Webinar Slides 16mar Final Changing Financial Landscape


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Webinar Slides 16mar Final Changing Financial Landscape

  1. 1. Risk & Performance Management<br />The Changing Financial Landscape: Lessons Learned, Impact of Financial Reform, and Hot Topics Surrounding Risk and Corporate Governance<br />PRESENTERThomas Day<br />Vice-Chairman, PRMIA Board of Directors and Managing Director of Risk Solutions and Policy, SunGard<br />16 March 2011<br />
  2. 2. Standard Disclaimer<br />The views, expressions and ideas of this presentation are those of the author(s) and do not necessarily reflect the views and opinions of SunGard<br />Thank you to SunGardand all the participants on the call..<br />We are going to strive to be thought-provoking and conversational as we proceed through the presentation. <br />We invite you to submit questions as we proceed through the presentation. We will leave time for Q&A at the end.<br />
  3. 3. Agenda<br />1. Current State. How did we get here?<br />2. How has the financial and regulatory landscape shifted?<br />3. What are the key lessons learned and how do we create value in the new financial landscape?<br />4. Areas of focus for risk management and corporate governance.<br />
  4. 4. Agenda<br />1. Current State. How did we get here?<br />2. How has the financial and regulatory landscape shifted?<br />3. What are the key lessons learned and how do we create value in the new financial landscape?<br />4. Areas of focus for risk management and corporate governance.<br />
  5. 5. So What Happened?ANS:A Systemic Failure Due to our “Home Ownership is a Right” National Policy Goals + Poor Monetary Policy<br /> “To those of you who have not yet reached President's Club, I want each and every one you to believe you have the potential to achieve this great reward. Now is the time to really kick it into high gear and drive for attending this awesome event! Rankings are updated and posted monthly... I'm especially pleased with your ability to change with the market and responsibly sell more higher-margin product - Option ARM, Home Equity, Non-prime, and Alt-A.” - November 2006, WaMu Internal E-mail<br />Can’t compete head-to-head with GSEs. A funding curve we can’t match. Improperly priced credit derivatives & taxpayer funded dividends.<br />Cheap credit: A “glut” of liquidity<br />Incentive Plans: Focus on today’s GAAP earnings, not value-creation<br />Poor risk-controls: growth, concentrations, funding<br />Lack of transparency<br />New and untested product(s)<br />Risk Adjusted Returns (in Basis Points)<br /> ???<br />
  6. 6. So What Happened?ANS:…. + Poor Monetary Policy<br />From October of 2001 through September of 2005, the average spread between 10-year UST and 3-mo UST was 262bp<br />Coincident with the “removal” of this spread via the curve flattening which began in ~ Summer 2004, the market for “opacity” picked-up. Reminiscent of the 1992-1994 structured note boom, but on houses (whose values never decline!)<br />In the search for yield, opacity/complexity pays (sell-side reigns)<br /><ul><li>CDO, PLRMBS, CDS, CLO, SCDO, CDO^2, LCDS, CMBS, CCOs, etc.</li></ul>Period of rapid SIV growth<br />
  7. 7. …and poor corporate governance<br />Bonuses:<br />2006 = $60 billion<br />2007 = $66 billion<br />2008 = $72 billion<br />2009 = $90 billion<br /><ul><li>Compensation should be based on value-creation, not the ability to manufacturer short-term, GAAP (or IFRS) earnings; however, many compensation packages are based solely on ROE.
  8. 8. The market should discipline rent-seekers. Equity is meant to be “owned” not merely traded, and certainly not manipulated.
  9. 9. Like getting married. Should feel the full weight of “I Do.”</li></ul>Bonuses paid to the top 5 financial firms in the U.S. Can anyone guess if these are “risk-adjusted” bonuses?<br />
  10. 10. Summary Point: Not a lack of Regulation<br />Misguided public policy in the form of directed credit and capital to the housing industry spurred on by an aggressive curve slope for an “extended period”<br />USG writing mispriced credit derivatives on housing should come to an end. Dealing with housing policy should be the national priority, not simply the mortgage interest deduction as discussed in the 1-Dec-2010 National Commission on Fiscal Responsibility and Reform Report<br />USG writing of other guarantees should stop, or be accounted for via GAAP<br /><ul><li>Sidebar: Should USG finances be GAAP-based? According to shadow stats, debt using GAAP is ~$70.7 trillion in 2009, or approximately ~5x GDP
  11. 11. Poor incentive structures within firms and a “sell-side”, “HFT”, “make a quick buck” (i.e., “Noise”) mentality to equity ownership. This institutional arrangement fosters rationally unsavory capital allocation decisions in the pursuit of EPS.
