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Risk Appetite, Stress Testing & Capital Planning: Need for an integrated approach for your bank Pg. 7

The 2007-2012 Global Financial RiskJournal - A Quarterly Publication of PRMIA DC Y B ’ ACrisis: Perspectives Risk Appetite, from Asia Stress Testing Capital Planning Pg. 16 OUR

ANK S

PPROACH TO

There are also strong business reasons for building an integrated approach. Banks will have to manage and deploy capital more efficiently over the next few years as a result of the extra costs of Basel III’s capital and liquidity reforms. The integration of certain risk and finance planning tasks is one way to achieve this capital efficiency, while also gaining operational efficiencies in bank finance and risk management functions. How Are the Three Concepts Linked?

,ˆÃŽÊ>««ïÌi]ÊÃÌÀiÃÃÊÌiÃ̈˜}]Ê>˜`ÊV>«ˆÌ>Ê«>˜˜ˆ˜}Ê>Àiʈ˜iÝtricably linked because it is difficult to address any of the three concepts individually without addressing the others >ÃÊÜiÊ­ˆ}ÕÀiÊ£®°Ê,ˆÃŽÊ>««ïÌiÊV>˜ÊLiÊÀi}>À`i`Ê>ÃÊ̅iʓœÃÌÊ v՘`>“i˜Ì>ÊVœ˜Vi«ÌÊvœÀÊ̅iÊvœœÜˆ˜}ÊÀi>ܘÃ\Ê

The False Promise of Expected TOC Shortfall: Ineffective and Dangerous Pg. 13

UÊ ÌÊ`ÀˆÛiÃÊ̅iʜ̅iÀÊÌܜ\ÊÌʈÃʘœÌÊ>Ãʓi>˜ˆ˜}vՏÊ̜Ê>˜>ÞâiÊ the implications of a stress test, or to plan how much capital the bank will require, without first reconciling risk-taking and business goals. UÊ ÌÊVœ“iÃÊvÀœ“Ê̅iÊ̜«\Ê,ˆÃŽÊ>««ïÌiʈÃÊ>ÊLœ>À`‡iÛiÊ initiative that permeates the entire organization. UÊ ÌÊÀi“>ˆ˜ÃÊÀi>̈ÛiÞÊÃÌ>LiʜÛiÀÊLÕȘiÃÃÊVÞViÃ]ʈ“«Þing which actions the bank should take to respond to changing portfolio-level or macroeconomic conditions. However, the dependencies between the three concepts run in both directions. As discussed below, in order to define its risk appetite in a useful way, the bank may need to run a series of stress and scenario tests. In turn, once established, the risk appetite becomes a key yardstick for the bank’s wider, ongoing stress-testing program. In other

RiskJournal September 2012 The RMA Journal 43

FALL/ NOVEMBER 2012 A QUARTERLY PUBLICATION OF PRMIA DC

Progress in Financial Services Risk Management: A survey of Major Financial Institutions MOVING THE MARKET FORWARD: Principles for Returning FHA to its Traditional Mission PAGE 26

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The DC Chapter of the Professional Risk Managers’ International Association (PRMIA), in cooperation with the Robert H. Smith School of Business at the University of Maryland, presents

November 13, 2012, 8am - 6pm PRMIA DC 4th Annual Risk & Regulatory Summit Implementation Issues of Regulatory Reform

Keynote speakers: Edward J. DeMarco, Acting Director, FHFA; Dan Rodriguez, MD & Division CRO, Credit Suisse Panels on Living Wills, OFR Systemic Risk, OTC Derivatives Reforms, Top regulators from FDIC, FRB, NIAC, OFR, SEC Senior bankers, practitioners, thought leaders and academia

Venue: Ronald Reagan Building & International Trade Center 1300 Pennsylvania Avenue, N.W.


THANK YOU SPONSORS For supporting our PRMIA DC 4th Annual Policy & Risk Summit Ronald Reagan Building, Washington DC, November 13, 2012

PLATINUM SPONSOR

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RiskJournal - A Quarterly Publication of PRMIA DC

CONTENTS • •

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Click on a topic to be directed to a specific article Click TOC on the page header to be redirected back to the Table of Contents

PRMIA DC RiskJournal Fall November 2012

RiskEditorial Word from the Editor.................................... 5

RiskFeature Your Bank’s Approach Towards Integrating Risk Appetite, Stress Testing & Capital Planning......................................................... 7 The False Promise of Expected Shortfall... 13 The 2007-2012 Global Financial Crisis: Perspectives from Asia............................... 16 Operational Risk Management - Key Shifts Required to Rise to the Challenge.............. 22

Moving the Market Forward: Principles for Returning FHA to its Traditional Mission.... 26

RiskResources What’s on the Web: Addressing Systemic Risks............................................................... 32 Progress in Financial Services Risk Management: A survey of Major Financial Institutions..................................... 34

RiskTeam RiskJournal Editorial Committee.................. 41

We endeavor to bring a different quarterly newsletter to our members; one that will hopefully interest you to engage and participate actively in our PRMIA Global and PRMIA DC events and activities. It is our belief that only through active participation can we all benefit from our collective learning and information sharing. We encourage interested members to join us in this endeavor. Do feel free to contact any of us with suggestions and comments. RiskJournal accepts paid or sponsored advertising, separate from editorial content. Contact us at DC.PRMIA@gmail.com for more information on sponsorship and ad rate structure. RiskJournal’s primary goal is to serve PRMIA’s Washington D.C. chapter and its industrywide constituency as a credible source of up-to-date risk management information and thought-provoking discussion. We welcome written contributions on topics relevant to risk management. RiskJournal does not accept compensation of any kind, including money, gifts or other favors, in exchange for editorial. We welcome diverse topics, discussions and points of view. Publication is merit based, and submission does not guarantee publication. PRMIA DC’s Editorial Board makes all editorial decisions, and decisions are final. The Board reserves the right to edit all content for clarity, accuracy, length and/or other factors. Authors are responsible for the content and accuracy of reported data and statistics. The individual viewpoints represented in RiskJournal express the viewpoints of the author, and do not necessarily reflect the views of the Professional Risk Managers’ International Association organization (PRMIA), the DC Chapter or our sponsors and supporters.

!

4 RiskJournal encourages republication of content with the author’s consent. Any such republication should include the note, “This article originally appeared in the [DATE OF PUBLICATION] issue of RiskJournal, the publication of the PRMIA’s Washington, DC chapter.” Please contact members of our Editorial Committee for more information.


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WORD FROM THE EDITOR PRMIA DC RiskJournal Fall 2012

As expected, this has been an eventful year of living on nerves. We continue to have the euro area sovereign debt and banking crisis weighing over our heads. Extensive measures by governments, and their agencies, especially central banks, have been most notable. Despite the continued easing, markets have been lethargic and unemployment rates stayed high. There is continuing threat that the real economy will slip again into deep recession, while the high sovereign indebtedness has everyone concerned about a reversal of the past expansionary policies. Maintaining financial markets stability has been a difficult fine balance, especially with the urge by elected governments to ease the pain of a slow and sluggish economy and the effects of a protracted high unemployment. For many, this year has so far not been as bad as it could have been. Efforts by regulators to rein in on structural and other weaknesses in the financial system are beginning now to take shape. Many of the rules arising from the enactment of the Dodd-Frank Act are now final, and several have

Fall 2012 RiskJournal

gone into implementation, although there are still many rules to come. Banks and financial institutions are heavily engaged in addressing these as they come; wave after wave, with no clear end in sight yet. Yet with the US Congressional and Presidential election just round the corner, some argue that much could change depending on the outcome. Regardless, banks and financial institutions cannot wait. Implementation from the Regulatory Reform must continue, and there are many urgent matters that will need immediate attention. With this in mind, the PRMIA DC Chapter has organized as part of our 4th Annual Policy & Risk Symposium a full-day event to pour through in-depth many burning questions in this whole effort; which is why we call our event “Implementation Issues of Regulatory Reform�. Whether regulators, bankers, risk practitioners, lawyers, accountants, consultants, think-tank or the academia, there are many precious lessons that can be learned by leveraging our collective thinking and experience. We hope the conference will help all alike who are grappling with implementation considerations - where the rubber hits the road. We have therefore made this issue of RiskJournal somewhat special. We have included for example a survey of major financial institutions’ progress on risk management, especially in response to the crisis. There is also a compilation of resources on the web on systemic risks, a key ongoing challenge that is also part of the reform.

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RiskJournal - A Quarterly Publication of PRMIA DC

We have also included a special feature on Moving the Market Forward: Principles for Returning FHA to its Traditional Mission, an important development to start returning the housing market to maintain ongoing stability on a sustainable basis. Another feature article we have included is one for the banks; on Integrating Risk Appetite, Stress Testing and Capital Management. Of course the details are not all here; it would have been too much to cover in this newsletter. Rather than have everything delivered quarterly in this RiskJournal, we are developing a blog for PRMIA DC. This is currently still in beta testing, but some of you will have no doubt already visited the site. The amount information that we have to keep up-to-speed with just on DoddFrank implementation alone is just incredible. We encourage all our members and readers to engage each other actively to share experiences, knowledge, information and interesting materials so we can all speed up our learning curve. We will cover a wide range of topics there, and I would like to use the next issue to explain more. In this issue, we have also included an interesting perspective on the wisdom of Basel Committee’s dependence on Expected Shortfall instead of VAR as the central metric for market regulatory risk capital. You will see an article on an Asian perspective of Global Crisis, and an article arguing for the need to make a serious change and shift to rise to today’s challenge to manage risk.

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our RiskJournal something that you can use in keeping abreast and developing the acumen for better risk management.

And don’t forget, join us this coming November 13, 2012, at the Ronald Reagan Building, Washington DC for our 4th Annual Policy & Risk Symposium on “Implementation Issues of Regulatory Reform”

Steven Lee Managing Director, Global Client Consulting Editor, RiskJournal PRMIA DC Regional Director

We hope you will like the compilation, and we welcome suggestions and contributions to make

Fall 2012 RiskJournal

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Your Bank’s Approach To Integrating Risk Appetite, Stress Testing & Capital This article is a republication of Mr. Kenneth Yu’s article on the September 2012 issue of the RMA Journal ABOUT THE AUTHOR: Kenneth Yu is a senior consultant in SunGard’s risk management advisory practice and the Ambit Risk Institute.

HIGHLIGHTS ❖

Risk appetite, stress testing, and capital planning exercises must be approached using an integrated plan that reflects their close conceptual relationship and interdependence The links among the three concepts are evident in recent global regulatory trends, and banks need to respond.

