Risk Management Lessons from Metallgesellschaft

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					                Session I
Motivation / Need for Risk Management /
   Lessons from Financial Disasters
              Dr. Peter Kandl
              March 19, 2007
• Comprehend the need for risk management
• Understand topology of risks
• Lessons learned from case studies

          The need for risk management
• Why risk management?
  – Every business is about managing risks
• What is risk management?
  – Process, by which various exposures are identified,
    measured, controlled and if deemed to high, mitigated
• What is exactly risk?
  – Negative deviation of a planned (expected) outcome
  – Volatility of unexpected outcomes
  – ...

                      Business risk
• The risk that corporations are willingly to assume to create
  competitive advantage and shareholder value
• Pertains to particular product market, in which a firm
• Includes technological innovations, product design,
  marketing activities
• Judicious exposure to business risk is a core competency
  of all business activity

                   Non-business risk
• Other risk, over which firm has no control
• Includes strategic (environmental) risk
   – Results from fundamental shifts in economy or political
   – Difficult to hedge (diversification across business lines
     and different countries)

                     Financial risk
• Risk to incur losses in financial markets
   – due to e.g. interest rate movements, equity market
      downturns, ...
• Exposure to financial risk
   – should be optimised carefully and
   – is part of a business strategy
• Allocation of resources to managing business risks („core
• Primarily function of financial institution is managing
  financial risk actively
   – Assume, intermediate or advise on financial risks
   – Is part of their core activity (“products”)
                    Sources of risk
• Human-created
   – Business cycles, inflation, changes in government
     policies, wars
• Natural phenomena (disasters)
   – Earthquakes, hurricanes, flooding
• Long-term economic growth
   – Technological innovations

               How to live with risks?
• Risk and willingness to take risks are essential to the
  growth of our economy
• Finance / insurance industry create markets to share risks
• Financial markets cannot protect against all risks
• “Safety nets” can be thought as service provision of
  government (forced participation of individuals), where
  markets fail to take and share the risks

        Financial Industry - Banks

                     Asset Management /
                       Private Banking


                       Payment system

                      Securities houses /
                       Investment banks

     Financial Industry - Insurance


Insurance           Non-Life


      Types of financial risks – market risk
• Arises from movements in the level or volatility of market
• Directional risk relates to movements of direction of
  financial variables (stock prices, interest rates, exchange
  rates, commodity prices)
• Non-directional risks relates to non-linear exposures or
  exposures to hedged positions or to volatilities
   – Second-order or quadratic exposures (options)
   – Basis risk (hedged positions)
   – Volatility risk (actual or implied)
• Controlling: Limits on exposures

       Types of financial risks – credit risk
• Counterparties unwilling or unable to fulfil contractual
• Effect is measured by the cost of replacing cash flows in
  the event of default, encompasses
   – Exposure (amount at risk)
   – Recovery rate (proportion paid back to the lender)
• More general:
   – Potential loss in the mark-to-market value due to a
     credit event (change in the counterparty‟s ability to
     perform its obligation

                  Credit risk (cont„)
• Sovereign risk:
   – Impose foreign-exchange controls (impossibility for
     counterparties to honour their obligation)
• Settlement risk:
   – One counterparty makes payment whereas other
     defaults (Herstatt Bank)

                   Credit risk (cont‟)
• Credit exposures of traditional instruments (bonds, loans):
   – Face value
• Credit risk of derivatives (e.g. swaps):
   – Involves detailed analysis of market risk interacting
     with credit risk (exposure changes with time)
• Controlling
   – Limits on Notionals, Credit lines
   – Limits on current and potential exposures
   – Credit enhancement features (e.g. collateral of marking
     to market)

                      Liquidity risk
• Asset liquidity: transaction cannot be conducted at
  prevailing market prices due to the size of the position
  relative to normal trading lots
• Funding liquidity (cash flow risk): inability to meet
  payments obligations. Interacts with asset liquidity risk if
  portfolio contains illiquid assets that must be sold at less
  than market value.
• Controlling:
   – Asset liquidity: setting limits on certain markets or
      products and by means of diversification
   – Funding risk: proper planning on cash flow needs
      (limits on cash flow gaps) and early consideration of
      how new funds can be raised
                    Operational risk
• Arises from human and technological errors or accidents
• Includes fraud, management failure and inadequate
  procedures and controls
• Can lead to market and credit risk
• Model risk: model used to value positions is flawed

• Protection / Controlling:
   – Redundancies of systems
   – Clear separation of responsibilities with strong internal
   – Regular contingency planning and testing
                        Legal risk
• Arises when a transaction proves unenforceable in law
• Related to credit risk (counterparties may find legal
  grounds for invalidating transaction)

