimes theoretical purity must be sacrificed for ease of understanding. • Risk distributions and aggregation: Capital calculations, by definition, seek to measure potential losses in risk distribution tails. Unfortunately, limited data exists to understand and illustrate the actual shapes of the tails and how risks are correlated within them. These assumptions typically require significant judgment and have greater uncertainty. It is instructive to perform calculations for a range of assumptions to understand the sensitivity of the results and where significant model risk may be present. • Coordinating across the organization: Insurance companies are generally organized around multiple business units and corporate functions, each with responsibility for balances that feed the enterprise results. To produce meaningful and timely results, the capital modeling approach must be consistently applied across the organization and be efficiently aggregated.
Stress testing Stress testing is a powerful tool to supplement a company’s internal capital model due to its conceptual simplicity. Stress-testing results are easy to explain to senior management and can drive home an understanding of a company’s most material risk exposures. The approach does not attempt to capture all quantifiable risks, but instead illustrates the future financial impact over several periods
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of adverse, yet plausible, scenarios involving one or more risk factors. Executives hesitate to act on measures they do not fully comprehend — like a diversified 99.5% value-at-risk measure on an economic balance sheet, for example. Conversely, “If this economic scenario unfolds over the next several years, here’s how our balance sheet will look” can be powerful enough to drive management actions. A forward-looking stress test projects a balance sheet for a given adverse deterministic scenario. Consider the following in such an approach: • Balance sheet: Any balance sheet definition that is important to the organization (e.g., GAAP, statutory, economic) should be considered. The Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) framework is built around a GAAP balance sheet, but for some organizations statutory and/or economic balance sheets may take priority. • Income statement: For companies utilizing a GAAP-based stress- testing approach, the balance sheet and income statement respond differently to market changes (e.g., unrealized gains flow through other comprehensive income rather than net income). Typically a projected balance sheet is the test’s focal point, but management also values understanding the income impacts. • Scenario types: The risk materiality should drive the scenarios selected. This will vary by company, though commonly market risk is the most material and scenarios are hence focused on market events. • Scenario quantity: No absolute rules exist for the number of scenarios. Companies should use enough scenarios to cover the most material risks, but not so many that the message gets lost. • Projection length: The emerging consensus is to project the balance sheet for the business planning period (typically three to five years) since the purpose of the exercise is to inform management decisions. Stress testing, while simple in concept, can be challenging to implement. An insurance company balance sheet is complicated enough to calculate at a point in time; calculating it several years in the future in severe market conditions is even more difficult. Some particular challenges are: • Forecasting complicated balances: Stochastic balances are particularly difficult to project, because they require stochastic- on-deterministic calculations. Additionally, the complicated and non-continuous rules in GAAP and statutory reporting (e.g., asset- adequacy reserves, Actuarial Guideline 43, Actuarial Guideline 38, GAAP loss recognition) present significant challenges. Well- designed processes and sufficient computing power are essential.
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• Setting assumptions for adverse scenarios: Secondary effects of the scenario tested must be considered. For example, policyholder behavior will respond to adverse market environments. Assumptions for this are required for the models, but experience needed to set the assumptions probably does not exist. As a result, significant actuarial judgment is required, and a range of assumptions should be tested. • Precision level: As noted above, precise calculations of future balances are not trivial, leading companies to rely on simplifications and rules of thumb. However, overdependence on such techniques can lead to answers that are less meaningful and can draw ire from regulators. • Coordinating across the organization: The same coordination challenges noted for economic capital are present for stress testing as well.
Asset-liability management The purpose of asset-liability management is to make informed and coordinated decisions around assets and liabilities. Certain factors, namely market inputs like interest rates and equity performance, influence the value of each. Through asset-liability management activities, companies should ensure that they understand the differences in asset and liability cash flows and market sensitivity and that any gaps are intended and within risk appetite. Asset-liability management (ALM) has long been a consideration for insurance companies. While calculated and monitored, economic ALM measures like duration and convexity have not always been prioritized relative to statutory and GAAP considerations, like asset adequacy testing and loss recognition, which capture interest rate risk in a delayed book-value manner. For a couple of reasons, thisprioritization should shift and lead to greater focus on more economic asset-liability management measures. As companies begin to disclose economic capital results to management and regulators, mismatches will be directly linked to capital needs. And second, the emerging insurance contracts framework — which will ultimately replace current US GAAP and IFRS — utilizes current market inputs to calculate the balance sheet. Asset and liability mismatches will create volatility in a company’s equity, and some of the inconsistencies between financial reporting and economics will dissipate. Both of these issues will make ALM positions more transparent to regulators and investors and should encourage greater ALM focus. A single established industry approach to measuring and managing a ALM position does not exist; approaches vary considerably and there is value in monitoring positions through multiple lenses. It is useful, however, to develop a comprehensive ALM framework to define objectives, constraints and approaches. Some ALM considerations are as follows: • Balance sheet: Similar to stress testing and capital, ALM measures are built on a valuation/ reporting framework: economic, GAAP or statutory. Utilizing an economic framework is best for understanding economic exposures, with GAAP and statutory measures layered on as
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constraints. As noted above, the insurance contracts framework will eliminate some of the contradictions between economics and GAAP/IFRS financial reporting. • Metrics: Duration and convexity, which are short-term parallel price sensitivity metrics, are most commonly calculated for assets and liabilities. Also measuring key-rate durations is useful to provide an understanding of hidden exposure to changes in yield curve shape. These metrics each measure price sensitivity and provide a framework for simple estimates of potential loss. To better quantify potential losses for changes in rates, value-at-risk measures are also utilized and ideally linked to risk appetite. • Monitoring and reporting: Monitoring is the ongoing tracking of positions, while reporting refers to regular and ad hoc reports provided to stakeholders. Calculating exposures, due to the nature of liability models, often takes significant effort. Calculation frequency (e.g., real time, daily, weekly, monthly, quarterly) of different metrics should consider materiality and how quickly exposures change with passing time and rate changes. • Portfolio selection: Nearly all insurance companies consider liability profiles in portfolio selection, but this usually takes the form of selecting assets within some range of liability durations or cash flows. These approaches do not directly quantify the trade-off between risk and return. A liabilitydriven investment approach, in which an efficient frontier is developed for potential portfolios, provides a framework to evaluate integrated asset and liability risk and return trade-offs.
Some challenges to implementing ALM measurement and managing exposures are as follows: • Calculation demands: To manage ALM exposures, it is important to provide timely information. A key challenge is that liability calculations, performed with different models across the organization, are time-consuming and difficult to coordinate. • A replicating portfolio approach can address this issue. Liability models can be run less frequently to calibrate representative portfolios of assets. The replicated assets can be combined with actual assets to support ALM analysis, including frequent price sensitivity and value-at-risk calculations. If calibrated with sufficient frequency, replicating portfolios can greatly enhance speed while maintaining sufficiency accuracy. • Exposure management: Once exposures are understood, management actions should be taken to ensure that the level of risk is acceptable. However, it can be difficult to achieve the desired profile with available assets due to long duration and highly convex liabilities. To the extent available in the market, derivatives (e.g., swaps, swaptions, caps) can provide a tool to alter the ALM profile as desired in a way that traditional assets may not.
