rizzi_joseph_june20

Report
Risk Governance and Risk Management:
Oxymorons?
J. V. Rizzi
June, 2013
Macrostrategies, LLC
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Introduction
Decisions
Governance
Why Change
Conclusion
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Risk governance worked, except for “rare” exceptions…
◦ Never attribute to malice or stupidity that which can be explained by
moderately rational individuals following incentives in a complex system
of interactions. – Douglas Hubbard
◦ Purpose of governance is to protect the institution from being driven by
the narrow interests of an individual or group of individuals.
◦ Absent governance, the institutional imperatives takes hold: 1) an
institution will resist any change in its current direction; 2) business
cravings of the leader(s), however foolish, will be supported by detailed
rate-of-return and strategic studies prepared by his troops; 3) behavior of
peer companies will be mindlessly imitated. – Warren Buffett
Role of the Board is to understand and monitor senior management behavior
to protect shareholder interests…
…like financial crisis, MF Global, London Whale…ha.
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Process
(Governance Puzzle: How to resist excessive risk e.g. JPMC Big Whale…
Governance (Board)
Montoring & Rebalancing
Investment Strategy &
Risk Appetite
Performance
(Asymmetric information)
…taking in benign market(s).
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(The birds do it, the bees do it…
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Herding
◦ Safety in Numbers
◦ Peer Comparisons
◦ Cycle Amplifications
 Momentum
 Liquidity
 Leverage
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Information Cascade
◦ Feedback Loops
◦ Self-fulfilling Prophecies
…everyone is doing it.)
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(Risk as a challenge to overcome…
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Fooled by Randomness
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Extrapolation
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Model Struck: illusion of knowledge
◦ The star banker problem
◦ Risk vs. uncertainty
◦ Historical experience
◦ Mean reversion
◦ Market efficiency
◦ Liquidity
◦ Rational Participants
…or an uncontrollable chance outcome?)
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(The influence of Risk Management…
Defined: underestimate the impact of low probability high impact events.
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Psychological Basis
◦ Availability
◦ Threshold
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Reinforced by internal accounting & bonus schemes
◦ Line managers
◦ Breakdown of pricing
◦ Herding
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Impact
…decreases by the square of the time since the last crisis.)
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(If it cannot go wrong – it will.)
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Group Think: Shared Reasoning Deficiency
◦ Sources
 Conformity
 Organizational Pressures and Optimism
 Expert Illusion
◦ Results
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Married to positions
Absence of critical thinking
Lack of exit or downside plan
Denial
(Fools are always certain, while the wise are doubtful.)
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(Who decides…
Uncertainty &
Asymmetric
Information
Beyond the data
events:
- Experiences
- Exposures
Black Swans
Adverse Selection
Moral Hazard
Behavioral Bias
Over Confidence
Illusion of Control
Hindsight Bias
Anchoring
Amplifiers
Incentives
Bureaucracy
Opaque
Accounting
Leverage
Complexity
Control
Internal
- Board monitoring
- Incentives
- Sanction
External
- Regulators
- Rating Agencies
- Marked for Control
…how do they decide?)
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(We do not need better models…
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Unnoticed Risk Appetite Change
Failure to understand Risk Implications of Strategy
Inconsistent capital Structure and Stakeholder
Communications
Top management and Board failed to understand
arcane models
Entering new activities can misalign incentives
requiring organizational, compensation and control
structure changes
…we need better governance.)
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(Ignorance is not bliss…
Although 90% of directors say they understand the risk
implications of the current strategy…
◦ Only 77% of directors say they understand the risk/return
tradeoffs underlying the current strategy.
◦ Only 73% of directors say their companies fully manage risk.
◦ Only 59% of directors understand how business segments interact
in the company’s overall risk portfolio.
◦ Only 54% have clearly defined risk tolerance levels.
◦ Only 48% of boards rank key risks.
◦ Only 42% have formal practices and policies in place to address
reputational risk.
Source: The Conference Board
…it is rot.)
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(I admire individuals unafraid to speak their
minds…
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Rewards for Risk Taking
Acceptance of Bad News
Internal Competition Level
Performance Pressure
More than Compliance
Hero Worship and the Great Man Problem
Succession Plan
…even if it costs them their job. – L.B. Mayer)
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(Risk management as…
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Organizational and Transaction Complexity and Transparency.
Diagnostic Performance Gaps
Extent of Decentralization: decisions made without direct senior
management oversight.
Board Awareness/Board Understanding
Judgment vs. Models
◦ Illusory profits given inadequate reserving
◦ Ability to put organization at risk
◦ Speed
Financial risks are opaque and do not immediately manifest
themselves
◦ Track records of limited use
◦ Difficult to distinguish luck vs. skill
…exposure measurement and accounting.)
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(In God we trust…
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Risk Appetite
◦ Relative to capital
Limit Setting
Monitoring
Discipline
Reward
Succession Plan
Annual Independent Assessment of Risk Governance
Framework
…every else must bring the data.)
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(Do you want to believe what you see…
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Size
Outside to Inside Ratio
Lead Director
Dedication: limit number of directorships
Splitting CEO – Chairman Roles
Meeting Frequency
Experience
Compensation
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Financial commitment: eat own cooking
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Limit tenure
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Risk
Compliance
Compensation
Selection and Tenure
Chair Board Committees with Independent Directors
…or what I am telling you?)
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(Now they tell us…
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Fight Complacency: do not assume tomorrow will look like
today, especially after a long period of good times.
Overcome Conflict Avoidance: ask hard questions.
Control Must Match the Size of the Risk Involved: big bet
your bank type risk exposures require rigorous review
process
Trust but Verify: make them verify their plans – do not
blindly assume they are correct.
Do Not Shoot the Messenger: encourage surfacing
problems before they become fatal.
…do they believe it, and if so for how long?)
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(Beware turning risk management and governance…
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CAMELS: management “m” to include Board competence
and engagement
Dodd Frank
◦ Risk committee requirement: $10B ≤ assets < $50
 Chaired by independent direction; one risk management professional
◦ Chief Risk Office requirement: assets ≥ $50B
 Reports to risk committee and CEO
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Components
◦ Risk Appetite: policies and processes for risk oversight
◦ Monitoring: management compliance with risk limits
◦ Control: management of risk exposures and controls
…into a compliance and audit function.)
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(Change before…
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Just one crisis away from shareholder action
◦ JPM
◦ Goldman
◦ Non-banks
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Activists
Supporters
◦ Advisors
◦ Pensions
…being changed.)
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(Purpose of governance is to protect institution
from being…
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Role of Board: understand and monitor senior
management to protect shareholder interests
Beware of Bias
Judgment vs. Model
Risk Appetite
Risk Management vs. Risk Measurement
Duty of Care
…manipulated towards narrow management
interests.)
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