Risk appetite, stress testing, and capital planning exercises must be approached using an integrated plan that reflects their close conceptual relationship and interdependence. The links among the three concepts are evident in recent global regulatory trends that push banks to think about risk and capital planning in a more closely linked way. In Europe, banks have been developing an Internal Capital Adequacy Assessment Process (ICAAP) over the past few years to comply with Pillar 2 of Basel II. This move can be seen as a formalization of the links between board-approved risk appetite, risk management, business strategy, and capital planning, supplemented by stress testing and scenario analysis 1. In the United States during the same period, the stress testing programs for that nation’s 19 largest banks2 had led regulators to forge a robust link between big-picture macro-economic stress testing and bank capital planning. The regulators are now applying these lessons more widely, as is apparent both in new stress testing requirements for medium Fall 2012 RiskJournal

size banks3 (with more than $10 billion in assets) and in recent remarks by U.S. regulators that make clear why banks must supplement traditional capital adequacy calculations with more comprehensive and forward looking stress testing and capital planning4. There are also strong business reasons for building an integrated approach. Banks will have to manage and deploy capital more efficiently over the next few years as a result of the extra costs of Basel III’s capital and liquidity reforms. The integration of certain risk and finance planning tasks is one way to Figure 1

Interconnected Processes

Stress Testing

Capital Planning

Risk Appetite

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achieve this capital efficiency, while also gaining operational efficiencies in bank finance and risk management functions. How Are The Three Concepts Linked? Risk appetite, stress testing, and capital planning are inextricably linked because it is difficult to address any of the three concepts individually without addressing the others as well (Figure 1). Risk appetite can be regarded as the most fundamental concept for the following reasons: • It drives the other two: It is not as meaningful to analyze the implications of a stress test , or to plan how much capital the bank will require, without first reconciling risk-taking and business goals. • It comes from the top: Risk appetite is a board-level initiative that permeates the entire organization. • It remains relatively stable over the business cycles: implying which actions the bank should take to respond to changing portfolio-level or macroeconomic conditions. However, the dependencies between the three concepts run in both directions. As discussed below, in order to define its risk appetite in a useful way, the bank may need to run a series of stress and scenario tests. In turn, once established, the risk appetite becomes a key yardstick for the bank’s wider, ongoing stress-testing program. In other words, what capital or loss threshold should the bank use in assessing the impact and acceptability of each adverse scenario? Capital planning, meanwhile, depends on both a clear risk appetite and a thorough program of forward-looking stress testing. For ex- ample, how much risk is the bank prepared to assume in pursuit of its business strategy, and how much capital will this consume across the planning horizon in light of forward-looking stress tests? For clarity, the focus here is on the credit risk implications of these interconnections; however, banks can apply similar logic to build an integrated approach across all the other major risk types. Setting Credit Risk Appetite through EC-based Scenario Analysis Many banks have now developed some kind of risk appetite statement that sets out the level of risk the bank is willing to assume in order to achieve its Fall 2012 RiskJournal

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business goals. However, most banks have not succeeded in transforming this largely qualitative statement into a coherent quantitative expression of risk appetite that can drive day-to-day bank decisions at the line level, help the bank interpret stress-test results, and conduct capital planning. One way to resolve this issue involves articulating the bank’s risk appetite using a series of economiccapital-based scenario analyses. First, the bank looks at its expected return on equity (ROE) and potential credit losses under various positive and negative scenarios. For example, the bank can consider the scale of losses that might be associated with the portfolio once during every economic cycle or as a result of some rare tail-risk event. Second, the bank alters the current portfolio to create a series of new portfolios with different riskreward profiles. Their creation must be grounded in reality through an honest and analytical assessment of the spreads available and risks inherent in the available market opportunities. Portfolio may increase the chances of higher returns) and different potential credit losses (a higher-risk portfolio will also increase the chances of higher losses). Figure 2 sets out how two different portfolios might be characterized using this process. The scenario net income is set out for each portfolio, and the resulting returns make clear the trade-off between the different risk profiles of each portfolio under varying scenario conditions. This objective survey process allows the bank to find the consensus among those polled, arriving at a collective and objective risk appetite that can be further refined through rounds of healthy debate and discussion. The beauty of this approach, which leverages scenario analysis, is that it combines management opinions on risk with objective quantitative analysis, such that the bank’s risk appetite can be expressed in quantitative terms then more effectively facilitate stress testing and capital planning through limit setting, concentration analysis, and loss thresholds. Stress Testing and the Application of Bank Risk Appetite Once quantified, the bank’s risk appetite can then be used as a yardstick against which to measure the results of the stress tests. There are two main ways this can be done.

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Figure 2

Which Portfolio Best Expresses the Bank’s Quantitative Risk Appetite? Portfolio C

Expected ROE= 10% Description

Probability of Occurrence

Net Income, Post Credit Losses, $MM

ROE*

Upside

~10%

575

24%

Highest Probability

~75%

295

12%

Once in an Economic Cycle

~10%

–56

–2%

Once in Two Economic Cycles

~5%

–248

–10%

Once in a Career

~2%

–548

–23%

Worst-Case Event

0.07%

–1,256

–52%

Portfolio D

Potential credit losses

Expected ROE= 14% Probability of Occurrence

Net Income, Post Credit Losses, $MM

ROE*

Upside

Description

~10%

1,115

43%

Highest Probability

~75%

486

18%

Once in an Economic Cycle

~10%

–334

–13%

Once in Two Economic Cycles

~5%

–771

–29%

Once in a Career

~2%

–1,442

–54%

Worst-Case Event

0.07%

–2,975

–112%

1. Macroeconomic Scenario-based Stress Testing The kind of stress testing that first comes to mind, scenario-based stress testing has been popularized recently by regulator-conducted initiatives and codified by regulatory guidance. Here, risk appetite thresholds and limits can be leveraged by comparing the losses being predicted in each adverse scenario to the losses deemed acceptable under the bank’s risk appetite. To the extent that the predicted losses exceed the loss appetite amount, the scenario may be deemed unacceptable and the bank will need to reduce or mitigate the exposure. The advantage of using risk appetite metrics for comparison with stress-test outputs is that the thresholds have already been agreed to and approved by the board. Therefore, the owners of the stresstesting process would not need to spend additional effort obtaining buy-in for those metrics, which often is one of the most challenging aspects of the stresstesting process. 2. Reverse Stress Testing Fall 2012 RiskJournal

Loss potentials from a credit portfolio model translate into net income outcomes at varying probability levels.

Regulators are keen that banks also conduct reverse stress testing, where the bank first works out the level of loss that might damage the institution and then thinks through how such losses might occur. Banks can look at two key risk- appetite metrics— expected loss (EL) and economic capital (EC)—as extreme loss thresholds. The EL would be the least conservative level of loss, while the EC would be the most conservative level of loss (for example, a “break the bank” scenario). The actual level of loss that the bank should focus on in its reverse-stress-testing process should be a loss level in between the EL and EC. This could be a “once in an economic cycle” (1 in 10) or “once in a career” (1 in 50) level of loss that can be defined through the risk- appetite-setting process, thus ensuring that the reverse stress test aligns with board-approved loss thresholds. Figure 3 illustrates how risk appetite can be used as a key yardstick for scenario-based stress testing. The bank’s loss forecasts in a baseline macroeconomic scenario are shown in blue, and its loss forecasts in an adverse macroeconomic scenario are shown in red. Here, the expected loss for the

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commercial real estate (CRE) portfolio in the adverse macroeconomic scenario is forecast to cross an

much less risky profile, located between Profile B and Profile C. Meanwhile, the bank’s anticipated position based on its intended capital and business plans is shown by a red dot. We can see that the bank’s current plans move it toward its risk appetite, but not enough. Therefore, this bank’s business plans will need to be revisited and refined further (with contingency plans such as loan sales, for example) if the bank is to achieve the board-approved risk profile. This kind of integration between risk appetite and capital planning can be done at the portfolio or business-line levels as well. The key prerequisite is that the risk appetite be quantified and operationalized. Meanwhile, capital planning can and should take account of forward-looking macroeconomic stresses. While a business line may be consuming capital at a rate that is below the risk appetite limit in a baseline scenario, what if the economy takes a turn for the worse and capital consumption increases above the limit in an adverse scenario? Clearly, the bank should

expected loss risk-appetite threshold. This should prompt the bank to take mitigating action, such as reducing the riskiness of the CRE portfolio. Capital Planning in Light of Risk Appetite and Stress Tests

Figure 4

Linking Risk Appetite and Capital Planning

Banks with quantitatively based risk appetites can integrate their risk appetite into the bank’s capital planning programs, loss, and unexpected loss, the bank-level risk appetite can be operationalized by associating each portfolio or line of business with expected loss and unexpected loss thresholds in line with the top-of-house view. The capital management and allocation process can then determine whether growth projected for the portfolio, or projected changes in the risk profile of the portfolio, will lead the bank closer toward its risk appetite or further away from it.

Risk-Reward Profile

Portfolio direction based on initial business plan Surveyed risk appetite

Scenario:

A

B

C

D

E

F

G

ROE:

8%

10%

12%

14%

16%

18%

20%

EL:

0.4%

0.6%

0.8%

1.0%

1.2%

1.5%

1.8%

EC:

2.2%

3.2%

4.7%

5.5%

6.1%

7.3%

10.9%

Figure 4 sets out an example of how the two steps can be achieved. The figure shows seven different risk-reward profiles for a sample bank. Each profile is defined by three from lowest risk-lowest reward (on the left-hand side) to highest risk-highest reward (on the right-hand side). The bank’s current position, as shown by a green dot, is between Profile D and Profile E. The bank’s agreed-to risk appetite, indicated by a blue dot, is a Fall 2012 RiskJournal

Current portfolio

leverage and extend its investment in scenario analysis to make its capital planning as robust as possible. Integration and Operational Efficiency While risk appetite, stress testing, and capital planning can be done in isolation, banks that do so will not only perpetuate a siloed approach to risk management but also miss out on significant operational efficiencies that can be gained by using

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The challenge is worth tackling, however, and not only for reasons of best-practice risk management. Banks will have to complete more business planning and risk management exercises, stress testing, and capital planning with far fewer resources over the next few years. Operational efficiencies can be gained by leveraging existing components and metrics from related initiatives.

ÌÊ`ÀˆÛiÃÊ̅iʜ̅iÀÊÌܜ\ÊÌʈÃʘœÌÊ>Ãʓi>˜ˆ˜}vՏÊ̜Ê>˜>ÞâiÊ an integrated approach. Each of these UÊprocesses has the implications of a stress test, or to plan how much components that feed or can leverage parts of other capital the bank will require, without first reconciling processes: risk-taking and business goals.

There are also strong business reasons for building an integrated approach. Banks will have to manage and deploy capital more efficiently over the next few years as a result of the extra costs of Basel III’s capital and liquidity reforms. The integration of certain risk and finance planning tasks is one way to achieve this capital efficiency, while also gaining operational efficiencies in bank finance and risk management functions.

Moreover, for exercises that require so much attention and input from senior management, banks should make the most of their top executives’ time by combining disparate decision-making processes. Approaching the three concepts of risk appetite, stress testing, and capital planning in a holistic and integrated fashion will allow the bank to achieve these efficiencies.

