amm 2008 lawrence

7/30/2019 AMM 2008 Lawrence

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Risk Management: Where toFrom Here?

Institute of International Finance2008 Annual Membership Meeting

Special Briefing: Industrys response to the Credit Crisis: Next Steps Toward

Implementation of the Final Report of the IIFs Committee on Market Best Practices

Washington, 10 October 2008

Dr. Mark LawrenceManaging Director, Mark Lawrence GroupSenior Advisor to McKinsey & Company

[email protected]

Lessons learned from the credit & liquidity crisis of 2007/08


2/18

Discussion topics

Risk management lessons learned and keyglobal industry recommendations

The risk management imperative today

1


3/18

2


4/18

Crisis had many important causes, including risk management

failures, weak culture and poorly aligned incentives

Specific USissues

Capital adequacy

"Laissez faire"policy

Fair-valueaccounting

Liquiditymanagement

Stress testing

Interpretationof regulations

Weaknesses in

supervision,

regulation and

accounting

standards

Ineffective

risk

management

practices

Operational risk

Valuation

Riskmeasurement

Incentivestructure

Supervision

Governance

Capital incentives to shift risky assets off balance sheet Low capital requirements for securitization

Marketexpectations on

profit beyondeconomic reality

Poor underwriting standards in the US(in particular, by non-regulatedinstitutions)

Inadequate supervisory structure

Business not aligned withriskappetite/"risk competence

Insufficient timing and quality ofinformation flow Too much reliance on

quantitative models Risk concerns pushed aside Lack of courage to act against

market expectations

Insufficiently robust monitoring ofbanks' risk managementpractices

Aggressive interpretations, e.g. 364-day liquidity lines Consolidation of SPVs

Lack of transparency andaccountability

Conflicts of interest Lack of diligence Weaknesses in methodologies

Compensation schemeswith excessive short-term incentives

"High greed culture", inparticular, for originators

Partiallyinadequate,

largely failedmanagementresponse

True risk of complex transactions nottransparent

Excessive reliance on Credit RatingAgencies, insufficient own due diligence

Weak incentives for originator/investor togenerate transparency/monitor

Accountabilities not clearly defined Banks' risk profile not sufficiently

understood by (supervisory)boards

Reputational risk underestimated Weak operational controls

Insufficient internalvaluation models

Passive reliance onexternal valuations

Models failed credit cycle test Scenarios not extreme enough Not forward-looking

"Domino effects" of risksunderestimated

Lack of integrated view on risks Insufficient data history

Insufficient liquidity practices Failed in stress situations Inadequate contingency plans

No catch-up of regulations with complex business

Pro-cyclical effect not fullyunderstood/underestimated Weaknesses in stress situations

Credit RatingAgencies

SELECTION

Transparency

Early warningsystemsMarket

expectations

Managementoversight

Wrong

incentives

and behavior

3Source: FSF, IIF, Senior Supervisors Group, U.S. Treasury, McKinsey analysis


5/18

Key lessons learned from risk management failures and successes are

driving the global industry response

Rich dialogue among senior management,business lines, and control functions

Quick escalation process Risk appetite and risk control well balanced Senior managers with prior experience in

capital markets

"Organizational silos" (Aggressive) expansion of risk without clear

guidance Little capital market experience in senior

management

Close alignment between treasury function andrisk management

Internal pricing mechanisms to incentivizebuilding of liquidity exposure

Multiple tools drawing on different underlyingassumptions, which can be altered rapidly

Wide range of measures Effective balance of quantitative and qualitative

information

Rigorous internal processes to challengevaluations

Internal experience to conduct independentassessment

Consistent application of values across firm

Manage-

ment

oversight

Liquidity

manage-

ment

Risk

measure-

ment and

stress

testing

Valuation

Treasury function lacked information across allbusinesses

Contingency plans based on incompleteinformation

Specific measures only, incorporating outdatedor inflexible assumptions

Limited integrated view across businesses

Lack of relevant internal valuation models Heavy reliance on external valuations

Characteristics of firms that did not do well Characteristics of firms that did well

SELECTION

* This assessment is based on an analysis of 11 of the largest banks and securities firms

Source: Senior Supervisors Group; Observations on Risk management Practices during the Recent Market Turbulence (March 6, 2008);McKinsey analysis 4


6/18

The IIF Committee on Market Best Practices has recommended 6 areas for

industry action in its July 2008 final report

Risk Management

Compensation Policies

Liquidity Risk, Conduitsand Securitization

Valuation

Credit Underwriting,Ratings and InvestorDue Diligence in

Securitization Markets

Transparency andDisclosure

Areas for industry

action

Next steps areindustryfollow-up andimplementation

The global industry response tothe credit and liquidity crisis wasformulated through theCommittee on Market BestPractices (CMBP) of the