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enterprise risk quantification
onclusion
conclusion
h internal and external risk management drivers vary from company to company, but enhancing risk nagement isBoth a common goalexternal across the industry. high-quality risk information to internal and risk insurance management driversProducing vary from company to company, but enhancing risk orm management decisions critical goal to anacross organization’s success. Risk management information must management is a is common the insurance industry. Producing high-quality risk information to ovide management perspectivedecisions throughisvarious and at various levels of detail. inform management critical lenses to an organization’s success. Risk management information must provide management perspective through various lenses and at various levels of detail.
onomic capital, stress testing and ALM measures each require coordination across the organization to ovide management with vital risk information. There is no single correct approach for each topic and Economic capital, stress testing and ALM measures each require coordination across the organization eful consideration is required both in setting up the right approach for the organization and the plan to to provide management with vital risk information. There is no single correct approach for each topic and plement. Ascareful the external environment and strategic objectives differ from organization to organization, consideration is required both in setting up the right approach for the organization and the plan to implement. As the external environment and strategic objectives differ from organization to organization, so too should risk quantification.
authors Rick Marx Rick Marx is a principal in EY’s Business Advisory Services practice focusing on financial and risk management in the insurance industry. He has more than 28 years of experience in financial services, primarily in the insurance industry. Prior to joining EY, Rick was Vice President, Corporate Risk Management and Vice President, Investment Controller at MetLife. Rick earned his MBA with a concentration in Finance and an emphasis on Quality Management from the University of Chicago and his BBA in Accounting and Management Information Systems from the University of Wisconsin at Madison. He is a member of the American Institute of Certified Public Accountants and the Minnesota Society of Certified Public Accountants.
Chad Runchey Chad Runchey, FSA, MAAA is a senior manager in the Insurance Risk Management practice of EY and has over nine years of experience in actuarial consulting with focus on risk and capital management. Chad co-authored SOA research papers Stochastic Analysis of Long Term Multiple Decrement Contracts and Longevity Risk Quantification and Management: A Review of Relevant Literature.
David Wicklund David Wicklund, FSA, CFA, MAAA is a manager in EY’s Insurance and Actuarial Advisory Services practice, specializing in risk and capital management. He has more than nine years of life insurance experience. David joined EY in 2008 and previously worked for a large US life insurer.
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PRMIA survey
by Julian Fisher In a changing world how do we view changes to Capital? Recently a capital approval survey was sent to senior members of the PRMIA Subject Matter Expert (SME) Advisory groups to garner opinions as to their current approval processes for changes in market, credit and operational risk capital levels. The survey’s results can be split into 3 Sections.
SECTION 01 - Changes in capital approval requirements Respondents were asked their views on what % changes in capital on a month-on-month and quarteron-quarter would require Board sign-off.
Month-On-Month 80 70 60 50
market credit
40
operational
30 20 10 0
<1%
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5-10%
>10%
Quarter-on-Quarter 80 70 60 50
market
40
credit operational
30 20 10 0
<1%
1-5%
5-10%
>10%
Overall, it is apparent that smaller changes in capital are required for sign off on a month-on-month basis compared to quarter-on-quarter. This is, presumably, because as the month-on-month changes are known, the same approvers will have already approved, such that the root cause for quarter-onquarter changes are known. When analyzing risk category changes it appears that Market and Credit risk have lower sensitivity of movement for approval than for Operational Risk. On discussion with some of the respondents it appears that this is due to a combination of: â&#x20AC;˘ Capital charges are significantly higher for Market and Credit risk compared to Operational Risk â&#x20AC;˘ Operational Risk is still in its infancy and, due to its nature Operational Risk is seen as being substantially driven by tail risk events (hence the greater than 10% change bucket) and, therefore, one-off large changes are to be expected. This is corroborated by the survey results illustrating the grouping of % change levels â&#x20AC;&#x201C; market and credit risk have smaller % change swing approval
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SECTION 02 - Risk type specific approval requirements Building on Section 1 respondents were asked their views on approvals required based on changes at a risk element level.
MARKET RISK For Market Risk it is apparent that more, is more. Respondents believe that Liquidity coverage ratios should be approved at both the funding and market risk level and that VaR calculations should be conducted for each separate asset class. If approvals are in place for Liquidity Coverage Ratios, should they be broken out by funding and market sensitivity?
Funding Risk (bank operations) only Market Risk (market volatility) only Both Neither - just view the LCR in total
How should a VaR calculation take into consideration the banking book’s “smoothing effects” that occur due to the different classifications such as HTM, AVS, trading, and basic book valuation (deposits)?
Calculate each asset class based on its appropriate IFRS classifications. Calculate all assets under the same classification for comparison / contrast and replicate the calculation under all classifications.
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PRMIA survey
CREDIT RISK Should the approval levels be different for retail and commercial banking books?
Higher thresholds from commercial Higher thresholds for retail The same thresholds
On the subject of whether approval thresholds should differ by lines of business responses were inconclusive. Very few respondents wanted thresholds to remain the same throughout but there appears to be no firm direction on whether thresholds should be higher for retail or commercial banking books. In addition to approving capital, should the percentage changes in the following inputs also be approved:
90.0% 80.0% 70.0% 60.0% 50.0% 40.0%
61.9%
52.4%
33.3%
10.0%
61.9%
20.0%
81.0%
30.0%
RWA
Macro Economics Variables (Unemployment, Housing, Price index, Corporate credit...)
General Ledger and Basel Capital Database reconciliation
0.0%
PD
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LGD
When asked should the same percentage month-on-month and quarter-on-quarter changes be applied to the components of Credit Risk as they were to the capital, respondents showed no strong preference around LGD, RWA and Macro Economic variables. The only outliers were Probability of Default and General Ledger & Basel Capital Database.
OPERATIONAL RISK Should the approval thresholds differ based on Lines of Business?
Thresholds should remain the same throughout?
Thresholds should be adjusted based on management defined scalars Thresholds should be adjusted based on a product of both size and % change in capital?
On the issue of approval thresholds by lines of business responses, again, were inconclusive. As with Credit Risk, very few respondents want thresholds to remain the same throughout but there is no firm direction on how thresholds should be set. This corroborates the postulation that Operational Risk is in its infancy from Section 1.
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PRMIA survey
In addition to approving capital should the same percentage changes as above, in the following inputs, also be approved: 90.0% 80.0% 70.0% 60.0% 50.0%
47.6%
80.1%
71.4%
42.9%
33.3%
Scenario Analysis
Business environment and internal control factors
Macro Variables (Unemployment, Market Volatility, etc.) Micro Variables, if not included in Scenario...
