The Financial Crisis:Impacts on Risk Management

and Key Lessons LearnedImpacts on Risk Management

and Key Lessons Learned

Presented by: Thomas DayVice-Chairman PRMIA Board of Directors andPresented by: Thomas DayVice-Chairman PRMIA Board of Directors andVice-Chairman, PRMIA Board of Directors and Managing Director of Risk Solutions and Policy, SunGard

Vice-Chairman, PRMIA Board of Directors and Managing Director of Risk Solutions and Policy, SunGard

Standard Disclaimer

• The views, expressions and ideas of this presentation are those of the author and do not necessarily reflect the views and opinions of SunGard or the Professional Risk Managers’ InternationalSunGard or the Professional Risk Managers International Association (PRMIA)

• Thank you to PRMIA, the Federal Reserve System, SunGard and y yall the participants and organizers of this conference. It is noteworthy the duration and importance of this annual event at the Chicago Federal Reserve Bank. Sixteen years in a row…in November couldn’t we have figured out by now a better date is inNovember…couldn t we have figured out by now a better date is in July or August?

• I am going to strive to be slightly thought provoking as we hop on-I am going to strive to be slightly thought provoking as we hop onboard the regulatory reform tsunami.

Agenda

• Now about that regulatory failure…

• Some words on the Dodd-Frank Act (DFA)

• The future of finance and, importantly, financial risk management?

Agenda

• Now about that regulatory failure…

• Some words on the Dodd-Frank Act (DFA)

• The future of finance and, importantly, financial risk management?

Do you recognize this quote?

This is “…the most important federal legislationrelating to the financial community since the 1930s ”

1. “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

relating to the financial community since the 1930s.

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

2. “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 reformsGramm 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

…and here we are, once again, with the most important federal legislation since the 1930s: The Dodd-Frank Act (DFA) Collectivelylegislation since the 1930s: The Dodd Frank Act (DFA). Collectively, it seems we have a rather short memory. History is important. More of us should study it.

What Really Happened?

• According to the media and, to some degree, the DFA itself (and too many academics it seems):Answer #1: The regulators failed to control the excesses of the now

infamous “banksters”. Therefore, we need much more and better regulation. Thus, the Dodd-Frank Act’s (DFA) majesty will protect us from the next crisis because we’ve fundamentally addressed the problems that created the global financial crisis.

DFA DFA

Banksters? Asleep at the wheel?

DFA DFA

We take this Commercial Break to Set theWe take this Commercial Break to Set the Record Straight: It wasn’t the regulators

Without the direct influence of congressional action(s), the breadth, depth, duration, and

We continue to possess a patchwork of regulatory agencies, even if we have vested one agency with more 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

power than any other – the Fed. While the number of supporting characters is vast, the fault rests squarely with our legislators – which eg s at e ept tude a d a a ost

complete absence of timely and responsible action by our legislature.

means it rests with the American people. What happens when the sovereign becomes the greatest sources of systemic risk?

The Truth About Regulation

• Charter shopping has been common for many years. One of the best storied examples may be Colonial Bank, which failed on August 14 2009August 14, 2009.

• Goal: Which regulator will be most useful for me, the “ tit t”?“constituent”?

o 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?

“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.”

– May 2007, OTS internal e-mail

• 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 banksters - is wrong. Contributors? Sure. Foremost to blame? Not a chance.

The Truth About Regulation

• The regulators have had sufficient authority to clamp down on excesses for a long time. We all know this fact.

• A strong approach didn’t happen for a large # of reasons:o Charter shopping and “functional regulation”:

1) Divide and conquer, a good war-plan. Fighting battles on many fronts1) Divide and conquer, a good war plan. Fighting battles on many fronts has never had much success.

2) A Congress eager to appease and “tear down those walls”

o “Ability” to supervise versus “Will” to supervisey p p1) “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.

o APA (P.L. 79-404) and the PRA (P.L. 96-511)1) Good examples of how to institutionalize poor agility, flexibility and timeliness

IMF’s Lessons for us?

Worth reviewing:1. Good supervision is intrusive2. Good supervision is skeptical but proactive3. Good supervision is comprehensive4. Good supervision is adaptive5. Good supervision is conclusive

To achieve these elements you need adequate resourcesTo 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.g

So, if not regulation, what then?

Idea: Capitalism and markets have failed. We can “fine-tune” the economy. We have the right levers and knobs, we simply need to “fix” the inherent failures of the market system. Put the right people in the cockpit and she willfailures of the market system. Put the right people in the cockpit and she will fly.

LIFE LIBERTY and theLIFE LIBERTY and the (…)

This is a fallacy. We haven’t had a “free” market system in a long-time. Our current GSE (i.e., Government Sponsored Economy) is a direct result of “covert collectivism”. In the United States you have the right to:y g

…pursuit of a 5/1 IO mortgage at an affordable rate with little or no $ down. If that doesn’t work, a Pick-a-Pay Option ARM with a 125% neg am cap will do.

