Canadian Annual Derivatives Conference
of the Montréal exchange
Characteristics of Superior
Risk Management Solutions
Fairmont Le Chateau Frontenac
Quebec, Canada
Friday, August 19, 2005
9:40 am – 10:20 am
Dr. Robert M. Mark
Bmark.blackdiamond@tmo.blackberry.net
925 299 6859
Dr Bob Mark
1
A significant challenge is to stay on top of a
complex combination of “Characteristics” which are
at the “Core of Superior ERM Solutions”
The
ability to efficiently
integrate all the components
of risk on a *portfolio basis
as well as to effectively
operate in complex *markets
*Customers
Investors
while
serving *customers
as well as satisfying
*regulators is a direct
function of the quality of
the policies,
methodologies and
*Regulators
infrastructure
Financial Risk
-Market Risk
-Credit Risk
Non Financial Risk
-Operational Risk
-Business Risk
Rating
Agencies
Equity Analysts
*Markets
Methodologies
Dr Bob Mark
2
Basel has driven a significant
spend on risk management
Three Basic Pillars
Minimum
Capital
Requirement
Supervisory
Review Process
Dr Bob Mark
Market
Discipline
Requirements
3
The ability to proactively manage risk
on an integrated portfolio mgmt* basis:
-stems from having several sophisticated
layers of functionality .
-is based on a relentless commitment
toward superior analytics and
infrastructure

= Portfolio
Mgmt
+ Performance Measurement
+ Facilitate Pricing
Manage
+ Accounting Capital
Reserves
+ Economic (Risk) Capital
and Capital
+ Regulatory Capital (Basel)
+ Stress Test & Scenario Analysis
Risk Analysis
+ Value at Risk
+ Monitor
Identify
& Avoid
Limit Management
Superior ERM Solutions
Dr Bob Mark
4
Example 1: The Credit Portfolio Management
Group(CPMG) proactively manages credit risk
on an integrated* basis
Capital and Risk Committee
•
I
S
S
U
E
R
S
&
B
O
R
R
O
W
E
R
S
Client
Coverage
Policy setting
Limit setting
Risk reporting
Syndication /
Distribution
Origination/
Underwriting
CPMG
Risk Evaluation
Asset Sales &
Trading
Quantification of risk (EL,
capital)
Model selection/ Validation
Product
Structuring/
Securitization
Monitoring & Review
B
A
N
K
S
&
I
N
V
E
S
T
O
R
S
Servicing
Dr Bob Mark
5
A significant challenge is to build a
“Superior ERM Solution” in partnership with the
C Suite whose “Characteristics” can be
benchmarked in terms of:
Dr Bob Mark
6
Characteristics of Policies at the
Core of Superior ERM Solutions
These
include:
The tolerance for risk (financial
and non financial) is integrated
and consistent with the
Business Strategies (and visa
versa)
Risk
measures are backtested,
authorities are expressed in
meaningful terms and reflect a
desired tolerance for risk
Independent
Superior ERM
Solutions
Risk
is properly disclosed (e.g.
Chinese walls may exist)
internally and externally on a
drill down and integrated
portfolio management * basis
Dr Bob Mark
7
Risk Disclosure
Key
characteristics of
disclosure include having the
ability to provide disclosures
such as:
Slicing
and dicing the risk in
real time (or near real time) by
risk type, asset class ,business,
product, industry, country, etc
mark-to-market
(mark- tomodel) vs. cash flow views
GAAP
Independent
Superior ERM
Solutions
vs. Economic view
Capital
(e.g. GAAP Capital vs.
Economic Capital vs. Basel
Capital)
the
main drivers of risk
Dr Bob Mark
8
Disclosing the main drivers of financial and non
financial risk would include answering such
questions as :

What are the top risks in the trading book and banking book
(i.e. a literal hit parade of risks)

Where are the concentrations of risk
(e.g. hot spots)

How often the list of main risks change

Have the forecasts of the top financial and operational risks (e.g.
stress tests) been predictive?

Have any of the top risks listed caused management to take
action to alter them in any way? If so, how?

