1. Filename ERM in Banking James Lam President, James Lam & Associates Sponsored by Casualty Actuarial Society and Society of Actuaries July 28-30, 2003

2. Filename 1 James Lam’s biography Professional  President, James Lam & Associates  Founder and President, ERisk  Partner, Oliver, Wyman & Company  CRO, Fidelity Investments  CRO, Capital Markets Services Inc., a GE Capital company Industry Activities  PRMIA Blue Ribbon Panel Member  GARP 1997 Financial Risk Manager of the Year  Published over 50 articles and book chapters  Quoted in Wall Street Journal, Financial Times, and CFO Magazine Academic  Adjunct Professor of Finance, Babson College  Lectured at Harvard Business School as the subject of a HBS case study  MBA, UCLA School of Business  BBA, Baruch College Recent Clients  The World Bank  Salomon Smith Barney  Allied Capital  Risk Management Association  First Data Corporation  GMAC

3. Filename 2 New book on ERM

4. Filename 3  The business case for ERM  Lessons learned and best practices  ERM going forward – 10 Predictions Discussion outline

5. Filename 4 Risks and linkages Event Risk Operational Risk Financial Risk September 11 impact on operations Loan document and credit loss severity Kobe earthquake and Nikkei fall Enterprise-Wide Risks Financial Risks Market Risk Liquidity Risk Credit Risk Credit Risk Associated with Investments Credit Risk Associated with Borrowers and Counterparties Funding Liquidity Asset Liquidity

6. Filename 5 Key risk trends Enterprise Risk Management Corporate Disasters Enron WorldCom Tyco Industry Initiatives Treadway Report, US Turnbull Report, UK Dey Report, Canada Corporate Programs Banks Asset Managers Energy Forms Corporations Regulatory Actions Sarbanes-Oxley SEC Initiatives Basel II

7. Filename 6 The Wheel of Misfortune

8. Filename 7 Benefits of risk management BenefitCompanyActual Results Market value improvement Top money center bankOutperformed S&P 500 banks by 58% Early warning of risks Large investment bankIdentified over 80% of future losses; risk limits cut by 1/3 prior to Russian crisis Loss reductionTop asset management company 30% reduction in the overall loss ratio; up to 80% loss reduction at business units Regulatory capital relief Large commercial bank$1 billion regulatory capital relief, or about 8-10% Insurance cost reduction Large manufacturing company 20-25% reduction in annual insurance premium

9. Filename 8  Pressure on sales and earnings  Unforgiving stock market  SEC crackdown on "earnings management"  New legislative, regulatory, and accounting requirements  More demanding boards and outside analysts CEOs face a challenging environment Companies must identify, measure, and manage the underlying sources of earnings volatility

10. Filename 9  The business case for ERM  Lessons learned and best practices  ERM going forward – 10 Predictions Discussion outline

11. Filename 10 Establishing an ERM framework 2. Line Management Business strategy alignment 3. Portfolio Management Think and act like a “fund manager” 4. Risk Transfer Transfer out concentrated or inefficient risks 5. Risk Analytics Develop advanced analytical tools 6. Data and Technology Resources Integrate data and system capabilities 7. Stakeholders Management Improve risk transparency for key stakeholders 1. Corporate Governance Establish top-down risk management ERM Framework

12. Filename 11 Enterprise-Wide Risk Management (Integration) Credit Risk Business & Operational Risk Now Year 1Year 2Year 3+ Market Risk Goal: Target State Risk Management Now Year 1 Year 2 Year 3+ Credit policy framework established – key credit policies approved Market risk methodologies Operational reliability models and business objectives in place ERM concept introduced – support from board and management Develop data models and systems capability Automated reporting Active portfolio management Transactional process alignment Ad hoc reporting Early warning indicators Align reporting with policies Develop portfolio stress-testing Establish market risk controls Enhance framework and policy Develop risk metrics and reporting Align insurance programs Define framework and policy Establish organiza- tional responsibilities Establish CRO Define framework and policy Align with strategy Define risk tolerance Apply economic capital as common risk unit Create integrated risk report and success measures Integrate risk management into business processes` Develop stress-testing and response plan Evolve risk culture through awareness, training and incentives Establish a vision and a roadmap Unique workplans are developed for each deliverable milestone

13. Filename 12 Risk taxonomy (a common language) RISK TYPE FINANCIAL / OPERATIONALEVENT Investment / Credit MarketOperationalReputationalCatastrophe Loan Losses Interest Rates People Systems Processes Employees Clients Investors Analysts Rating Agencies Regulators Press Key Person Investment Performance Real Estate Terrorist Attacks Liquidity-Funding Leverage Fires/Other One-time Events Capital Markets Accounting / Valuation Fraud EconomicComplianceAdversaries Controlled InvestmentsCompetitors