So What Happened?So What Happened?ANS: A Systemic Failure Due to our “Home Ownership is a Right” National Policy Goals + “Fine-tuned” Monetary Policy

“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 forreward. 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, p y g g p pHome Equity, Non-prime, and Alt-A.” - November 2006, WaMu Internal E-mail

Risk Adjusted Returns (in Basis Points)

1. Can’t compete head-to-head with GSEs. A funding curve we can’t match. Improperly priced

???

Basis Points)funding curve we can t match. Improperly priced credit derivatives & taxpayer funded dividends.

2. Cheap credit: A “glut” of liquidity3. Incentive Plans: Focus on today’s GAAP

earnings, not value-creation ???earnings, not value creation4. Poor risk-controls: growth, concentrations, funding5. Lack of transparency6. New and untested product(s)

S Wh t H d?So What Happened?ANS: …. + Poor Monetary Policy

• From October of 2001 through September of 2005, the average spread between 10-year UST and 3-mo UST3 5

410 Year less 3-Month CMT

between 10 year UST and 3 mo UST was 262bp

• Coincident with the “removal” of this spread via the curve flattening which

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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!)

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houses (whose values never decline!)

• In the search for yield, opacity/complexity pays (or it did)

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o CDO, PLRMBS, CDS, CLO, SCDO, CDO^2, LCDS, CMBS, CCOs, etc.

10 Year less 3-Month CMT

…and poor corporate governance

• Bonuses:2006 = $60 billion Bonuses paid to the top 5

fi i l fi i th U S A2007 = $66 billion2008 = $72 billion2009 = $90 billion

financial firms in the U.S. Are these “risk-adjusted” bonuses?

2009 $90 billion

• Compensation should be based on value-creation, not the ability t f t h t t GAAP ( IFRS) i hto manufacturer short-term, GAAP (or IFRS) earnings; however, many compensation packages have been based solely on ROE.• The market should discipline rent-seekers. Equity is meant to be

“ d” t l t d d d t i l t i l t d“owned” not merely traded, and certainly not manipulated. • Like getting married. Should feel the full weight of “I Do.”

Summary Point: Not a lack of Regulation

• 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”extended period

1. 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 ReportResponsibility and Reform Report

2. USG writing of other guarantees should stop, or be accounted for via GAAPo Sidebar: Should USG finances be GAAP-based? According to shadow stats, debt using

GAAP is ~$70.7 trillion in 2009, or approximately ~5x GDP

• 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

it f EPSpursuit of EPS. • It raises profound questions about the corporate structure itself, and especially

corporate governance.

Agenda

• Now about that regulatory failure…

• Some words on the Dodd-Frank Act (DFA)

• The future of finance and, importantly, financial risk management?

Regulatory Reform:Regulatory Reform: Timeline to the Current State

Broad Principles:Broad Principles:Robustness, Transparency, Resilience

• FSOC• Resolution Authority• Office of Fin’l Research

• CCPs• CFTC (from 14 to 20)• FMUs

• Countercyclical capital• Contingent capital• FDIC assessments

• Volker Rule• Routine stress-testing• Non-bank Fis• Growth restrictions

FMUs• Improved disclosures• OFR• CFPB• FIO (“US Solvency 2”)

FDIC assessments• Basel-3 quality & quantity of

capital liquidity standards

Robust Transparent Resilient

• Redefine capital FIO ( US Solvency 2 ) liquidity standards

International Harmonization and Coordination

ESRB FSB G-20 FSB BCBS IOSCO (…)(…)

Does the DFA help?

• The premise of the DFA is that the “problem” was weak regulation. “If only the regulation had been stronger….”o As noted previously, this is an incorrect starting point. Regulation in the

United States hasn’t been weak, it simply hasn’t been applied.

• But what about “Systemic Risk” and “Resolution yAuthority”?o The President’s Working Group (PWG), or any other number of forums,

could’ve easily been leveraged as the equivalent of the FSOCy g qo Establishing “living wills” is a critical step for the TBTF/TCTM firms, as is

the effort to harmonize these resolution cross-border.o OPINION: Ultimately, we will need to “show” the market RA is ‘red in tooth

d l ’ b ll i TBTF/TCTM d hi i h di k jand claw’ by collapsing a TBTF/TCTM and hitting the credit stack, not just equity.

DFA: It passes the “size” test

• DFA is only ~385,361 words• However, the policy multiplier is ~10x

~3 853 610 d f li ~3,853,610 words of policy• How many words in the Bible?

774,746, or a 4.97x factor Gettysburg address 269 words

(14,325x) Declaration of Independence is p

1,337 words (2,882x)• IRS code?