What financial risks keep management up late at night?
Dr Bob Mark
9
Example 2: August 1998:
 Equity prices dropped sharply
 Equity Volatility increased
 Liquidity dried up
(Flight to quality)
August ‘98
High
Volatility
 Correlations broke down
 Credit spreads widened
 Credit quality deteriorated
Wide
Credit
Spread
Low
Liquidity
Dr Bob Mark
10
Example 3 :Certain types of backtesting disclosure have
become standard (e.g. market risk).Ultimately,similar
disclosure will become standard across all risk types
ALCO Limit - Upper Boundary
Daily Net Trading Revenue
C$ Millions
Potential Predicted Positive Revenue
ALCO Limit - Lower Boundary
Potential Negative Revenue
Predicted
August 27, 1998
Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
Dr Bob Mark
11
Characteristics of Methodologies at the
Core of Superior ERM Solutions

These include:

VaR and Stress Test
methodologies are predictive of
the actual losses and integrated
across all risks and all books of
business

Ongoing dedication toward first
class risk methodology
research

Mathematical models are
properly vetted.

Positions are properly valued
(and becomes a bigger deal
with SOX).

Risk methodologies are tied
into pricing and performance
measurement.
Independent
First-Class
Proactive Risk
Management
Dr Bob Mark
12
Example 4: A key characteristic of superior
market risk methodologies is to realistically
capture liquidity risk
Positions
Scenarios
Trading
Rules
Initial
Position
Data
Scenarios
Data
Change in
Positions
Hedging
Horizon
Volatility
Price Path
Impact on
Liquidity
Dynamic
Adjustments of
The Greeks
Positions
Adjust
Over Time
Market
Movements
Over Time
P&L
Results
Dr Bob Mark
13
Example 5:A key characteristic of superior credit risk solutions is to
build a robust Risk Rating Process that enables you to calculate the PD,
LGD ,attribute capital and price credits
Collateral
Transaction
Structure
Maturity of
Transaction
Facility
Rating
Third Party Support
Managerial Capability,Competitive Position
Quality of Financial Information, Country Risk
Financial Assessment
(Floor on obligor rating)
Dr Bob Mark
Obligor
Rating
14
A term structure of risk is calculated over
multiple time periods
The term structure of PD’s (from the obligor
rating) and RR’s (from the facility rating ) is
typically applied to price as well as determine
the capital for credit risk
EXAMPLE
PROBABILITY
EXPOSURE
DEFAULTS
0
tN
t0
RECOVERIES
Dr Bob Mark
15
Credit risk models (eg Merton’s model)
have also become deeply practical for the purposes of
predicting such things as:
Probability of default (PD)
Assets Value


VT  V0 exp m   22 T   TZ T
Distribution
of asset
values at
maturity of
the debt
obligation

E(VT)=VOemT
VT
V0
F
Probability of default
T
Dr Bob Mark
Time
16
Example 6: A key characteristic of superior credit
risk stress test solutions is to arrive at reasonable
paranoia stress tests
Stressing
the boundaries of credit risk
EXAMPLE
Shocks
EXPOSURE
DEFAULTS
. . .To produce
perturbations of
combined distributions of
simulated future credit
losses
PROBABILITY
Credit risk factors
may be shocked . . .
0
RECOVERIES
Dr Bob Mark
tN
t0
17
Example 7:A key characteristic of being able to
calculate credit risk is to be able to calculate a joint
PDF for such things as credit grade migration…
Obligor #2 (single-A)
Obligor #1
AAA
AA
A
BBB
BB
B
CCC
Default
BB
AAA
AA
A
BBB
BB
B
0.03
0.14
0.67
7.73
80.53
8.84
1.00
1.06
0.09
0.00
0.00
0.00
0.01
0.07
0.01
0.00
0.00
2.27
0.00
0.00
0.02
0.18
1.83
0.20
0.02
0.02
91.05
0.03
0.13
0.61
7.04
73.32
8.05
0.91
0.97
5.52
0.00
0.01
0.40
0.43
4.45
0.49
0.06
0.06
0.74
0.00
0.00
0.00
0.06
0.60
0.07
0.01
0.01
0.26
0.00
0.00
0.00
0.02
0.20
0.02
0.00
0.00
CCC Default
0.01
0.00
0.00
0.00
0.00
0.01
0.00
0.00
0.00
0.06
0.00
0.00
0.00
0.00
0.05
0.00
0.00
0.00
Joint migration probabilities (%) with zero correlation for 2 issuers
rated BB and A
Dr Bob Mark
18
….which includes being able to calculate
meaningful estimates of correlation between
asset returns

-Typical
assumption is that the
joint normalized return distribution
for the assets is a bivariate normal
PDF