UÊ ÌÊVœ“iÃÊvÀœ“Ê̅iÊ̜«\Ê,ˆÃŽÊ>««ïÌiʈÃÊ>ÊLœ>À`‡iÛiÊ

at a that permeates the entire organization. • Scenario analysis can be used to arriveinitiative UÊ ÌÊÀi“>ˆ˜ÃÊÀi>̈ÛiÞÊÃÌ>LiʜÛiÀÊLÕȘiÃÃÊVÞViÃ]ʈ“«Þtransparent and objective risk appetite.ing which actions the bank should take to respond to changing portfolio-level or macroeconomic conditions.

yardsticks • Risk appetite metrics can be used as key However, the dependencies between the three concepts Notes ,ˆÃŽÊ>««ïÌi]ÊÃÌÀiÃÃÊÌiÃ̈˜}]Ê>˜`ÊV>«ˆÌ>Ê«>˜˜ˆ˜}Ê>Àiʈ˜iÝrun in both directions. As discussed below, in order to in the stress-testing process. 1. See, for example, the Financial Services Authority’s “ICAAP How Are the Three Concepts Linked?

tricably linked because it is difficult to address any of the three concepts individually without addressing the others >ÃÊÜiÊ­ˆ}ÕÀiÊ£®°Ê,ˆÃŽÊ>««ïÌiÊV>˜ÊLiÊÀi}>À`i`Ê>ÃÊ̅iʓœÃÌÊ v՘`>“i˜Ì>ÊVœ˜Vi«ÌÊvœÀÊ̅iÊvœœÜˆ˜}ÊÀi>ܘÃ\Ê

define its risk appetite in a useful way, the bank may need

Submissions: Suggested Format,” v2.0, November 22, 2007 run aappetite series of stress and scenario tests. In turn, once risk • Capital planning should incorporate toestablished, the risk appetite becomes a key yardstick for thresholds and account for stress scenarios. 2. The stress tests mandated by U.S. regulators were performed as the bank’s wider, ongoing stress-testing program. In other

This implies a degree of organizational integration —or coordination, at a minimum—between various bank functions. The necessary information, data, and skills to develop an integrated approach will likely have to be brought together across the functions of treasury (interest rate risk information), finance (capital adequacy), and risk (stress testing).

Fall 2012 RiskJournal

part of the Supervisory Capital Assessment Program (SCAP), completed in

2012 The RMA Journal 43 3.September See “Supervisory Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets,” Federal Reserve/ OCC/ FDIC, May 17, 2012

4. See, for example, remarks by Federal Reserve Board Governor, Daniel K. Tarullo, “Developing Tools for Dynamic Capital Supervision,” Chicago, Illinois, April 10, 2012.

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PRMIA DC 4TH ANNUAL POLICY & RISK SUMMIT TOC

RiskJournal - A Quarterly Publication of PRMIA DC

NOVEMBER 13, 2012

OUR SINCERE APPRECIATION TO THE MANY WHO MAKE THIS POSSIBLE… We are very pleased that to have so many highly esteemed companies and institutions supporting our PRMIA DC 4th Annual Policy & Risk Symposium to be held on November 13, 2012 at the Ronald Reagan Building, Washington DC on Implementation Issues of Regulatory Reform, including:

Presents Regulators & Federal Agencies: • • • • • •

PRMIA DC 4th Annual Risk & Regulatory Summit

Board of Governors of the Federal Reserve System (FRB) Commodities Futures Trading Commission (CFTC) Federal Deposit Insurance Corporation (FDIC) Federal Housing Finance Agency (FHFA) Office of Financial Research (OFR) Securities Exchange Commission (SEC)

Financial Institutions, Academia, Trade Associations and Private Sector Firms • • • • • • • • • •

Bank of America, Merrill Lynch Credit Suisse State Street, Inc. Deloitte Ernst & Young SunGard University of Delaware Stanford University National Association of Insurance Commissioners (NAIC) International Swaps and Derivatives Association (ISDA)

Implementation Issues of Regulatory Reform

Keynote speakers: Edward J. DeMarco, Acting Director, FHFA; Dan Rodriguez, MD & Division CRO, Credit Suisse

Panels on Living Wills, OFR Systemic Risk, OTC Derivatives Reforms, Top regulators from FDIC, FRB, NIAC, OFR, SEC Senior bankers, practitioners, thought leaders and academia

Fall 2012 RiskJournal

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The False Promise of Expected Shortfall This article is a republication of Mr. David Rowe’s article on Risk Magazine, November 2012

SYNOPSIS: The Basel Committee on Banking Supervision has proposed using expected shortfall instead of value-at-risk as the central metric for regulatory market risk capital. David Rowe argues this will be both ineffective and dangerous ABOUT THE AUTHOR: David M. Rowe is founder and president of David M. Rowe Risk Advisory, a risk management consulting firm.

So much ink has been spilled over the strengths and weaknesses of value-at-risk that it seems pointless to restate them at length here. In brief, my view is that VAR was a major advance over the disjointed framework of non-commensurable limits that preceded its introduction. It addressed the issue of exposure to short-term market fluctuations in a consistent way. What it did not do, and never claimed to do, was say anything about what “lurks beyond the 1% threshold”, and the unfortunate fact is that too many executives outside the risk function failed to grasp its limitations. This led to insufficient emphasis on the much messier task of stress testing and scenario analysis (Risk January 2010, page 109, www.risk.net/1567662). Not surprisingly, in the wake of the global financial crisis, the Basel Committee on Banking SuperviFall 2012 RiskJournal

sion has sought to revise market risk regulations to take greater account of possible extreme events. One element of its proposed revision is to use expected shortfall instead of VAR as the basic metric when setting market risk capital requirements. The committee argues that expected shortfall “accounts for tail risk in a more comprehensive manner”. It also points out some theoretical shortcomings of VAR, especially that it is not strictly sub-additive in all cases. This means portfolio measures of VAR are not necessarily smaller than the sum of VAR for two or more mutually exclusive and exhaustive partitions of the positions in the portfolio. Hypothetical conditions can be constructed in which VAR is sub-additive, but despite this theoretical possibility, my experience is that such circumstances rarely arise in practice. While one must be careful when using VAR in certain situations, I believe its theoretical shortcomings have few practical consequences. Furthermore, while expected shortfall accounts for tail risk in a more comprehensive manner than VAR, I believe its advantages in this regard are overstated and its severe shortcomings are being ignored by the committee.

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Shifting from VAR to expected shortfall would be a genuine advance – but only if we actually had well-defined and reliable measures of the probabilities of tail events. The problem, of course, is that we do not. Lacking these, we try to fit theoretical distributions to the known observations and use these in our loss simulation process. The result is that expected shortfall will inevitably be a fairly stable multiple of VAR rather than a sensitive indicator of potential tail risk. The limited advantage of expected shortfall might still make it a worthwhile replacement for VAR if it did not have two serious shortcomings. The first is that it is virtually impossible to back-test. Every one-day VAR estimate is a statement of the likelihood of an event the following day. As such it can be subjected to a simple and easily understood back-test by looking at the frequency of VAR excesses and asking whether they conform to the confidence level used to construct the metric. Estimates of expected shortfall, on the other hand, depend on the full shape of the tail of the loss distribution, which is fundamentally unknown – there are no ex-post realizations against which to test the accuracy of such estimates. Shifting from VAR to a measure whose empirical verification is virtually impossible would be a major step backwards.

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The second shortcoming of a shift to expected shortfall is that it would reinforce the idea that we can deal with extreme event risk by tinkering with our distributional framework. This is a fundamentally dangerous idea. Purely distributional analysis will not provide the insights needed to avoid the next major crisis. Only a messy, qualitative, judgmental and somewhat unsatisfying process of grappling institutionally with potential crisis scenarios and their impact can set the stage for prompt action when lowprobability, high-impact events take place. Anything that discourages this arduous process should be avoided at all cost.

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Presents

PRMIA DC 4th Annual Risk & Regulatory Summit Ronald Reagan Building, Washington DC November 13, 2012

Implementation Issues of Regulatory Reform

Keynote speakers: Edward J. DeMarco, Acting Director, FHFA; Dan Rodriguez, MD & Division CRO, Credit Suisse Panels on Living Wills, OFR Systemic Risk, OTC Derivatives Reforms,

Fall 2012 RiskJournal Top regulators from FDIC, FRB, NIAC, OFR, SEC

Senior bankers, practitioners, thought leaders and academia

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The 2007-2012 Global Financial Crisis: Perspectives from Asia

livepage.apple.com

ABOUT THE AUTHOR: Tham Ming Soong was former Chief Risk Officer for the United Overseas Bank Group. He was appointed to the position Dec 1, 2005. He recently left his job to spend more time with family and pursue personal interests.

HIGHLIGHTS

❖ ❖

The impact of the Financial Crisis on Asian economies has been relatively muted, not because of better risk management but a different business and operating focus, culture and model

A sustainable governance structure must be supported by comprehensive policies and infrastructure that are designed to meet the institution’s internal needs and not just regulatory requirements

The implementation of a well thought through technology-based risk management solution would allow for a better understanding of the interconnected risks

The Global Financial Crisis of 2007-2012 is considered by many as the worst financial crisis since the Great Depression of the 1930s. The crisis has seen the failure and bailout of major financial institutions, and the destabilization of economies. Much has been said and written about who dropped the proverbial ball. It is not the intent of this article to add to that trail. Instead, I will seek to explore the implications and opportunities for financial institutions, and for the practice of risk management. The crisis has sparked many significant changes to financial regulations. This in itself is a good development. But when it is driven by preservation of governmental self-interests and political haggling, the cracks will show even before the cement is dry.

Fall 2012 RiskJournal

The objective of regulatory capital framework is to encourage a truly effective and comprehensive management of risk and capital within financial institutions. However, we have seen that even institutions that were compliant with regulatory requirements had to seek government bailout. Is the regulatory approach and underlying assumptions of safety and soundness flawed? Or, perhaps it is not so much that the regulatory framework is flawed than a lack of understanding of the limitation of regulations, and the responsibilities of the institutions regulated. In May 2008, the Senior Supervisors Group issued its report evaluating the effectiveness of risk management practices. That was followed closely in July of the same year, when the Institute of International Finance (IIF), a global association of financial institutions, issued its proposal to strengthen global financial markets and the financial industry. These reports identified risk management practices that set stronger financial institutions apart from weaker ones. Former Federal Reserve Bank Chairman, Alan Greenspan added to the possibly well-meaning diagnosis of the issues and suggestions for improvements. There are certainly many important lessons to be learned. It would be a great opportunity lost if financial institutions that seemingly experienced only limited impacts feel a sense of strength and security. Such sense of security is likely a sign of complacency that will be a precursor for the next crisis. Whatever direction the blame finger ends up pointing, the bottom line is that the failures were due to poor risk management and insufficient or

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poorly managed capital or liquidity, or both. Governments had to intervene to ensure the stability of their respective economic and financial systems to avert a global meltdown. Measures are intense and broad, including extended quantitative easing to hopefully untangle the capital gridlock. These will likely translate into other costs and even burden on the taxpayer for years to come. At its September 2009 meeting in Pittsburgh, the G20 group of systemically important industrialized and developing economies agreed to adopt US President Obama’s Framework for Strong, Sustainable and Balanced Growth, which outlines a process for economic cooperation and coordination to help ensure that post-crisis policies avoid a return to dangerous imbalances that undermine long-term economic growth. Following the G20 leaders’ commitment to financial reforms, the Basel Committee on Banking Supervision (BCBS), led global regulators toward higher standards in capital and liquidity management requirements. Since then the Basel Committee has issued its Basel III standards to strengthen global financial institutions’ capital and liquidity standards. And even before that ink is dry, there are already discussions on Basel 3.5. And more recently, there are comments by senior members of our community here in Asia on the unintended consequence of the standards.

