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Enterprise Risk Management- A closer look at the issues Mr. Ravi Varadachari November 18, 2008.

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Presentation on theme: "Enterprise Risk Management- A closer look at the issues Mr. Ravi Varadachari November 18, 2008."— Presentation transcript:

1 Enterprise Risk Management- A closer look at the issues Mr. Ravi Varadachari November 18, 2008

2 The following is intended to outline our general product direction. It is intended for information purposes only, and may not be incorporated into any contract. It is not a commitment to deliver any material, code, or functionality, and should not be relied upon in making purchasing decisions. The development, release, and timing of any features or functionality described for Oracle’s products remains at the sole discretion of Oracle. Safe Harbor Statement

3 Agenda ERM defined Goals of ERM ERM Framework ERM implementation 3 © 2008 Oracle Corporation – Proprietary and Confidential

4 Enterprise Risk Management © 2008 Oracle Corporation – Proprietary and Confidential 4 Financial institutions are exposed to a variety of risks like financial risk, economic risk, geo-political risk and societal risk. Traditionally, the focus has been on understanding and managing the financial risk. Enterprise Risk Management is a mechanism to have a holistic view of all the risks that a financial institution is exposed to at the right level of granularity. Economic Risk Societal Risk Financial Risk Technological Risk Geopolitical Risk Market risk Credit risk Operational risk Liquidity risk Interest rate risk ALM Concentration risk

5 Global risks © 2008 Oracle Corporation – Proprietary and Confidential 5 Economic Oil price shock/energy supply interruptions US economy Chinese economic hard landing Fiscal crises caused by demographic shift Blow up in asset prices/excessive indebtedness Geopolitical International terrorism Proliferation of weapons of mass destruction Civil wars and failed and failing states Retrenchment from globalization Middle East instability Technological Breakdown of critical information infrastructure Emergence of risks associated with nanotechnology Societal Pandemics Infectious diseases in the developing world Chronic disease in the developed world Liability regimes Financial Market risk Credit risk Operations risk Liquidity risk Interest rate risk Concentration risk

6 ERM- key drivers © 2008 Oracle Corporation – Proprietary and Confidential 6 ERM External stakeholders -Rating agencies -Investors Regulatory - Sarbanes Oxley Legislature Other - Basel II Internal stakeholders -Employees -Strategic partners Management - Align risk with strategy Board and Audit Committee - Understand risk profile Other External Internal

7 Agenda ERM defined Goals of ERM ERM Framework ERM implementation 7 © 2008 Oracle Corporation – Proprietary and Confidential

8 The goals of ERM © 2008 Oracle Corporation – Proprietary and Confidential 8 Establish sustainable competitive advantage Manage risk at lower cost Support Business decisions Integrate with business planning and value management processes Avoid missing key risks and losing vital opportunities Optimize balance between capital preservation and growth/profit-generation Minimize risk averse behavior Develop cost-effective risk strategies and solutions Eliminate redundant or unnecessary risk controls Support more informed/proactive risk management decisions aligned with business objectives/strategies Link to enterprise performance, measurement and monitoring Reduce volatility and prevent surprises

9 Estimate the “Right” amount of capital Capital depends on various factors including:  Exposure to type of asset class - corporate, bank, sovereign and the like  Country of incorporation of the exposures  Credit ratings/Credit Score  Term of exposure – short term or long term  Collateral  Policy, processes and systems for risk management

10 ERM and Capital can i mpact growth ambitions and funding cost  Impact on Growth:  Asset growth would require additional capital  Additional capital required depends on growth in “risk weights” and not just asset growth  Cost of Funds:  Lower wholesale deposit rates for banks that demonstrate good risk management systems and adequate capital  No substantial impact on retail deposit rates

11 and also profitability … Capital10 Borrowings Total assets Average cost of borrowings 4% Average yield on loans 7% Average costs1% Interest Income Interest Expenses Other Expenses Net Income Return on Equity24%26%28%30%

