risk appetite – taking the right amounts of the right risks

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Risk Appetite Taking the Right Amounts of the Right Risks. ACSDA Senior Summit December 5, 2013. Agenda. Introduction and Risk Appetite Overview (20 minutes) CDS Case Study (60 minutes) Discussion Groups (45 minutes) Presentation of Discussion Group Results (45 minutes) - PowerPoint PPT Presentation

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Risk Appetite Taking the Right Amounts of the Right RisksACSDA Senior Summit December 5, 20132AgendaIntroduction and Risk Appetite Overview (20 minutes)CDS Case Study (60 minutes)Discussion Groups (45 minutes)Presentation of Discussion Group Results (45 minutes)

Please ask questions or provide comments at any time and share your experiences!Defining Risk Capacity and Risk AppetiteRisk capacity refers to the maximum potential impact of a risk event that the firm could withstand and remain a going concern(1).Risk appetite expresses the total amount of risk that an organization is willing to take to achieve its strategic objectives and meet its obligations to its stakeholders(2)3Committee of Sponsoring Organizations of the Treadway Commission (COSO), Strengthening Enterprise Risk Management for Strategic Advantage, 2009Towers Watson, Risk Appetite The Foundation of Enterprise Risk Management, 2010Capacity AppetiteOverviewNeed for a Risk Appetite Statement4Not having a risk appetite statement can:lead to inadequate control resulting in the acceptance of undesirable risk positions, or an avoidance of acceptable risks and underperformanceAll the cool kids are doing itOrganizations that we consider our peers in risk management have developed or are developing risk appetite statementsLastly, the regulators require it!The CPSS/IOSCO Principles for Financial Market Infrastructures (PFMIs) explicitly require FMIs to have a risk tolerance statementOverviewCDS Case StudyObjective: To share the experience that CDS has had in order to (a) provide useful guidance to CSDs beginning a similar exercise (b) provoke discussion of experiences of other CSDs (c) to inform CDSs next phase of enhancements

CDSs experience in developing and using risk appetite has had 3 distinct phases:Phase 1 (2007 to 2010)Phase 2 (2010 to 2013)Phase 3 (2013+)5CDS Case StudyPhase 1 A Starting PointDefined risk tolerance only for the purposes of identifying our most important risks

A key enterprise risk is an event which, if it occurred, could plausibly create an outcome exceeding CDSs risk tolerance, more specifically:A financial loss to CDS in excess of its reserves, currently $10 million;A financial loss to participants who are members of a collateralized credit ring in CDSX or cross-border services in excess of realized value of the collateral available in the relevant collateral pools;An inability of CDS to meet fundamental services requirements;An inability of CDS to meet its financial obligations as contractually obligated;A reputational loss to CDS such that its ability to effectively provide services to its participants and customers is seriously questioned. 6CDS Case StudyIn 2007, CDS had not expressed its willingness to take risk in any meaningful way7

December 2007Risk tolerance used as threshold for identifying risks that require attention by senior management and BoardMissed opportunity to use expression of willingness to take risks as part of day-to-day management of risksIn 2007, we thought that if these risks really existed, we would likely have been put out of business by thenCDS Case StudyRisk metrics without context8

CDS presented these charts as part of a presentation on responding to market turmoil at the 2008 ACSDA general assembly in TorontoAre these results good or bad? What can we measure them against in order to determine if they are acceptable?CDS Case StudyZero RiskPhase 2 The light starts to go on!We realized that our risk tolerance was not our willingness to take risk, but our maximum capacity to take riskWe needed to distinguish the risk appetite and capacity of our participants from that of CDSMost importantly, we needed to address critical cultural issues:Need to eliminate zero risk tolerance mindsetNeed to drive ownership and accountability for risk management to the business units9

CDS Case StudyRelative Size of Proprietary and Participant Risk Capacity and Appetite10

The Eye Chart was presented to CDSs Risk Management Committee in December 2010CDS Case StudyDevelopment of CDSs risk appetite statement 4 key inputs11Risk AppetiteGoverning objective representing the value proposition of CDS to its key stakeholdersRisk capacity and constraints representing CDSs ability to bear riskRisk philosophy representing CDSs set of shared beliefs and attitudes on risk takingBusiness strategy and objectives which embody the strategic direction of CDS over the planned time horizonCDS Case StudyPhase 2 - Risk Appetite Development Cycle12Governing objective, risk capacity and constraints, risk philosophy, business strategy and objectivesKeep senior management in the loop as statement changes with stakeholder input!Stakeholders: participants, regulators, Board members (should have included staff!)CDS Case StudyRisk appetite considerationsRisk appetite is still an evolving concept and CDSs risk appetite statement will evolve as we better understand our willingness to accept risk and as the environment and our strategy changesA risk appetite is not an excuse for poor performance, unexpected losses or lack of commitment to operational excellenceExpressing a risk appetite does not mean that we dont care about losses within our risk appetitewe will investigate and learn from lossescould it have been worse?do we need to adjust our behavour in light of the loss?