As we have observed in the past, regulatory standards motivated by politics and hastily put together are unlikely to gain wide acceptance let alone adoption. Will this be different this time? From an Asian perspective, the impact of the crisis on Asian financial institutions and financial markets had been relatively muted. This is not because these Fall 2012 RiskJournal

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institutions are better managed, but that they have very different business and operating models compared to that of their western counterparts. For one, they are certainly less quick to adopt sophisticated though untried products, and most do not see great needs for these. Also, having been through a crisis of its own between 1997-1998, Asian institutions are generally a whole lot more cautious, though not necessarily better managed. On the whole, Asian financial institutions entered the 2007-2012 Crisis with very different starting positions, and have very different future challenges. The relatively muted impact on Asian financial institutions was probably due more to their business models, and their focus on riding the growth curve of the Chinese economy, rather than better risk management practices. Following the Japanese financial crisis in the 1990s and the Asian Financial Crisis between 1997 and 1998, Asian institutions are generally better capitalized, and more reluctant to engage in innovative financial instruments that may have hidden risks or risks that they do not fully understand. Liquidity at Asian banks is also generally strong, with a heavy reliance on deposit funding as opposed to wholesale funding. Asian institutions are also less leveraged than their European and American counterparts. Given the differences between Asian and Western financial institutions, any revision to regulatory standards that focuses on addressing idiosyncratic issues ignoring systematic weaknesses is likely to lead to unintended consequences. The increased capital and liquidity requirements are likely to be overly punitive for some economies. Any revision to regulatory standards should, instead, include a robust incentive mechanism that will encourage financial institutions to voluntarily address risk management weaknesses. Financial institutions must be encouraged to develop internal motivations that are focused on long term sustainability and financial soundness. This requires the collective effort of all the stakeholders of the economic and financial systems – the financial institutions, the regulators, the rating agencies – working in collaboration. A sustainable governance structure must be supported by comprehensive policies and infrastructure that are designed to meet the institution’s internal needs and not just regulatory requirements. Governance structures, business

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models and risk management practices change to meet the different demands of economies at different stages of maturity. It would be ideal if the evolution kept pace with economic maturity. The sooner our industry realizes this and acts appropriately, the sooner we can emerge stronger and more robust, and better prepared to face future market dislocations. Overall, financial institutions that fared well during periods of crises were those with strong corporate governance structures, supported by policies that ensured robust control functions, and an infrastructure that enables superior business intelligence and analytics. However, recent events have taught us that complacency can and will lead to disastrous outcomes. It is unlikely that we have seen the last of major financial bubbles and crises. But we need to be better prepared for the next ones. We cannot assure the future survival of global financial system by the removal of innovation in financial products. The financial industry has a deep capacity and an innate ability to innovate. Such innovations must be paced with innovations to develop better understanding of the interconnections between risks types and between events. Our financial needs change and the problems we need to deal with will demand new solutions. Without innovation, clients’ needs will not be properly served and financial institutions will lose relevance. While the crisis has been painful, it provides the industry a unique opportunity to learn, especially from the institutions that had been successful in weathering this crisis and those that did not. Financial markets could be likened to champagne. Just as champagne’s charm is in its bubbles, there will always be bubbles in financial markets. The goal of reforms should not be to prevent the next financial crisis or the removal of bubbles from the system. It is just not possible. Regulatory reforms Fall 2012 RiskJournal

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must encourage financial institutions to develop the motivations to implement comprehensive capabilities and processes aimed at long term sustainable growth and solvency. They must actively encourage financial institutions to embrace the best possible technology and practices, especially to proactively understand and manage tail risks. Advances in stress testing and tail risk management are but one of the areas banks will have to build better practices. Massive injections of liquidity and capital, and higher standards of capital and risk management regulatory requirements can only be temporal measures. Financial institutions must take a very different approach to the management of risks and adopt the best possible the infrastructure required to support a robust corporate governance and risk management framework. There must be a departure from ticking boxes on a regulatory checklist, and progress towards an operating model that is driven by effective controls, financial innovation, and financial soundness to achieve long term sustainable growth. We also need to learn from the implementation of Basel II. This could have been more robust if the focus was to implement Pillar 2 ahead of Pillar 1. The heart of the Accord is the effective management of a financial institution’s capital in supporting all the risks associated with its business activities. Is it any wonder that institutions that are Basel II compliant teetered on the brink of failure? With the focus on CCAR in the US and ICAAP in other jurisdictions, financial institutions have an opportunity to enhance their systems to achieve greater effectiveness in business intelligence and analytics, with a focus to understand and manage portfolio effects on stressed scenarios, tail risks, liquidity and capital management. These need not be costly exercises. Technology has moved so far ahead that such solutions are affordable even to the smaller institutions. The current crisis has demonstrated that the cause of most bank failures were due to a failure to identify, recognize risks and compensate for weaknesses in funding liquidity and capital

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management, and where these were seen more as regulatory requirements than business imperatives.

responsibility of the risk management function. It is about the culture of the institution.

It is important for the financial institution to develop a good understanding, the means to quantify the risks in its portfolio, and a comprehensive process for managing those risks. The crisis has underscored the inter-connectivity of the different risk types. The March 2011 earthquake in Fukushima, Japan underscored the interconnection between events – an earthquake followed by a tsunami and nuclear contamination. For the industry to emerge stronger, and for confidence to return, we have no choice but to embrace these interconnections and be more prepared. Preparedness that is brought about by better understanding of our operating environment, assessing various possible scenarios and effects on global portfolios and not to take anything for granted. There must be willingness to deploy the best possible tools to enable and enhance environmental knowledge. And the knowledge must be accompanied by the moral courage to do the right thing.

The current crisis is a wake-up call. While governments have taken unprecedented steps to prevent their systemically important institutions from failing, such bailouts come with a heavy social and economic cost. It is no longer a guarantee that compliance with regulatory requirements would result in financial soundness. Ticking the boxes of a regulatory requirement checklist is simply not good enough. Financial institutions must develop internal motivations and do what is right for themselves and their shareholders. We have an unique opportunity to learn from the current crisis, and leverage on the best available technology to develop and implement comprehensive and effective risk management process and systems. Driven by strong internal motivations and culture, there are few reasons why we will not emerge stronger and can look towards a more sustainable long term growth of our industry.

The implementation of a well thought through technologybased risk management solution would allow for a better understanding of the interconnectivity of risks – both risk factors and potential stress scenarios. Perhaps the holy grail of managing risks of financial institutions is to be able to achieve a true Enterprise-wide Risk Management (ERM) approach. While interconnectivity of risks seems to suggest almost an entirely quantitative approach, ERM is not about models only. ERM is about understanding how the entire institution takes ownership of the identification, assessment and management of the risks that are inherent to its business model. It is about how the risk management process is embedded within every level of the organization, and not just the sole

Fall 2012 RiskJournal

If every financial institution adopts a proactive approach to managing the risks, the global economic and financial systems will be more stable. This will require a significant change in risk culture and the first steps will not be easy. However, it is not impossible. If the dream of robust and stable economic and financial systems is to be realized, that first few courageous steps of commitment must be taken, and they must be taken now. Unless there is commitment, there will always be hesitancy. Actualize the dream and release the genius, power and magic. Or this will be an opportunity squandered, and lessons of this crisis will be lost.

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Operational Risk Management Key Shifts Required to Rise to the Challenge ABOUT THE AUTHOR: Brian Barnier, of ValueBridge Advisors, is an OCEG Fellow and the author of The Operational Risk Handbook for Financial Companies (Harriman House, London, 2011).

HIGHLIGHTS ❖

Achieving performance objectives incurs risk

A performance driven approach drives the identification of the sources of risk and what really works to improve performance

An ad hoc approach to operational risk management and addressing risk in silos should be avoided

Mastering Plan B will help ensure the ongoing operation of an institution

Mastering Plan B will help ensure the ongoing operation

The news headlines keep coming -- Mortgage melt-down, massive data breach, foreclosure robosignings, trading fraud, client portfolio risk matching errors, ATM and payments system outages, liquidity traps, money laundering through mobile networks. These are just some of the recent sinkholes in operational risk land. The question is, Why? Why do they keep coming, despite the efforts of financial institutions to improve and reduce their occurrence? At the same time, board members, shareholders, policy-makers and consumers all need financial companies to better manage risk relative to return in order to improve business performance and aid economic recovery. Standing still is not an option.

