A Risk Management Paradigm
      November 17, 2009
          Scott Lane
Risk Management Paradigm                                          My Background

•   Graduated from UWEC with Accounting m...
Risk Management Paradigm                                              Agenda

    I.    Overview of Risk Management Paradi...
Risk Management Paradigm                                                     I. Overview

                          What i...
Risk Management Paradigm                               I. Overview

                   What is Risk Management?

         ...
Risk Management Paradigm                                  I. Overview (continued)

                  What is Risk Manageme...
Risk Management Paradigm                I. Overview (continued)
                       Flood Example:




                ...
Risk Management Paradigm                       I. Overview (continued)

      Bank Loss Reserve Example (same concept as t...
Risk Management Paradigm                            I. Overview (continued)

                               More Examples:...
Risk Management Paradigm                               II. Financial Crisis
     US Housing Prices on the Eve of the Finan...
Risk Management Paradigm                 II. Financial Crisis (continued)
                  The Credit Crisis: What Happen...
Risk Management Paradigm                 II. Financial Crisis (continued)
                  The Credit Crisis: What Happen...
Risk Management Paradigm                       II. Financial Crisis (continued)
                  The Credit Crisis: How D...
Risk Management Paradigm                     II. Financial Crisis (continued)
                 The Credit Crisis: How Did ...
Risk Management Paradigm                        II. Financial Crisis (continued)

      Bad Model Assumption: Housing Pric...
Risk Management Paradigm                   II. Financial Crisis (continued)

                The Credit Crisis: What Can R...
Risk Management Paradigm                                                 III. Careers

                       Corporate Fu...
Risk Management Paradigm                                IV. Further Reading
     When Genius Failed: The Rise and Fall of...
Risk Management Paradigm                 V. Summary and Recap

•   Risk management is about preparing for unlikely events
...
Risk Management Paradigm   VI. Questions




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Risk Management at UWEC

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An overview of risk management for undergraduates at the University of Wisconsin, Eau Claire. Also includes thoughts on the credit crisis. Preseted on 11.17.09.

