evolution and changing expectations of risk management in ... · evolution of financial service...

Evolution and Changing Expectations of Risk Management in Financial Institutions

Dr John Lee

Group Chief Risk Officer

Maybank Group

27 August 2014

2

The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

3 | © 2014 Global Association of Risk Professionals. All rights reserved.

Agenda

Evolution of Financial Service Industry and Global Financial Crisis

Regulatory Development Resulting from GFC

Risk Management Trends

Moving Forward


Evolution of Financial Service Industry and Global Financial Crisis (GFC)


Evolution of Financial Service Industry and GFC

Financial Services Sector

Financial Services sector is made up of companies and firms which act as intermediaries that

facilitate the flow of capital and liquidity to industries and players within the economy:

Financial Services

Companies

Banks

Credit Unions

Credit Card Companies

Insurance Companies

Consumer Finance

Stock Broking

Investment Funds

Government Linked

Enterprises

Loans

Deposit Taking

Checking Accounts

Capital Raising

Revolving Credit

Risk Management

Traditional Products & Services



However, Interest Spreads have been Thinning for Traditional Lending

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

World

East Asia and Pacific (Developing Only)

High Income OECD

Malaysia

Interest spreads of more

mature banking markets

have been on a

downward trend over the

past decade…

Source: Worldbank (latest available data as of 2011) (Interest rate spread = lending rate minus deposit rate, %)



Resulting in Banks’ Evolving their Business Models

…10 YEARS AGO…

In recent years, financial institutions and private equity/opportunity investors

have demonstrated a willingness to allocate more capital to principal investing

activities

Credit and

Capital Market

ActivitiesSpecialised Lending

Mezzanine Investments

Principal Investing

Private Equity

Hedge Funds

Infrastructure Funds

Corporate Acquisitions

…TODAY…



Era of Financial Innovation and Proliferation Started

As traditional savings & loans business became less profitable, banks needed to find a more

profitable way of using their capital and funds.

Traditional

Savings & Loans

activities

Banks

traditionally

made profit

from the

spread

between its

loans &

deposits

Increasing

profitability would

mean increasing

risk

Banks began a

period of

financial

innovation to

‘churn’ its

capital

Complex

Financial

Derivatives were

invented

Derivatives

sought to

securitize the

assets of

banks, and

‘unlock’ capital

to create more

loans

Financial

Services

ushered in an

era of

unprecedented

profitability

Bankers and

Financiers

made huge

profits, which

saw the sector

more than

double its size,

which

overtook the

real economy Source: Maybank Analysis



Complex Financial Derivatives Swelled to Unprecedented Levels

Source: OTC Derivatives and Post Trading Infrastructure, Sept 2009, European Central Bank; Maybank Analysis

Interest Rate Swaps (‘IRS’)

Equity Derivatives

Credit Default Swaps (‘CDS’)

FX Derivatives

Repo’s

Financial

Derivatives were

largely being

traded Over-The-

Counter (‘OTC’)

between a few

large players

Large notional

amounts were

being traded

OTC and

virtually

unregulated

The total OTC

‘notional’

exposures being

traded were

estimated at

US$592 trillion in

2008, at the height

of the housing

bubble

Derivative Products Traded Volumes were

‘Systemic’Risks it Created

Systemic Risks due to Sheer

Volume and Size

Opacity of OTC market caused

significant complexity

Trading Processes did not keep

pace with growth of OTC Market

Increased Counterparty Credit

Risk

Increased liquidity risks due to

sudden shocks to the system



Hence Banking is NOT What it Used To Be

Banking is

NOT the

Same as

Before

Banks have been

required to take

more risk to

generate the

returns required

by the

shareholders and

financial markets

- Traditional banking will not generate the returns

required, more capital leverage is necessary

- The move of financial assets from traditional

banking services to asset management services due

to the demographics will also have a major impact

- It is all about moving from “stocks” to “flows” of

capital.

Velocity of Capital

- Asset based lending

- Simple products

- Unsophisticated customers

- High net interest margin



Credit Growth has been Evident Worldwide

0

20

40

60

80

100

120

140

160

1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

East Asia & Pacific (Developing Only)

European Union

Source: Domestic Credit provided by banking sector (%) of GDP, Worldbank Data, Maybank Analysis

Cre

dit

% o

f G

DP

Growth in economies were more and more

reliant on financial markets growing



Financial Services Became a Key Driver of Growth Itself Globally

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Banking Assets

GDP

in b

illi

on

s o

f U

S$

Growth of the economy was driven in large part by the financial sector, which wasn’t creating

‘real assets’ , but financial assets which were being churned for profits.