 1
2
2 
f rBB , rA ;   
exp 
rBB  2 rBB rA  rA 
2
2 1   2
 2(1   )

1
Note: Equity returns are sometimes used as a proxy for asset returns.
Dr Bob Mark
19
Example 8: A key characteristic of superior methodologies is
that they are used to price market, credit and operational risk.
For example, a Credit Derivative can be modeled as a put
l P = - N (- d
- rt
)1 V0 + Fe N (- d 2 )
l where P is the current value of the put, N(.) is the
cumulative standard normal distribution, and
- rT
1 s 2
+
+
s
+
ln(V0 / F) (r 2 )T ln(V0 / Fe ) 2 T
=
d1 =
S T
S T
1
2
d 2 = d1 - s T
Dr Bob Mark
l
20
…and can be used to calculate expected
credit spreads (CS). Liquidity is a key
element

-
B0
Fe rT - P
ln
ln
F =
F
yT = T
T
csT = yT - r
csT = yT - r = -
1
V0
+
[
ln N (d 2 )
- rT N ( d1 )]
T
Fe
Dr Bob Mark
21
The Credit Insurance market has exploded
Global Credit Derivatives Volume now over 5 trillion US$
($ in billions)
5,000+
5,000
4,000
3,000
3,000
2,097
2,000
1,009
1,000
1,280
668
180
350
1997
Sources:
1998
1999
2000
2001
2002
Mar-03
British Bankers Association 2001-2002 Credit Derivatives Survey and
Standard and Poor’s Financial Institutions:
Demystifying Banks’ Use of Credit Derivatives
Dr Bob Mark
(December 8, 2003)
2004E
22
Percent of Accounts
Example9: A key characteristic of superior retail
methodologies is that credit scoring analytics
can be supplemented with sophisticated analytics…..
Cut-off Score
Good Accounts
Bad Accounts
Credit Score
The presumption underlying credit scoring models is that there exists a metric
that can divide good credits and bad credits into distinct distributions
Dr Bob Mark
23
….. which can be used to construct an
efficient frontier so as to optimally make
market share vs. risk tradeoff decisions
Low
cutoffs
E [ Volume ]
high
High
cutoffs
low
Dr Bob Mark
high
24
Significant progress has been made in
measuring market risk and credit risk ….
with some early success at measuring
operational risk but…
having a a highly reliable unified measure of risk
inside of a common risk architecture is at the core
of superior ERM solutions
Dr Bob Mark
25
Valuation and Performance
Key
Characteristics
includes an ability to :
Independent
 accurately
vet and value
transactions (e.g. loan
valuations and derivative
valuations)
Superior ERM
Solutions
 appropriately
(e.g.
traditional RAROC is
flawed) quantify the
return to risk
relationships of the
individual as well as
portfolio of transactions
Dr Bob Mark
26
Example 10:A key characteristic of superior solutions is that
all models to measure risk are fully vetted
Input
Risk
Estimation Risk
Model Risk
(valuation)
Deal
Database
Market
Database
Statistical
Tools
Model 1
Vendors of
parameters
Model n
Model N
Model
Calibration
Deal Valuation
Hedging Risk
Hedging Models
Dr Bob Mark
27
Key Characteristics of Infrastructure at the
Core of Superior ERM Solutions
includes
having:
 The
appropriate people in
place

A single enterprise wide risk
and data architecture
A
integrated risk architecture
which incorporates and
replaces many of the mid office
functions (e.g. valuing deals)
 Single
Independent
Superior ERM
Solutions
integrated risk engine
 Real
time access to data
(e.g. market data,transaction
data,legal data,etc)
 Periodic
Change initiatives
Dr Bob Mark
28
Building the infrastructure to support an Independent
and Integrated Comprehensive ERM integrated
framework is
Operational Risk
Business Risk
Incremental Risk
Total Risk
Dr Bob Mark
Price Deal
Risks
Manage Business Unit Risk
Market Risk
Confirm/ Settle
Credit Risk
Execute
Framework
Compare Risk to Limit
tough ,efficient (e.g. replaces mid
office costs) and effective (e.g. for
direct risk takers) and has become a
competitive necessity
Analyze Deal