Washington-based Institute ofInternational Finance (IIF)

The Committee (consisting ofrepresentatives from over 65 IIF

member institutions, includingrating agencies and investors)engaged 6 Working Groups toaddress key areas of focus

Its J uly 2008 report containsPrinciples of Conduct and >100specific recommendations ineach of 6 main areas forindustry action

5Source: IIF Committee on Market Best Practices


7/18

Risk Management Key Recommendations

Risk culture and

accountability

Develop a robust risk culture - incorporated in the way the firm operates -covering all areas and activities. Accountability for risk management should be apriority for the whole institution, with particular care taken in challenging areassuch as risk modeling and stress testing

Role of the BoardSenior management, particularly the CEO, is responsible for risk management;the Board has an essential oversight role

Role of the CRO Ensure that the Chief Risk Officer (CRO) can influence decision making withinthe firm and assess firm-wide risk

Comprehensive

perspective

Define and articulate risk appetite and ensure its adoption throughout the firm;

take an integrated approach to capturing all sources of risk (notably off-balancesheet exposures); risk models should not be based on a single risk methodology

Official sector

considerations

The Basel II framework for securitization should be improved, allowing options forfirms to use external ratings in conjunction with internal models; greater

collaboration between the official and private sectors is needed in the area ofstress testing, promoting practices under a Pillar 2 approach suitable to thespecifics of each firm

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8/18

Compensation Key Recommendations

Shareholders'

interestsIncentives should be aligned with long-term, firm-wide profitability

Risk-adjusted

compensation

Incentives should not induce risk-taking in excess of the firm's risk appetite; firmsshould base compensation on risk-adjusted performance

Severance payThis should take into account realized performance for shareholders over time,and consider the circumstances of severance

TransparencyThe industry must show leadership in developing a better, more transparentapproach to compensation practices

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9/18

Liquidity Key Recommendations

IIF March 2007

liquidity report

Recommendations of the IIF's 2007 Principles of Liquidity Risk Managementhave been validated by recent experience and updated in the Final Report; firmsshould complete their implementation

Funding and stress

testing

Firms should diversify their funding sources for asset portfolios held for liquiditypurposes; firms should ensure that stress testing includes contingent liquidityexposures

Contingency

planning

Firms that rely on market funding, particularly asset securitization or conduits,should conduct rigorous contingency planning for market liquidity risks

Central banks have made an essential contribution to market liquidity new toolsshould be kept available for use when needed. Greater clarity of central banks'roles in firm-specific and market- related crises would also be welcome. For firmliquidity, standards should be better harmonized and based on qualitative ratherthan specific quantitative requirements. Supervisory dialogue and review of off-

balance sheet issues under Pillar 2 is preferable to revision of regulatory capitalrules

Official sector

considerations

8


10/18

Valuation Key Recommendations

Fair-value

accounting

Essential for global capital markets, fosters transparency, discipline andaccountability. However, mark-to-market valuation is challenging in illiquidmarkets

Valuation in liquid

markets

Comprehensive technical dialogue should address the problems of assigningappropriate values in dislocated or illiquid markets

ConvergenceAligning U.S. GAAP and International Accounting Standards is more critical thanever and should be accelerated

Dialogue needed A high-level dialogue of all relevant parties with bothstandard setters should consider the effects of mark-to-market techniquesduring times of excess liquidity as well as illiquid markets, and the apparentpro-cyclical effects with macroeconomic implications that concern many in theprivate and official sector

Standard setters should provide additional guidance on valuation in inactive,illiquid and/or stressed market conditions

Official Sector

Considerations

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11/18

Credit underwriting, Ratings and Investor Due Diligence Key

Recommendations

Broad scopeRecommendations cover the process from origination and underwriting throughto ultimate investors. Firms should subject assets they help originate anddistribute to the same credit due diligence standards as used for similar assetsthat are to be carried on their own balance sheets

External reviewEstablish an external review of rating agencies' internal processes for monitoringand validation of models against defined industry standards

Separate rating scaleRating agencies should introduce a differentiated rating scale for structuredproducts

Underwriting Non-bank mortgage originators should be held to the samestandards as banks on consumer protection and loan origination

Authorities should consider external review of internal processes within CreditRating Agencies, possibly via an SRO

Official sector

considerations

10


12/18

Transparency and Disclosure Key Recommendations

More accessible and

useful information

Better disclosure on products is required to restore market confidence, as ismore transparency about firms themselves

