where do we go from here? penny cagan managing director
TRANSCRIPT
Where Do We Go From Here?
Penny CaganManaging Director
© 2008 Algorithmics Incorporated. All rights reserved.
Where We Have Come From
© 2008 Algorithmics Incorporated. All rights reserved.
2008: A year of great volatility
March 2008: Bear Stearns is acquired by JP Morgan in a transaction orchestrated by the US government
July 2008: US Federal government seizes IndyMac (largest thrift to fail in US history)
Sept. 7, 2008: US government takes over Freddie Mac and Fannie Mae
Sept. 14, 2008: Bank of America announces it will acquire Merrill Lynch
Sept 15, 2008: Lehman Brothers files for bankruptcy
Pieter Bruegel the Elder, The Fall of the Rebel Angels
© 2008 Algorithmics Incorporated. All rights reserved.
2008: A Year of Great Volatility
Sept. 16, 2008: US government announces $85 billion emergency aid package for AIG
Sept. 18, 2008: Federal Reserve and central banks in Asia and Europe pump up to $180 billion into money markets. US Congress considers $700 billion facility to buy bad debt from banks.
Sept. 19, 2008: US government announces that it will insure all money market funds. The SEC bans short selling of shares in 799 financial stocks.
Sept. 22, 2008: Goldman Sachs and Morgan Stanley announce they have requested a change in their status to Bank Holding Companies, regulated by Federal Reserve
Pieter Bruegel the Elder, Landscape with the Fall of Icarus
© 2008 Algorithmics Incorporated. All rights reserved.
Where Risk Lies
Underwriting of new loans: Credit Risk (loan quality) & OpRisk (documentation, background check, integrity of loan process)
Securitization: Reputation & OpRisk (mis-selling, valuation, investor issues) & Liquidity Risk (cash shortages)
Investor: Credit, Market & OpRisk (mark-to-market issues, what are securitized loans worth when they are sold in volatile markets, will the investment pay off, what’s under the hood of structured products)
Market Reactions: Market Risk, OpRisk (increased volatility leads to behavior that can increase oprisk, such as unauthorized trades, questionable valuations, processing issues), Credit Risk (bankruptcies can occur if investors, issuers and packagers can not raise funds.)
© 2008 Algorithmics Incorporated. All rights reserved.
Events by Trigger
Source: Algo FIRST
© 2008 Algorithmics Incorporated. All rights reserved.
Events by Trigger
Source: Algo FIRST
© 2008 Algorithmics Incorporated. All rights reserved.
“At any given time there exists an inventory of undiscovered embezzlement in - or more
precisely not in - the country's business and banks. This
inventory - it should be called the bezzle. It also varies in size with
the business cycle."
from “The Great Crash: 1929” by John Kenneth Galbraith.
The Bezzle
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Procylicality of Fraud & Market Practice Issues
Supply of fraud is correlated with supply of credit Access to credit allows for the continuance of both fraud
and gray-matter market practice issues Corporations push the boundaries when credit is available
in terms of compensation, disclosure, client relationships, profit taking and financial reporting
Enron, Worldcom, and Madoff frauds initiated during bubble and uncovered during retraction
The absence of credit during a downturn results in uncovering of frauds
© 2008 Algorithmics Incorporated. All rights reserved.
CBOE Volatility Index,1990-2008, vs. events in the FIRST database
Source: CBOE, Bloomberg and FIRST
Vix
Daily C
losin
g P
rices
Kidder Peabody/J. Jett $350m UAT
Codelco $170m UAT
Barings $1.3 billionUAT
BankBoston$73m fraud
WGZ $230m UAT Enron$2.2 billion
fraud
AIB Allfirst$691m UAT
Hamilton Bank$130m fraud
December 2008:Bernard Madoff
$50 billionPonzi Scheme
SocGen $7.2bUAT
Calyon $247mUAT
© 2008 Algorithmics Incorporated. All rights reserved.
Bernard Lawrence "Bernie" Madoff (born April 29, 1938 ) is an American businessman and former chairman of the NASDAQ stock exchange. He founded the Wall Street firm Bernard L. Madoff Investment Securities LLC in 1960 and was its chairman until December 11, 2008, when he was charged with perpetrating what may be the largest investor fraud ever committed by a single person.