General ledger and Basel Capital Data Base reconcilliation
10.0%
External Loss Data
20.0%
52.4%
30.0%
Internal Data
40.0%
0.0%
As to whether the same percentage month-on-month and quarter-on-quarter changes should be applied to the components of Ops Risk as they were to the capital respondents, they were split 50:50 with regard to internal data, external loss data, macro variables and â&#x20AC;&#x153;otherâ&#x20AC;?. Somewhat surprising is the result that internal and external loss data only 50% believe the same thresholds should apply as one would assume that significant changes in either would merit investigation. Indeed with respect to respondentsâ&#x20AC;&#x2122; strong views around business environment & internal control factors one may expect the internal data category to mirror it! Of more interest is that 80% of respondents favored different weighting to scenario analysis potentially due to it being perceived as more of a future risk indicator.
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SECTION 03 - Who should be included in Basel capital approval process Having defined capital change tolerances and further subdivided these changes into key drivers, respondents were asked which departments should be included in the Basel Capital approval process.
120% 100% 80%
market
60%
credit 40%
operational
20%
sin
t di
bu
Au
s es
ry su Tr ea
of e in tl uc Pr od
ta pi Ca
O
w
n
lM
Ri
an
sk
ag
St
em
re a
en
m
t
0%
As expected, minus an odd blip in Operational Risk, all risk departments responsible for calculating risk charges wished to be involved in the Basel Capital approval process for their risk type. Across the board itâ&#x20AC;&#x2122;s 50:50 whether or not product business lines should be involved in the approval process. Whether this is due to a perceived conflict of interest as well as diminishment of risk groupsâ&#x20AC;&#x2122; autonomous authority is a subject for speculation. In the area of Capital Management, Operational Risk respondents stand out, as only 70% believe that Capital Management should be involved in the Basel capital approval process. Whether this is due to the relatively low capital charge that is set aside for Operational Risk or that one does not set aside Capital to take ever bigger Operational Risks in order to generate revenue, or other reasons altogether is open to debate. As to be somewhat expected, Operational Risk has a significantly higher request for involvement of the Audit group in the approval process given the perception that many of the root causes of Operational Risk reside within the world of audit and internal controls, however mistaken that may be. Somewhat disturbing is the Credit Risk response to Audit involvement, with less than 20% of respondents believing that Audit should be involved. Given the many high profile credit risk losses that have stemmed from failures in internal processes this result seems somewhat at odds with reality.
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PRMIA survey
CONCLUSION Throughout, respondents believe that quarterly sign-offs should have higher change bands than monthly as movements will have been captured and signed-off via the monthly process. Whilst the majority of respondents believe that risk component level sign off should vary by component, there was no clear direction over which of these components should take precedent. Market Risk was seen by respondents as the most mature of risk types with low monthly and quarterly volatility and any slight deviation requiring investigation and sign-off. It is apparent that Operational Risk is viewed by the majority as the most immature of risk types. Losses appear to be driven by one-offs which are seen to be mainly control, or lack thereof, related. In brevity is truth; even though this was billed as a â&#x20AC;&#x153;1 minute surveyâ&#x20AC;?, much has been revealed.
author Julian Fisher Executive Director, Crest Rider Julian Fisher has extensive experience in risk management on the buy and sell sides. He is currently an Executive Director at Crest Rider where he aids financial service clients in developing and implementing cutting-edge risk management solutions designed to comply with an ever increasing number of international regulations. He has also held senior roles in New York and London for PwC, Capco, Reuters and Deutsche Bank and sits on several Industry Risk Steering Committees.
PRMIA Riskcasts Hear the latest London chapter podcasts and PRMIA Interviews at www.soundcloud.com/prmia
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Chapter profile - London chapter
by Robert McWilliam We kicked-off the year with a planning session at which the Steering Committee reviewed the previous year’s achievements and set out our goals for 2013. After lots of great ideas and discussion, we decided to focus on 3 key areas:
1.
Establishing a stronger online presence around our PRMIA webpage supplemented with social media eg LinkedIn, SoundCloud to build a stronger sense of community across our membership. We decided to record – whenever possible – our events to make them available to a wider audience etc.
2.
Secondly, we increased the fee to $30 for non-Sustaining members to attend events with the twin objective of encouraging Sustaining membership and enhancing the perceived value of our events.
3.
Finally, we agreed to focus on raising awareness at the corporate level through for example, our popular Speaker dinner, a new CRO Keynote series and the establishing of an Advisory Committee.
So did we live up to our goals? Our biggest success was on the events front where 41 speakers contributed to 15 events in 2013. Attendance did decline with the $30 charge but the quality of the Q&A and networking only served to show the value members attached to these events. In addition we started sound recordings and publishing on a dedicated SoundCloud channel; the first 5 events attracted over 1,000 plays from across 50 countries vindicating our decision to provide content to our global followers. Our events were all either kindly hosted by firms or generously supported by sponsors. This – together with registration fees - enabled London to contribute to PRMIA Global and retain sufficient surplus to support our other activities. Such an active event schedule would not have been possible without a strong Events Committee and we successfully recruited additional volunteers from our membership. In addition to the expanded Events Committee, London also established an Advisory Committee
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comprising a group of senior risk professionals from across a range of industries and disciplines. The AC is there to support the Steering Committee’s goals and to promote risk education, training and membership in their own firms and across the industry. We held our first meeting in Jan 2014 and the discussion and contacts are already bearing fruit. December 2013 saw the first of our CRO Keynote speaker series and with a further 4 planned for 2014 already this promises to be an exciting development. We decided to restrict access to Sustaining members only to give them more personal access to the leaders in our profession. Check our webpage for more CRO Keynote speakers as 2014 unfolds.
So how would you rate us in 2013 against those objectives? 2014 is off to a flying start. In addition to the Advisory Committee meeting, we held a speaker dinner to thank our 2013 speakers and further develop our network with leaders in risk management. London participated in the PRMIA Risk Management Challenge with 8 teams entering from 6 universities. The competition was won by a team from Imperial College Business School who go forward to the final in Toronto – good luck!. We intend to build on this platform for further liaison with universities in and around London. The half day PRMC was then followed by a PRM Alumni reception in the evening as part of our efforts to engage more effectively with those who have committed most to PRMIA. Again, we intend to engage more actively with our PRM Alumni community during 2014. In Q1’13, we have held 2 CRO Keynote addresses: David Coleman CRO EBRD (and former CRO RBS GBM) and Raj Singh CRO Standard Life. In addition we have held a panel discussion event on Risk and Regulation. If you missed something, do not forget to listen to the SoundCloud recordings. A key target for 2014 is to increase membership at the Contributor and Sustaining levels. To this end we intend to survey our members for feedback on our events; times. location, format, topic etc. We are also forming “Forum Groups” to bring together risk managers from like-minded areas eg Hedge Funds, Asset Managers, Technology and Quants, Women in Risk, Islamic Finance etc. The aim here is to increase our understanding of the risk issues that these groups face and through PRMIA to provide a forum for debate and resolution.