  12. 12. It raises profound questions about the corporate structure itself, and especially corporate governance.</li></ul>To dissuade some that view this as a new or radical idea:<br />“But as longer-term commitments have come to dominate tax and spending decisions, such cash accounting has been rendered progressively less meaningful as the principal indicator of the state of our fiscal affairs. An accrual-based accounting system geared to the longer horizon could be constructed with a reasonable amount of additional effort.” “An accrual system would allow us to keep better track of the government's overall accrued obligations and deferred assets. Future benefit obligations and taxes would be recognized as they are incurred rather than when they are paid out by the government.” - Alan Greenspan, February 11, 2003<br /> - http://www.federalreserve.gov/boarddocs/hh/2003/february/testimony.htm<br />
  13. 13. The Truth About Regulation<br />Charter shopping has been common for many years. One of the best storied examples may be Colonial Bank, which failed on August 14, 2009. <br /><ul><li>Goal: Which regulator will be most useful for me, the “constituent”?
  14. 14. Some regulators, in their “relationship” management capacity, fancy themselves as consultant/advisors, not beat-cops. Very few risk-focused exams that labor on the USC and CFR. TBTF or TCTM?
  15. 15. However: Weak regulation didn’t “cause” the problem. Moreover, adding more of what didn’t work won’t fix the structural issues that continue to exist. Thus, Answer #1 – regulators and ineffectual regulation - is wrong. Contributors? Sure. Foremost to blame? Not a chance.</li></ul>“Kerry Killinger, the CEO of Washington Mutual (WaMu) will be in town Friday and wants to have a lunch meeting. He’s my largest constituent asset wise.” <br /> – May 2007, OTS internal e-mail<br />
  16. 16. The Truth About Regulation<br />The regulators have had sufficient authority to clamp down on excesses for a long time. We all know this fact.<br />A strong approach didn’t happen for a large # of reasons:<br /><ul><li>Charter shopping and “functional regulation”: </li></ul>Divide and conquer, a good war-plan. Fighting battles on many fronts has never had much success.<br />2) A Congress eager to appease and “tear down those walls”<br /><ul><li>“Ability” to supervise versus “Will” to supervise</li></ul>1) “The banks are always two steps ahead of us.” Why? This is fixable. However, in the years of enlightened regulation, it was assumed proper and fitting.<br /><ul><li>APA (P.L. 79-404) and the PRA (P.L. 96-511)</li></ul>1) Good examples of how to institutionalize poor agility, flexibility and timeliness<br />"Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion.“<br /> - James Gilleran<br />We may be tempted to chuckle and point a finger. Truth is that all danced to the deregulation, light-touch, non-intrusive, risk-scoping and ‘exam-vetting’ piper.<br />
  17. 17. IMF’s Lessons for us?<br />Worth reviewing:<br />Good supervision is intrusive<br />Good supervision is skeptical but proactive<br />Good supervision is comprehensive<br />Good supervision is adaptive<br />Good supervision is conclusive<br />To achieve these elements you need adequate resources, clear strategy, robust internal organization, effective working relationship with other agencies (e.g., umbrella supervision) and the willingness to act.<br />According to Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, SIFIs could borrow at 29bps beneath small banks prior to the crisis; today the SIFIs can borrow at 78bps below. According to their analysis, this amounts to a $34.1 billion subsidy courtesy of our unusual and exigent circumstances. As an economist colleague said to me recently: “Not only are we all Keynesians. It seems we are all Frenchmen too.”<br />“In addition to the broad issues of capital and liquidity, I also argue that the doctrine of ‘too big to fail’ (or, more appropriately, ‘too interconnected to be liquidated quickly’) cannot be allowed to stand.” “I agree with Gary Stern, the former President of the Federal Reserve Bank of Minneapolis, who has long held the position that ‘. . . creditors will continue to under-price the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline. Facing prices that are too low, systemically important firms will take on too much risk.” <br /> - Alan Greenspan, FCIC, April 7, 2010<br />Said differently: Is it necessary for the market to see Title II of the DFA in action?<br />
