Strategic Management of Risk - Session 7. 2023. student version.pptx

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1. Session 7: Risk Management in the Financial Sector Strategic Management of Risk 1

2. 2 The financial risk landscape Financial Crisis 2007-2008 Fraud and risk management Core Reading Case Study: Baring’s Bank Session Outline

3. 3 Appreciate the various risks that organizations operating within the financial sector confront Recognize some of the challenges associated with managing risk in the financial sector Understand the causes and consequences of fraud and other acts of financial misconduct Learning Outcomes

4. 4 Part I: The financial risk landscape

5. Financial Risk Management in Banks 5

6. Financial Risk Management Strategies 6 internal strategies risk-sharing strategies risk transfer strategies

7. 7 Regression Analysis

8. 8 Value-at-Risk ( VaR )

9. 9 Monte Carlo Simulations

10. 10 Tools for Assessing Financial Risk Method Ease of Use Uses Advantages Disadvantages Regression Analysis simple reducing exposure to specific risks; determining hedging strategies easy to understand; Excel -based equations may not be stable – giving unreliable results Value-at-Risk ( VaR ) potentially complex, requiring good statistical knowledge as a risk control tool; to understand a wide range of risks easy to understand; gives a sense of likelihood of an event no idea of potential scale of losses; can give false sense of security Monte Carlo Simulations use complex formulas and huge amounts of data predicting potential future outcomes flexible; integrates a degree of randomness and uncertainty relies upon subjective selections as to what data to input; based on historical data

11. How to explain complex financial models to non-experts? How to ensure that senior management fully understand the risks that they are exposed to? How to make clear the limits of financial models? Communication Issues 11

12. 12 " Investment banking is a trap, a game and an addiction. The reward is big, but uncertain, which makes it exciting and keeps you coming back for more. Once the money starts flowing it's very, very hard to take yourself away from it. Doing a deal is like scoring a goal…The game element is in the rivalry with other teams, winning the mandate, legging over the competition…Also the emptiness that comes with addiction." [Former Investment Banker, Guardian ] Addicted to Risk?

13. 13 Bonus Payments Bonuses as a percentage of total pay, financial year ending 2001 to financial year ending 2016

14. 14 “During years 1–3, bankers construed their bodies as objects that the mind controls. They worked long hours, neglected family and hobbies, and fought their [bodies’] needs in order to enhance productivity.” [USC Study of bank working conditions] Working Conditions

15. 15 “ The real threat is not a bank's management hiding things from us: it's the management not knowing themselves what the risks are, either because nobody realises it or because some people are keeping it from their bosses .“ [Anonymous Regulator, Guardian ] Increasing Complexity & Systemic Risk

16. 16 Part II: The 2007-2008 Financial Crisis

17. The Rise and Fall of Asset-Backed Securities 17

18. “ As the current financial meltdown makes clear, private financial markets do not always manage risk effectively on their own. In fact, to a large extent, the current crisis can be understood as the product of a profound failure in private risk management, combined with an equally profound failure in public risk management, particularly at the federal level.” [US Congressional Oversight Panel (2009)] “ Bankers complicated banking to the point where the location of risk was obscured, abandoned time-honoured principles of prudent lending and failed to manage their funding requirements appropriately. There were major failures in the modelling, procedures and structures for risk management.” [UK Parliament (House of Commons Treasury Committee 2009)] A Failure of Risk Management? 18

19. 19 “ You had to sell, whether it was for the customer or not. You’d like to think that if you knew the customer you could sell them the right product but some people didn’t do that because they were trying to reach a target and they sold whatever they could .” [Evidence from Employee of HSBC to the Future of Banking Commission, 2010] Aggressive Sales Culture

20. 20 “It’s the danger of putting too much faith in models – models are only right some of the time and are only useful some of the time and people need to understand that at the outset. It’s the application of a little common sense. It’s like these people who use a sat-nav when they’re in the middle of a pond – just look up once and you’ll see the pond in front of you.” Overreliance on Models

21. 21 “When I arrived the first thing I did was look at the risk report and it was something like 76 pages long in size 8 font, it was absolutely incredibly detailed and I couldn’t read it.... So I basically cut that report down to 12 pages and it still did not get enough attention, so I cut it down to 3 and then it received air time.” “One of the big problems is whether boards have relevant and accurate info to be able to monitor a firm’s risk exposures. Risk reports get diluted at every level as they go up until eventually something that is presentable, won’t upset anyone, or rock the boat is presented to the board. We’ve all seen that.” Communication Issues

22. 22 “The culture of the whole organisation was sales driven. The rewards and promotion were all internal and rapid. People were hugely rewarded with lots of share options and bonuses. The risk people were disaggregated, not rewarded....There was no incentive for any of the risk people to stand up and challenge.” Skewed Incentives

23. 23 “ In the housing crisis, group-think was pervasive, affecting rating agencies, regulators, legislators, lenders, borrowers, mortgage brokers, pundits, thousands of handsomely-paid securities dealers, and most of the economics profession.” [Stan Sorscher ] Groupthink

24. 24 Lehman Brothers

25. What About Those Banks That Weren’t Affected? 25

26. 26 “I’m an old-school banker. I don’t think you should do something you don’t understand, hoping there’s somebody at the bottom of the organization who does. The whole thing didn’t make common sense to me. You’re going to get all your money back, or you’re going to get none of your money back. I said, ‘Wow! If this ever went against us, we could take some serious losses here.’” [Edmund Clark, CEO] Toronto Dominion Bank

27. 27 Part III: Fraud and Risk Management

28. 28 “… all those activities involving dishonesty and deception that can drain value from a business, directly or indirectly, whether or not there is personal benefit to the fraudster. ” [Davies, 2003] Fraud: Definition

29. Types of Fraud 29

30. 30 financial pressures (e.g. debt) unethical working cultures dissatisfaction with work egotism/hubris pressure to meet targets greed to hide losses sense of challenge Why do Employees Commit Fraud?

31. 31 The Fraud Triangle what motivates the crime (e.g. debt, pressure from work, etc.) the circumstances/method by which the crime can be committed (e.g. the individual has access to accounts) how the fraudster justifies the crime in a way that is acceptable to his or her internal moral compass

32. 32 (a) 59% (b) 69% (c) 79% (a) 18-35 (b) 36-55 (c) 55+ (a) 16% (b) 26% (c) 36% (a) 0-3 years (b) 4-6 years (c) 6+ years What percentage of fraudsters are male? Which age-range do 68% of fraudsters fall into? What % of internal frauds are committed by people who work in financial roles? How long had the majority of fraudsters been employed by their organisations? Profile of a ‘Typical’ Fraudster

33. 33 Profile of ‘Typical’ Fraudster

34. 34 external auditors company accountants senior management colleagues financial authorities (e.g. FSA) police Who is Responsible for Detecting Internal Fraud?

35. 35 Part IV: Core Reading

36. 36 Based on your reading, please consider the following questions: Why is it so important for banks to work out an optimal risk appetite? Why does the author argue that ‘ it would be wrong to believe that somehow better governance makes banks safer’? According to the author, what are the main limitations of VaR models? Why does the author argue that incentives are so important in establishing effective risk management frameworks within banks? Core Reading

37. 37 Part V: Case Studies

38. 38 Barings Bank & Silicon Valley Bank different times; same problems?