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university chapter profile
by Sean O’Regan On the 11th of March 2014, the first PRMIA university chapter was launched in University College Cork. With the help of Bord Gáis Energy Traders, the committee managed to convey the message of sound professional risk management, and the importance of the open forum that exists between members. Andrew Bevan and Marie O’Dea shared their insights into the trading world with those students who anticipate future careers in such markets. Andrew, who holds the position as Head of Portfolio Optimisation and Risk, came to Bord Gáis in 2007 to help set up risk capability due to deregulation of the energy markets and to develop growth ambitions of Bord Gáis. He discussed the areas of hedging, risk management and governance. In particular he discussed the commodity risks that Bord Gáis face on a day to day basis, and the policies implemented in order to minimise such risk. One key factor that students
failed to identify was that Volume Forecasting is key to the short term risk management of gas. Mr Bevan also highlighted the different contracts that exist for each customer, something the committee found students tend to overlook. The majority felt that there was a “standard/average” customer but in reality this is not the case. Importantly Mr Bevan talked about the need for diversification within the market, not to be over relying on one particular sector such as gas for consumption in the commercial market. Andrew and his team also look for alternative forms of energy such as renewable.
Marie O’Dea is the Head of the Trading Department within Bord Gáis Energy; she was responsible for the setting up of the department within the company. Her responsibilities include contract origination, gas, electricity and carbon trading, 20/7 Operations, market modelling and SEM market bidding and also sales of gas to large wholesale users. In particular Marie talked about how the anticipation of different weather periods effect the demand for gas. Crucially she discussed the close ties with the U.K with 95% of our gas coming from our neighbours over the water. Therefore it highlighted how any movement in U.K gas prices or regulations directly effects Ireland’s. Marie also highlighted the difference between each office within the department, the front dealing with trading while the back deals with the regulations and compliance. While many students knew of the front office, few understood the importance of the back office, adhering to the regulations it is means that it is possible to trade. Marie informed the students that you do not have to trade just based on the present day, and that trading can take place on gas two or three years in the future. Overall the evening was a success. With many students interested in trading this was a great way to launch the existence of PRMIA within UCC. The college year has now ended, and the student director is confident that next year the chapter will have more success. It is his plan to arrange future talks during the summer with senior members of the Irish Chapter, so that when the college year begins, a plan of action will be in place to ensure the chapter’s future success.
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UCC University chapter event
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ease the pain, without sacrificing return: next generational risk management
by dr. Frank Schmielewski As a consequence of extensive turbulence on the markets, macro-economic crises and dwindling confidence in the markets, the investment industry is increasingly seeking solutions which go beyond the classic processes of Markowitz portfolio theory, and is taking more into consideration the vulnerability of the finance industry to extraordinary happenings. Innovative methods of title selection and portfolio construction which enable damage-free survival from market turbulences while still reaching the set targets for return, are becoming more and more the focus of the asset manager. Or, to put it another way: they are looking to avoid painful spells of drawdown, without having to forfeit potential profits. Although such ambitions may sound like wishful thinking, the assertions of Benoit Mandelbrot and Nassim Taleb offer a promising starting point for bringing the achievement of this objective a good deal closer. Both authors refer to the rare but extreme events which influence, either positively or negatively, the lasting success of a portfolio. If investors are rewarded on a long-term basis with an above-average performance, they are better able to avoid major setbacks to their portfolios. However, measuring extreme risks is no easy task. It requires the appropriate tools specially tailored for this purpose. This article seeks to make a critical evaluation of the extreme Value-at-Risk (eVaR), as a finetuned measuring instrument. As a result of international co-operation with renowned academic institutions and quantitative analysts in the investment industry, the eVaR has established itself as an innovative technique for measuring extreme risks. The eVaR has enhanced its process of title selection and portfolio construction, by means of tried and tested methods applied to research into natural catastrophes, in order to achieve efficient monitoring of the financial markets or investment portfolios for tail risk within the context of an efficient early warning system. At the same time, by means of an integrated ‘airbag’ eVaR reduces painful periods of drastic drawdown, without losing out on recovery or indeed on periods of sustainable growth. The eVaR can accomplish valid and reliable estimates of extreme risk (‘tail risk’) using methods from the extreme value theory. The technologies which are applied have been used in research into natural catastrophes for decades and are part of standard procedure for predicting floods, storms or torrential
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rainfall. In contrast to this, the finance industry has up to now by and large declined to apply the complex parameter estimation of extreme value distributions. The eVaR has now also tapped into this field with its systematic, quasi-deterministic parameter estimation thus enabling, along with extensive monitoring of financial markets, involvement in customised investment philosophy. The eVaR which is based on generalised extreme value distributions is not only an efficient risk measure, it also explores new ways of selecting shares and portfolio construction (for further readings see Intelligent Risk June 2013). Among these for example eVaR optimises different ‘Low-VolatilityStrategies’ which (already publicised by Haugen and Heins in 1972) have generated increasing interest among the investment industry since the financial crisis of 2007/2008. Further to this, the portfolio weights along with clearly defined constraints can be adjusted with the ‘eVaR Strategy Finder’ by means of a proprietary genetic algorithm, in order to minimise coordinated extreme losses in the target portfolio within the context of a minimum eVaR strategy. The results of comprehensive backtesting in different markets illustrate that investors can significantly reduce the risk of losses as well as increasing the value of their portfolios on a permanent basis by applying a ‘Low-eVaR-Strategy’. Above all, painful periods of losses from an investor viewpoint can be reduced considerably. This has been confirmed by the low so-called Ulcer and Pain Indexes, that quantify the length and depth of painful periods of losses and present us with much more meaningful risk measures than often-misleading ‘volatility’ which is as a rule systematically underestimating risk for structural reasons. For example, a long-only ‘Low-eVaR-Strategy’ based on 100 equally weighted shares from the S&P 500 universe with the least VaR and a three month turnover underscores the reduction depicted here in portfolio risk with a simultaneous increase in returns (Table 1). Table 1 - ‘Low-eVaR-Strategy’ reduces extreme risks significantly (backtesting from 1994 to 2013) Low-eVaR Strategy
S&P 500 Index
Change with respect to S&P 500
Maximum Drawdown
45.15%
55.2%
-18.21%
2nd Strongest Drawdown
26.15%
47.41%
-44.84%
3rd Strongest Drawdown
19.03%
19.19%
-0.83%
Length of Drawdown>5% in Days
2764
3965
-30.29%
Drawdown>5% (Decline) in Days
1301
1470
-11.5%
Drawdown>5% (Recovery) in Days
1455
2490
-41.57%
1.65%
2.25%
-26.67%
Ulcer Index
51.25
71.8
-28.62%
Pain Index
3.95
10.53
-62.49%
Annualised Return
13.98%
8.81%
58.68%
Annualised Volatility
16.02%
19.20%
-16.56%
0.87
0.46
89.13%
Risk Measure
Average Amount of Drawdown
Sharp Ratio Tracking Error Information Ratio
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7.34% 0.70
Investors who opt for virtually painless investments along with their targeted returns and extensive capital protection mechanisms will prefer a long/short ‘Low-eVaR-Strategy’ or will choose a lower level of investment, as these strategies with for example 50% hedging or a 60% level of investment reduce the Pain Index by more than 80% in backtesting (Table 2). To say it in other words, ‘Low-eVaR-Strategies’ ease the pain, without sacrificing return.