Structured products

Recommendations here includeA short-form summary of the offer documentGlobal harmonization of market definitions & structuresCommon platforms (such as data portals) for improved access to information

on structured products

Firms' risk profiles

Institutions should ensure that their disclosure provides a sufficient overview oftheir current risk profiles including securitization activities and off-balance sheetexposures

Regulators should support the private sector's efforts to improve transparency,with particular reference to harmonization of disclosure requirements amongdifferent jurisdictions.The official sector should work closely with industry andmarket participants to improve market understanding of Pillar 3 disclosurecontent. Disclosure requirements should be based on a risk- and principles-

based approach to qualitative as well as quantitative information

Official sector

considerations

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13/18

Discussion topics

Risk management lessons learned and keyglobal industry recommendations

The risk management imperative today

12


14/18

Creation of a robust, integrated risk management framework is now

imperative for survival and sustainable performance & growth

Integrated

risk-return

management

1313

Insight and risk t ransparency

Are risks that affect future performance

transparent? Do you have insight intorisks that matter most?

Natural ownership, risk appetite,

and strategy

Which risks are you advantaged to

own? Which should you transfer or

mitigate? Is your risk capacity alignedwith your strategy?

Risk-related decisions and managerial

processes

Are critical business decisions made with a

clear view of how they change your

companys risk profile?

Risk organization and

governance

Are structures, systems,

controls, and infrastructure in

place for you to manage riskand comply with regulatory

requirements? Is your

governance model robust?

Risk culture and performance

transformation

Does your culture reinforce risk

management principles?

What formal and informal

mechanisms support the right

mindsets and behaviors?


15/18

3Processes

5Culture

Banks need to first fix the fundamentals of risk management

1Transparency

Ensure ful l transparency into important risks and developintegrated view of risks across all businesses (e.g., redesign riskreporting, stress test for often substantial tail-risk, focus on what is changing,new or growing rapidly, descriptive analysis to drive mgmt action)

Benchmark against IIF Market Best Practices recommendations

Assess and adjust portfolio to reflect current realities (e.g., redirectstrategy away from businesses consuming scarce capital and liquidity or withinadequate risk management capabilities, reduce waste in capital and funding)2Ownership

Enhance capabili ties in end-to-end credit risk management (e.g.,strengthen collections, workout strategies and execution)

Leverage Basel II investments to capture value

Respond rapidly to regulatory changes

4Governance

Fix risk organization gaps and empower risk management (e.g.,resolve CRO/CFO conflicts, proper separation of duties, CEO leadership)

Ensure appropriate risk accountability (e.g., reinforce BU-ownershipand responsibility as first line of defense)

Increase risk awareness across the bank & strengthen r iskculture (e.g., strive to consciously balance risk and return at every levelthrough questioning & open dialogue, foster culture of vigilance in front-, mid-,and back-offices, launch education and cultural change programs)

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16/18

3Processes

4Governance

Make unstated assumptions explici t (e.g., home price appreciation)

Embed risk in strategic planning and budgeting (e.g., understand

and accept risk implications of operating plans and growth targets)

2If you dont understand it, dont own it!

Dont grow more than your r isk appetite & capabil ities allowMaintain perspective through-the-cycle (e.g., lean against the wind)Ownership

and then go beyond fundamentals to increase resil ience in the next crisis

1Transparency

Empower CRO and risk organization to partner with business(alignment of control functions/CFO/CRO, right mindset, skills, profile)

Make Board and management risk oversight effective (e.g., ensureBoard has risk skills/experience, avoid socialized accountability for risks)

5Culture

Make importance of strong risk culture explicit (e.g., ensure badnews travels, codify principles & include culture in performance assessment)

Align risk-based incentives (e.g., compensation based on risk-adjustedperformance, deferred payouts and claw-backs)

Improve understanding and foresight on structural, systemicand emerging risks

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17/18

Three immediate CEO priorities

Ensure sufficient capital and liquidity key tosurvival

Improve transparency of risk profile

Coordinate closely with regulators

Survive

Make steady progress on Fixing theFundamentalsand Go beyondto fix past

failures and increase resiliency in next crisis

Enhance

risk mgmt

capabilities

Look for opportunities to:

Buy attractively-valued assetsCherry-pick talent

Transform industry practices (e.g.,incentives)

Seizeopportunity

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18/18

Risk Management: Where toFrom Here?

Institute of International Finance2008 Annual Membership Meeting

Special Briefing: Industrys response to the Credit Crisis: Next Steps Toward

Implementation of the Final Report of the IIFs Committee on Market Best Practices

Washington, 10 October 2008

Dr. Mark LawrenceManaging Director, Mark Lawrence GroupSenior Advisor to McKinsey & Company

[email protected]

Lessons learned from the credit & liquidity crisis of 2007/08

amm 2008 lawrence

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