A Gallery of Rogues: Bernard Madoff and Robert Stanford
• Robert Alan Stanford, charged with running $9.2 billion investment fraud
• Sold $8 billion of Certificates of Deposit through Stanford International Bank, based in Antigua
• Promised double-digit returns over the past 15 years• Bank claimed $51 billion in deposits and assets under
management, with more than 70,000 clients in 140 countries
• Possible money laundering charges pending
© 2008 Algorithmics Incorporated. All rights reserved.
Largest Losses from Credit Crisis
Source: Algo FIRST
Organization Name Sum of Loss Amount Percentage
American International Group Inc. 96,278,000,000 27.85%
Citigroup Inc. 63,400,000,000 18.34%
Bank of America Corporation 55,038,000,000 15.92%
UBS AG 48,400,000,000 14.00%
Wells Fargo & Co. 8,617,925,000 2.49%
Morgan Stanley & Company 3,700,000,000 1.07%
Goldman Sachs Group, Inc., The 3,060,000,000 0.89%
JPMorgan Chase & Co 1,600,000,000 0.46%
Top 8 Total 280,093,925,000 81.02%
Others 65,634,029,280 18.98%
Grand Total 345,727,954,280 100.00%
© 2008 Algorithmics Incorporated. All rights reserved.
Product Types Behind Subprime losses
Source: Algo FIRST
© 2008 Algorithmics Incorporated. All rights reserved.
The Opportunity: OpRisk at the Core of the Solution
We will see a fundamental re-design of risk management:
Operational Risk provides the governing framework
IN: Integrated. Consistent. Actionable. Non-deterministic.
OUT: Silos, automatic models, compliance running on auto-pilot
Categorizations have become meaningless!
Operational risk is the driver for change
© 2008 Algorithmics Incorporated. All rights reserved.
Largest Bank Failures
Source: Algo FIRST
Organization Name Loss Amount Percentage
Kaupthing hf 28,200,000,000 24.64%
Glitnir Bank 23,400,000,000 20.45%
Landsbanki Ãslands hf. 15,900,000,000 13.90%
Indymac Bancorp Inc 9,400,000,000 8.21%
BankUnited FSB, Coral Gables, Florida 4,900,000,000 4.28%
Wachovia 4,500,000,000 3.93%
Guaranty Bank, Austin, TX 3,000,000,000 2.62%
Colonial Bank, Montgomery, Alabama 2,800,000,000 2.45%
Franklin Bank, S.S.B., Houston, Texas 1,500,000,000 1.31%
Downey Financial Corp. 1,400,000,000 1.22%
Top 10 Total 95,000,000,000 83.02%
Others 19,429,024,512 16.98%
Grand Total 114,429,024,512 100.00%
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Control Failings Behind Bank Failures
Source: Algo FIRST
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Product Types Behind Bank Failures
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Where We Came From: Five Deadly Sins
1. Lack of care for stakeholders
2. Automatic approach
3. Unknowns ignored
4. Silos accepted
5. Risk and return managed separately Domenico di Michelino, La commedia illumina Firenze
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1. Lack of Care for Stakeholders
Short-term earnings culture threatened shareholder value
Failure to put clients’ interests first
Fiduciary duties became secondary
Compensation
Community Role
Pieter Bruegel the Elder, The Fall of the Rebel Angels
© 2008 Algorithmics Incorporated. All rights reserved.
Perfecting standard models
2. Automatic Approach
Firms that experienced more significant problems tended to apply a mechanical risk management approach.
Senior Supervisors Group (2008)
The tendency to overly formalize arcane aspects of an analysis often detracts from the bigger picture.
Corrigan Report (2008)
Pieter Bruegel the Elder, Parable of the Blind
© 2008 Algorithmics Incorporated. All rights reserved.
3. Unknowns ignored
Pieter Bruegel the Elder, The Adoration of Kings
Methodology can convey a false sense of precision
All models use assumptions and assumptions can have a material impact on the model outcomes. However, most models do not specifically acknowledge what assumptions they are making.