8% Banking

Assets 10 yr CAGR

4% Total GDP 10

yr CAGR

Banking Assets vs. Nominal GDP of G7 Countries

Source: Economist Intelligence Unit, Maybank Analysis



Events Leading Up to the Crisis

Prior to Summer of 2007

August 2007

April 2008

September 2008

Post- September 2008

Crash of the U.S.

Subprime Mortgage

Market shakes confidence

in the global financial

markets

Unprecedented growth in

the global economy over

the past 4 years –

averaging 5% yearly

growth from 2003 to mid

of 2007

“Fire Sale” of the major

U.S. investment bank

Bear Stearns

Market confidence in

counterparties vanish as the

global economy entered a

negative feedback loop with

the financial system.

2009 onwards

Eurozone Debt

Crisis looming,

potential

sovereign bail

outs

Source/Notes: [1] Meeting of the Governors & Central Bankers G20, March 13-14 2009, [2] Negative feedback loops between the real economy and the financial system, IMF , March 2009, [3]

Asian Development Outlook 2009, Asian Development Bank

The non-financial corporate

sectors are hit by the financial

crisis as borrowing spreads widen

and equity markets crash – DJIA

was down by 54% and S&P down

by 57%[3] by March 2009.

The unthinkable happened, credit markets crashed, players locked up, and market

confidence dwindled, which created a financial tsunami that wiped out Wall Street and

Main Street.

U.S. and European credit

markets lock-up due to

waning confidence after

the folding of Lehman

Brothers and the merger

of Merrill Lynch & Co.

with BOA.

The US Economy is

downgraded by S&P

and global equities

tumble



Key Risk Lessons from the GFC

OVER RELIANCE ON RATING AGENCIES

Government and investors were over reliant on rating agencies’

assessment of mortgage securities

RELIABILITY OF DATA INPUT

Quality of external ratings and inaccurate valuation of mortgage securities reduced the credibility

of data input for VaRcalculations.

MARKET LIQUIDITYASSUMPTION

Market liquidity was assumed be available at all levels, in all time periods, for all maturities, at an

appropriate price

COMPLEXITY OF PRODUCTS

Investors did not fully understand the underlying assumptions and collaterals attached to mortgage

securities led to inaccurate valuation of products

INEFFECTIVENESS OF CAPITAL MANAGEMENT

Financial Institutions did not have a comprehensive capital

management programme and did not adequately link their capital management to stress testing

NON COMPREHENSIVE STRESS TESTING

Lack of spill over and second round effects and inadequate magnitude of shocks on risk

parameters for stressed scenarios

MODEL RISK

Identification of wrong risk factors (e.g. ignoring basis risk) and incorrect distribution of risk

parameters, i.e. volatility and correlations led to MTM losses

and non-reflective VaRcalculations.

LACK OF OVERSIGHT BY CENTRAL BANKS

Central banks lacked oversight over the dealings of the

investment banks, basing information only on internally

generated VaR calculations of the banks.

CORRELATION OF RISKS

Lack of analysis and consideration on the impact of credit default and counterparty

credit risk to market and liquidity risk



Outcomes from the GFC

Increased demand on

risk IT and

Infrastructure due to

evolving regulations

Risk management

needs greater

integration to

strategic decision

processes

Risk

interdependencies

need to be

considered across

risk types, entities

and jurisdictions

Macroeconomic and

systemic risk

monitoring and

assessments will gain

greater importance

Market liquidity

assumptions of banks

need to be revisited

Greater granularity

required of risk data

and aggregation for

large banking groups

The GFC and the ensuing regulatory scrutiny has increased the demands on banks to rethink

their current operating models to gain competitive advantages and drive value for the

organization:



