Economic Crisis _ Risk Management

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Economic Crisis _ Risk Management Powered By Docstoc
					Economic Crisis
Risk Management

1. The Economic Crisis
2. The questions
3. The lessons to be learned

           De Credit Crisis
                   De Credit Crisis

     The elements of the credit crisis

1.   (Too) low interest rates
2.   Financial innovations
3.   Political pressures to promote house
4.   Greed of consumers and bankers

                  The Credit Crisis

•     Started in 2007 in the residential home mortgage
      market in the US
•     Exploded September 2008 into the severest
      worldwide financial crisis ever
•     There was enormous build up of risks in the financial
•     Despite all national and international rules, risk
      managers, auditors, risk rating agencies,
      supervisors, etc. etc.

Did risk management fail and if so why?
What does this mean for the future of
   risk management?
    Declining interest rates

The bubble in home values

    The Credit Crisis
          Structured Products – 1/2

•   ABS – Asset Backed Securities
    •   Securities whose value and income payments are
        derived from and collateralized (or "backed") by a
        specified pool of underlying assets. The pool of
        assets is typically a group of small and illiquid assets
        that are unable to be sold individually.
•   RMBS – Residential Mortgage Backed
    •   Securities whose cash flows come from residential
        debt such as mortgages, home-equity loans and
        subprime mortgages.
•   CMBS – Commercial Mortgage Backed
    •   Mortgage-backed securities secured by the loan on a
        commercial property.

          Structured Products – 2/2

•   CDO – Collateralized Debt Obligation
    •   An ABS backed by a portfolio of fixed-income assets,
        typically split into different risk classes, or tranches.
        Interest and principal payments are made in order of
        seniority, so that junior tranches offer higher coupon
•   CDS – Credit Default Swap
    •   A contract designed to transfer the credit exposure of
        fixed income products between parties. A CDS can be
        seen as a kind of insurance on a portfolio of fixed
        income assets.
         The piling of risks and the crisis

•       Bonus hunting agents sold mortgages to non credit worthy
        consumers - NINJA (No Income, No Job or Assets),
        “subprime mortgages”)
•       Banks bundled mortgages into portfolio’s en and
        repackaged them in tranches of different risk classes.
•       Rating Agencies (Moodies, S&P, Finch) provided positive
        credit ratings
•       These products were sold worldwide to banks and
        investment funds.
•       Banks kept the risks off-balance by the use of SPV’s
        (Special Purpose Vehicles)
•       Hedge funds bought CDO’s with high leverage and insured
        them using CDS
•       When residential house prices started to fall and defaults
        started rising, liquidity dried up. Banks went bankrupt and
        the confidence in the financial system disappeared.

          The attractiveness of Structured

    •    Structured products were interesting for hedge funds
         because of the need for:
         •    Low correlation to equity markets
         •    Low income volatility
    •    Structured products stimulated leverages
         •    They seemed low risk
         •    Income could be increased easily by leveraging
    •    Banks were willing to provide the leverage to hedge
         •    Banks needed buyers for their structured products
         •    Banks were also the traders for hedge funds
    •    Symbiotic Relations pushed the system:
         •    Everybody was happy
         •    Risks seemed to be laid elsewhere
 The increase of the CDS market

De opbouw van de CDS

       The domino effect

    1.   The Economic Crisis
    2.   The questions
    3.   The lessons to be learned

    The questions from the credit crisis

•    Where were the Risk Managers?
•    Why didn’t CFO’s and Treasurers report risks?
•    Where were the internal and external
•    Why didn’t the board of directors disclose and
     report the risks to the shareholders?
•    Did the supervisory boards understand and
     discuss the risks?
•    Did the rating agencies do their job?
•    Where were the central banks and the
     government regulators?
               ERM questions

•   Did ERM fail?
•   Did it give the warning signals?
•   Were the signals ignored?
•   Is ERM effective for the real big
•   What can we do to improve ERM?

           Shortcomings in ERM

•   Culture of focus on rules and processes for
    risk management (COSO)
•   No integrated oversight of risks who were
    or could have been known (“silo’s”)
•   No real-time monitoring of risks in a very
    dynamic environment
•   Inability to understand, define,
    communicate and monitor risks
•   Weak governance culture and business
•   Opportunism, cowardice and sheer

1.   The Economic Crisis
2.   The questions
3.   The lessons to be learned

         Risks and elusiveness
    The Black Swan – Nasib Nicholas Taleb

Human misunderstandings of risks :

•    The narrative fallacy. The tendency to make
     events understandable by making a story. Events are
     brought into a context that is not necessarily right or
     the only possible one.

•    The lucid fallacy. The tendency to see a model as
     more than just a simplification of reality. The
     structure defined thus tends to replace the real thing.

•    The statistical regress fallacy. The tendency to
     thing tht the future is just an extension of the past.
     Historic trends are used as predictions.

    The Black Swan – Nasib Nicholas Taleb

•      Mediocristan”
      An (economic) environment where normal
      statistics apply. Events are uncertain but
      statistically predictable.

•      Extremistan”
      An (economic) environment where totally
      unprecedented and explosive events are
              What do we know?

              Unknown            Unknown
              Knowns             Unknowns

              Known               Known
              Knowns             Unknowns

Advancement of knowledge

              Unknown            Unknown
              Knowns             Unknowns


              Known               Known
              Knowns             Unknowns

            The lessons from the Credit Crisis

     •      Too much confidence in complex financial
            models based on historical data.
             • Models are just simplifications
             • Past is not always representative for the future

     •      Too limited insight in risks.
             •   Risks interact an correlate heavily
             •   Mark-to-Market valuations work only with
                 efficient markets
     •      The culture of compliance and rule driven
             • Compliance is not sufficient
             • Risks require awareness and transparency

           Development of Risk Management

                                             Value based Risk Mgt
                                       Enterprise Risk Mgt                  P   ro-

                   Risk Scenario's & simulation

         Strategic & Operational Risk Mgt                ve
            Financial Risk Mgt                   Pr

                             ti   ve
    Insurace of risks   Re
                                            Negative event

    Management vs. Risk Management

           Aspect       Management        Riskmanagement

         Approach    Driving             Scanning

         Subject     Goals               Uncertainty

         Character   Specific            Holistic

         Stile       Focusing            Assessing

         Methods     Plans, Processes,   Brainstorms,
                     Projects            Discussions, Tests


                 ERM after the Credit Crisis

    1.     ERM should be incorporated as a strategic
           imperative on senior board level
    2.     Enhance understanding of risks and the
           quality of risk assessment principles and
    3.     Improve risk culture, the values and
           behaviors that drive business decisions
    4.     A principle based approach, stimulating
           learning processes and the right behavior
           is required

1.   “Things that can’t go on forever, don’t”
2.   “What goes up, must come down”
3.   “There is no such thing as a free lunch”
4.   “Never waste a good crisis”

                  THE END