14. Filename 13 Balance the hard and soft side of risk Hard Side Measures and reporting Risk oversight committees Policies & procedures Risk assessments Risk limits Audit processes Systems Soft Side Risk awareness People Skills Integrity Incentives Culture & values Trust & communication

15. Filename 14 Case study: New capital markets business Traders hired from foreign bank Aggressive business and growth targets Background2-Year ERM Program Established risk policies and systems Instilled risk culture Survived “Kidder” disaster Captured 25% market share with zero policy violations Recognized as best practice

16. Filename 15 Credit Risk Management Expected Loss Anticipated average loss rate Cost of doing business, cover through pricing and provisioning EL = f(credit quality, collateral, structure) Economic Capital Covers catastrophic losses Risk inherent in business, cover through capital allocation and adequacy EC = f(credit quality, collateral, structure, industry sector, maturity, credit rating) Catastrophic Loss Protection Expected Loss (EL) Average Loss Rate Economic Capital (EC) Economic Capital Expected Loss Time Loss Rate ($) Frequent Low Losses Infrequent Catastrophic Losses

17. Filename 16 Market Risk Management Nonlinear Products ProductBalance Mortgage Deposits :  Value vs  Rate -300 bp +300 bp ……  Value  Rate      6 mo30 yr10 yr Structural Position Cash Flow  Rate Time shift twist Change in Term Structure – ILLUSTRATIVE – Distribution Change in value = Simulation Step 1: Analyze sensitivity of asset and liability value to changes in interest rates Step 2: Simulate changes in term structure of interest rates Step 3: Recalculate value of assets and liabilities (repeatedly) Step 4: Read EC from distribution of changes in AL values 9 bps EC

18. Filename 17 Risk Metrics Risk Event Log Event Loss Root Causes Controls Needed Education New associates Management Business/Operational processes Best practices Lessons learned Goal MAP Actual Loss Experience 85% Decline Operational Risk Management

19. Filename 18 Economic capital as common currency Credit Risk Earnings volatility due to variation in credit losses Market Risk Earnings volatility due to market price movements Operational Risk Earnings volatility due to changes in operating economics (e.g. volume, margins or costs) or one-off events Credit Risk Market Risk Operational Risk Probability Change in Value Enterprise-wide Risk

20. Filename 19 Expenses - Revenue Equity  - Losses M&A New Business Risk Management by Silos (5, 6) Value creation through ERM 4.Risk oversight costs 5.Insurance/hedging expense 6.Credit, market operational write-offs 7.Capital management 8.Risk transparency 9.New business development 10. M&A/Diversification strategy 1.Risk-based pricing 2.Target customer selection 3.Relationship management Risk Management Impact Integrated risk management (4–7) Growth ROE Shareholder Value Enterprise risk management (1-10)

21. Filename 20 Calculate ROECalculate Pricing Exposure$100 mm Margin2.50% Revenue$2.5 mm$2.2 mm Risk Losses Expense Pre-Tax Net Income$1.0 mm$0.7 mm Tax Net Income$0.6 mm$0.4 mm Economic Capital$2.0 mm RAROC20% Measuring profitability and pricing 2.20% 30%

22. Filename 21   Return –Pay cashflows or insurance premium –Include transaction and ongoing management costs –Reduce Economic Capital ‘benefit’   Economic Capital –Reduce Economic Capital held for risk –Increase Economic Capital counterparty exposure –Increase operating risk Economic Capital  Return  Economic Capital Ceded RAROC = Rationalized risk transfer Common Cost/Benefit Framework Different Structures Derivatives Structured Finance Insurance

23. Filename 22 Case study: $1 trillion of assets under management Private company Decentralized business culture Background3-Year ERM Program Organized Global Risk Forum Implemented annual Global Risk Review Built loss/event tracking system Developed ERM framework Implemented intranet-based Global Risk MIS Experienced 30% reduction in loss ratio

24. Filename 23  The business case for ERM  Lessons learned and best practices  ERM going forward – 10 Predictions Discussion outline

25. Filename 24 1. ERM will become the industry standard 2. CROs prevalent in risk-intensive companies 3. Audit committees will evolve into risk committees 4. Economic capital in; VaR out 5. Risk transfer executed at enterprise level 6. Advanced technologies key to advancement 7. A measurement standard will emerge for operational risk 8. Mark-to-market accounting becomes standard 9. Risk becomes part of corporate and college programs 10. Salary gap among risk professionals continues to widen Ten Predictions

26. Filename 25 James Lam’s contact information  Phone: 781-772-1961  Email: jameslam@comcast.com Thank you