Fall 2012 RiskJournal

Operational risk leaders face a mountain of challenges. In trying to improve the process of risk management, they ask, “Is there a consistent basis for ‘risk appetite?’ What information needs to be in a scenario? To what depth do we need to document policies? What key risk indicators (KRIs) matter most? How can risk and control self-assessments (RCSAs) be more cost-effective? How can I better engage ‘the business?’” Such questions are asked by leaders seeking to do more with less. Increasingly, doing “more” includes more business value, not just more RCSAs. Douglas Webster is a former CFO of the U.S. Department of Labor, and now a Partner at CSC and board member of the third largest U.S. credit union, Pentagon Federal. From the boardroom, he sees the challenges, “Managing to achieve performance against organizational objectives is the ultimate goal of management. I have yet to meet the person who does not understand that achieving performance objectives is subject to risk. Yet people frequently ignore risk unless it is blatant. It is as if any plan deemed feasible at first glance could be managed with fire-fighting--responding to risks after they are unfolding. It is quicker to get started this way, but

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there can be costly--even disastrous--consequences to performance in the end.” Amidst this mountain (“mountain range” is probably more appropriate) of challenges, leaders want to know the critical steps needed to climb these mountains and overcome these challenges.  In analyzing problems at financial institutions, it turns out there are similar underlying causes to these challenges. This is good news. It suggests there is a potential path through the mountains.  In seeking this path, we can turn to lessons learned in overcoming similar challenges in other risk disciplines (including in financial institutions) and other industries. Operational risk managers are frequently frustrated in their efforts when compliance is the driver of risk management programs. Focusing primarily on compliance has a host of negative effects that structurally leave operational risk management bogged down in fixing yesterday’s problems, excessive paperwork and churn. Operational risk managers are left without a clear touchstone for decisions on everything from risk appetite to scenarios to KRIs to reporting. A huge lesson learned from decades of success elsewhere is the need to shift to a more performancedriven approach. A race car driver doesn’t buckle a seatbelt to avoid a traffic ticket – it’s to avoid injury or death in pursuit of the prize. Consider medical practice. Jim Bagian, professor of engineering pracFall 2012 RiskJournal

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tice at The University of Michigan, is an engineer who is a medical doctor, an astronaut, and a member of the National Academy of Engineering and the Institute of Medicine. He is also the co-author of a 2010 study on methods for improving outcomes in medical care at Department of Veterans Affairs (VA) hospitals. With great passion, Professor Bagian describes the need to understand sources of risk and what really works to improve performance: “In our VA study, we found that understanding what is better and turning that into decision guides, checklists in some cases, for evaluating conditions and structuring responses clearly improves communication among health care providers and results in better outcomes. This was part of a program called Medical Team Training. The 74 facilities in the training program experienced an 18% reduction in annual mortality, compared with a 7% decrease among the 34 facilities that had not yet undergone training.” He found a few key features that created big benefits in reducing risk and enhancing performance at the same time. Combined with efficient communication, the results have proven very noteworthy. Similarly, risk of theft at bank branches must be managed so those branches can earn return.  Property & casualty insurance marketing leaders must manage risk of customer turnover.  Financial company CFOs must manage risk to earnings and share price. And, whether inside or outside of financial institutions, the performance-focused approach is

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vital to success at such tasks. In a competitive world, risk management that aims mostly at box-ticking or damage control is doomed.

unfold cannot be sufficiently described unless people actually know the business – how products and processes work in everyday life.

Douglas Webster continues, “Fortunately, not everyone went to the fire-fighting school of performance management. Yet, even those who recognize risk to performance often succumb to two failures. First, they take an ad hoc, non-systematic approach to risk management, so their ability to identify and manage risks is itself risky and dependent on luck. Second, they tend to address risks in silos instead of an integrated view of risk to the performance of the enterprise.”

To manage risk in a system, systems must be designed with margin to be forgiving -- with“plan b” back-ups ready for when problems arise. Preparing and reacting with back-up plans is all about understanding the costs and benefits of your options in time – if you delay, your options will narrow, costs go up and benefits go down.

In looking at lessons learned that apply to operational risk management in financial companies, key insights emerge: Speed of change and complexity are key drivers of operational risk anywhere. Both of these are increasing in today’s financial companies, especially given the global economy, regulatory environment, mergers and acquisitions, new markets and technology. This demands viewing operations as a system – similar to supply chains, air travel, electric utilities, sporting events, telecommunications or even fast food restaurants, not just as isolated events and controls. The heart of evaluating risk in a system is scenario analysis -- a thorough understanding of how events can unfold in business product processes given an environment and a set of capabilities in action. Scenarios – life-like, realistic stories of how situations

Fall 2012 RiskJournal

For each of these insights, there are specific tools, connected in a highly usable process, to help leaders translate learning into actions to make risk management more efficient and effective, and improve business performance. Marshall Carter, Chair of the NYSE Group and Vice Chair of NYSE Euronext, summarizes clearly: “This change and growing importance of operations in the performance of an institution means that boards and CEOs are more concerned than ever with risk to operations that would hurt performance. This is why the role of operational risk leader has never been more important. And it’s why operational risk leaders need to be smart in using the right approaches and techniques to help business leaders manage that risk. For operational risk leaders in our changing and complex environment, mastering the Plan B is your opportunity to make a difference in your institution.” This article was first published by OCEG, July 2011; it is based on The Operational Risk Handbook, © 2011 Harriman House, London, UK.

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Individuals and corporations interested in learning more about the Associate PRM certification visit WWW.PRMIA.ORG Fall 2012 RiskJournal or send an inquiry to support@prmia.org. 40 RiskJournal Summer 2012

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Moving the Market Forward: Principles for Returning FHA to its Traditional Mission

ABOUT THE AUTHOR: Ed Pinto is American Enterprise Institute’s Resident Fellow & Chief Credit Officer for Fannie Mae in the late 1980s.

HIGHLIGHTS Four key principles of reform is needed to return FHA to its traditional mission: • Step back from the markets that can be served by the private sector • Stop knowingly lending to people who cannot afford to repay their loans • Set loan terms that help homeowners establish meaningful equity in their homes

Many look at today’s Federal Housing Administration (FHA) and nostalgically recall the Depression-era FHA. Set up in 1934, it insured fully amortizing 20 year term loans combined with a 20% down payment. As a result homebuyers could accumulate nearly 30% equity after 4 years without relying on inflation. Initially FHA’s loan terms were sustainable and appraisal standards countercyclical. When introduced in 1934, a fully amortizing 20 year loan term combined with a 20% down payment was designed to build substantial equity over 5 years Market’s  transition  to  unsustainable  lending:  lower  down   without needing inflation. payments + longer loan terms = reliance on house price inflation

• Concentrate on those homebuyers who truly need help purchasing their first home

Year

Moving forward: Real Estate is Cyclical and Responds to Leverage

1934 1938 1948

Maximum LTV limit 80% (FHA) 90% (FHA) [ 90% (FHA)

Maximum /average loan term 20 years (max.) 25 years (max.) 30 years (max.)

Monthly payment* $670 $695 $660

Homeowner equity after five years (with no increase in house prices) 30% 17% 14%

1956 1956 1984

95% (FHA) 80% (conv.) 97% (FHA)

30 years (max.) 15 years (aver.) 30 years

$697 $764 $712

10% 37% 8% -this is about equal to the buy/sell spread.

2000 2006 2006

100% (F/F) 100% (FNM) 100% (FNM)

30 years 40 years 40 years (10 yr. interest only)

$734 $695 $667

5% 2% 0%

An upward trend of balance sheet and income leveraging continued for 70 years. – Policy makers were oblivious to the fact that during economic expansions, lenders become less risk-averse (Kindleberger).

FHA lending was backed by a rigorous property – This policy relies on inflation toThe create unearned equity. appraisal process. appraiser’s role, as set forth – Sustainable lending relies on earned equity: the sum of downpayment and scheduled loan amortization. by FHA in the late-1940s, was defined as determining “a price at which a purchaser is warranted in paying for a property, rather than the price at which the property may be sold....”, noted in McMichael’s Appraising Manual, 4th Edition, 1951. As a result, FHA’s default experience was extraordinarily low. From 1934 through 1954, FHA

FHA must put an end to destructive lending--layering ultra-slow 30-year amortization loan terms, ultra-low down payments, and impaired credit in the same loan.

* For ease of comparison, all examples based on the purchase of a $100,000 home at the maximum LTV and term with an interest rate of 8 percent. 9

Sources: S. J. Loyd (Lord Overstone),  “ Tracts  and  Other  Publications  on  Metalic and Paper Currency,”,  1858 Edward  Chancellor,  “Between  Errors  of  Optimism  and  Pessimism”,  GMO  White  Paper,  2011

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The good news

insured 2.9 million mortgages. During this period, disproportionately at the lowcorrections end of the and low rates • Zillow: the combination ofmore home price FHA paid claims on 5,712 properties for a market. has  made  today’s  housing  market  the most affordable in decade The claims history and no down cumulative rateofoflow 0.2 percent.. In 1951 lending FHA averaged apayment down payment of 18% on new homes and 23% on existing homes, with an average • FHA/VA/USDA’s  high  leverage  lending   loan term of 23 years on new homes and 21 years practices spread throughout the market. on exiting homes.

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FHA is oblivious to this good news Source: JCHS

Today the FHA has 7.5 million loans outstanding ratios and pays 12,000 claims per month. This is •notDebt-to-income your Today, the combination of home price corrections great-grandmother’s FHA. High leverage lending and rates declined, FHA andprices low rates have madehave the housing market the first increa through the FHA, VA, and USDA continue to – As home mostmaintained affordable in the decades. However, as home share of its loans with a very h spread throughout the market. The private sector and then prices and rates declined, the FHA first increased Excess leverage and loosened underwriting followed the government’s lead in increasing LTVstotal debt-to-income ratio. and then maintained the share of its loans with a and loan terms. sowed the seeds of the financial crisis• Thisvery high total debt-to-income ratio. and Thisisiscreating short- a new bu is short-sighted and unsustainable sighted, unsustainable, and is creating a new bubble. Impact of FHA's Increasing LTVs on Annual Foreclosure Starts – What happens when rates go to 7% or higher? as a Percentage of Insured Loans

7.0%

Total debt-to-income ratio >45%

FHA annual foreclosure starts as a percentage of outstanding insured loans (unadjusted for denominator effect)

45.0%

6.0%

FHA annual foreclosure starts as a percentage of outstanding insured loans (adjusted for denominator effect using MBA methodology)

40.0%

5.0%

4.0%

1991: percentage of loans with LTV >=97% increases to 17% from 4% to in 1990 and percentage >90% increases to 79%

3.0%

2.0%

1.0%

1956: LTV limit raised to 90%/95% (first increase since 1938)

1988-1990: percentage of loans with an LTV >90% increases to 74% from 54% (1984-1987)

1999: percentage of loans with LTV >=97% increases to 44% and percentage >90% increases to 88%

35.0% 30.0% 25.0%

10.0%

1993: percentage of loans with LTV >=97% increases to 25% and percentage >90% increases to 83%

Source: FDIC, MBA, and Ed Pinto

FHA

15.0%

5.0% 0.0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0.0%

*projected based on first 3 quarters of 2009

Conventional

20.0%

2000-2008: percentage of loans with LTV >=97% averages 51% and 85% had an LTV >90%

The FHA is impeding the return to a normal market. In an effort to return to prime lending standards, between 2007 and 2011, Fannie and Freddie reduced their acquisitions in the <675 FICO category to 5% of volume in 2011, down from 24% in 2007. They are back to level for prime loans in 1990, at 6%. To bolster its deteriorating financial condition, the FHA expanded into the prime >=675 FICO category. In 2011, 65% of FHA’s business had a FICO of >= 675, from from 22% in 2007. The GSEs can’t compete on FICOs of 675-725.

Monthly Report to the FHA Commissioner Department of Housing and Urban Development on FHA Business Activity, October 2010. 10

The upward trend of balance sheet and income leveraging continued for 70 years. The combination of lower down payments and longer term loans results in a reliance on inflation to create unearned equity. Increased leverage and loosened underwriting standards sowed the seeds of the financial crisis. The increased leverage and affordable housing mandates have resulted in home prices falling

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FHA

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YEAR

<675

>=675

2007

24%

22%

Principle 1: Step back from markets that can be served by the private sector.

