World Bank Risk Management Seminar James Lam President ph: Enterprise Risk Management May 19, 2004

1 Enterprise risk management should be defined as a value added function “An integrated framework for managing credit risk, market risk, operational risk, economic capital, and risk transfer in order to maximize firm value.” Definition of ERM:

2 ERM is useful because the risks faced by companies are highly interdependent Business Risk Operational Risk Financial Risk Technology and operations outsourcing Derivatives documentation and counterparty risk FX risk in a new foreign market 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

3 The growing acceptance of ERM is driven by four key forces Corporate Disasters Enron WorldCom Adelphia Mutual Funds Industry Initiatives Treadway Report, US Turnbull Report, UK Dey Report, Canada Best Practices Banks Asset Managers Energy Firms Corporations Regulatory Actions S.E.C. Sarbanes-Oxley Basel II Enterprise Risk Management

4 While regulatory mandates are useful, don’t let the tail wag the dog Reactive Approach Proactive Approach Current state New industry standards Sarbanes- Oxley Basel II Governance Requirements Desired state (best practices or best-in-class practices) Benchmarking Gap analysis Recommendations Common themes Unique standards Sarbanes- Oxley Basel II New industry standards Governance Requirements ? ? ? ? ? CEO

5 “Not so long ago, risk managers were second-class citizens…that was before LTCM …The result has been the rise of a powerful new breed of risk manager.” Risk Magazine 3/99 “This decade's hot executive is shaping up to be the CRO.” 5/00 “As interest in enterprise risk management grows, so does the acceptance of the role of chief risk officers to manage such programs.” 5/00 “Once it sold its own power…today Duke [Energy] is a major trader and marketer… Hence Duke’s naming of a chief risk officer.” 7/7/00 “The chief risk officer has come to all kinds of companies.” 3/00 Over the past decade, CROs have gained acceptance and prominence

6 An ERM framework should encompass seven key building blocks 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

7  Inertia – absence of crisis; general resistance to change  Lack of management sponsorship or line support  Episodic initiatives with no long-term vision  Ineffective and inconsistent risk metrics and reporting  Insufficient human, systems, and data resources  Failure to clearly demonstrate “early wins” and sustainable benefits  Move too fast or too slow, without addressing change management issues CROs must overcome significant barriers to success

8 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 Automated loss accounting Developed ERM framework Implemented intranet-based Global Risk MIS Experienced significant reduction in loss ratio

9 Early adopters of ERM have reported significant and tangible benefits BenefitCompanyActual Results Market value improvementTop money center bankOutperformed S&P 500 banks by 58% Early warning of risksLarge investment bankGlobal risk limits cut by 1/3 prior to Russian crisis Loss reductionTop asset management company Loss-to-revenue ratio declined by 30% Regulatory capital reliefLarge commercial bank $1 billion regulatory capital relief Insurance cost reduction Large manufacturing company 20-25% reduction in insurance premium

10 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. Risk-based or economic reporting becomes standard 9. Risk becomes part of corporate and college programs 10. Salary gap among risk professionals continues to widen Ten predictions on the future of enterprise risk management