Table 1 - ‘Low-eVaR-Strategy’ reduces extreme risks significantly (backtesting from 1994 to 2013)
Low-eVaR Strategy 60% invested
Low-eVaR Strategy 50% hedged
S&P 500 Index
Maximum Drawdown
29.15%
24.03%
55.20%
-47.19%
-56.47%
2nd Strongest Drawdown
16.07%
11.96%
47.41%
-66.10%
-74.77%
3rd Strongest Drawdown
12.03%
11.32%
19.19%
-37.31%
-41.01%
Length of Drawdown>5% in Days
1655
1439
3965
-58.26%
-63.71%
Drawdown>5% (Decline) in Days
787
772
1142
-31.09%
-32.40%
Drawdown>5% (Recovery) in Days
868
667
2490
-65.14%
-73.21%
1.00%
0.83%
2.25%
-55.56%
-63.11%
Ulcer Index
21.19
15.12
71.80
-70.49%
-78.94%
Pain Index
2.26
1.60
10.53
-78.54%
-84.81%
Annualised Return
8.95%
10.93%
8.32%
7.57%
31.37%
Annualised Volatility
9.68%
7.98%
18.68%
-48.13%
-57.28%
0.92
1.3
0.45
104.44%
188.89%
Risk Measure
Average Amount of Drawdown
Sharp Ratio
Change with respect to S&P 500
The practical application is convincing. The eVaR interacts synergistically with other investment strategies. It is used by some well-known asset managers within the framework of their ‘Quality-Value’ strategies, eg: Acatis Investment GmbH with the Index Certificate Acatis Modulator Mandelbrot (ISIN: DE000LBB2JZ5) and by the Veritas Investment GmbH with the Veri Global (since 1/05/2013, ISIN: DE0009763342) and the Veri Europe ((since 1/05/2013, ISIN: DE0009763276). Conclusion: The results demonstrate the broad spectrum of deployment possibilities for eVaR and provide evidence that investors with a ‘Low-eVaR-Strategy’ which is designed to meet their expectations, can curb extreme risk substantially.
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next generational risk management
author Frank Schmielewski Member of the Executive Board, RC Banken Group Frank Schmielewski is a leading practitioner, academic, and advisor working at the forefront of risk management methodologies. He is Member of the Executive Board at RC Banken Group, a German company with a successful history of more than 25 years in the financial industry that is highly specialized on risk management methodologies. He holds a PhD in Economics and a diploma in natural sciences. He is a frequent speaker at industry conferences and has published several papers and book chapters on modeling extreme risks and risk based portfolio optimizations.
references 1. Bensalah, Y. (2000). Steps in Applying Extreme Value Theory to Finance: A Review. Bank of Canada Working Paper 2000-20. 2. Blitz, D., Van Vliet, P., (2007). The Volatility Effect: Lower Risk Without Lower Return. Journal of Portfolio Management, Fall 2007, pp 102-113 3. Embrechts, P., Klüppelberg, C.,& Mikosch, T. (1997). Modelling extremal events for insurance and finance. Springer. 4. Haugen, R. and Heins, J. (1972). On the evidence supporting the existence of risk premiums in the capital market. Wisconsin working paper Dec. 1972. 5. Schmielewski, F. (2009). Quantitative Messung der Liquiditätsrisiken. Risiko Manger12/2009. 6. Schmielewski, F. (2011). Messung und Steuerung der Liquiditätsrisiken in Publikums-und Spezialfonds. Risiko-Manager 5/2011. 7. Schmielewski, F. (2012). Quantitative Messung der Liquiditätsrisiken eines Kreditinstitutes auf der Grundlage extremwerttheoretischer Ansätze. Erschienen Jacobs, Riegler, Schulte-Mattler, Weinrich: Frühwarnindikatoren und Krisenfrühaufklärung - Konzepte zum präventiven Risikomanagement. Gabler 2012. 8. Schmielewski, F. (2012). Antifragilität und Portfoliooptimierung – eine alte Geschichte in neuem Gewand? Alternative News. Heft 07/2012. 9. Schmielewski, F. (2011). “Black swans in a white box.” Risiko Manager 20/2012. 10. Schmielewski, F. (2013). From VaR to eVaR: Next Generational Risk Management. Intelligent Risk June 2013. 11. Taleb, N. N. (2007). Black swans and the domains of statistics. The American Statistician Vol. 61, Issue 3, 2007. 12. Taleb, N. N. (2010). Antifragility, Robustness, Fragility, Inside the “Black Swan” Domain. SSRN 2010.
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economic capital
by Daniel O’Neill economic capital and solvency With the advent of Basel III, many banking institutions have seen a threat to the usefulness of their Economic Capital (EC) models. Regulators globally have been increasingly wary of internal risk models following the economic crisis. Regulators are concerned that the complexity required to build an effective EC model means they are ill-equipped to provide insight into risk within a stressed environment – precisely the function that EC was supposed to fulfil. Regulatory concerns are generally two-fold: • Modelling complexity: The reliance on historical data means that EC is unable to predict complex interactions between risk types that have not previously been observed. Since each crisis will, by definition, involve events that were not foreseen, the lack of forward looking metrics is a concern • O pacity: Being used as a tool for solvency often meant that EC models focused on generating aggressive capital estimates that were often removed from intuitive risk management Combined, these can lead to a number of counter-intuitive outcomes, for instance: • Zero PDs for sovereign debt • A separation between liquidity and capital management • Inter-risk correlations and loss assumptions based on “business as usual” rather than stress • Maximum losses divorced from key stresses of concern to management As a tool for assessing solvency, EC therefore has a number of problems. Although most sophisticated institutions continue to use EC models to support their discussion with regulators, the results often have little impact on decision making.