FHA has significant advantages that allow it to offer much lower rates than the private sector. These 2011 5% 65% include a free explicit federal guarantee and no need to earn a return on capital, or pay taxes. FHA also Currently one-in-six FHA loans are delinquent 30has a lower minimum capital requirement than days+, predominantly on borrowers with FICOs private competitors and the Federal budget covers below 660. By not focusing on the sustainable nonadministrative costs, currently running at 25 basis prime market, the FHA is impeding on the return of points per year. Much like private mortgage a normal market. The private sector could do more insurance, FHA’s risks are cross-collateralized across the 675+ FICO market. isinimpeding the return to a normal market multiple book years, but rely on weak government accounting principles. Unless these substantial advantages are narrowly targeted, they lead to unfair and dangerous competition with the prime and subprime private sector, political interference, and the muting of pricing signals. The loss rates associated with non-prime borrowers require greater levels of initial capital (and Principle 1: Step back from markets that the build-up of substantial reserves) to meet high levelsbe of both expected served by and theunexpected privatelosses. sector

can

In 2011 the median FICOthe scoremedian on new reaI estate loans In 2011, FICO scorewasonabout new765. real –

As a result only about 9% of new loans had a FICO of between 580 and 675 .

estate was about As a with result only The median FICO loans should return to about 765. 735 resulting about 97% about being above 580.

9% of new loans had a FICO of between 580 and 15 675. The median FICO should return to about 735 resulting with about 97% being above 580. Of these, showswith the required interest rate torequire • The The loss table rates below associated non-prime borrowers • About 20% would have a FICO between 580-675 greater cover risk. Rates of 3+ percent above the prime levels of initial capital (and the build-up of substantial and should be served by FHA. loan rate of 4.5% not predatory; they areand the risk reserves) to meet highare levels of both expected adjusted rates necessary to cover expected and unexpected losses. • About 77% would have a FICO above 675. and unexpected default losses. should be served by the private sector. Note: At a 50% loss severity rate, claim incidence rates are roughly double the expected losses shown above. 18

– About 20% would have a FICO between 580-675 and should be served by FHA. – About 77% would have a FICO above 675. and should be served by the private sector. Source: Fair-Isaac

Principle 1: Step back from markets that ca be served by the private sector

Principles for Reforming the FHA The FHA needs to return to its traditional mission of being a targeted provider of mortgage credit for low- and moderate-income Americans and first-time homebuyers. It performs a disservice to American families and communities by continuing practices that result in a high proportion of families losing their homes. Reform can be accomplished by following these four principles: risksrate associated • Required The interest to coverwith risk.non-prime borrowers Fall 2012 RiskJournal

– Rates of 3+ percent above the prime loan rate of 4.5% are not predatory they are the risk adjusted rates necessary to cover expected and unexpe 28 default losses.

• The risks associated with non-prime borrowers cannot be funded by private capi except at high rates of interest. • FHA loans have lower rates due to a combination of its substantial government advantages and cross-subsidies transferred flowing from high FICO loans guarant


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cannot be funded by private capital except at high rates of interest. FHA loans have lower rates due to a combination of its substantial government advantages and cross-subsidies transferred flowing from high FICO loans guaranteed by FHA to its riskiest loans. The Treasury / HUD Report on Housing Reform stated “FHA should be returned to its pre-crisis role as a targeted provider of mortgage credit access for low- and moderate- income Americans and first-time homebuyers.”. Over a period of 3-5 years FHA should return to a purchase market share of 10% rather than today’s 30%

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Principle 3: Set loan terms that help homeowner establish meaningful equity in their homes. FHA should help home owners build meaningful equity by limiting guaranty to home purchase loans and refinance loans where the lower rate is used for term reduction only. The benefit of lower interest rate on a refinance should be used to speed amortization. FHA should not enable cash-out refinances, since3:these against wealth building. Principle Helpwork homeowner establish

meaningful equity in theirloan homes FHA should balance downpayment, term, FICO anddownpayment, debt-to-income (DTI) ratio soand as todebt-toallow • Balance loan term, FICO, borrowers to achieve meaningful equity. income (DTI) to achieve meaningful equity. [

Principle 2: Stop knowingly lending to people who cannot afford to repay their loans.

FICO

Maximum LTV limit 580+ 97.5% (current)** 660-675 95.5% (proposed)** 620-659 95.5%/90% (proposed)** 580-621 92%/85% (proposed)**

Maximum Maximum loan term total DTI 30 years

Equity after MIP 4 years Upfront/annual 8% 30 yr.: 1.75%/1.20-1.25% 15yr.: 1.75%/0.35-0.60% 10% 30 yr.: 1%/1.50%

30 years <50% While the loans FHA insured in 2009-2011 are called the good books of business, the 2011 21/30 <50%/40% 15% 21 yr.: 1%/1.50% years 30 yr.: 1%/1.50% Actuarial Study projects that even under a rosy 15/20 <45%/40% 25% 15 yr.: 1%/1.50% scenario these will experience an average cumulative years 20 yr.: 1%/1.50% claim rate of 8.5 per 100 loans or about 1 in 12 * For ease of comparison, all examples are based on the purchase of a $100,000 home at the maximum LTV and loans. But averages can be deceiving. The worst term with an interest rate of 6 percent. ** Maximum with upfront mortgage insurance premium financed performing twenty-five percent will likely have a Principle 4: Concentrate on those homebuyers who claim rate of 15% under the rosy scenarios used in truly need help purchasing their first home. FHA’s 2011 Actuarial Study and of 20% or more under more likely scenarios. This group is largely In fiscal year 2011, 54% of FHA’s dollar volume comprised of thirty-year fixed rate term loans with went to finance homes that were greater than 125% Concentrate on This homebuyers who an loan-to-value (LTV) >90% and a FICO credit Principle of an4: area’s median house price. is up from score less than 660 with most also having a total 22%need in 2009.help purchasing a first home truly debt-to-income (DTI) ratio >40%. The FHA is Percent Of FHA Originations With House Price >125% Of Median projecting that by 2015, over 40% of its loans will & Case Shiller HPI 200 60% have these high risk characteristics. 180 26

50%

160

Fall 2012 RiskJournal

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

CS HPI

FHA Percent >125%

Instead, the FHA should aim for a projected rate 140 40% 120 of 5 foreclosures per 100 loans. While this is about 100 30% Case Shiller HPI 50% of FHA’s long-term average, it is still five and 80 FHA Percent >125% Median 20% 60 two times the historic default level for 90% LTV 40 10% loans with private mortgage insurance. FHA should 20 0 0% limit the worst credit risk categories to a claim rate of 7.5, and eliminate risky lending practices, such as FHA Book Of Business loans with FICO < 580, ARMS and those with seller In FY  2011,  54%  of  FHA’s  dollar  volume  went  to  finance  homes  that  were  greater   concessions greater than 3%. FHA should also price How does this happen if FHA has been limited to than  125%  of  an  area’s  median  house  price.    This  is  up  from  22%  in  2009. 125% of the median priced home? First, the law for risk. Not doing so deprives the borrower of price How does mandates this happen the if FHA hasofbeen limited to 125% the median priced home? use home prices fromofthe 2007 peak information needed to understand the true risk being 1. The law mandates the use ofprices home prices from the 2007 peak even though prices today are even though today are substantially lower. entered into. Until it does so, it should disclose to the substantially lower. Second, the county with the highest median home borrower his expected claim rate, assuming no price 2. The county with the highest median home price has that price applied to the entire MSA. Sources: Case Shillerprice National HPIhas NSA as ofthat Q1, Actuarial Review ofapplied FHA MMIF FY 2011 IV-7, andentire James E. LynnMSA. Consulting appreciation or depreciation. price toEx. the 27

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– Example: Riverside, CA: • $500,000: 125% of the 2008 limit, based on 2007 prices (current FHA loan limit) TOC • $228,000: 100% of 2010 median home price

RiskJournal - A Quarterly Publication of PRMIA DC

Given FHA’s mission is to help low- and moderateincome homebuyers, the homes it finances should cost less than the median priced home for an area. Additionally, first-time homebuyers should be limited to an income of less than 100% of area median income and repeat home buyers to an income of less than 80% of area median income.

Principlehas 4: set Concentrate homebuyers who Congress 80% of areaonmedian income as guide forneed CRAhelp lending and Fannie/ truly purchasing theirFreddie first home affordable housinglending goals, whypolicy would this not be • Targeting sustainable has so positive impacts: – Income andfor homethe prices have obvious utility. appropriate FHA? – Targeting to 580-675 FICO band has significant benefits.

centrate on homebuyers who p purchasing their first home Category

% in 580-675 FICO*

Ratio to Non-Hispanic white

Non-Hispanic white

20.5%

1:1

Black

38%

1.9:1

Hispanic

30%

1.5:1

Low-income census tract (<50% of median)

33.5%

1.60:1

Moderate-income cen. tract (>49% & -<80% of median)

29.75%

1.45:1

p  low- and homebuyers, limiting 2141moderate-income Westminster Drive, Riverside CA, 92506 8024FHA Wendover Drive, Riverside CA, 92509 edian house price3 is appropriate. 5 bedrooms, baths, 4083 sq. ft. 4 bedrooms, 2½ baths, 2213 sq. ft.

Listed for $560,000, At a sales price of $518,000 (93% of list price), 2008 limit,eligible basedfor ona2007 prices loan limit) $500,000 FHA(current loan withFHA 3.5% down.

0 median home price

n.

Minority population >=80% for census tract

33.75%

1.65:1

Age: <30 years

31.1%

1.5:1

Age : 30-39 years

28%

1.35:1

Urban census tract

23%

1.1:1 Listed for $245,000 Rural census tract 23.8% 1.16;1 Assuming a sales price of $228,000, (93% of1.1:1list price), All 23% eligible foronawww.federalreserve.gov/boarddocs/.../creditscore/creditscore.pdf $220,020 FHA loan with 3.5% down. 30 * Estimates based

Targeting sustainable lending has positive policy impacts. Income and home prices have obvious utility and targeting to 580-675 FICO band has significant benefits. Conclusion Adopting these four principles would return FHA to its traditional mission of being a targeted provider of sustainable mortgage credit to low- and moderateincome Americans and first-time homebuyers.

8024 Wendover Drive, Riverside CA, 92509 4 bedrooms, 2½ baths, 2213 sq. ft. Listed for $245,000 Assuming a sales price of $228,000, (93% of list price), eligible for a $220,020 FHA loan with 3.5% down.

For example, Riverside, CA in the two properties shown here:

Implementing these principles will have positive market impacts. FHA, using sustainable lending standards, would serve a targeted market focused on borrowers with poor credit (a FICO below 675 - the current median credit score of all scored households is 720). Also, this would also allow the private sector (Fannie and Freddie and private mortgage insurance today and a much expanded private sector in the future) to better serve the prime market, since these markets can price for risk without resorting to government subsidies or cross-subsidies. 28

• $500,000: which is 125% of the 2008 limit, based on 2007 prices (current FHA loan limit) • $228,000: which is 100% of 2010 median price. Fall 2012 RiskJournal

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RiskJournal - A Quarterly Publication of PRMIA DC

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As we come near to the close of

2012,

It is time again for

Year-end holidays!

