Joseph V. Rizzi June 15, 2011 Setting Risk Appetite in the New Regulatory Environment Linking Strategy, Risk and Capital Structure © The views expressed are the author’s, and do not reflect those of CapGen Financial RISK MINDS USA

2 Risk Appetite 2 Introduction 1 Capital Structure 3 Conclusions 4

1. INTRODUCTION 3

Introduction 4 Need to incorporate capital structure and risk considerations as an input versus consequence of strategy Capital as cost of risk Return as cost of capital Risk as cost of return Risk appetite links strategy, risk and capital –represents total risk exposure an organization is willing (and capable?) to accept and retain in pursuit of its strategy (Risk Appetite as a Process… … Not a Number)

Introduction (cont) (Once set… 5 Return Opportunities Governance VolatilityLiquidity Strategic Capital Budgeting (CEO) Correlations Risk Management (CRO) Risk Appetite Capabilities External Stakeholders Shareholders Risk/Return Regulators Performance Capital Structure CFO Rating Agencies …Risk appetite is continuously monitored and revised)

Introduction (cont) CAPGEN FINANCIAL 6 Governance Monitoring and Rebalancing Investment Strategy And Risk Appetite Performance (Asymmetric information) (Governance Puzzle: How to resist excessive risk …taking in benign markets)

2. RISK APPETITE 7

8 (Return on equity value illusion… …Confusing key performance Indicators with value drivers)

Implications of Risk Appetite Charges 9 (Not all Risk is the Same… Return EF Risk Capital Requirement Efficient Frontier (Beta) C A B …Cost of Risk is Capital) A – Current B – Target D – C = Capital Need to Support Target EF = Increased Risk Appetite D Rf

10 (High Returns Evidence of Skill…… … Or Extreme Risk Taking?)

Problem – Procyclical Risk Appetite 11 Low High Bull Bear Strong Capital Weak Market State Risk 2003/ Reinforcement Budgets and Bonuses - KillerBs hard to recognize risk if you are paid not to do so Preoccupation with Growth – Barclays? Herding … and vary over time depending on wealth) Risk Appetite (Risk Appetite Changes are Prone to Behavior Bias and Drift…

3. CAPITAL STRUCTURE 12

Capital Structure – Integration of Capital and Risk Management 13 Mix of securities (Capital Structure) and Risk Management Products Capital structure optimization is the purpose of risk management – 2 sides of same coin Risk management is capital structure in disguise Risk management as synthetic or substitute equity Approaches Risk transfer transfer (Cause) Risk Finance (Effect) Integration of corporate finance and risk management Cost/Benefit analysis regarding use of risk management or risk finance Issue is whether it is more efficient to (self insure) hold capital or to use risk management to eliminate the risk cause Risk never disappears…. ---someone is always on the other side of the trade

Stakeholder Views of Capital Differ 14 Capital focus is primarily on tangible equity capital and capital replenishment capabilities. Concern on through the cycle capital and buffers Are focused on capital discipline and allocation Capital Returns and bonuses Rating Agencies Regulators Shareholders Is the glass half full or half empty … it depends on whether you are pouring or drinking Management

Capital Guidelines S&P: RAC Very strong >15% Strong 15/≤ X <10% Adequate 10 ≤ X < 7% Moderate 7% ≤ X < 5% Weak5% ≤ X < 3% Very Weak>3% CAMELS – “C” and “A”:Classified Assets/T1 + ALL 1 - O ≤ X ≤ 25% 2 – 26%< X ≤ 40% % < X ≤ 80% % ≤ X ≤ 100% 5 - > 100 CAPGEN FINANCIAL 15 (How much is enough?… …it depends

Scenarios: To Assess Possible Strategies Against Capital Structure Robustness 16 Financial policy implications: The upside (U) and base (B) cases generate excess capital which points toward shareholder distributions The downturn (D) scenario suggests possible changes in risk appetite and the development of appropriate contingency plans to maintain ratios, sell assets and raise capital. Forward looking Core Tier 1 development under alternative scenarios U B D T Core Tier 1 Ratio Return Capital Raise/release Capital Probably May be Unlikely May be Probably (Can I survive and tolerate….. …the worst plausible outcome?) (Stress testing)

17 Decisions at Risk (DAR) Control Framework (Who decides… …And how do they decide?)

Elements of Strategy Based Capital Structure Management Choice of Markets with Attractive economics in which the organization enjoys a competitive advantage Risk the organization is willing and able to accept in pursuit of its strategy Risks underwritten and retained Capital relative to Ratings Agencies, Regulators and peers Actual Capital Return capital to shareholders when actual capital exceeds need, or raise capital when exceeds actual capital Allocation to business units based on an economic capital determination 18 (Risk and capital as inputs into strategic planning….) (…and not just consequences) Strategy Risk Appetite Risk Assessment Capital Need and Capital Assessment Capital Plan Capital Allocation

4. CONCLUSION 19

Conclusion Risk is not volatility Beware procyclical risk appetite Set too high in good times Reduced during bad times Avoid just-in-time capital structures Wealth dependent risk appetite is the primary determinant of tipping points with leverage as an amplier 20 Manage risk but…… …. live with uncertainty