13CDS Case StudyRisk philosophyWith the senior management team, we identified a number of basic beliefs and expressions about how we think about risk:CDS Clearing is fundamentally a risk averse organization. CDS Clearing recognizes that its ability to manage risk can ultimately affect the financial welfare of Canadians.CDS Clearing has a fiduciary responsibility as a result of holding assets in safekeeping for our participants.CDS Clearing considers its peers in risk management to include large financial institutions, public institutions vital to the health and welfare of Canadians and enterprises whose products require extreme levels of safety and reliability.CDS Clearing is too important to fail (without the moral hazard implications).CDS INC and CDS Innovations are able to take more risk than CDS Clearing.

14CDS Case StudyRisk outcome rating exercise conducted with BoardConducted workshops with the Risk Management and Audit Committee of Board:Discuss a number of risk exposures faced by CDS;Identify the relevant risk capacity for that type of exposure;Identify and quantify actual or potential scenarios that have caused or could cause losses due to this type of risk exposure;Rate CDSs appetite for the risk that could cause this outcome or scenario on an appropriate scale.15CDS Case StudyShould be about 3 pmBoard Workshop Exercise #1CDS holds cash owned by its participants and customers and invests that cash to generate a return. These investments can fluctuate in value as a result of changes in prices (market risk). The total value of these investments typically range between $50 million and $100 million. What is an acceptable level of risk for these investments?

16CDS Case StudyBoard Workshop Exercise #2In order to record securities in CDSX, critical information about the characteristics of each security such as conversion and extension privileges must be extracted from various documents and entered into the system. Interpreting and recording this information is subject to error (operational risk). What is an acceptable level of risk?

Observed historical loss17CDS Case StudyBoard Workshop Exercise #3The daily operation of CDSX is vital. As an IT system, CDSXs availability can be affected by hardware, software and network failures. The recovery time objective (RTO) for CDSX is 2 hours after declaration of disruption. How much risk of a CDSX outage is acceptable?

18CDS Case StudyPhase 2 Where did we end up?19CDS Case Study

Quantitative and qualitative statements of our willingness to take specific kinds of risksDifferent legal entities are willing to take different amounts of riskExamples of these statements are provided in the appendixExample 1 Using risk appetite to manage risk exposure20

October 2008November 2013Relevant Risk Appetite Statement: Participants are willing to accept losses which result from a defaulters collateral in a central counterparty service being insufficient. Participants expect that these uncollateralized losses should occur in no more than 1% of potential defaults for CNS. CDS Case StudyExample 2 Using risk appetite to manage risk exposure21

October 2008November 2013Relevant Risk Appetite Statement: Participants are willing to accept losses resulting from the default of a fellow member of a category credit ring up to the amount of the collateral pledged to the collateral pool by the surviving members (red line in graph).CDS Case StudyPhase 3 Risk appetite becomes fundamental part of decision making for everyone at CDSToday, there are still a number of issues that CDS needs to address:The use of risk appetite as a key input into risk decisions is not consistent Many parts of the organization are unfamiliar with relevant risk appetite statementsOperational risk appetite statement has not successfully been translated to day-to-day operationsLingering cultural issues perception of zero risk tolerance still exists; often viewed as an excuse for not taking riskOur ownership structure has fundamentally changed and we need to generate return for our shareholders while appropriately balancing that return with the resulting risks given our systemic importance22CDS Case StudyPhase 3 - Risk appetite in the context of a comprehensive approach to managing our business23Organizational ObjectivesRCSA Risk AssessmentControl ObjectivesControl DesignProcess RCSAControl ProceduresInternal Audit ReviewBusiness StrategyCompliance RulesRisk AppetiteMngt SupervisionEscalationSelf-AssessmentCreate coaching oppo