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Regulators themselves1 are increasingly looking to stress testing as a means to assess loss. Under this environment, asking the question “What would happen if…” becomes more for understanding risk than looking backwards. This approach allows for a clear link to risk and ties into operational governance including recoverability and also has the advantage of being simple, harmonised and easy to benchmark across institutions. At least in theory. In reality, stress testing is likely subject to the same issues. Much like risk based models, the outcome of stress tests are based heavily on modelling assumptions while also relying on the appropriate choice of scenario. Although forward looking, response to stress is still based on historical relationships between macro and operational factors. They can also be clouded by management perception of their ability to respond to any given scenario. Experience within banks suggests that most banks still believe that both senior management and the regulators see significant value in the use of EC. Since EC is typically not used to set publicly disclosed capital targets, the explanation for this view must be that EC provides a tool for firms to set appropriate risk appetite targets and demonstrate alignment across their risk management framework. Therefore, having a consistent framework with which to understand risk is where EC has a role to play.
an aligned risk management framework What is clear is that the alignment of the tools used to manage risk, capital and liquidity need to be stronger. EC, regardless of its efficacy in predicting solvency requirements, provides a quantified measure of relative risk that is aligned across the organisation. In so doing it can provide an excellent foundation for decision making. Surprisingly, perhaps, EC can provide greater value in supporting risk decision making than within capital management. Since it includes all sources of risk, it allows numerous decision processes to be made in an objective manner. These include: • Strategic business planning, including setting risk appetite • Operational decision making, such as compensation and pricing 1 / For example, refer to CEBS Guidelines on Stress Testing, 2009 or the Federal Reserve’s Capital Planning at Large Bank Holding Companies, 2013
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Many firms are now making best use of EC to provide alignment between decision making and risk. In providing a true record of relative risk, EC facilitates enhanced understanding of risk not available by other means.
strategic planning The best risk management frameworks are intrinsically linked to strategy. An aligned framework can be represented as follows:
This is a starting step to build risk into actual strategic decision making. However, EC is often not fully embedded.
Risk appetite
Economic Capital Stress testing
experience demonstrates that banks now value EC most for its ability to input into risk appetite and business planning.
Strategic planning
Fundamental to the setting of strategy is the setting of risk appetite. Risk appetite should be thought of as setting the position on the efficient frontier that the institution chooses to occupy. The institution must then decide how to achieve this objective. Different portfolio compositions will provide different return profiles, and understanding those returns needs to be based on the underlying risk. In using the business planning process, return on EC provides insight as to whether returns are appropriate for the level of risk or whether an alternate resource allocation decision needs to be made.
Supporting EC with a robust stress testing process and informed management discussion allows for risk to guide the optimal portfolio structure and provides a management framework (through the risk appetite) to get there. In so doing, EC and stress testing support one another. EC provides the basis for understanding performance and can also be used to ensure that the interactions between risks are consistent with those observed through the modelling framework. Stress testing itself also provides a valuable feedback mechanism to validate EC. The following simple illustration of risk adjusted return under a stress shows why EC is appropriate.
Using reg capital
Risk appetite
Time Using EC
It is in this area that many institutions are driving the most value. Consistent with a finding by the BIS
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Under a regulatory capital approach, risks are not appropriately accounted for, leading to a distortion economic capital
of risk adjusted performance. Using EC, which takes account of all risk, means that performance across the cycle can be understood more fully. By aligning this view to the risk appetite, business decisions are made with a conscious insight into risk. Using this approach also allows institutions to have a clear picture of recoverability. Continuing the above example, recovery options can be easily demonstrated and their efficacy understood. Hedge asset class A Reduce exposure to lending in B Securitise portfolio C
Risk appetite Time
operational decision making Once the risk appetite is set and plans are made, EC is also critical to operational decision making. Many institutions already use EC for pricing. Setting hurdle rates of return on transactions, plus including liquidity costs, ensures that a formalised process exists to ensure that all risks are incorporated into return expectations. Although EC should not be the only driver of pricing, it is important for decisions to be made with knowledge of likely profitability, not just for long term profitability but to enhance deal selection as well. EC can also be the driver of risk management. Consider operational risk. Capital was allocated on the basis of extreme scenarios, often relating to historical events. This meant that operational risk was an unwieldy capital value that
did nothing to encourage risk management. Instead, some institutions are now moving to an approach where the risk self-assessment is used. As management of the risk changes, so capital allocated improves. In this way, EC supports risk decision making. One methodology to enhance this link is to link compensation, limit setting and pricing. Regulatory guidance on assessing performance and setting risk limits require a risk adjustment mechanism that references all risks. Guidance from the BIS, FSB and individual regulators2 requires that both are explicitly linked to the underlying and complete risk profile of the organisation. The BIS and FSB papers specifically indicate that EC can be used to meet expectations relating to aligning compensation and risk. Clearly, for a firm to be prudent in its own processes, it must ensure that pricing reflects all risk â&#x20AC;&#x201C; not just the regulatory perception of that risk. Using EC for compensation ensures that the marginal contribution to risk across all risks is taken into account. This has the advantage of reducing the opportunity for arbitrage.
modelling assumptions The change in focus necessarily means a change in approach. EC models are, by their nature, complex. However, complexity is often the enemy of transparency. As such, constructing an EC framework needs to consider its eventual objective.
2 / For example, refer to: FSB - Thematic Review on Risk Governance, 2013; FSB - Principles for An Effective Risk Appetite Framework, 2013; IIF - Implementing robust risk appetite frameworks to strengthen financial institutions, 2011; BIS - Range of practices and issues in economic capital frameworks, 2011; FSB Principles for Sound Compensation Practices, 2009; Federal Reserve - Incentive Compensation Practices: A Report on the Horizontal Review of Practices at Large Banking Organisations, 2011
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For example; â&#x20AC;˘ Modelling complexity: The reliance on historical data means that EC is unable to predict complex interactions between risk types that have not previously been observed. Since each crisis will, by definition, involve events that were not foreseen, the lack of forward looking metrics is a concern â&#x20AC;˘ O pacity: Being used as a tool for solvency often meant that EC models focused on generating aggressive capital estimates that were often removed from intuitive risk management behaviour, with front office focused on deals that provide large diversification benefit rather than seeking the best return for risk in isolation.
the balance sheet and the tools to actively manage what risks are taken going forward.
disclaimer Information in this publication is intended to provide only a general outline of the subjects covered. It should not be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young accepts no responsibility for loss arising from any action taken or not taken by anyone using this publication.
â&#x20AC;˘ O ften ignored is the relationship to real shareholder capital. Since EC is a notional number, it does not automatically align to actual business targets. Firms must go a step beyond allocation and link to profitability. This allows risk to become fully integrated into risk appetite and decision making. In reality, there is no perfect approach. What is the most robust for solvency estimation will often not drive behaviour in line with risk objectives. Understanding the objective of the framework is critical to deciding the modelling approach.
in summary EC remains highly valued for banks, despite its role in setting external capital minima being overshadowed by its ability to support risk management. EC should be seen as an objective means to enable decision making such as limit setting, performance assessment and compensation into one strategic framework. The most accomplished framework will allow both backward looking understanding of risk already on
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economic capital
author Daniel O’Neill Senior Manager, Ernst & Young Daniel works in the Financial Services advisory practice of EY. In this role he is focused on the management of capital within Financial Services institutions, especially:
SPONSORSHIP OPPORTUNITIES Interested in partnering with PRMIA as a sponsor?