12 Agenda ERM defined Goals of ERM ERM Framework ERM implementation 12 © 2008 Oracle Corporation – Proprietary and Confidential

13 Key to effective Enterprise Risk Management How Do We Address ERM? Risk measurement and management Regulatory capital Economic capital Risk based pricing and compensation Stress testing Internal controls and mechanisms Strategy Governance Organization structure Processes, Policies and Procedures © 2008 Oracle Corporation – Proprietary and Confidential 13

14 14 The “Risk Management” Value Chain Source: i-flex study based on various surveys Risk Identification Identification of risks and Go - No Go Decision Risk Management Collateral, Guarantees, Covenants Capital Allocation Capital estimation commensurate with risk Risk Based Pricing Pricing takes into account capital charge apart from expenses Stage IStage IIStage IIIStage IV

15 15 Regulatory, Economic and Book Capital Regulatory Capital : Capital that banks are required to hold by their regulator “The amount of capital a bank must have to stay in business” Under the Basel II framework – computed based on a prescriptive formula for credit risk Economic Capital : Capital that is required commensurate with the risk profile of the bank “The amount of capital a bank should have” Various models to estimate economic capital - stochastic view Endeavor is to use it for business decisions Book Capital : Capital that a prudent bank would choose to hold “The amount of capital a bank that a bank has on its book” Economic book value – different from accounting concept of book value Concept of risk appetite

16 16 The meaning of capital- different when perceived in the context of risk management Regulators are now trying to align regulatory capital with economic capital… Regulatory Capital : Capital that banks are required to hold by their regulator “The amount of capital a bank must have” Economic Capital : Capital that a prudent bank would choose to hold – commensurate with the risk of the bank “The amount of capital a bank should have” = To maintain Capital Adequacy Ratio = Capital/ Risk Weighted Assets >= 8% Capital depends on the risk profile of the bank’s portfolio

17 The “Stochastic” Representation Risk ExpectedBest Market0% or Bid/AskPrice% CreditAverage Loss%0 Loss% OperationalAverage Error%0 Error% Worst Price% Unexpected Loss% Unexpected Error% SET LIMITS Probability Distribution WorstExpected Best

18 Economic Capital for Credit Risk EC = Coverage against “unexpected” losses at desired confidence level Probability of Loss Amount of Loss ($) Unexpected Loss Expected Loss MeanConfidence Level ECONOMIC CAPITAL Typically 99.96% to 99.98% denoting risk appetite

19 ERM frameworks- A global perspective UK - The Combined Code (2003) and Turnbull (2005) US – Committee of Sponsoring Organizations (COSO) ERM (2004) Australia/New Zealand 4360 Standard on Risk Management 1999, 2004 South Africa– King II Report (2002) Federation of European Risk Management Association (FERMA) (2004) Basel II (2004) © 2008 Oracle Corporation – Proprietary and Confidential 19

20 The COSO ERM framework © 2008 Oracle Corporation – Proprietary and Confidential 20 ERM Framework Internal environment Objective setting Event identification Risk assessment Risk response Control activities Information and communication Monitoring The eight components of the framework are interrelated. It considers activities at all levels of the organization. The objectives can be viewed in the context of four categories- Strategic Operations Reporting Compliance A strong system of internal control is essential to effective enterprise risk management.

21 Agenda ERM defined Goals of ERM ERM Framework ERM implementation 21 © 2008 Oracle Corporation – Proprietary and Confidential

22 A structured approach to ERM implementation © 2008 Oracle Corporation – Proprietary and Confidential 22 An as-is analysis Establishing the value proposition Develop a model Pilot the model Review/revise the road map Core Banking implementation A thorough understanding of the organization’s current approach to risk management is the first step in migrating to ERM. The next step is the establishment of the value proposition of ERM in the context of the organization. It should cover the financial and business advantages that the organization draws from this revised approach to risk management. Adopting a robust model that can be customized to meet the requirements of the organization with minimum change requirements. Running a pilot and proving the concept before a full-scale implementation allows for refinement of the program if needed. Review and revise the road map for transition to steady-state.

