Despite all the hot air coming out of Washington on the need to bolster the renewable energy sector, much of the recent investment in American wind technology and wind farms stems from places like Japan, China, and Europe. New wind energy projects, it seems, are having difficulty locating funding and gaining traction in the U.S. With an unemployment rate hovering at ten percent, it’s a wonder that a sector with such promise for growth and job creation has to go overseas to get a helping hand. What gives? Three elements stand out: frozen credit lines, regulatory and legislative uncertainty, and risk aversion to new projects.


Illiquidity
It’s no secret that small and medium businesses, which make up half of the nation’s workforce and create the most new jobs, are having difficulty getting loans from banks to invest in new infrastructure, more labor, and new research and technology. Banks are holding their cards close for now, but it’s not as if the finance sector is holding out on the energy sector specifically; the same holds true no matter which industry these mid-size companies work within.

Nevertheless, according to the Union of Concerned Scientists (UCS), hundreds of billions of dollars in new capital investment and 300,000 new jobs could be created with the enforcement of a Renewable Energy Standard (RES). UCS reports that in 2007 and 2008, “more wind power was installed in the United States than in the previous 20 years combined, representing a $27 billion investment. More than 70 wind turbine component manufacturing facilities opened, expanded, or were announced. Moreover, according to their respective trade associations, the U.S. wind industry employed 85,000 people in 2008, up 35,000 from 2007.” Despite these arguments, strong winds behind this sector in the U.S. are coming from foreign rather than from Washington or American banks.

Billions of investment dollars are floating around, yet someone like Tom Carnahan of Missouri could not get a single American bank to invest in his $240 million, 150-megawatt wind farm project. Instead, European and Japanese banks stepped up to the plate. In October, Renewable Energy Group and Cielo Wind Power announced a joint venture agreement with the Chinese Shenyang Power Group to construct a 600 megawatt wind farm in Texas. On November 6th, AES Corporation announced that China Investment Corporation (CIC) was purchasing a fifteen percent stake in the company for $1.58 billion. Moreover, a recent report by the Investigative Reporting Workshop finds that 84 percent of $1.05 billion ($849 million) in energy grants have gone to foreign wind companies, with Spanish firm Iberdrola S.A. receiving the bulk of the funds. (Iberdrola employs about 800 people in the U.S.).

(Investigative Reporting Workshop)

The Obama Administration allocated about $80 billion of its economic recovery act to stimulate the renewable energy sector. According to the Department of Energy, as of November nearly $17 billion has been authorized for allocation to companies in the renewable energy sector. Of that, $10.6 billion has been awarded, and of this amount, a mere $348 million has been spent. According to the DOE, of the over 130 projects awarded funds, only three relate directly to wind energy, and even then these projects focus on research and technology rather than manufacturing.

Wind power, one part of a multifaceted energy generation future, shows no sign of slowing down—indeed the sector is growing rapidly. Illiquidity, unfortunately, is putting the brakes on its promising future. Despite the known risks (below), banks should ease up and start doling out cash for these hungry wind projects.


Regulatory Uncertainty
Uncertainty in Washington toward climate and energy policy has put the brakes on any major investments in renewable and new energy technologies. Investors are waiting to hear from Congress which way tax breaks will lean, which industries will be saddled with more stringent regulations, and so forth. “The process of passing climate change legislation that would explicitly encourage investment in low-carbon and alternative energy production has stalled in the Senate, amid opposition from Republicans as well as Democrats from coal and agricultural states,” says the Financial Times. The ball is very much in Obama’s court.

Or is it? Barron’s reports that three sectors of the economy look promising for the next six to twelve months: technology, health and energy. The hullabaloo surrounding potential health care reform at the federal level does not appear to dissuade investors in that industry. Yet debate in Washington, Brussels and Copenhagen about climate change legislation at domestic and international levels seems to instill a sense of “wait and see” amongst alternative energy investors. Considering the broad diversity of the energy sector, however, such stall tactics are possible. Oil, natural gas and coal markets are rather more predictable than untested carbon trading schemes and alternative energy investment sectors, thus providing an outlet for energy investment funds that might otherwise sit idle.

Meanwhile, local governments like those of Maryland, Virginia, and Delaware aren’t waiting on Washington, choosing instead to team-up to incentivize investment in offshore wind development in the Mid-Atlantic. For now, though, state and regional efforts appear to have a minimal effect on overall wind project investment patterns.