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Risk Management at UWEC

  1. 1. A Risk Management Paradigm November 17, 2009 Scott Lane
  2. 2. Risk Management Paradigm My Background • Graduated from UWEC with Accounting major, 1995 • Public accounting after graduation, mostly with KPMG  CPA (currently inactive)  Two years consulting Credit Suisse on US GAAP in Zurich, Switzerland • GMAC-RFC, subprime mortgage banking & securitization  Corporate Accounting Director, then VP Risk Management  Implemented Sarbanes-Oxley 404 in 2004, reinvented the wheel  MBA from Duke University while at GMAC • TPG Credit, hedge fund manager in Minneapolis  Controller there since early 2006, built people, processes, systems, from ground up  Endured 2008 financial melt down 1
  3. 3. Risk Management Paradigm Agenda I. Overview of Risk Management Paradigm II. Financial Crisis: − What Happened? − Risk Managers Contribution to the Problem? − What can be done? III. Careers in Risk Management IV. Further Reading V. Summary and Recap VI. Questions Focus is on Financial Service Organizations (i.e., banks, hedge funds) 2
  4. 4. Risk Management Paradigm I. Overview What is Risk Management? General Definition Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. 1 Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. 1 Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It" pg. 46, John Wiley & Sons, 2009 3
  5. 5. Risk Management Paradigm I. Overview What is Risk Management? My Definition Risk management is the identification of events that could result in unwanted negative consequences or economic losses and then taking steps to mitigate or manage those events. Ultimately risk management is planning for the unlikely event that could cause harm. 4
  6. 6. Risk Management Paradigm I. Overview (continued) What is Risk Management? Risk Management for Financial Services Market Risk Credit Risk Operations Risk Risk of loss from a Risk of loss from the Risk of loss from a failure of people, value change of an borrower or counter- processes, or asset or liability party not meeting systems / obligations infrastructure Often measured via Involves forecasting Primarily qualitative at Monte Carlo defaults and severities this point, use tools simulations (Value at using such as “heat maps” Risk) using historical historical data etc. data 5
  7. 7. Risk Management Paradigm I. Overview (continued) Flood Example: 6
  8. 8. Risk Management Paradigm I. Overview (continued) Bank Loss Reserve Example (same concept as the flood): Known as a “tail event” or “black swan” 7
  9. 9. Risk Management Paradigm I. Overview (continued) More Examples: • GPA Risk Management − When you take a couple difficult classes in a semester, do you look for some easier classes to offset? − If so then you are actively managing your GPA risk − You might be able to manage all hard classes but why take that risk? • Career Risk Management − Did you join SAS just to make or friends or were you looking to build your resume and network with employers? • Event Risk Management − If you needed to be in Minneapolis tomorrow at 10 AM for an important interview, what time would you leave? 8
  10. 10. Risk Management Paradigm II. Financial Crisis US Housing Prices on the Eve of the Financial Crisis, Everyone Assumed Values Would Always Rise 9
  11. 11. Risk Management Paradigm II. Financial Crisis (continued) The Credit Crisis: What Happened? • After September 11, 2001 and during the subsequent recession the US adopted a loose monetary policy (keep America rolling, go out and shop)  Credit became cheap, underwriting standards were loosened, consumers treated their houses as ATM’s and borrowed against the increase values, thus increasing consumer spending  Consumer spending is roughly 70% of US GDP • Complex investments / products were developed and sold to investors that were based on housing and consumer credit  Securitization led to wide dispersion of credit risk, the use of credit default swaps and derivatives exploded, adding further dispersion of risk  These products were highly complex 10
  12. 12. Risk Management Paradigm II. Financial Crisis (continued) The Credit Crisis: What Happened? • Memories were short: things were too good for too long • Ultimately there was too much leverage in the financial system / economy as credit risk was drastically undervalued 11
  13. 13. Risk Management Paradigm II. Financial Crisis (continued) The Credit Crisis: How Did Risk Managers Contribute to the Problem? • Risk Managers Relied too Heavily on Historical Data  US housing prices never decreased in the past, therefore it was assumed they would not in the future, this was a critical assumption that did not come true • Hubris: Risk Managers Relied too Heavily on Quantitative Models • Risk Managers Assumed Individual Risks were not Correlated  Correlation goes to 1 in a crisis 12
  14. 14. Risk Management Paradigm II. Financial Crisis (continued) The Credit Crisis: How Did Risk Managers Contribute to the Problem? • Models Became Too Complex  Advancements in computing power resulted in incredibly complex models, too complex for most people to fully understand • In short: What Was Deemed Statistically Remote Actually Happened and Nobody was Prepared for it 13
  15. 15. Risk Management Paradigm II. Financial Crisis (continued) Bad Model Assumption: Housing Prices Did Actually Fall, by a lot! 14
  16. 16. Risk Management Paradigm II. Financial Crisis (continued) The Credit Crisis: What Can Risk Managers do Now? • The good news: we now have a large tail event to include in our models (the current crisis) • Ensure proper rewards and punishments, not just rewards – current bonus structure shares only upside • Counter balance complexity with simplicity  “Derivatives are financial weapons of mass destruction” Warren Buffet • Consider model assumptions and output in the context of what makes sense, including qualitative considerations • Push for counter-cyclical loss reserving 15
  17. 17. Risk Management Paradigm III. Careers Corporate Functions / Roles “Everyone is a risk manager” Operations Risk Market & Credit Risk Auditing / Risk Underwriting Controller / Internal or Treasury / Investing Accounting Management Public Undergraduate Course Work: Statistics, Economics, Finance, Accounting Degree a Good Start Graduate School, MBA, Statistics, etc. 16
  18. 18. Risk Management Paradigm IV. Further Reading  When Genius Failed: The Rise and Fall of Long-Term Capital Management, Roger Lowenstein  The Black Swan, Nicholas Taleb  House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, William Cohan  The Economist, best weekly or daily periodical available 17
  19. 19. Risk Management Paradigm V. Summary and Recap • Risk management is about preparing for unlikely events • Reliance on historical data and quantitative models, coupled with hubris and bad assumptions, greatly contributed to the current financial crisis • Common sense and qualitative considerations should always be layered on top of any model • Overly complex models can make the situation worse • Everyone is a risk manager at some level • There is plenty of good reading out there on risk management, both case studies and technical analysis and theories 18
  20. 20. Risk Management Paradigm VI. Questions 19
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