23 ERM implementation impediments © 2008 Oracle Corporation – Proprietary and Confidential 23 Implementation impediments Operational: -Inadequate tools and systems for statistical analysis. -Lack of adequate decision support mechanisms. Strategic: -ERM objectives nor aligned to corporate objectives. -Inadequate conceptualization of ERM model. People: -Insufficient commitment from top management. - Challenges of change management.

24 24 Changing Landscape of Risk Financial Crisis Experienced by Banks/Financial Institutions Increase in “Rare Events”

25 Key Events that Shaped Regulation … Bank Herstatt Failure Credit Risk Barings/LTCM Collapse Operational Risk Banking Crisis of 1929 Conflict of Interest Orange County Operational Risk Proctor & Gamble Derivative Loss Strategy Risk Enron/WorldCom Financial Statement Accuracy Risk S&L Crisis ALM/ Market Risk ALM/ Market Risk Conflict of InterestConflict of Interest Deposit Guarantee InstitutionsDeposit Guarantee Institutions Credit RiskCredit Risk Market RiskMarket Risk Operational RiskOperational Risk Regulatory RiskRegulatory Risk Financial Statement Accuracy RiskFinancial Statement Accuracy Risk Reputation RiskReputation Risk Strategy RiskStrategy Risk

26 © 2008 Oracle Corporation – Proprietary and Confidential The current financial crisis 16 th Mar ’08- Bear Stearns Bear Stearns gets acquired for $2 a share by JP Morgan Chase in a fire sale avoiding bankruptcy. 7 th Sept ’08- Fannie Mae & Freddie Mac Federal takeover of Fannie Mae and Freddie Mac was based on a growing concern about the liquidity of the firms These two companies back-up nearly half the country’s mortgages. The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy 17 th Sept ’08- AIG 15 th Sept ’08- Lehman Brothers Liquidity crisis forced Lehman Brothers to file for bankruptcy 26 © 2008 Oracle Corporation – Proprietary and Confidential 25 th Sept ’08- Washington Mutual Liquidity crisis due to a 10-day bank run forced the OTS (Office of Thrift and Supervision) to place the bank under FDIC. The banking assets were sold to J P Morgan Chase. 29 th Sept ’08- Wachovia Bank Wachovia Bank was acquired by Wells Fargo The bank was invested heavily in adjustable-rate-mortgages and faced severe losses.

27 © 2008 Oracle Corporation – Proprietary and Confidential The Global Story … 14 th Sept ’07- Northern Rock Bank, UK UKs fifth largest mortgage lender sought financial support from the Bank of England. The bank was taken into state ownership/nationalized This was on account of the global credit crunch triggered by the sub-prime mortgage crisis in the US. 18 th Sept ’08- HBOS, UK HBOS was taken over by Lloyds Bank TSB. The share prices suffered heavy fluctuations on account of short selling and rumors of a credit crunch. 27 © 2008 Oracle Corporation – Proprietary and Confidential 29 th Sept ’08- Bradford & Bingley, UK The share prices of the bank fell on account of the credit crunch. The bank was nationalized and the Spanish bank Group Santander acquired all the savings bank assets. 29 th Sept ’08- Fortis Bank, Belgium The bank was partially nationalized by the European Central Bank The share prices fell dramatically on account of rumors of insolvency. Can be attributed to the sub-prime mortgage crisis in the US

28 The Black Swam Phenomenon “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.” What is a Black Swam? It is an Event Hard to predict based on historical data After the event – many people saw it coming Stress testing models must assume black swan events to ensure greater predictive power.

29 The London “Millennium Bridge” Incident Source:

30 The London “Millennium Bridge” Incident London Bridge – Architect Lord Norman Foster Source:

31 Thank you Mr. Ravi Varadachari Practice Leader – Risk Management & Compliance © 2008 Oracle Corporation – Proprietary and Confidential 31


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