FINANCIAL CRISIS: WHERE DID RISK MANAGEMENT FAIL ?

Gabriele Sabato

Royal Bank of Scotland

Arsalan AliSyed Jahanzeb

Sabih Ur RehmanMohsin

Aamir Shahid

FINANCIAL CRISES 07-08

• REAL ESTATE MARKET BUBBLE & SUBPRIME MORTGAGES

?• A POOR REGULATORY FRAMEWORK & TRUSTWORTHINESS

on BANKS

Failed to enforce safe business – AVOID STRONG CONCENTRATIONS – MINIMIZE VOLATILITY OF RETURN

Reason of Failure 1) CAPITAL ALLOCATION STRATEGY2) DISAGGREGATED VISION OF RISKS 3) RISK GOVERNANCE STRUCTURE

INTRODUCTION

• REAL ESTATE MARKET focus on SUBPRIME MORTGAGES and DISHONEST LENDING

• A POOR REGULATORY FRAMEWORK that banks could be trusted to regulate is the main sources of the crisis.

• LENDING PORTFOLIOS through MARKET DEMAND without a clear CAPITAL ALLOCATION STRATEGY

• Regulatory pressures, such as Basel II and a greater 3 focus on CORPORATE GOVERNANCE

• Need to ARTICULATE RISK APPETITE

• RISK APPETITE – risk metrics and methods into business decisions – reporting and day-to-day business discussions– link between strategy, target setting and risk management

• Balancing ARTICULATE RISK APPETITE • QUANTIFIABLE, but JUDGMENTAL

• Risk appetite framework – internal senior management – external stakeholders – Current position and expected growth

• Enterprise Risk Management (ERM) approaches

– proactive methods of RISK MONITORING and DETECTION

– Large national and international financial institutions have adopted

• SILO APPROACHES to risk management can be insufficient

SILO-based approaches occurs– Due to lack of communication with one another and

across business lines

• DIVERSIFIED RISKS – Credit, – Market– Operational risks

CAPITAL ALLOCATION STRATEGY

• Cheap and easy to raise for banking organizations

• Currently Banks are more greedy which creates problems like– Creating the market demand to drive the asset

growth– social function providing funds to companies in order

to start or grow their business and to consumers

• Please shareholders and to outperform peers

• Aggressively invested in COMPLEX ASSETS MIXING

• The business model – EQUITY CULTURE with a focus on FASTER SHARE PRICE GROWTH and

EARNINGS EXPANSION

• Model, based on balance sheets and old fashioned – spreads on loans, not beneficial for “GROWTH STOCKS”– trading income and fees via SECURITIZATION– enabled banks to grow earnings– focused on the expected return side leaving risk side out

• Focus in highly correlated assets - increased without any consideration of the volatility of their losses

• Portfolio diversification – purely theoretical concept – easy to be sacrificed to allow the market share to grow

• Pricing – competitive in the market and not to guarantee an appropriate return

Markowitz (1952) Portfolio Selection Theory

Markowitz explains:

• How to build the most EFFICIENT INVESTMENT PORTFOLIO

• The right balance between EXPECTED RETURNS and VOLATILITY OF LOSSES

• DIVERSIFICATION is the best tool to reduce the risk of the entire portfolio

• The concept is EASILY APPLICABLE to banks portfolios.

Mortgages (P1), Credit Cards (P2) and

SME Loans (P3)

Figure 2. Definition of the risk appetite frameworkThis figure shows how a risk appetite framework can be defined. Following theBoard guidelines, the risk tolerance and the risk appetite lines can be drawn in the picture. As such, portfolios can be classified into red/amber/green. The followingstep will consist in defining the mitigating actions to be implemented in order tomove portfolios at desired levels of returns and volatility.

ENTERPRISE RISK MANAGEMENT• Risks affect value of an organization

• CORRELATIONS and COVARIANCES – when different risks are aggregated– Helps assessing and addressing all form of risks

• Provide a comprehensive and coherent view

• Focus must be on– Bigger Picture and not on the single “silo”– “Pure” risks (or hazard risks)– Speculative risks

ERM is to identify the risks the firm is exposed to,– Market risk– Credit risks. – Operational risk.

• OPERATIONAL RISK except market and credit risk

• Operational risk much narrower in banks

• Many firms have gone beyond measuring market, credit, and operational risks

• In recent years, firms have also attempted to MEASURE LIQUIDITY, REPUTATION, TAX, PENSION and STRATEGIC RISKS

RISK GOVERNANCE STRUCTURE

• The lack of an appropriate risk governance

• The current crisis by risk managers as an excuse to justify their failures

• Role of risk management was extremely marginal at most institutions

• Skills of each risk manager and not to his authority

CONCLUSION

• Three most significant failures of risk management at most banks:

1) Lack of a defined capital allocation strategy 2) Disaggregated vision of risks and 3) Inappropriate risk governance structure

• A Capital Allocation Strategy should be thoroughly defined for the short and long term using a risk appetite framework. This should specify the bank’s risk capacity (maximum risk tolerance) and risk appetite (desired risk tolerance) following the guidelines proposed by the Board

• Implementing a sound ERM APPROACH to monitor and report risks Large investments in info structure will be needed if financial institutions are willing to succeed.

• THE RISK GOVERNANCE STRUCTURE are weak reporting lines and lack of visibility of the CRO at Board level are the main issues that should be solved in order to ensure the independence of the risk function