The financial crisis of 2007-2008 was caused by a real estate market bubble fueled by subprime mortgages and a poor regulatory framework that trusted banks to self-regulate. Risk management failed in three key areas: a lack of a clear capital allocation strategy, a disaggregated view of risks across business lines, and an inappropriate risk governance structure where the role of risk managers was marginal. Moving forward, banks need to define their risk appetite framework, implement enterprise risk management to monitor all risks holistically, and strengthen their risk governance structure with independent oversight of risk at the board level.

1. FINANCIAL CRISIS: WHERE DID RISK
MANAGEMENT FAIL ?
Gabriele Sabato
Royal Bank of Scotland
Arsalan Ali
Syed Jahanzeb
Sabih Ur Rehman
Mohsin
Aamir Shahid

2. FINANCIAL CRISES 07-08
• REAL ESTATE MARKET BUBBLE & SUBPRIME MORTGAGES
?• A POOR REGULATORY FRAMEWORK & TRUSTWORTHINESS
on BANKS

3. Failed to enforce safe business
– AVOID STRONG CONCENTRATIONS
– MINIMIZE VOLATILITY OF RETURN
Reason of Failure
1) CAPITAL ALLOCATION STRATEGY
2) DISAGGREGATED VISION OF RISKS
3) RISK GOVERNANCE STRUCTURE

4. INTRODUCTION
• REAL ESTATE MARKET focus on SUBPRIME
MORTGAGES and DISHONEST LENDING
• A POOR REGULATORY FRAMEWORK that
banks could be trusted to regulate is the main
sources of the crisis.

5. • LENDING PORTFOLIOS through MARKET DEMAND
without a clear CAPITAL ALLOCATION STRATEGY
• Regulatory pressures, such as Basel II and a greater 3
focus on CORPORATE GOVERNANCE
• Need to ARTICULATE RISK APPETITE
• RISK APPETITE
– risk metrics and methods into business decisions
– reporting and day-to-day business discussions
– link between strategy, target setting and risk management

6. • Balancing ARTICULATE RISK APPETITE
• QUANTIFIABLE, but JUDGMENTAL
• Risk appetite framework
– internal senior management
– external stakeholders
– Current position and expected growth

7. • Enterprise Risk Management (ERM)
approaches
– proactive methods of RISK MONITORING and
DETECTION
– Large national and international financial
institutions have adopted

8. • SILO APPROACHES to risk management can be
insufficient
SILO-based approaches occurs
– Due to lack of communication with one another and
across business lines
• DIVERSIFIED RISKS
– Credit,
– Market
– Operational risks

9. CAPITAL ALLOCATION STRATEGY
• Cheap and easy to raise for banking organizations
• Currently Banks are more greedy which creates
problems like
– Creating the market demand to drive the asset growth
– social function providing funds to companies in order to
start or grow their business and to consumers
• Please shareholders and to outperform peers

10. • Aggressively invested in COMPLEX ASSETS MIXING
• The business model
– EQUITY CULTURE with a focus on FASTER SHARE PRICE GROWTH and
EARNINGS EXPANSION
• Model, based on balance sheets and old fashioned
– spreads on loans, not beneficial for “GROWTH STOCKS”
– trading income and fees via SECURITIZATION
– enabled banks to grow earnings
– focused on the expected return side leaving risk side out

11. • Focus in highly correlated assets - increased without any consideration of
the volatility of their losses
• Portfolio diversification
– purely theoretical concept
– easy to be sacrificed to allow the market share to grow
• Pricing
– competitive in the market and not to guarantee an appropriate return

12. Markowitz (1952)
Portfolio Selection Theory
Markowitz explains:
• How to build the most EFFICIENT INVESTMENT PORTFOLIO
• The right balance between EXPECTED RETURNS and
VOLATILITY OF LOSSES
• DIVERSIFICATION is the best tool to reduce the risk of the
entire portfolio
• The concept is EASILY APPLICABLE to banks portfolios.

13. Mortgages (P1),
Credit Cards (P2) and
SME Loans (P3)

14. Figure 2. Definition of the risk appetite framework
This figure shows how a risk appetite framework can be defined. Following the
Board guidelines, the risk tolerance and the risk appetite lines can be drawn in the picture.
As such, portfolios can be classified into red/amber/green. The following
step will consist in defining the mitigating actions to be implemented in order to
move portfolios at desired levels of returns and volatility.

15. ENTERPRISE RISK MANAGEMENT
• Risks affect value of an organization
• CORRELATIONS and COVARIANCES
– when different risks are aggregated
– Helps assessing and addressing all form of risks
• Provide a comprehensive and coherent view
• Focus must be on
– Bigger Picture and not on the single “silo”
– “Pure” risks (or hazard risks)
– Speculative risks

16. ERM is to identify the risks the firm is exposed to,
– Market risk
– Credit risks.
– Operational risk.
• OPERATIONAL RISK except market and credit risk
• Operational risk much narrower in banks
• Many firms have gone beyond measuring market, credit,
and operational risks
• In recent years, firms have also attempted to MEASURE
LIQUIDITY, REPUTATION, TAX, PENSION and STRATEGIC
RISKS

17. RISK GOVERNANCE STRUCTURE
• The lack of an appropriate risk governance
• The current crisis by risk managers as an excuse to
justify their failures
• Role of risk management was extremely marginal at
most institutions
• Skills of each risk manager and not to his authority

18. CONCLUSION
• Three most significant failures of risk management at
most banks:
1) Lack of a defined capital allocation strategy
2) Disaggregated vision of risks and
3) Inappropriate risk governance structure
• A Capital Allocation Strategy should be thoroughly
defined for the short and long term using a risk
appetite framework. This should specify the bank’s risk
capacity (maximum risk tolerance) and risk appetite
(desired risk tolerance) following the guidelines
proposed by the Board

19. • Implementing a sound ERM APPROACH to
monitor and report risks Large investments in
info structure will be needed if financial
institutions are willing to succeed.
• THE RISK GOVERNANCE STRUCTURE are weak
reporting lines and lack of visibility of the CRO
at Board level are the main issues that should
be solved in order to ensure the independence
of the risk function