  18. 18. Agenda<br />Current State. How did we get here?<br />How has the financial and regulatory landscape shifted?<br />What are the key lessons learned and how do we create value in the new financial landscape?<br />Areas of focus for risk management and corporate governance.<br />
  19. 19. Do you recognize this quote?<br />This is “…the most important federal legislation<br />relating to the financial community since the 1930s.”<br />“On March 31, 1980, President Carter signed into law the Depository Institutions Deregulation and Monetary Control Act of 1980, the most important federal legislation relating to the financial community since the 1930s. The act has nine titles covering a wide range of subjects, including reserve requirements, access to and pricing of Federal Reserve services, a phase-out of Regulation Q and new powers for thrift institutions.” – Frank Morris, Former President, FRB Boston<br />“Last year the Financial Modernization Act of 1999 (FMA) was signed into law. Also known as the Gramm-Leach-Bliley Act, this statute represents the single most important set of regulatory reforms since the Glass-Steagall Act of 1933.” - James Thompson, FRB Cleveland, 15-April-2000<br />…and here we are, once again, with the most important federal legislation since the 1930s: The Dodd-Frank Act (DFA), B3, and the G-20 reform agenda. Collectively, it seems we have a rather short memory. History is important. More of us should study it.<br />
  20. 20. What Really Happened?<br />According to the media and, to some degree, the DFA itself (and too many academics it seems):<br />Answer #1:<br /><ul><li>The regulators failed to control the excesses of the now infamous “banksters”. Therefore, we need more and better regulation. Thus, the Dodd-Frank Act (DFA) will protect us from the next crisis because we’ve fundamentally addressed the problems that created the global financial crisis.</li></ul>DFA<br />DFA<br />Irregulators?<br />Banksters?<br />
  21. 21. We take this Commercial Break to Set the Record Straight: It’s About Incentives<br />We continue to possess a patchwork of regulatory agencies, even if we have vested one agency with more power than any other – the Fed. While the number of supporting characters is vast, the fault rests squarely with our legislators – which means it rests with the American people. What happens when the sovereign becomes the greatest sources of systemic risk?<br />Without the direct influence of congressional action(s), the breadth, depth, duration, and scope of the financial crisis could never have happened. This crisis is a direct consequence of legislative ineptitude and an almost complete absence of timely and responsible action by our legislature.<br />
  22. 22. Broad Principles:Robustness, Transparency, Resilience<br /><ul><li>Countercyclical capital
  23. 23. Contingent capital
  24. 24. FDIC assessments
  25. 25. Basel-3
  26. 26. quality & quantity of capital
  27. 27. liquidity standards
  28. 28. FSOC
  29. 29. Resolution Authority
  30. 30. Office of Fin’l Research
  31. 31. Volker Rule
  32. 32. Routine stress-testing
  33. 33. Non-bank Fis
  34. 34. Growth restrictions
  35. 35. Redefine capital
  36. 36. CCPs
  37. 37. CFTC (from 14 to 20)
  38. 38. FMUs
  39. 39. Improved disclosures
  40. 40. OFR
  41. 41. CFPB
  42. 42. FIO (“US Solvency 2”)</li></ul>[NOTE: Insert Miracle Here]<br />Transparent<br />Resilient<br />Robust<br />International Harmonization and Coordination<br />(…)<br />(…)<br />FSB<br />G-20<br />BCBS<br />ESRB<br />CEBS<br />IOSCO<br />
  43. 43. Regulatory Reform: Timeline to the Current State<br />
  44. 44. Regulatory Considerations<br />Despite our best attempts, human behavior is difficult to regulate completely<br />Although we must strive to improve our abilities to see around corners, we must not fool ourselves into believing we know how to identify bubbles and prevent systemic risk events<br />A number of policies and practices at financial institutions were inherently pro-cyclical, further magnifying effects during the boom and bust<br />Incentives are important to regulating behavior, however, establishing strong risk discipline at financial institutions is genetic; and something not mandated through regulatory edict<br />
  45. 45. Key Questions and Themes<br /><ul><li>The financial crisis precipitated the most expansive set of regulation of global financial services in history
  46. 46. The recent crisis exposed significant management, process, regulatory and governance deficiencies across the industry
  47. 47. Has this new regulatory regime focused on the right things to be effective at preventing a future crisis?