Risk Aversion
Perhaps the biggest obstacle—or obstacles—to getting wind projects up and running lie in the difficulty of surmounting and mitigating the myriad of risks associated with this wind energy. A number of financial, social and political risks immediately spring to mind:

• windmills are unsightly;
  
• windmills maim and kill birds while underwater transmission lines disrupt sea life;
• wind is not cost-effective when compared to other energy sources (e.g., natural gas);
• wind farm construction is cost-prohibitive (esp. when it comes to constructing transmission lines);
• wind farms lower nearby property values;
• wind energy is inconsistent (i.e., dependent on the weather);
• regulatory permits are difficult to obtain

Yet these are not insurmountable hurdles. Many claim, for instance, that offshore windmills will be unsightly and will ruin pristine ocean views. But of the proposed offshore wind farm in Maryland, “on the clearest of all days ... [the windmills] may appear as a slight toothpick on the horizon”—hardly a landscaping disaster. And in regards to avian mortality rates, it appears that more birds are killed by cars, birds running into windows, transmission lines, feral cats and a whole host of other sources than are slain by wind turbines. And a new study by Lawrence Berkeley National Laboratory finds that “proximity to wind energy facilities does not have a pervasive or widespread adverse effect on the property values of nearby homes.” And while wind energy is not a constant force, intermittency problems can be mitigated by mixing other energy resources into the grid to compensate for non-breezy days. Nearby hydropower turbines could be opened up, for instance, when the wind dies down.

Yes, it is true billionaire T. Boone Pickens abandoned a plan to build the world’s largest wind farm in Texas when natural gas prices dropped. Likewise the lack of transmission infrastructure was problematic (in the U.S., the wind blows hardest in the most remote places, including offshore). But it’s also true that Pickens didn’t abandon investing in wind altogether, and big companies like GE Energy and Iberdrola continue to invest in wind energy technology and infrastructure in the U.S. and worldwide. The joint Texas-Chinese venture mentioned above also lends to the idea that funding wind projects is an investment that is sure to pay off.

So, yes, there are many risks, but none seem to be particularly or individually dissuasive to wind energy investing. Taken as a whole, however, the list of risks is formidable. (But is this a sentiment based more in psychology than reality?)


For now…
For now though, it appears we will have to wait for legislative initiatives coming post-Copenhagen before a surge in wind energy investment materializes in the U.S. Yet even the slightest breezes off the mid-Atlantic coast, in California, Missouri and Texas indicate the winds are a-changin’. Senator Charles Schumer, for one, has called for a halt to the deal between REG, Cielo and Shenyang, claiming the money received from the government’s stimulus plan for manufacturing wind turbines should stay in the U.S. This could be a shot over the bow that Washington is getting ready to throw its weight behind this burgeoning power sector.

Readers: what other reasons and risks are there for a slow embrace of wind energy investment?

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Posted by Shaun Randol at 10:59 AM 1 comments

And on this cold winter day, some thoughts on Liquidity Risk, a matter of increasing interest in the market. Or so they tell me. Probably so at least till the current round of batten-the-hatches is in history.

The truth of the matter is that Liquidity Risk remains the least developed of the Risk Management disciplines…and I don’t really care for the debate on whether Liquidity is more important than profitability or the other way around.

• We rarely talk about Liquidity Risk except in crisis situations (and the immediate aftermath) by when of course it is too late
• There is little or no common language or dimensions around Liquidity, both of the Funding type and of the Trading/Transactional type
• Liquidity projections and exercises typically continue to focus on ‘contractual maturities’ of assets and liabilities instead of adding or superimposing views based on ‘behavioral-maturities’ and ‘stress-maturities’
• Models continue to assume that the markets fully absorb all required trades with unchanged small spreads, whereas we know for fact that at the margin there is limiting absorption of trades and that spreads can widen significantly, and that in crisis situations the absence of liquidity may go well beyond just a spread-widening issue to a complete lack of liquidity i.e. Liquidity can be binary – either there, or not at all

The perception of Liquidity, as we know, is as important as the reality of liquidity. And systemic risk is significantly about liquidity. And I argue that Liquidity Risk may well be the silo-breaker between different risk types – is it not true that when Liquidity disappears, Credit Risk and Market Risk are the same thing?

I like stress-testing exercises that include strong considerations of Liquidity crisis, whether at the level of the specific institution or the market as a whole. I like considerations of cumulative outflows, and varying defeasance assumptions (holding periods) and I like the LVAR focus on widening spreads. What I am still missing is a holistic approach to Liquidity Risk in the risk community, clear language and dimensions and metrics, explicit recognition of the role of committed liquidity facilities, and of course regulatory recognition of Liquidity in the context of systemic risk and leverage and capital adequacy

Thoughts?

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Posted by Jaidev Iyer, MD, GARP at 3:43 PM 0 comments

There has been much debate about when the government’s investment in the banking industry should end. I told someone recently that this reminds me of a patient being prescribed a 5-day course of antibiotics. After two days, she feels better and wants to know if she can stop taking the medicine now? The answer of course is NO, you must complete the course. The government seems to be at the same stage with the banking industry – but do we really know what the best course is or should be and when does this phase end?

