Session I
Motivation / Need for Risk Management /
Lessons from Financial Disasters
Dr. Peter Kandl
March 19, 2007
Objectives
• Comprehend the need for risk management
• Understand topology of risks
• Lessons learned from case studies
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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
– ...
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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
operates
• Includes technological innovations, product design,
marketing activities
• Judicious exposure to business risk is a core competency
of all business activity
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Non-business risk
• Other risk, over which firm has no control
• Includes strategic (environmental) risk
– Results from fundamental shifts in economy or political
environment
– Difficult to hedge (diversification across business lines
and different countries)
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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
competence“)
• Primarily function of financial institution is managing
financial risk actively
– Assume, intermediate or advise on financial risks
– Is part of their core activity (“products”)
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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
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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
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Financial Industry - Banks
Retail
Asset Management /
Private Banking
Banks
Payment system
Securities houses /
Investment banks
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Financial Industry - Insurance
Life
Insurance
Non-Life
Reinsurance
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Types of financial risks – market risk
• Arises from movements in the level or volatility of market
prices
• 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
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Types of financial risks – credit risk
• Counterparties unwilling or unable to fulfil contractual
obligation
• 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
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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)
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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)
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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
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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
controls
– Regular contingency planning and testing
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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
management
– Ensure that agreements with counterparties can be
enforced before any transaction
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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
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Digression
Risk Map for Insurers
Total risk
Underwriting
risk
Non-Life specific
underwriting risks
Market risk
Credit risk
Issuer Default
Premium risk
Interest rate
risk
Reserve risk
Equity risk
Reinsurer
Default
Life specific
underwriting risks
Operational
risk
Legal risk
Compliance
risk
Foreign
Exchange risk
Model risk
Morbidity risk
(disability,
illness)
Spread risk
Parameter
uncertainty
risk
Mortality risk
Liquidity risk
Business risk
Longevity risk
Lapse risk
Expense risk
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Valuation and risk management
Securities
Valuation
Risk
Management
Principle
Expected
discounted value
Distribution of
future values
Focus
Centre of
distribution
Tails of
distribution
Precision
High precision
needed for
pricing purposes
Less precision
needed, simply
approximate tails
Distribution
Risk-neutral
distributions and
discounting
Actual, objective
distributions
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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.
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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.
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Lessons from recent losses
• Losses attributed to derivatives grew sharply in the past 15
years
• 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 $)
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Case studies
Risk factors in losses
Market
Operational Funding
Lack of
Controls
Barings
Yes, Japanese
Stocks
Yes, rogue
trader (fraud)
Yes
Metallgessellschaft
Yes, oil
Yes,
recapitalisation
Yes
Orange County
Yes, interest
rates
Yes
Yes
Daiwa
Yes
Yes, rogue
trader (fraud)
Yes
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Exercise / Homework
• Write a summary report (audit report) of one past incident (2-3
pages)
– 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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