• Controlling:
   – Policies developed by institution„s legal counsel in
     consultation with risk managers and senior
   – Ensure that agreements with counterparties can be
     enforced before any transaction

            Integrated risk management
• Market-based methodologies are extended to measure
  integrated market and credit risk
• Measurement of operational risk by actuarial methods
  (developed by the insurance industry), focus on
  distribution of losses from historical experience

• Goal: measure all financial risk on a integrated basis

                        Risk Map for Insurers
                                           Total risk

    Underwriting                                                         Operational
                         Market risk                     Credit risk
        risk                                                                risk
Non-Life specific
underwriting risks        Interest rate
                                                        Issuer Default     Legal risk
       Premium risk            risk

       Reserve risk        Equity risk                   Reinsurer
Life specific
underwriting risks         Foreign                                         Model risk
                         Exchange risk
       Longevity risk
       Morbidity risk     Spread risk                                     uncertainty
        (disability,                                                         risk
                          Liquidity risk                                 Business risk
       Mortality risk

        Lapse risk                                                        Expense risk

    Valuation and risk management

               Securities          Risk
               Valuation           Management
Principle      Expected            Distribution of
               discounted value    future values
Focus          Centre of           Tails of
               distribution        distribution
Precision      High precision      Less precision
               needed for          needed, simply
               pricing purposes    approximate tails
Distribution   Risk-neutral        Actual, objective
               distributions and   distributions

                   Large historical losses
• Dec 2001: Enron ($31.2bn)         ROGUE MANAGERS / FRAUD
   – CEO Kenneth Lay, CFO Andrew Fastow and other top executives
      inflated revenues and dissimulated losses with creative accounting
      while making fortunes from allocating themselves fat bonuses and
      from selling their shares.
• Jun 1996: Sumimoto ($2,6bn) ROGUE TRADER / FRAUD
   – Unreported losses over 3 years of copper trader Yasuo Hamanaka
• Feb 1995: Barings ($1,6bn)        ROGUE TRADER / FRAUD
   – Unreported losses over 2 years of Nick Leeson led to bankruptcy
• July 1995: Daiwa ($1,1bn)         ROGUE TRADER / FRAUD
   – Toshihide Iguchi, at Daiwa Bank in New York, fiddled with
      confirmations to sell off securities owned by clients. Unreported
      losses over 11 years by rogue trader led to insolvency.

            Large historical losses (cont'd)
• Sep 1996: Deutsche Morgan Grenfell ($720m)
   – Fund manager breaches guidelines; IMPROPER PRACTICES
      Deutsche Bank compensates investors.
• Feb 2002: Allied Irish Bank ($750m) ROGUE TRADER / FRAUD
   – FX trader John Rusnak accumulated losses on the spot and forward
      $/¥ market, hiding them by recording fake options offsetting his
      exposure. For liquidity, he wrote deep in-the-money options
      without recording them.
• Jan 2004: National Australia Bank (US$277m) ROGUE TRADERS
   – Four traders masked the losses they had incurred since Oct03 on
      huge positions on the AUD with the help of fictitious trades.

             Lessons from recent losses
• Losses attributed to derivatives grew sharply in the past 15
• Incidents caused by a combination of exposures to several
  risk types and some “stressed factors” (catalyst)
• In some instances lack of derivatives increase risks or
  funding costs (can be used for hedging purposes)
• Losses attributed to derivatives
   – Orange County: Reverse repos (Loss: 1,810 million $)
   – Metallgesellschaft: Oil futures (Loss: 1,340 million $)
   – Barings (U.K.): Stock index futures (1,330 million $)

                                Case studies
                           Risk factors in losses
                Market            Operational Funding                 Lack of
Barings         Yes, Japanese     Yes, rogue                          Yes
                Stocks            trader (fraud)

Metall-         Yes, oil                           Yes,               Yes
Orange County   Yes, interest                      Yes                Yes

Daiwa           Yes               Yes, rogue                          Yes
                                  trader (fraud)

                   Exercise / Homework
• Write a summary report (audit report) of one past incident (2-3
   – Describe the business of the company in short
   – Describe the culture, sophistication of controls and environmental
     factors (corporate policy, ethical aspects) that the company was
     operating in
   – Describe the risk types that the company was exposed to at the
     time of the break-down
   – Explain, why the incident happened, what the ultimate cause was
     and if early warning signals (could) have been observed
   – Explain, what type of controls broke down, were breached or were
     not in place
• Deadline: Monday, 21 May 2007


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