From all of us at PRMIA Washington DC.

Fall 2012 RiskJournal

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RiskJournal - A Quarterly P WHAT’S ON THE WEB: REGULATORY REFORM CHALLENGES - ADDRESSING SYSTEMIC RISKS

ABOUT THE AUTHOR: Weihua Ni is a risk management consultant and also a member of the RiskJournal Editorial Committee.

Addressing Systemic Risk is one of the key remaining challenges in regulatory reform, specified by Mr Jaime Caruana, General Manager of BIS, at the annual Pierre Werner lecture in 2011. We hope you will find the following resources helpful in implementing the systemic risk management from macroeconomics, financial policy, framework, models and analytic tools perspectives.

1.

Bank for International Settlements: http://www.bis.org BIS has a Consultative Council for the Americas Conference "Systemic risk, bank behavior and regulation over the business cycle" with agenda and presentations (http://bit.ly/VCRNN7). The Committee on Global Financial System, has a Systemic Risk publications category(http://bit.ly/TmlRug). Besides that, BIS also has articles including but not limited to “A Framework for Assessing the Systemic Risk of Major Financial Institutions” (http://bit.ly/T4tGH4), “Systemic Risks in Global Banking: What Can Available Data Tell Us and What More Data Are Needed?” (http://bit.ly/TtFzsF), “Applying CoV aR to Measure Systemic Market Risk: the Colombian Case 2010” (http://bit.ly/TmlZtY), and “Measuring Systemic Risk Fall 2012 RiskJournal

in the Finance and Insurance Sectors” (http://bit.ly/TW5rzt).

2. European Systemic Risk Board http://www.esrb.europa.eu

European Systemic Risk Board (ESRB) is responsible for the macro-prudential oversight of the financial system within the European Union. It publishes speeches, interviews, and hearing at:Bank of Internationa http://bit.ly/T4utrw. It also publishes annual reports, http://bit.ly/ATBM7 Ba commentaries, papers, and reports at: on Banking Supervision (B http://bit.ly/W5ixvF. counterparty credit risk (C

tandards in “Basel III: A Glo Framework for more Resil 3. European Central Bank Systems” in December 20 http://www.ecb.int , a revised version was issu is available here - (http://b ECB hosted the forth joint central bank research condocument is also availab ference on Risk Management and Systemic Risk, in shLphC). cooperation with Bank of Japan and Federal Reserve

under the auspices of the Committee on the Global Financial System (CGFS) . Papers on this a pape BIScompiled also presented are available here: http://bit.ly/Q5MOaZ. “SystemicCounterp for Backtesting risk diagnostic: coincident indicators and early warnin December 2010 (http:/ ing signals” is available here: http://bit.ly/SwdHDf. backtesting principles, ter

 

examples for banks who t methods to calculate regu counterparty risk exposur 32

Counterparty Risk M Group (CRMPG): http


RiskJournal - A Quarterly Publication of PRMIA DC

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4. Systemic Risk Council

8. New York University Volatility Institute

The Systemic Risk Council (SRC) is formed by CFA Institute and the Pew Charitable Trusts to monitor and encourage regulatory reform of U.S. capital markets with a focus on systemic risk. A webcast of “Systemic Risk Council News Conference” is available here: http://cfa.is/T4vuzO. More updates of the council including audio and videos are available here: http://bit.ly/Swe2Gb.

This institute provides online real-time systemic risk analysis and simulation by selective countries, Global and U.S. Financial institutes, as well as publications of systemic risk measurement available at http://bit.ly/XXJcc3.

http://cfa.is/T4vuzO

5. U.S. Department of Treasury http://www.treasury.gov

Department of Treasury provides a good source for systematic risk analytics. “A Survey of Systemic Risk Analytics” covering 31 quantitative measures of systemic risk is available at: http://1.usa.gov/PGpbGd. Slides are available here: http://1.usa.gov/Swei81. Follow up discussion is available here: http://1.usa.gov/Rs9kJA. Treasury also hosted a conference, entitled “The Macroprudential Toolkit: Measurement and Analysis”, with archived webcast available at: http://1.usa.gov/RpO1oK.

6. Macro Financial Modeling Group (MFM) http://www.mfmgroup.org/

MFM is a committee of prominent and accomplished economists from Macroeconomics and finance with a goal to build better models to access systemic risk and frame policy discussions. MFM have compiled a group of papers and background readings in its database available at: http://bit.ly/V814Bg.

7. University of Maryland Center for Financial Policy

http://bit.ly/XXIXxD

9. University of Chicago Becker Friedman Institute for Research in Economics http://bfi.uchicago.edu/

This institute hosted a conference entitled “measuring systemic risk”. The slides are available here: http://bit.ly/PGq4i0, and articles available here: http://bit.ly/Swf8BQ.

10. University of Pennsylvania Wharton Financial Institutions Center http://bit.ly/VCTVog

This center hosted a conference on Framework for Systemic Risk Monitoring, available at: http://bit.ly/Tmn5G9. In addition, this center publishes articles of the Pew Financial Reform Project available at: http://bit.ly/TTo40Y.

11. CE-NIF.org

http://www.ce-nif.org The Committee to Establish the National Institute of Finance is group of volunteers contribute to the financial reform. CE-NIF has a good collection of systemic risk articles from internal and external sources available at: http://bit.ly/PGqmp3.

http://bit.ly/TtGCc0

This center hosted Conference on Systemic Risk and Data Issues with papers available at: http://bit.ly/QTK6Cq. Conference videos are available at: http://bit.ly/TTntwb.

Fall 2012 RiskJournal

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RiskJournal - A Quarterly Publication of PRMIA DC

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Progress in Financial Services Risk Management: A survey of Major Financial Institutions

This is an extract from the survey report on “Progress in Financial Services Risk Management: A survey of Major Financial Institutions”, co-sponsored by the IIF and E&Y.

HIGHLIGHTS ❖

The crisis has brought significant changes to structure of Risk Management at financial institutions, including changes to the role of the board, the CROs, the size and skills of the risk teams, liquidity management, models, stress testing, and risk culture.

Regulatory reform has significant impact on business models, costs, and created significant systems and data challenges for financial institutions.

Progress in Financial Services Risk Management is the third annual study on risk management conducted by the Institute of International Finance (IIF) and Ernst & Young since the 2008 crisis. This year’s study took place against a backdrop of global issues — continuing economic pressures in the US and Europe, the European sovereign debt crisis and a fast-changing regulatory environment. Responses from the 69 banks and six insurance companies that participated in the study highlight the degree to which agendas in the industry have been influenced Fall 2012 RiskJournal

by this picture. The scope, timing and potential impact of the still-evolving global and national regulatory reform was the top challenge cited by almost three-quarters of respondents (see Exhibit 1) and is driving a reshaping of the financial industry. The challenges from the regulatory environment are further complicated by the continued market, macroeconomic and geopolitical volatility. Despite the challenges, firms in this year’s survey reported continued progress on risk management improvements. When the IIF and Ernst & Young’s annual study of risk practices was first launched in mid-2009, the financial services industry was still recovering from the brunt of the 2008 crisis. The inherent weaknesses in risk management exposed by the crisis were very apparent. Study participants at that time were in the process of conducting firmwide assessments to identify gaps against risk management recommendations from the IIF and the Basel Committee on Banking Supervision, and plans were being developed and resources deployed to ad-

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RiskJournal - A Quarterly Publication of PRMIA DC

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dress areas targeted for improvement. Last year’s study found organizations in various stages of progress against these plans, and this year’s study shows continued effort and achievement.

stantially, with board risk committees now almost universal. The amount of time devoted to risk has increased, as has the range of risk reports provided to the board. The composition of the board has been changed in a number of firms to upgrade the skill Overall, the results of the three surveys demlevel and experience in banking and risk. Respononstrate that the structure of risk management has dents to this year’s survey reported that boards are undergone a significant change since before the criplaying an influential role in several key areas of risk sis. However, there is still much to be done to change management, including: risk appetite, liquidity, culand fully embed new methodologies and processes. ture and compensation. However, there are still Risk appetite, which post-crisis emerged as a critical challenges to overcome. Board members complain foundation of the risk manof too much undigested material, “During the crisis, we probably agement process, remains a high expectations from regulators key challenge for many firms. and difficulties challenging busilearned more about the risk in our While most have established company that we had in the previous ness models. an enterprise-wide risk appe10 years. I’m sure everyone felt the tite, many have not yet been Role of CROs. There has been same way able to embed it into their a similar shift in terms of the role businesses, with only 37% of and seniority of the CRO. One this year’s survey participants indicating they have finding post crisis was that many CROs had only linked it to day-to-day business decisions. The partial coverage of risk decisions and did not always methodologies and approaches to monitor complihave the stature to challenge business heads. Today, ance and enforce risk appetite are still evolving and over 80% of CROs report either directly to CEOs or must be further addressed. Data and systems are jointly to CEOs and board risk committees. The persistent impediments to risk management. And breadth and scope of responsibilities has expanded while many are investing substantial time and rewell beyond the traditional focus areas of credit and sources to improvement initiatives (77% reported an market risk, with CROs now involved throughout the increase in IT spend post-crisis and 63% predict it chain of decisions from new products through to will continue for at least the next several years), it will strategy. be many years before all these upgrades are fully operational. Changing the culture to make risk “every Size and skill level of risk team. Post-crisis, one’s business” is an ongoing effort. the industry has invested substantially to expand the size and level of sophistication of the risk function at Key areas of change in risk management include: both the group and business unit levels. This is particularly apparent in this year’s study results. While Role of boards. One area of criticism postmany firms are reducing headcount to adjust to both crisis was that boards were not sufficiently engaged in economic and regulatory pressure on profitability, challenging the risk profile. Since 2008, the in57% of respondents reported an increase in group volvement of the board on risk has increased subFall 2012 RiskJournal

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RiskJournal - A Quarterly Publication of PRMIA DC

risk headcount, and 48% reported an increase in business unit risk headcount over the past 12 months. Models. Another area of focus has been to upgrade the methodologies to identify risks, particularly concentrations of risk. Many agree that the economic capital models in place before the crisis often underestimated the size and risk of some exposures, particularly across business units. Correlations were far too optimistic and many models ignored risk types that proved to be at the center of some of the pressures during the crisis. Almost all firms have changed economic capital models since the crisis, with 70% of respondents reporting changes in the past 12 months. There is now much more coverage of business risks and risks not in VaR, consolidation across groups and conservatism in correlations. Increasing internal transparency has also been a heightened area of focus with stress testing, stress VaR, counterparty risk and liquidity risk cited as top areas of progress. Liquidity management. In a separate risk management study conducted by Ernst & Young released in December 2008, 88% of firms interviewed cited better liquidity management as the number one lesson learned from the crisis. In the IIF/EY 2011 study, 92% of firms interviewed reported they had made changes to their approaches to managing liquidity risk: increasing buffers of liquid assets; enhancing liquidity stress testing; introducing more rigorous internal and external pricing structures; elevating the discussion and approval of liquidity risk appetite and contingency planning to the board level; and giving the CRO more responsibility and involvement in liquidity management. Stress testing. The crisis clearly demonstrated a need for a more robust enterprise-wide asFall 2012 RiskJournal