Federal Reserve Bank of New York (2008)
© 2008 Algorithmics Incorporated. All rights reserved.
4. Silos Accepted
The existence of organizational silos appeared to be detrimental to performance during the turmoil. Business areas [made] decisions in isolation and in ignorance of other area’s insights.
Senior Supervisors Group (2008)
Pieter Bruegel the Elder, The Tower of Babel
© 2008 Algorithmics Incorporated. All rights reserved.
5. Risk and Reward Separated
Pursuing returns without managing risk
Firms that recorded relatively larger unexpected losses tended to champion the expansion of risk without commensurate focus on controls.
Senior Supervisors Group (2008)
Pieter Bruegel the Elder, Gluttony
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Where We Can Go From Here: Five Virtues
1. Focus on the Stakeholders
2. Acknowledge uncertainty transparently
3. Imagine and Challenge assumptions
4. Manage risk at the enterprise level
5. Manage risk and return proactively Pieter Bruegel the Elder, Fortitude
© 2008 Algorithmics Incorporated. All rights reserved.
1. Focus on the Stakeholders
Develop a culture of risk governance
Risk management must rely heavily on judgment, communication and coordination. This culture of governance will help to break down the silo mentality.
It [requires] rigorous and continuous attention at the highest levels.
Corrigan Report (2008)
Pieter Bruegel the Elder, Justice
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2. Acknowledge Uncertainty
Risk is more than a single number
[We] must recognize the limitations of mathematical models.
Corrigan Report (2008)
Managers at better performing firms relied on a wide range of measures of risk.
Senior Supervisor Group (2008)
Pieter Bruegel the Elder, Prudence
© 2008 Algorithmics Incorporated. All rights reserved.
3. Imagine. Challenge Assumptions
Firms [must] think creatively about how stress tests can be conducted.
Corrigan Report (2008)
Firms that tended to avoid significant challenges assessed risk positions drawing on different underlying assumptions.
Senior Supervisors Group (2008)
Discover the Unknown, Don’t Perfect the Known
© 2008 Algorithmics Incorporated. All rights reserved.
4. Manage Risk at the Enterprise Level
Dismantle silos
Firms that understood quickly the risk they faced relied on information from many parts of their businesses.
Better performing firms were able to integrate their measures of market risk and counterparty risk across businesses.
Senior Supervisors Group (2008) Institute of International Finance (2008)
Pieter Bruegel the Elder, The Tower of Babel
© 2008 Algorithmics Incorporated. All rights reserved.
5. Manage Risk (and Return) Pro-actively
The need for speed
[Firms] must have the capacity to monitor risk concentrations as well as exposures to institutional counterparties in a matter of hours and provide effective and coherent reports to senior management.
Corrigan Report (2008)
© 2008 Algorithmics Incorporated. All rights reserved.
The Next Wave: A Prediction
Black Swans will happen There will be more risk-related regulation:
Recent G20 and BIS actions are just a start
Comprehensive and active ERM is “back”
Assumptions, models and results will become context specific
Client-centric financial innovation is here to stay
Pieter Bruegel the Elder, The Battle about Money
© 2008 Algorithmics Incorporated. All rights reserved.
The Next Wave: A Hope
Think!
Imagine. Explore what you don’t know
Challenge your assumptions
Communicate, don’t “report”
Use sound judgment
Risk management = Decision making under uncertainty Pieter Bruegel the Elder, Hope
© 2008 Algorithmics Incorporated. All rights reserved.
Where do we go from here
OpRisk Best Practices is part of the solution Manage risk on a firm-wide basis and overcome silos
Integrate risk identification, risk and self assessments, monitoring and testing of controls within the enterprise-wide risk framework
Look at all material risks together, and not be limited to market, credit, liquidity and operational risk
Understand assumptions and what happens if assumptions fail
Integrate scenario approaches within overall framework
Lobby to change an organization’s culture
Supplement quantitative tools with qualitative judgment
© 2008 Algorithmics Incorporated. All rights reserved.
Thank you for your time
For further information contact:
Penny CaganManaging Director