29
Appendix
Operational Risk Matrix
(Basel II)
Dr Bob Mark
30
Appendix
Basel II Level 2. Operational Risk Loss Event Classification to Level 3.
Event Type, (7)
1. Internal Fraud
2. External Fraud
3. Employment
Practices &
Workplace Safety
Categories (Level 2)
Definitions
Losses due to acts of a type intended to defraud,
misappropriate property or circumvent relations, the
law or company policy , excluding
diversity/discrimination events, which involves at 1. A. Unauthorized
Activity
least one internal party
1.B. Theft & Fraud
Losses due to acts of a type intended to defraud,
misappropriate property or circumvent the law, by a
2.A. Theft & Fraud
third party
2.B. Systems Security
Losses arising from acts inconsistent with
employment, health or safety laws or agreements,
from payment of personal injury claims, or from 3.A. Employee
Relations
diversity/discrimination events
3.B. Safe Environment
3.C. Diversity &
Discrimination
Dr Bob Mark
Insurance
Coverage
Available
Activity (Some Examples Only - Not
Comprehensive) (Level 3)
Yes
1.A.1. Transactions not reported,
(intentional), 1.A.2. Transaction type
unauthorized, (w/$ loss) 1.A.3. Mismarking
of position, (intentional), 1.A.4. Frontrunning,
Yes
1.B.1. Fraud, 1.B.2. Credit fraud, 1.B.3.
Worthless deposits, 1.B.4. Theft, 1.B.5.
Extortion, 1.B.6. Embezzlement, 1.B.7.
Robbery, 1.B.8. Misappropriation of assets,
1.B.9. Malicious destruction of assets,
1.B.10. Forgery, 1.B.11. Check kiting, 1.B.12.
Smuggling, 1.B.13. Account take
over/impersonation, 1.B.14. Tax noncompliance/willful evasion, 1.B.15. Bribes,
1.B.16. Kickbacks, 1.B.17. Insider Trading
Yes
2.A.1. Theft/Robbery, 2.A.2. Forgery, 2.A.3.
Check Kiting
2.B.1. Hacking Damage, 2.B.2. Theft of
Information, (w/& loss)
No
3.A.1. Compensation, 3.A.2. Benefit, 3.A.3.
Termination issues, 3.A.4. Organized labor
activity
Yes
3.B.1. General Liability, 3.B.2. Employee
health & safety rules events, 3.B.3. Workers
Compensation
Yes
3.C.1. All discrimination types
Yes
31
Appendix
Basel II Level 2. Operational Risk Loss Event Classification to Level 3.
Event Type, (7)
Definitions
Insurance
Coverage
Available
Activity (Some Examples Only - Not
Comprehensive) (Level 3)
Yes
4.A.1. Fiduciary breaches/guideline
violations, 4.A.2. Suitability/disclosure issues,
(KYC, etc.), 4.A.3. Retail customer disclosure
violations, 4.A.4. Breach of privacy, 4.A.5.
Aggressive sales, 4.A.6. Account churning,
4.A.7. Misuse of confidential information,
4.A.8. Lender Liability
4.B. Improper
Business or Market
Practices
No
4.B.1. Antitrust, 4.B.2. Improperly
trade/market practices, 4.B.3. Market
manipulation, 4.B.4. Insider trading on a
firm's account, 4.B.5. Unlicensed activity,
4.B.6. Money Laundering
4.C. Product Flaws
No
4.C.1. Product defects, (unauthorized, etc.),
4.C.2. Model Errors
No
4.D.1. Failure to investigate client per
guidelines, 4.D.2. Exceeding client exposure
limits
No
4.E.1. Disputes over performance of advisory
activities
Yes
5.A.1. Natural disaster losses, 5.A.2. Human
losses from external sources, (terrorism,
vandalism)
Categories (Level 2)
Losses arising from an unintentional or negligent
failure to meet a professional obligation to specific
4. Clients,
clients, (including fiduciary and suitability
Products &
requirements), or from the nature or design of a 4.A. Suitability,
Disclosure & Fiduciary
Business Practices
product
4.D. Selection,
Sponsorship &
Exposure
4.E. Advisory
Activities
5. Damage to
Physical Assets
Losses arising from loss or damage to physical
assets from natural disaster or other events
5.A. Disasters & other
events
Dr Bob Mark
32
Appendix
Basel II Level 2. Operational Risk Loss Event Classification to Level 3.
Event Type, (7)
6. Business
disruption &
System Failures
Definitions
Categories (Level 2)
Insurance
Coverage
Available
Activity (Some Examples Only - Not
Comprehensive) (Level 3)
Yes
6.A.1. Hardware, 6.A.2. Software, 6.A.3.
Telecommunications, 6.A.4. Utility
outage/disruptions
No
7.A.1. Miscommunication, 7.A.2. Data Entry maintenance or loading error, 7.A.3. Missed
deadline or responsibility, 7.A.4.
Model/system misoperation, 7.A.5.
Accounting Error/entity attribution error,
7.A.6. Other task misperformance, 7.A.7.
Delivery failure, 7.A.8. Collateral
management failure, 7.A.9. Reference Data
Maintenance
No
7.B.1. Failed mandatory reporting obligation,
7.B.2. Inaccurate external report, (loss
incurred)
No
7.C.1. Client permissions/disclaimers
missing, 7.C.2. Legal documents
missing/incomplete
Yes
7.D.1. Unapproved access given to accounts,
7.D.2. Incorrect client records, (loss
incurred), 7.D.3. Negligent loss or damage of
client assets
7.E. Trade
Counterparties
No
7.E.1. Non-client counterparty
misperformance,7.E.2. Misc. non-client
counterparty disputes
7.F. Vendors &
Suppliers
No
7.F.1. Outsourcing, 7.F.2. Vendor disputes
Losses arising from disruption of business or system
failures
6.A. Systems
7. Execution,
Losses from failed transaction processing or process 7.A. Transaction
Delivery & Process
management, from relations with trade
Capture, Execution &
Management
Counterparties and vendors
Maintenance
7.B. Monitoring &
Reporting
7.C. Customer Intake
& Documentation
7.D. Customer/client
Account Management
Dr Bob Mark
33
ANNOUNCING
Risk Management
Michel Crouhy, Dan Galai,
and Robert Mark
Crouhy,Galai and
Mark Co-Authored
a leading
Risk Management
Book. This
Book is considered
the Risk
Management
benchmark for
technical and
practical
Risk Management
strategies.
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In today’s world of multibillion-dollar credit
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
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Dr Bob Mark
34
Bio of Dr. Mark