  48. 48. Dodd-Frank and Basel III address a number of critical pressure points in financial markets and governance
  49. 49. The regulations, however, offer a false sense of hope regarding the ability to avoid future bubbles and systemic market crises</li></li></ul><li>Other Areas of Impact<br />Enterprise Risk Management<br /><ul><li>Expect a greater emphasis on enterprise risk management, a deeper analysis of processes, need for adherence to established best-practice, and Board level risk-committee structure(s) [culture not compliance]</li></ul>Executive and Incentive Compensation<br /><ul><li>Expect your risk management group to be part of these discussions</li></ul>Consumer Protection Rules<br />Liquidity and Capital<br />“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability.” – Chairman Ben Bernanke, October 2009<br />
  50. 50. Agenda<br />Current State. How did we get here?<br />How has the financial and regulatory landscape shifted?<br />What are the key lessons learned and how do we create value in the new financial landscape?<br />Areas of focus for risk management and corporate governance.<br />
  51. 51. Financial Crisis Inquiry Commission: Lessons Learned<br />It always bugged us that DFA was issued in July 2010 and the FCIC report was issued in January 2011. <br /><ul><li>Does this seems problematic to you?
  52. 52. Conclusions:
  53. 53. Avoidable
  54. 54. Regulation and supervision (blame the cops for the crime?) (#4?)
  55. 55. “Dramatic” failures in corporate governance and risk management (#2?)
  56. 56. Leverage, opacity, and lack of disclosure (#3?)
  57. 57. Poor government preparedness
  58. 58. Breakdown in accountability and ethics (#1?)
  59. 59. Failure in OTC and rating agency oversight</li></ul>In the FRS Holding Company Manual corporate governance – while referred to repeatedly in §1050 – is never defined; however, if one takes from the text the intended theme, it seems that corporate governance is predominately concerned with treasury, audit, Sarbanes-Oxley §404, and corporate finance. This is inconsistent with a multiplicity of definitions available in the marketplace that suggest a much richer definition and scope; a scope that includes notions of strong and active board culture, business savvy, ethics and fair business conduct, accountability, integrity, a concern over capital stewardship and value, incentive compensation, and other principle-based statements. Note that the FRB’s Handbook didn’t include any procedures relating to incentive compensation, other than for retail non-deposit investment products, until July 2010.<br />
  60. 60. Lessons Learned<br /><ul><li>Overreliance on performance metrics not properly adjusted for risk
  61. 61. Data and analytical limitations leading to underestimation of risks
  62. 62. Cognitive biases among senior management leading to:
  63. 63. Lower aversion to risk due to perceptions of continued low losses based on prior experience
  64. 64. Poor risk management culture and stature and uncertainty bias
  65. 65. Herd behavior in development and expansion of riskier products
  66. 66. Possible regulatory capture and resource/complexity issues of regulators</li></li></ul><li>Procyclicality and Regulation<br /><ul><li>Interconnectedness of several procyclical policies and procedures at banks exacerbated the effects of the crisis – what are these?
  67. 67. Loan Loss Reserves
  68. 68. Bank Capital Requirements
  69. 69. Liquidity
  70. 70. Deposit Insurance Premiums
  71. 71. Fair Value Accounting (Level III assets)</li></li></ul><li>Loan Loss Reserves<br /><ul><li>Incurred Loss model under FAS 5 (GAAP) accounting policies
  72. 72. Banks slow to buildup credit reserves during good economic times, must accelerate buildup as markets deteriorate
  73. 73. Inability to apply forward-looking metrics handicaps process</li></li></ul><li>Countercyclical Capital Buffers<br />SCAP stress test results revealed procyclical effects of bank capital - $185B capital deficiency<br /><ul><li>Basel risk-weighted capital ratios introduce procyclical effects by underestimating credit risk in good times, leading to lower capital requirements
  74. 74. But are proposals such as countercyclical capital buffers an effective mechanism to address this problem?</li></ul>Countercyclical Capital Buffer (%)<br />KMax<br /> H L zt<br />
  75. 75. Liquidity<br /><ul><li>Liquidity crisis in 2007-2008 of several firms led to liquidity contagion
  76. 76. Responses and outcomes are detrimental to financial system
  77. 77. Asset dumping at firesale prices
  78. 78. Credit tightening
  79. 79. Are Basel liquidity ratio requirements the right answer?