~5,500,000, or ~70%5,500,000, or 70%• Moral: We should be very busy http://bit.ly/DFA_DavisPolk

Good summary of implementation timelines

Estimated Rulemaking by Agency

* Chart produced by DavidPolk in its July 9, 2010 Summary of the DFA

DFA: Structure

A Useful Index of DFA Elements:TITLE I—FINANCIAL STABILITYTITLE II ORDERLY LIQUIDATION AUTHORITYTITLE II—ORDERLY LIQUIDATION AUTHORITYTITLE III—TRANSFER OF POWERS TO THE OCC, FDIC, AND THE BOARD TITLE IV—REGULATION OF ADVISERS TO HEDGE FUNDS AND OTHERSTITLE V—INSURANCETITLE VI - IMPROVEMENTS TO REGULATION OF OTS REGULATED FIRMS (shortened)TITLE VI IMPROVEMENTS TO REGULATION OF OTS REGULATED FIRMS (shortened)TITLE VII—WALL STREET TRANSPARENCY AND ACCOUNTABILITYTITLE VIII—PAYMENT, CLEARING, AND SETTLEMENT SUPERVISIONTITLE IX—INVESTOR PROTECTIONS AND IMPROVEMENTS TO THE REGULATION OF SECURITIESTITLE X—BUREAU OF CONSUMER FINANCIAL PROTECTIONTITLE X BUREAU OF CONSUMER FINANCIAL PROTECTIONTITLE XI—FEDERAL RESERVE SYSTEM PROVISIONSTITLE XII—IMPROVING ACCESS TO MAINSTREAM FINANCIAL INSTITUTIONSTITLE XIII—PAY IT BACK ACTTITLE XIV—MORTGAGE REFORM AND ANTI-PREDATORY LENDING ACTTITLE XV—MISCELLANEOUS PROVISIONSTITLE XVI—SECTION 1256 CONTRACTS

Fi i l St bilit O i ht C ilFinancial Stability Oversight CouncilSubtitle A of Title I

• The FSOC is established to oversee large, complex financial organizations (bank and non-bank)

• Stress-testing: Banks and non-banks deemed systemically important are

expected to perform internal enterprise-wide stress-test semi-p p pannually (over than $10 billion – a low threshold – annually)

• Impact: Over-emphasis is possible. FRB, Basel, FDIC, OFR FSA and other approaches toward stress-testingOFR, FSA, and other approaches toward stress-testing See: 1) Supervisory Capital Assessment Program (SCAP), 2) BCBS 155 –

“Principles for Sound Stress Testing Practices and Supervision”, 3) CP32 – CEBS – “Guidelines on Stress Testing”, 4) etc

Is anyone trying and harmonize across borders? Much of the TBTF/TCTM should be the product of a more universal set of enterprise-stress packages. Disclosure should be a key element.

The Powers of the FSOC

• Arguably the centerpiece of the DFA (http://www.treas.gov/fsoc/)

• Has the power to define systemically important entities, bank or non-bank

• Has the ability to subject such firms to regulationo Credit Capital Liquidity Concentration Disclosures Stresso Credit, Capital, Liquidity, Concentration, Disclosures, Stress-

testing, and other required risk management protocols

• To date:• Have held two well rehearsed public meetings (October 1, November 23rd)• Notably, and startlingly, virtual silence after Barr’s preliminary findings

from the Foreclosure Task Force – “…inexcusable breakdowns in basic controls…” and

these issues are “…widespread…”

Subtitle B: Office of Financial Research

• Can and should be one of the most important elements of Title I

• Began as S.3005: CE-NIF (http://www.ce-nif.org/)o Idea is to harmonize data standards

“Bank information systems are not designed to aggregate information in this way on a regular basis. Much improvement is needed in these systems…but until strides are made, comprehensive stress-testing will remain very difficult ”” the issues I’ve just mentioned make me reluctant toremain very difficult. …the issues I ve just mentioned make me reluctant to begin conducting such tests routinely as the cornerstone of our supervision.” (also emphasized that PFRs shouldn’t disclose the results)

– Former Comptroller John Dugan, April 15, 2010, Richmond FRB

o Idea, one of many, is to analyze and assess cross-entity risks

OFR: The Dream v. the Reality

• Federal Reserve announces its own Office of Financial Stability Policy and Research on November 4th

o How will these interact?o What are the intentions of the FRB with regard to OFR?

• OFR could be viewed as a needed “fixer” and “motivator” of the technology infrastructure improvements that are desperately needed in SIFIs

• Requires vigilance and participation by industry risk managersRequires vigilance and participation by industry risk managersand IT professionals, esp when you hear sentiment such as:“The OFR must not duplicate existing government data collection efforts or impose unnecessary burden.”p y…and see meetings with the FRB like the recent Financial Services Roundtable, November 15, 2010 (http://bit.ly/FSR_FRB)

Living Wills:Living Wills: Orderly Liquidation Authority

• Warning: When you hear - “The Taxpayer will never….”