• Capital forecasting and stress testing • Economic capital
Many opportunities are available to you:
• Risk modeling and implementation • C apital optimisation through structuring and portfolio management • Alignment of capital and liquidity Daniel’s focus is on the integration of capital into holistic business decision making processes such as pricing, capital management, resource allocation and risk appetite. His role is to ensure institutions go beyond compliance and to drive business value and competitive advantage. Daniel began his career with Royal & SunAlliance insurance in Australia, holding several roles within Finance and Group Strategy before moving into consulting for PwC and, later, KPMG. There he focused on designing economic capital structures, risk models and capital planning frameworks for a range of banks and insurance companies in Australia and in the UK. After leaving consulting he spent 7 years as the head of capital management globally for Investec. In that role he was responsible for the Group’s ICAAP, capital forecasting, economic capital development and implementation along with risk appetite, recovery planning and all forms of stress testing along with implementation of CRD IV. 049
Intelligent Risk - April, 2014
•
Align your company with thought leadership and knowledge by sponsoring Intelligent Risk
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Take advantage of branding opportunities through a PRMIA website sponsorship
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Focus your promotions locally and regionally through chapter meetings and event sponsorships
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Directly reach out to PRMIA members through surveys and webinars
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PRMIA Risk Management Challenge (2014) We are pleased to conclude our first-ever international case competition, the PRMIA Risk Management Challenge (PRMC), a program created for post-secondary students to solve realistic problems in financial risk management.
On February 28, 2014, seven international team finalists met in Toronto, Canada to participate in the final championship round of the PRMC. The seven teams represented undergraduate and graduate students from universities/colleges across New York, Chicago, Toronto, Montreal, Vancouver, Ireland and London (UK). All finalists made it through a preliminary round competition from a case study on Conseco, Inc (contributed by Dr. Russell Walker from the Kellogg School of Management of Northwestern University) across 92 teams representing 344 students from 38 colleges/universities. At the international championship, finalists convened at the Ontario Investment and Trade Centre, where each team had 20 minutes to present their solution to a PRMIA case study on the Royal Bank of Scotland (RBS), followed by 10 minutes of questions and answers from a panel of judges. The RBS case study focused on three core themes: capital management, liquidity risk and firm strategic risk. All teams were privileged to attend a luncheon featuring two Keynote Speakers - Dr. Madelyn Antoncic, Vice President and Treasurer, World Bank and Dr. Dan Rodriguez, Managing Director & CRO, systematic market-making, Credit Suisse. The teams were also privileged to attend a wine-and-cheese reception and paneldiscussion featuring leaders from across the financial services industry. Congratulations to the 2014 PRMC International Champions - Team “Bronx Bankers” from Fordham University, New York City, NY.
From left to right: Blake Rodriguez Christopher McCloskey Neal Sukhia
Neal is a junior at the Gabelli School of Business at Fordham University majoring in Finance. This past summer and academic year he has interned with Alvarez & Marsal, a global consulting firm, in their Restructuring Division where he analyzed prominent distressed companies. Currently he is the emerging markets analyst on Fordham’s Student Managed Investment Fund where he is part of a select group of students that actively manage $1.35M of the school’s endowment. He is also a previous winner and competitor of JP Morgan’s Investment Banking Risk Case Challenge. Neal Sukhia
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Intelligent Risk - April, 2014
Blake is a junior at Fordham University’s Gabelli School of Business. He is currently pursuing a bachelor’s degree in finance and economics. During his time at Fordham, he has held internships at United Capital LLC and most recently Richard Bernstein Advisors LLC, where he gained exposure to both fundamental and quantitative portfolio management styles. Mr. Rodriguez is currently an active member within the school’s Alternative Investment Club, within which he is conducting research evaluating quantitative and fundamental sources of alpha. This summer Mr. Rodriguez will serve as a summer analyst within Bank of America’s investment bank. Blake Rodriguez
Stephen is a junior in the Gabelli School of Business at Fordham University majoring in finance. He has been interning on the crude oil derivatives trading desk at JPMorgan since September 2013 and was previously an intern in the Chief Investment Office of JPMorgan working on capital and liquidity risk. He is currently the President of the university Alternative Investment Club and the current energy analyst for the student managed investment fund on campus. Stephen Hearn
Chris is from Long Island, New York. He is a junior finance major with a concentration in alternative investments from Fordham University. Chris is a member of the Men’s Club Soccer team and serves as the Head of Speaker Series & Networking for the Alternative Investments Club. Chris has held six internships since entering Fordham. These experiences range across the insurance, wealth management, and investment banking industries. This summer, Chris will be interning at Neuberger Berman Alternatives, a private equity platform. After graduating from Fordham, Chris hopes to land a full time position in investment banking or private equity. Christopher McCloskey
Congratulations to the runners up, Team “Put Call Therapy” from Simon Fraser University of Vancouver, British Columbia.
From left to right:
From left to right:
Judges (Louise Tremblay, Desjardins; Deborah Ng, Ontario Teachers’ Pension Plan;
David Gontovnick; Peter Mak
Jonathan Patterson, TD Bank Group; and Andrea Yu, Accenture) and Keynote Speaker
Wing-Kan Chung; Viacheslav Trefilin
(Dan Rodriguez, Credit Suisse)
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Welcome address in Toronto by Dr. Catherine Chandler-Crichlow, Executive Director, Centre of Excellence in Financial Services Education (CoE)
PRMIA would like to thank all speakers, organizers and case study developers for their time and energy into the PRMIA Risk Management Challenge! Afternoon Keynote Speaker: Dr. Madelyn Antoncic, Vice President and Treasurer, World Bank Lunch Keynote Speaker: Dr. Dan Rodriguez, Managing Director and CRO, Systematic Market-Making, Credit Suisse International Championship Judges • Deborah Ng, Portfolio Manager, Ontario Teachers’ Pension Plan • Jonathan Patterson, Associate Vice President, Capital Markets Risk Management, TD Bank Group • Louise Tremblay, Director, Desjardins • Andrea Yu, Manager, Finance & Risk Practice, Accenture Financial Services Industry Panelists • Andrew Graham, Co-Chair, Toronto Homecoming; • Kelly Hastings, Chief Risk Officer, CIBC Mellon; • Keith McQueen, Senior Vice President, Capital Markets Risk Management, TD Bank Group; • Dr. Graham Pugh, Vice President, Investment Risk Management, OMERS; • Christopher Thompson, Managing Director, Finance & Risk Practice, Accenture
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PRMIA Risk Management Challenge (2014)
PRMIA Case Study Authors and Contributors Alex Voicu, PRMIA; Andy Condurache, PRMIA; Justin McCarthy, University College Cork; Karen Myers, TD Securities; Vadim Culic, TD Bank Group; Nick Jago, Ontario Teachersâ&#x20AC;&#x2122; Pension Plan; Arthur Kwok, TD Securities; Justin Lau, TD Securities.