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sessment of risk. Improving stress testing has been considered central to improving risk governance, and over the past three years, the industry has made many changes and improvements to its capabilities. In Ernst & Young’s 2008 study, only 13% of participants indicated they had formal enterprise-wide stress-testing processes in place. In last year’s IIF and Ernst & Young report, 93% reported they had created and implemented new enterprise-wide stresstesting methodologies — a dramatic difference. The evolving regulatory and business environment has heightened management’s attention to strengthening internal stress-testing strategies and processes, with 75% of this year’s respondents reporting they have created and implemented new processes in the past 12 months. Perhaps the most significant shift is the trowing interest in utilizing stress tests as a strategic management tool rather than for purely compliance or risk management purposes. However, there are still challenges, the most prominent of which is the sheer amount of time it takes to conduct bottom-up stress testing. Many are struggling with demands on resources needed to execute what is often a manual process of conducting tests and gathering results across portfolios and businesses. Many are struggling with demands on resources needed to execute what is often a manual process of conducting test and gathering results across portfolios and businesses. Many firms have major programs under way to address data aggregation and IT issues, but advances are needed to enable stress testing to become a flexible tool. Culture. Progress has also been made on softer areas such as culture, but these changes are hard to make quickly and are difficult to quantify. Post-crisis there has been widespread recognition that embedding an effective risk culture supported by a sustainable risk and control framework must be one

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RiskJournal - A Quarterly Publication of PRMIA DC

of the top agenda items for senior management. In the past three years, attention to risk culture has clearly increased and remains high, with 96% of respondents overall reporting a heightened and continued focus on risk culture since the crisis. Many initiatives have been launched to instill a strong and unified risk culture throughout all levels of the organization, not just in the risk function. However, for many firms, balancing the sales-driven business unit culture with a risk-control focus is still a challenge. And most agree that making risk everyoneâ&#x20AC;&#x2122;s business represents a significant shirt in mindset, policies, systems and processes and requires an ongoing, longterm commitment and investment.

TOC

listed data and systems as the top challenges to complying with the new regulatory requirements. Current systems are not designed for the new calculations inherent in the regulatory reforms, and everyone anticipates an enormous expenditure to make the necessary changes. The majority of respondents predict an increase in IT investment over the next two years, with 83% anticipating up to a 40% increase in spend.

Effect on business models. The proposed regulations have already led to changes in business models. Some are selling assets to increase capital; some are exiting businesses that will no longer be profitable; some are exiting geographies to avoid The impact of regulatory reform trapped capital and liquidity; others are retrenching, The survey also highlights the severe strain of merging legal entities and dealing with the magnitude of regulaactivities to consolidate in â&#x20AC;&#x153;Basica#y, the business model is being tory change. Basel III and the Doddcore locations; while others cha#enged by what is happening in Frank Act were both singled out for are exploring new products, their potential fundamental effects on the market, the regulatory environmarkets and acquisitions. the business. Many are concerned that ment and political sphere.â&#x20AC;? the appetite for investing in Effect on costs. The combinathe industry has been serition of higher capital and higher liquidity buffers is ously eroded by the pressures of the new regulations changing the economics of many businesses. Fiftyon cost and return on equity. Many executives disfour percent of respondents predict that the liquidity cussed the challenges to effective strategic planning coverage ratio will have a significant effect on costs. and management that result from the growing lack of And many predict some painful consequences from alignment between regulatory capital requirements both the liquidity and capital requirements proposed and internal measures of how much capital is under Basel III: returns on equity will go down, costs needed to profitably run the business. Over 60% and leverage will have to be reduced, and margins listed aligning economic capital with regulatory rewill have to go up. Of those firms that estimated the quirements as a key driver for changes to capital effect on margins on corporate loans, 40% was inmanagement. creases of over 50 basis points and 25% over 100 basis points. Below is a highlight of the 2012 Results. For a more in-depth review, please click here for the full survey Systems and data. Over 80% of respondents report. listed data quality and availability and over 70% Fall 2012 RiskJournal

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RiskJournal - A Quarterly Publication of PRMIA DC

Highlights of 2012 Results Risk culture. Survey responses confirmed that strengthening risk culture is a critical area of management focus, particularly for firms most severely impacted by the 2008 crisis. Strengthening risk roles and responsibilities, enhancing communication and training, and reinforcing accountability were the key initiatives reported to strengthen risk culture. Making risk â&#x20AC;&#x153;everyoneâ&#x20AC;&#x2122;s businessâ&#x20AC;? throughout the organization is an ongoing effort.

Risk appetite. Developing, implementing and embedding risk appetite ranked in the top three areas of focus for board members and CROs. All firms are under way to some degree with the risk appetite process. While many have been successful establishing a risk appetite at the enterprise level, many are struggling to effectively cascade the risk appetite through the operational levels of the organization and embed it into decision-making. For those furthest along in the development process, risk appetite is increasingly viewed as an important strategic management tool.

Fall 2012 RiskJournal

TOC

Roles and responsibilities. The involvement of boards in risk management and oversight has increased dramatically since the 2008 crisis and continues to grow. Liquidity risk, risk appetite, capital allocation and stress testing are the top areas of focus. The responsibilities and influence of the CRO continued to expand significantly post-crisis, and most are playing an active role in all key strategy and planning decisions.

Liquidity management. Liquidity and capital management are at the top of senior management agendas for most participants. Complying with the new costly and complex liquidity coverage ratio (LCR) requirements proposed under Basel III, together with multiple local liquidity requirements, are driving a host of initiatives to review and adjust business models and upgrade liquidity management systems and processes. The majority have made changes to both internal and external charging for liquidity and most are shifting the level at which liquidity is managed across group and local entities.

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RiskJournal - A Quarterly Publication of PRMIA DC

Capital Management. The impact of the proposed Basel III regime on capital will be substantial for most firms. Senior management teams are strategically reviewing their capital management priorities across geographic and political boundaries, legal entities and business lines, and the majority have changed their approaches to allocating capital across business units to more accurately reflect the risks taken throughout the enterprise. Aligning economic capital with regulatory requirements and reallocating capital with new risk-weighted asset goals are the key drivers for changes to capital allocation.

Stress testing. The evolving regulatory and business environment has heightened managementsâ&#x20AC;&#x2122; attention to strengthening stress- testing strategies, systems and procedures. Scenario planning in particular has become an increasingly important tool to help boards and senior management consider and assess the full range of market factors and macroeconomic events that could potentially influence revenue streams and stability.

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Recovery and resolution planning (RRP). RRP, often called living wills, is a work in progress for most of this yearâ&#x20AC;&#x2122;s participants. Regulators have moved at different speeds in requiring implementation of recovery and resolution plans, which has resulted in widely varying industry actions across jurisdictions. While many believe that recovery plans are a beneficial management tool, the overall view of resolution planning was varied. Confusion over regulatory expectations and variances in cross-border requirements and timelines, particularly for geographically dispersed firms, were the top challenges cited.

Internal transparency, data and systems. Improving internal transparency of information is an important initiative for study participants. Many firms face challenges extracting and aggregating appropriate data from multiple siloed systems, which translates into fragmented management information on the degree of risk facing the organization. The new regulatory regime is driving an increased investment in data and IT systems to support risk management. These projects, however, require multiyear investments of management time, people and resources.

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livepage.apple.comlivepage.apple.com

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RiskJournal - A Quarterly Publication of PRMIA DC

TEAM EDITORIAL COMMITTEE STEVEN LEE, Editor-in-charge NICK KIRITZ TIM MacDONALD WEIHUA NI JEFF BRASWELL JIM MICHAEL EDITORIAL ADVISORS THOMAS DAY STEPHEN LINDO DC STEERING COMMITTEE STEVEN LEE, Regional Director ASHISH GUPTA CLIFF ROSSI DAVID GREEN GREG COLEMAN JEFF BRASWELL JIM EMBERSIT JIM MICHAEL JOHN SCHWITZ KEITH LIGON KENNAN LOW KEVIN STEMP LINDSAY STEEDMAN MARLON ATTIKEN MELISSA VANOUSE NICK KIRITZ PAMELA GOGOL STEPHEN LINDO TIM MacDONALD TOM KIMNER WEIHUA NI

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MEET THE TEAM EDITORIAL COMMITTEE STEVEN LEE is Managing Director with Global Client Consulting llc where he provides Governance, Risk & Compliance consulting services to financial institutions. Previously, he was a Director with the Enterprise Risk Services Group at Deloitte. He is the Editor of RiskJournal Magazine and also serves as the Regional Director of PRMIA DC Chapter.

NICK KIRITZ is the Vice President of Risk Capital Pricing at Constellation Energy, Baltimore Maryland. Prior to joining Constellation Energy, he was a Risk Management Officer at Fannie Mae. He is a Chartered Financial Analyst (CFA) and also holds the Financial Risk Managers (FRM) designation. Nick is also a member of the DC Steering Committee. JEFF BRASWELL is founding partner of Tahoe Blue Ltd providing consulting services in design and implementation of risk management applications and enterprise solutions for financial institutions. He was previously founder and President of Risk Management Technologies (subsequently acquired by Fair Isaac). Jeff was recently admitted as a member of the DC Steering Committee. WEIHUA NI holds a Masters degree in Management Information System and he is into import and export business especially to and from China. He is a member of the DC Steering Committee and has written also for the Intelligent Risk magazine published by PRMIA Global.

JIM MICHAEL is a Vice President and Sr. Audit Manager at T. Rowe Price Associates. He is responsible for audit of Technology, Retail, Retirement Plan Services, and the Corporate office. Jim was recently admitted as a member of the DC Steering Committee.

Editorial Advisors THOMAS DAY is SunGard’s in-house expert on risk management solutions and policy across the banking sector. He was formerly Vice-Chair of the PRMIA Global Board and Co-Regional Director of the PRMIA DC Chapter, and currently serves as an Editorial Advisor to the RiskJournal Magazine

STEPHEN LINDO is a senior financial risk manager with over 30 years international experience. His most recent position was Director of Treasury Management and Mortgage Risk at Fifth Third Bancorp in Cincinnati, USA. Previously, he was PRMIA’s CEO for 2 years and also worked at GMAC, Cargill, First Chicago and Lloyds Bank. He has a BA and MA from Oxford University and speaks fluent French, German, Spanish and Portuguese.

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