While there is still uncertainty about the economy, it is becoming widely acknowledged that a divestiture plan needs to be put in place sooner than later, and is probably best executed over time to avoid negative market impact. Some progress appears to have been made in policy and practice reform; but the markets are not totally comfortable that proper risk management procedures have been implemented – I believe for example that stress testing could be dramatically improved with more robust scenario analysis; risk management organizations still appear to need some refurbishing; and not least, I am not sure we have done all the Training we need to do in the market across risk-takers and risk-managers, from Board Members to executives to analysts and everyone in between. It also seems counterintuitive for the government to pull out while various proposals for financial regulation are still pending. In many ways it seems continued Government investment makes the debate for reform easier – we need to protect the tax-payers. And would confidence not get totally destroyed if soon after a complete Government pull-out, there was need for them to come back in again.

The counter argument of course is that from a risk perspective, the issue is of the Government as regulator. Ergo, the role of Government as owner is irrelevant; some may even argue the ownership stake is a needless conflict and distraction. And shouldn’t the Government and the taxpayer take the profits off the table? (note though that the large profit is on paper!). Regardless of its ownership stake, the Government retains full rights and responsibilities as regulator and we should all expect best risk practices and governance across the financial industry and at TARP companies specifically. And taxpayers are better served by keeping them out of risky businesses, and it is time to let private shareholders back fully into that area as voluntary risk-takers (of course, and unfortunately, we operated under that assumption long before the financial crisis took hold and look where we are now).

It seems clear Government support of the financial industry at the height of the crisis instilled confidence in the markets and, perhaps, helped avert a greater economic downturn. The real question now seems to be can sustained economic growth be achieved when the major risk-taking enterprises operate in the shadow of Government ownership.

What do you think?

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Posted by Jaidev Iyer, MD, GARP at 1:14 PM 2 comments

Investors benefit from having access to meaningful information about the corporate governance practices of companies – including information related to risk management practices. Reflecting this, on July 10, 2009, the U.S. Securities and Exchange Commission published several proposals to amend existing corporate governance rules (S7-13-09.)

Some of the proposed amendments focus on the board’s involvement in the company's risk management processes and apply to both financial and non-financial corporations. Through various forms of disclosure, corporate boards and corporations will have to provide important information to investors about the relationship between the board and senior management relating to managing those material risks that can impact the earnings and profitability of the corporation. These proposed disclosures touch upon many aspects of the overall structure of the board's risk management function, including:

• Whether the board implements and manages its risk management function through the board as a whole or through a committee
• Whether the persons who oversee risk management report directly to the board as a whole or to a committee (and if so, which committee)
• Whether and how the board, or board committee, monitors risk

Before final adoption, the SEC has requested comments on specific areas that affect the risk governance of corporations. The first area relates to potential negative effects detailed risk management disclosures may have on the competitive and business position of individual companies. The second addresses the differences in risk management sophistication between corporations of different size. It is likely the small SEC reporting companies will be excluded from detailed disclosure. The final area relates to disseminating risk management related disclosures outside the proxy and in annual and quarterly reports to provide a wider reception and easier access to these policies and practices.

While much of the press has focused its attention on the amendments to executive compensation disclosures and on the increased proxy access afforded shareholders - both political hot button topics - there has been less attention and reporting on the impact these proposed rules could have on future corporate risk management practices (Sarah N. Lynch, SEC Plan Aims to Better Foretell Risks, July 2, 2009, The Wall Street Journal, page C3; Jeffrey McCracken and Kara Scannell, Fight Brews as Proxy Access Nears, The Wall Street Journal, page C1). If and when these proposals are enacted sometime in 2010, they will put increased focus on the importance of risk management in the evaluation of business risk, the different forms of corporate risk governance structures that exist, and the critical place of risk management at the board level.

For some time, the need for this increased focus has become evident to us from our conversations with investors, risk professionals, corporate executives, and board members. While we will remain agnostic on the need for additional regulation, we fully support the conceptual and practical importance of this information and recognize investors’ – and risk managers’ – need for it.

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Posted by William May & Peter Went, GARP Research Center at 3:50 PM 0 comments

Earlier this year the Basel Committee on Banking Supervision issued the paper Principles for sound stress testing practices and supervision. For full text of May 2009 final paper, Click Here.

“Stress Testing” has obviously gotten a lot of press this year; but what does it really mean?

What is commonly known as “Stress testing” could also be defined in terms of:

• Sensitivity analysis: the identification of how risky portfolios respond to shifts in relevant economic variables or underlying risk parameters or;
• Scenario Analysis: an assessment of the resilience of a portfolio, financial institution or the financial system as a whole in this age of systemic-risk-awareness to severe but plausible scenarios.

