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Risk Governance and Risk Management: Oxymorons? J. V. Rizzi June, 2013 Macrostrategies, LLC 1.

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Presentation on theme: "Risk Governance and Risk Management: Oxymorons? J. V. Rizzi June, 2013 Macrostrategies, LLC 1."— Presentation transcript:

1 Risk Governance and Risk Management: Oxymorons? J. V. Rizzi June, 2013 Macrostrategies, LLC 1

2  Introduction  Decisions  Governance  Why Change  Conclusion 2Macrostrategies, LLC

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4 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. Macrostrategies, LLC4

5 Process (Governance Puzzle: How to resist excessive risk e.g. JPMC Big Whale… Governance (Board) Montoring & RebalancingInvestment Strategy & Risk Appetite Performance (Asymmetric information) …taking in benign market(s). Macrostrategies, LLC5

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7 (The birds do it, the bees do it…  Herding ◦ Safety in Numbers ◦ Peer Comparisons ◦ Cycle Amplifications  Momentum  Liquidity  Leverage  Information Cascade ◦ Feedback Loops ◦ Self-fulfilling Prophecies …everyone is doing it.) Macrostrategies, LLC7

8 (Risk as a challenge to overcome…  Fooled by Randomness ◦ The star banker problem ◦ Risk vs. uncertainty  Extrapolation ◦ Historical experience ◦ Mean reversion  Model Struck: illusion of knowledge ◦ Market efficiency ◦ Liquidity ◦ Rational Participants …or an uncontrollable chance outcome?) Macrostrategies, LLC8

9 (The influence of Risk Management… Defined: underestimate the impact of low probability high impact events.  Psychological Basis ◦ Availability ◦ Threshold  Reinforced by internal accounting & bonus schemes ◦ Line managers ◦ Breakdown of pricing ◦ Herding  Impact …decreases by the square of the time since the last crisis.) Macrostrategies, LLC9

10 (If it cannot go wrong – it will.)  Group Think: Shared Reasoning Deficiency ◦ Sources  Conformity  Organizational Pressures and Optimism  Expert Illusion ◦ Results  Married to positions  Absence of critical thinking  Lack of exit or downside plan  Denial (Fools are always certain, while the wise are doubtful.) Macrostrategies, LLC10

11 (Who decides… Uncertainty &Behavioral BiasAmplifiersControl Asymmetric Over ConfidenceIncentivesInternal InformationIllusion of ControlBureaucracy- Board monitoring Beyond the dataHindsight BiasOpaque- Incentives events:AnchoringAccounting- Sanction - ExperiencesLeverageExternal - ExposuresComplexity- Regulators Black Swans- Rating Agencies Adverse Selection- Marked for Control Moral Hazard …how do they decide?) Macrostrategies, LLC11

12 Macrostrategies, LLC12

13 (We do not need better models…  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.) Macrostrategies, LLC13

14 (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.) Macrostrategies, LLC14

15 (I admire individuals unafraid to speak their minds…  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) Macrostrategies, LLC15

16 (Risk management as…  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.) Macrostrategies, LLC16

17 (In God we trust…  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.) Macrostrategies, LLC17

18 (Do you want to believe what you see…  Size  Outside to Inside Ratio  Lead Director  Dedication: limit number of directorships  Splitting CEO – Chairman Roles  Meeting Frequency  Experience  Compensation ◦ Financial commitment: eat own cooking  Selection and Tenure ◦ Limit tenure  Chair Board Committees with Independent Directors ◦ Risk ◦ Compliance ◦ Compensation …or what I am telling you?) Macrostrategies, LLC18

19 (Now they tell us…  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?) Macrostrategies, LLC19

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21 (Beware turning risk management and governance…  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  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.) Macrostrategies, LLC21

22 (Change before…  Just one crisis away from shareholder action ◦ JPM ◦ Goldman ◦ Non-banks  Activists  Supporters ◦ Advisors ◦ Pensions …being changed.) Macrostrategies, LLC22

23 Macrostrategies, LLC23

24 (Purpose of governance is to protect institution from being…  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.) Macrostrategies, LLC24


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