Organizing Partners Cheryl Buck, PRMIA; Beth Fossum, PRMIA; Dan Rodriguez, Credit Suisse; Ken Radigan, Aspen; Sol Steinberg, OTC Partners; Justin Lau, TD Securities; Andrea Yu, Accenture; Oleksandr Romanko, IBM; Timur Gok, Arditti Center for Risk Management; Jean-Philippe Tarte, HEC Montreal; Louise Tremblay, Desjardins; Alex Voicu, PRMIA; Karen Myers, TD Securities; Robert McWilliam, ING Bank; Graham Pugh, OMERS; Kruno Perkovic, Synchrony; Greg Frank, GRI; Isabel Dimitrov, Ryerson University; Timothy Li, OTPP; Erol Biceroglu, OPTrust; Vivian Young, TD Asset Management; Nick Jago, OTPP; Carlos Da Costa, University of British Columbia; Justin McCarthy, University College Cork; Monika Smatralova, Ulster Bank. Thank you again to all sponsors, speakers and organizing partners! PRMIA Risk Challenge 2014 Founding sponsor
Lead sponsors
Case study sponsor
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Final round host
Intelligent Risk - April, 2014
Program partner
learning opportunities In the current environment risk education is not just a choice, it is a necessity. Since the global recession began in 2008 the demand for risk management training has dramatically increased at all levels. In response, our training is evolving in line with member needs. PRMIA recognizes the diversity in this renewed demand and has responded by providing a library of risk education tools, delivered in brief via online and webbased training solutions, as well as through live classroom and customized inhouse training. All platforms are created and delivered by leading industry experts. Watch your e-mail and check the website for current training schedules.
UPCOMING OPEN ENROLLMENT COURSES COUNTERPARTY CREDIT RISK: THE IMPACT OF CVA, BASEL III, FUNDING AND CENTRAL CLEARING A Two-Day Course led by Jon Gregory London / May 8-9, 2014 / 9:00 a.m. - 5:00 P.M. More details here CONTINGENT CONVERTIBLES AND OTHER HYBRID FINANCIAL SECURITIES A Two-Day course led by Jan De Spiegeleer New York / May 8-9, 2014 / 9:00 a.m. – 5:00 P.M. More details here
CSA DISCOUNTING AND XVA PRICING A Two-Day course led by Roland Stamm and Chris Kenyon Dusseldorf / July 8th and 9th, 2014 / 9:00 a.m. – 5:00 P.M. More details here
A COMPLETE COURSE IN RISK MANAGEMENT Offered jointly by PRMIA & Kellogg School of Management, Zell Center for Risk Research Chicago / Monday – Friday, July 21 - 25, 2014 / 8:30 A.M. - 6:00 P.M. More details here
MANAGING REGULATION AND INSTITUTIONAL RISK Offered jointly by PRMIA & Kellogg School of Management, Zell Center for Risk Research Featuring Russell Walker and Timothy Feddersen Chicago / December 5-6, 2013 / 8:30 A.M. - 5:00 P.M. More details here 054
Intelligent Risk - April, 2014
submission guidelines CALL FOR ARTICLES Article submissions for future issues of Intelligent Risk are actively invited. Articles should be approximately 1,000–1,500 words, single spaced, and cover a topic of interest to PRMIA members. Please consult the submission guidelines located at the end of the publication prior to submitting your article. Please send all article submissions that you wish to be considered for publication to iRisk@prmia.org. Chosen pieces will be featured in future issues of iRisk, archived on PRMIA.org, and promoted throughout the PRMIA. community.
I-RISK SUBMISSION GUIDELINES Follow these instructions regarding the format of your articles and references. Article Submission - Please send all article submissions that you wish to be considered for publication to iRisk@prmia.org File Format - Please prepare your work using Microsoft Word, with any images inserted as objects into the document prior to submission. Abstract - Please present a brief summary or abstract of the paper on the page following the title page. Author Biography - Please include a biography, not exceeding 150 words, for each of the contributing authors listed. All biographies must be included at the end of the article. Author Photo - Please provide a professional photograph to be included with your article. The photo must be submitted as a separate file in jpeg or tiff format. Exhibits - Remember to attach all elements relevant to the paper (tables, graphs, charts and photos) on separate and individual pages at the end of the article. Please denote all tabular and graphical materials as Exhibits, and designate them using Arabic numerals, successively in order of appearance in the text. Exhibit Presentation - Please ensure that tables and other supplementary materials are organized and presented consistently throughout the paper, because they will be published as is. You may submit exhibits produced either in color or black and white. Use the exact same language in consecutive appearances; indicate all bold-faced or italicized entries in exhibits; arrange numbers consistently by decimal points; use the same number of decimal points for the same
types of numbers; center headings, columns, and numbers correctly; and incorporate any source notes when required. Consistency of fonts, capitalization, and abbreviations in graphs throughout the paper is required, and all axes and lines in graphs must be labeled in a consistent and coherent manner. Paste all graphs into Word documents as objects, and not as images, allowing access to the original graph. Please supply source materials for graphs such as Excel files. Equations - Please present equations on separate lines. All equations must be aligned with the paragraph indents, but not followed by any punctuation. Use Arabic numerals at the right-hand margin to number equations consecutively throughout the article. Use brackets to indicate all operation signs, Greek letters, or other such notations that may be ambiguous. Reference Citations - In-text citations of authors and works must be represented as: Smith (2000). Use parenthesis for the year, not brackets. Similarly, references within parentheses must be represented as: “(see also Smith, 2000).” References List - A reference is a source that is actually cited in the text. Please formally list only articles previously cited, using a separate alphabetical references list at the end of the article. Author Guidelines - PRMIA categorically values literary excellence in selecting articles for publication. To enhance clarity and coherence, we urge the use of simple sentences comprising of a minimal number of syllables per word.
Please follow these recommendations in the interests of meeting PRMIA’s publication standards, and to accelerate both the evaluation and editorial process. The review process will take up to 4-8 weeks. The author will receive articles due for revision, as well as those while accepted, departs in large part from these guidelines. Finally, PRMIA reserves the right to return to an author for reformatting purposes, any article, which is accepted for publication that deviates from the aforementioned standards. The editors always reserve the right to make further changes to your work for consistency and coherence.
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Intelligent Risk - April, 2014
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