Financial Services Landscape Today - The New Normal

Regulation, Regulation,

Regulation

Increased regulation and

intrusiveness by regulators and

governments on the FS sectors

Increased Market Volatility

Stock markets around the globe

experiencing increased volatility

and loss of wealth are still being

observed

Shaken Consumer

Confidence

Consumer confidence in FS has

fallen and a general backlash at

financial services companies is

causing a PR debacle for Wall

Street

Challenging Cost

Environment

Firms need to be able to manage

the increasing cost of doing

business, without sacrificing the

customer experience

Crisis of Confidence

Much of the cause of the

financial crisis has been due to

an unwillingness of banks to lend

to each other, which froze

liquidity in the market

Deleveraging Continuing

Many banks and financial

companies are still reeling from

the fallout of the financial crisis,

and will continue to do so in the

short to medium term

The impact of the financial crisis is still being felt across the globe, and banks and financial

services companies are adjusting to the ‘new normal’…

Source: Maybank Analysis



Back to Basics

Moving forward, it is important for greater linkages between the Real and Financial Economies

The challenge for governments and regulators is bring the two closer…

Borrower Balance

Sheet Channel

Bank Balance Sheet

Channel

Liquidity Channel

Financial Sector

Transmission of

shocks to the real

sector determined

through health of loan

book, balance sheet of

banks,

macroeconomic

situation and access to

liquidity

Real Sectors

Transmission of

shocks to the financial

sector determined

through access to

financing, health of the

economy and asset

price stability (e.g. real

estate sectors)

Regulation and

Supervision

Macroeconomic Policy

and Strategy



Humanising Financial Services Maybank’s Guiding Principles (1/2)

Humanizing Financial Services means that the customer’s welfare comes first. At

Maybank, our commitment to humanising financial services is based on four key principles:

Providing

People with

access to

funding

Offering Fair

Terms &

Pricing

Advising

Customers

Based on

their needs

1 2 3

Being at the

Heart of the

Community

4



Humanising Financial Services Maybank’s Guiding Principles (2/2)

Providing People with

access to funding

1 By putting people first, we are committed to providing access to

customers and businesses around the world to funding to grow and

prosper.

We are able to do this through our extensive network of 47,000

Maybankers across the globe and our commitment to service quality.

Offering Fair Terms &

Pricing

2 We are committed to providing fair terms and pricings to our

customers, because we want to see them grow with us.

Our Islamic First policy also provides an appropriate and effective

driver of this principle.

Advising Customers

Based on Needs

3 We intend to serve the needs of the community, small and medium

enterprises (‘SME’) and commercial customers.

We are committed to the values of the One Stop Shop, Needs Based

Selling and World Class Savings.

Being at the Heart of the

Community

We are committed to working at the very heart of our communities,

understanding that no one single decision applies to every situation.

We are committed to Serve From Your HEART – which means serving

our customers with Humility, Efficiency, Appreciation, Respect, and

Trust.

4



Basel III Reforms

The Basel III requirements intend to strengthen the resilience and soundness of the banking

system against systemic risks, which have implications on banks and risk management…

Cost of Capital & Liquidity will

Increase

Addressed

systematic risk

and inter-

connectedness

Increased

capital

requirements

(quality and

quantity)

Introduced

capital buffers

Included

Leverage Ratio

(backstop to

risk-based

measure)

Improved

liquidity

management

principles and

globalized

liquidity

standards

Basel III (Capital & Liquidity)

1 2 3 4 5



Basel III Requirements

Increased capital

requirements

(quality and quantity)

Introduced capital buffers

Included Leverage Ratio

(backstop to risk-based

measure)

Improved liquidity

management principles and

globalised liquidity standards

Addressed systematic risk

and inter-connectedness

Basel III introduces more stringent requirements to improve the

quality of capital banks are required to hold. It attempts to improve

transparency of regulatory capital and improve market discipline.

Basel III attempts to ensure that banks build up capital buffers outside

periods of stress which can be drawn down as losses are incurred.

A Leverage Ratio will function as a constrain to the build up of

excessive leverage in the banking sector and act as a backstop

measure.

Two key liquidity risk measures (LCR & NSFR) aimed at ensuring

banks maintain sufficient buffers of liquidity during times of stress.

Basel III specifically addresses the concept of ‘Systemically Important

Financial Institutions’.

1

2

3

4

5



Risk Management Essentials

Moving forward, banks’ Risk Management needs to focus on the following key areas:

Establishing the

appropriate risk appetite

Balancing more effectively

the risk reward dynamics

Enhancing the risk

governance through more

effective risk managers and

risk management function

Inculcating a stronger risk

culture within the

organization

Understanding and

measuring better the

correlation of risks

1 2 3

4 5



Establish Appropriate Risk Appetite

Risk

Appetite

Risk Taking Capacity

Target Risk Profile

Actual Risk Profile

Risk Appetite defines the quantum of risk a bank is

willing to accept based on its business model, target

rating, target share price, etc.