• Cross-border resolution of SIFIs was a missing element in the recent crisiso 13(3) powers of the FRB have been curtailed under DFAo 13(3) powers of the FRB have been curtailed under DFA

“…unusual and exigent circumstances…” clause of FRA §13

• FDIC, in collaboration with the other PFRs, is moving to create realistic Resolution Plans

• Numerous studies are required relative to operation of OLA v. BK, international issues, and other matters.

Other Areas of Impact

• Enterprise Risk Management Expect a greater emphasis on enterprise risk management, a deeper

analysis of processes, need for adherence to established best-practice,analysis of processes, need for adherence to established best practice, and Board level risk-committee structure(s) [culture not compliance]

• Executive and Incentive CompensationExecutive and Incentive Compensation Expect your risk management group to be part of these discussions

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk taking contributing to bank losses and financial

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk taking contributing to bank losses and financial

• Consumer Protection Rules

incentives and excessive risk-taking, contributing to bank losses and financial instability.” – Chairman Ben Bernanke, October 2009

incentives and excessive risk-taking, contributing to bank losses and financial instability.” – Chairman Ben Bernanke, October 2009

• Liquidity and Capital

What is missing from DFA?

• Doesn’t deal with the fundamental problems that created the crisis. Apologies to those that don’t like the term “malinvestment”. I find that the

shoe fitsshoe fits.

• FSOC. What is a bubble? How can you tell? What if the greatest source of Systemic risk is the sovereign or one of its

appendages? (and that’s the easy problem)pp g ( y p )

• CFPB. Just wondering what happened to caveat emptor. Off to a wobbly start. Wondering about warning labels.

• TBTF. Need to see how OLA works in practice.p• OFR and the OFSP&R

A lot of potential, potentially.

• Compensation Title IX is a good stretch Believe corporateCompensation. Title IX is a good stretch. Believe corporate governance should have as much attention as risk management.

Agenda

• Now about that regulatory failure…

• Some words on the Dodd-Frank Act (DFA)

• The future of finance and, importantly, financial risk management?

Impact of reform on risk management

• Risk Management Impact?

F ll l t t• Full employment at: Deloitte, KPMG, PwC, BAH,

Promontory Have regulatory experience Have regulatory experience,

will hire• Major areas of need:

Infrastructure issuesInfrastructure issues ERM is “for keeps” Massive need for education

PRMIA areas of influenceHolding to the Highest Standards in Institutional Risk Management Globally. Network. Understand. Act.

19 Chapters

28 Chapters

18 Chapters

Collaboration and SituationalCollaboration and Situational Awareness is Critical

• Our success throughout the reform process will be a function of effective collaboration.

– paraphrase of Neal Wolin

• “ global policy cooperation is fracturing at best ”• …global policy cooperation is fracturing at best. - John Lipsky, IMF

• Markets remain fragile and it’s imperative we avoid• Markets remain fragile and it s imperative we avoid sliding into financial protectionism

Many Opportunities forMany Opportunities for Improvement

• CRO Attestation to Internal Risk Management Practices• Developing a Uniform Set of Risk Management Standards

Principles, not rules

• Continued development of “specialists of the whole” “On a Global Foresight Commons”, Carol Dumaine, 23-Nov-2010On a Global Foresight Commons , Carol Dumaine, 23 Nov 2010 Unwinding Orthodoxy, the Value of Heresy, learning to “…profoundly challenge

the status quo.”

• The US is only “now” joining the International Association of y j gInsurance Supervisors (see FIO)

• Expert needs around stress-testing Subjectivity Risk Imagination and Expert-Based Systems Subjectivity, Risk Imagination, and Expert-Based Systems SME Swarming, Risk Mash-ups, Network Sensors, COEs (industry,

regulatory, intelligence industry, other?)

Areas of Current Risk Focus

• The search for earning assets Beware the rise of Interest Rate Risk

• Balance sheet management New volumes – credit spread, risk and duration Funding and deposit strategies (preparations made?) Funding and deposit strategies (preparations made?) Capital planning, including focus on non-organic

growth (M&A should pick up) B l b li idi d d f d Balance between liquidity and need for spread

• Profitability, margin-protection, and efficiency• Financial risk and corporate governanceFinancial risk and corporate governance• Regulatory preparedness

The Financial Crisis:Impacts on Risk Management

and Key Lessons LearnedImpacts on Risk Management

and Key Lessons Learned

Presented by: Thomas DayTHANK YOU!

Presented by: Thomas DayTHANK YOU!THANK YOU!

Contact at: dc.prmia@gmail.com

THANK YOU!

Contact at: dc.prmia@gmail.com