  80. 80. Net Stable Funding
  81. 81. Liquidity Coverage Ratio</li></li></ul><li>Deposit Insurance Premiums<br /><ul><li>As bank failures have risen, FDIC reserve fund has come under pressure
  82. 82. Deposit insurance premiums tied to Bank Insurance Fund (BIF) reserve levels
  83. 83. BIF Reserve/Bank Deposits >1.15%, only riskiest banks required to pay premiums
  84. 84. When ratio <1.21%, all firms must pay in accordance with FDIC premium schedule
  85. 85. Deposit premiums thus tend to rise at the worst time for the bank and the premium assessment process is thus highly procyclical as shown in the next slide</li></li></ul><li>Procyclicality of Deposit Insurance Premiums <br />A better approach would be to devise a long-term moving average, actuarially fair pricing methodology<br />
  86. 86. Regulation, Procyclicality & Governance<br /><ul><li>Regulations address procyclicality in piecemeal, incomplete fashion
  87. 87. Remedies not always an improvement
  88. 88. Countercyclical capital
  89. 89. Other remedies await important players
  90. 90. FASB for fair value accounting and loan loss reserve policy
  91. 91. Regulations also miss key contributing factor of the crisis
  92. 92. Poor risk governance
  93. 93. Limited reliance of robust risk-adjusted performance management capabilities</li></li></ul><li>Agenda<br />1. Current State. How did we get here?<br />2. How has the financial and regulatory landscape shifted?<br />3. What are the key lessons learned and how do we create value in the new financial landscape?<br />4. Areas of focus for risk management and corporate governance.<br />
  94. 94. Areas of Current Risk Focus: Hot Topics<br />The search for earning assets<br /><ul><li>Beware the rise of Interest Rate Risk</li></ul>Balance sheet management<br /><ul><li>New volumes – credit spread, risk and duration
  95. 95. Funding and deposit strategies (preparations made?)
  96. 96. Capital planning, including focus on non-organic growth (M&A should pick up)
  97. 97. Balance between liquidity and need for spread</li></ul>Profitability, margin-protection, and efficiency<br />Financial risk and corporate governance<br />Regulatory preparedness<br />
  98. 98. Many Opportunities for Improvement<br />CRO Attestation to Internal Risk Management Practices<br />Developing a Uniform Set of Risk Management Standards<br /><ul><li>Principles, not rules. THIS IS A RISK MANAGEMENT IMPERATIVE</li></ul>Continued development of “specialists of the whole”<br /><ul><li>“On a Global Foresight Commons”, Carol Dumaine, 23-Nov-2010
  99. 99. Unwinding Orthodoxy, the Value of Heresy, learning to “…profoundly challenge the status quo.”</li></ul>The US is only “now” joining the International Association of Insurance Supervisors (see FIO)<br />Expert needs around stress-testing<br /><ul><li>Subjectivity, Risk Imagination, and Expert-Based Systems
  100. 100. SME Swarming, Risk Mash-ups, Network Sensors, COEs (industry, regulatory, intelligence industry, other?)</li></li></ul><li>Impact of reform on risk management<br /><ul><li>Risk Management Impact?
  101. 101. Full employment at:
  102. 102. Deloitte, KPMG, PwC, BAH, Promontory
  103. 103. Have regulatory experience, will hire
  104. 104. Major areas of need:
  105. 105. Infrastructure issues
  106. 106. ERM is “for keeps”
  107. 107. Massive need for education </li></li></ul><li>Collaboration and Situational Awareness is Critical<br />http://www.riskmanagementcommunity.com<br />Site will be live by June 2011<br />Our success throughout the reform process will be a function of effective collaboration.<br /> – paraphrase of Neal Wolin<br />“…global policy cooperation is fracturing at best.” <br /> - John Lipsky, IMF<br />Markets remain fragile and it’s imperative we avoid sliding into financial protectionism<br />
  108. 108. Thank You!<br />Risk & Performance Management<br />The Changing Financial Landscape: Lessons Learned, Impact of Financial Reform, and Hot Topics Surrounding Risk and Corporate Governance<br />PRESENTERSThomas Day<br />Vice-Chairman, PRMIA Board of Directors and Managing Director of Risk Solutions and Policy, SunGard<br />16 March 2011<br />