Risk Taking Capacity (‘RTC’) is the maximum

amount of risk a bank’s capital base is able to

withstand, which are in turn linked to its limit

setting, etc.

The desired Risk Profile of the

bank will managed by the limits set

The desired Risk Profile of the

bank will managed by the limits

set

The bank’s actual Risk

Profile utilization of limits

Establishing an appropriate Risk Appetite is essential to link the Risk Strategy of the firm to its

business and strategic objectives…



Balancing Risk-Reward Dynamics

Banks’ Risk Management needs to strike a balance between its Capital Protection objectives

with its profit driven Capital Development objectives..

CAPITAL

(risk taking

capacity)

RISK

(economic

capital)

RETURN

(economic

performance)

Capital Adequacy



Enhancing Risk Governance

The financial crisis has underscored the importance of a strong risk governance structure,

which is independent and able to give challenge to the business…

1st Line of Defense

Business Operations

2nd Line of Defense

Oversight Functions

3rd Line of Defense

Independent Oversight and Assurance Functions

1st Line of defense is the business

operations which performs day-to-

day risk management and

implements an effective risk and

control environment to operate in

Bo

ard

, EX

CO

, Au

dit C

om

mitte

e

2nd Line of defense are the oversight

functions such as Group Finance,

Group Risk & Group Compliance

which set direction, define policy

and provide assurance

3rd Line of Defense are Group Internal

Audit and External Audit which

provide independent challenge to

the levels of assurance provided by

business and oversight functions



Inculcate Strong Risk Culture

Strong and effective risk management is driven from a strong ‘tone from the top’, and this is

evident in firms with a strong ‘Risk Culture’…

Senior Management has

to have collectively a

sound understanding of

the business and its

risks

Risk identification and

risk reporting must be

understood across all

levels of the organization

Risk culture objectives

has to be clearly defined

and communicated

across the organization

Risk understanding in

the organization has to

cover all risks both

financial and non-

financial risks (reputation

risk, business risk, etc.)

The organization’s risk

tolerance and risk

appetite must be

documented,

communicated and

updated.

Risk tolerances and risk

targets has to be aligned

with business strategy

(e.g. high target debt

rating can’t be consistent

with high ROE target)



Understanding Risk Correlations

The financial crisis has shown that risks can’t be looked at in isolation, and model outputs have

to be coupled with qualitative analysis and expert judgment…

Banks have to identify

and manage all relevant

risks, across business

lines and on a portfolio

basis

Avoid reliance on a

single methodology or

model, and couple risk

assessment with expert

judgment

Models which point to

high-returns on

economic capital may in

fact point to model

deficiencies

Decision making should

not only be based on

quantitative outcomes,

but also practical and

conceptual limitations of

models

Stress testing should

take into account risk

correlations and

macroeconomic trends

and analysis

Risk management must

participate in the product

approval process and

any significant changes

to products

Source: Adapted from: “High-level principles of Risk Management”, Committee of European Banking Supervisors February 2010.


Moving Forward


Moving Forward

Winning in The New Banking Era

1. High performers strive for a

customer centric—Universal

Banking model with a focus on

core customer groups and deep

relationships.

2. High performers demonstrate

that multichannel clients can

be twice as profitable and

exhibit greater loyalty.

3. High performers have been

early adopters of industrialized

operating models in order to

deliver best in class cost operating

performance balanced with

excellent customer service.

4. Despite the economic crisis, and the collapse of real estate prices in

some markets, high performers have applied prudent risk management

policies to ensure low bad-debt ratios, strong coverage for provisioning,

along with low reputational and operational risk.

5. Robust capital management

discipline is a key pillar for high

performers, combining high quality

capital, appropriate liquidity and

funding positions, with a proven

successful track record of

inorganic growth.

6. The success of the high-

performance Universal Banking

model has been demonstrated

by the ability to export

(replicate) the model to

global markets.

7. Technology is a crucial

building block supporting the

successful Universal Banking

customer centric model.

Source : Accenture – Winning in The New Banking Era (2011)


Questions & Answers

C r e a t i n g a c u l t u r e o f

r i s k a w a r e n e s s ®

Global Association of

Risk Professionals

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www.garp.org

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better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies,

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