Dr. Robert M. Mark is the Chief Executive Officer of Black Diamond which provides corporate governance, risk management
consulting and transaction services. He serves on several Boards such as the Fields Institute for Research in Mathematical
Sciences, IBM’s Deep Computing Institute, Checkpoint Canada, The Royal Conservatory and is an Advisory Director on
Entergy Koch’s Audit Committee of the Board . He also serves on Checkpoint’s Investment Committee. In 1998, he was
awarded the Financial Risk Manager of the Year by the Global Association of Risk Professionals (GARP). He is the Chairperson
of The Professional Risk Managers’ International Association’s (PRMIA) Blue Ribbon Panel

Prior to his current position, he was the Senior Executive Vice-President and Chief Risk Officer (CRO) at the Canadian Imperial
Bank of Commerce (CIBC). Dr. Mark was a member of the Management Committee. Dr. Mark’s global responsibility covered
all credit, market and operating risks for all of CIBC as well as for its subsidiaries. Prior to his CRO position, he was the
Corporate Treasurer at CIBC.

Prior to CIBC, he was the partner in charge of the Financial Risk Management Consulting practice at Coopers & Lybrand(C&L).
The Risk Management Practice and C&L advised clients on risk management issues and was directed toward financial
institutions and multi-national corporations. This specialty area also coordinated the delivery of the firm’s accounting, tax,
control, and litigation services to provide clients with integrated and comprehensive risk management solutions and
opportunities.

Prior to his position at C&L, he was a managing director in the Asia, Europe, and Capital Markets Group (AECM) at Chemical
Bank. His responsibilities within AECM encompassed risk management, asset/liability management, research (quantitative
analysis), strategic planning and analytical systems. He served on the Senior Credit Committee of the Bank. Before he joined
Chemical Bank, he was a senior officer at Marine Midland Bank/Hong KongShanghaiBank (HKSB) where he headed the
technical analysis trading group within the Capital Markets Sector.

He earned his Ph.D., with a dissertation in options pricing, from New York University’s Graduate School of Engineering and
Science, graduating first in his class. Subsequently, he received an Advanced Professional Certificate (APC) in accounting from
NYU’s Stern Graduate School of Business, and is a graduate of the Harvard Business School Advanced Management Program.
He is an Adjunct Professor and co-author of “Risk Management” (McGraw-Hill), published in October 2000. He also served on
the board of ISDA as well as the Chairperson of the National Asset/Liability Management Association (NALMA).
Dr Bob Mark
35