Sensitivity analysis has historically been the methodology used to quantify portfolio risk. It is however, a limited approach that might best be described as one-dimensional.

Scenario analysis is a dynamic and systematic process for analyzing possible future events by considering various alternative outcomes. It is designed to allow improved decision-making, invoking consideration of negative outcomes and implications on business strategy, franchise, risks, and rewards.

Scenario Analysis is geared towards enabling decision making on risk appetite versus risk levels, asset allocation, client and product segmentation strategies, implicit and explicit diversification tactics, and insurance/hedge considerations; institutions can also compute scenario-weighted expected returns, and improve their knowledge of the unknown i.e. potential unexpected losses and economic/regulatory capital adequacy. Scenario analysis can also be used to illuminate wild cards and “black swans”.

Scenario based stress testing defines a scenario and uses specific algorithms (ideally full revaluations) to determine the expected impact on a portfolio’s return should such a scenario occur.

There are typically three types of scenarios:

• Extreme Event: Hypothesize the portfolio (or enterprise) returns given the recurrence of a historical event. Current positions/risk exposures are combined with historical factor returns.
• Risk Factor Shock: Shock any factor in the chosen risk model by a user-specified amount. The factor exposures remain unchanged, while a covariance matrix is used to adjust the factor returns based on their correlation with the shocked factor.
• External Factor Shock: Instead of a risk factor, shock any index, macro-economic series (e.g., oil prices), or custom series (e.g., exchange rates). Using regression analysis, new factor returns are estimated as a result of the shock.

A mathematical approach to scenario analysis looks to estimate expected cash flows under various situations. The expected cash flows used to value risky assets can represent a probability-weighted average of cash flows under all possible scenarios, or, they can simply be the cash flows under a single most likely scenario. In either case the scenario based cash flows will be different from expectations:

For example, instead of doing financial projections on a "best estimate" basis, a company may do Stress Testing, against, say, the following distinct scenarios

• What happens if the equity market crashes by more than x% this year?
• What if interest rates go up at least y%?
• What if oil prices rise by 300%?
• What if half the instruments in the portfolio terminate their contacts in the 5th year?

One good definition of ‘risk’ is the extent to which actual outcomes may be different from what is expected. The creation of a robust stress testing program that includes scenario analysis will go a long way towards minimizing future surprises.

Please keep the comments coming. I will look to summarize the discussion in my next post a week or so from now. I also want to address the use of stress-testing in the real world (not just running some numbers in a vacuum that nobody can relate to!)

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Posted by Jaidev Iyer, MD, GARP at 11:55 AM 7 comments

Risk Measurement has become a whole new soul-search. In the late 1980s, financial markets began a transition into Risk Factor Sensitivities and Potential Loss Amount estimations, as alternatives to talking about Risk in notional amounts of exposure to one instrument or another. Senior management said well what does all that mean? How much could we lose?

And then came VaR!

And now a world with only two types of people – loud VaR-haters and very quiet and docile VaR lovers! Let me make my position crystal-clear: Some of my friends love VaR, some of my friends hate VaR. I agree with my friends.

Strengths of VaR

• Simple, with intuitive explanations as rough measure of how much a firm could lose e.g.
• VaR (95% confidence, 1-day): actual losses should exceed this only once in 20 days
• VaR (99%, 1-day horizon) : actual losses should only exceed this once in 100 days
• Broad application across instruments and classes; relatively easy to calculate and to understand in terms of dollars, additive, like all dollars fungible. Life was good!

VaR Assumptions, weaknesses, and misunderstandings

• Tendency to assume Normal distributions, and thus low probability of ‘extremes’. Reality is that financial returns are more skewed than normality suggests - excessively high and low return days are far more common than would be expected;
• There is often an assumption that history repeats itself, or, the past can predict the future;
• Now that we all know this, let me say it boldly: VaR does NOT describe the worst case loss (the problem of the little-knowledge-but-very-dangerous-manager). All it estimates is the worst case for a specified probability. In fact, an interpretation of VaR is that LOSSES WILL EXCEED VaR, with probability equal to (1 – VaR confidence level);
• VaR does not describe the losses in the extreme left “tail” of the distribution. (Conditional VaR can help to measure “the expected loss, given the loss exceeds VaR”)
• VaR does not distinguish portfolio liquidity; very different portfolios can have the same VaR i.e. VaR is a static measure of risk and does not capture the dynamics of possible losses if a portfolio were to be unwound;
• Computations can be very complex; there is model risk; precision should not be assumed;
• VaR-constrained traders can game the system i.e. maximize risk subject to keeping VaR steady. The game repeats itself at several levels; and can trigger an avalanche, because everyone misjudges risk in the same way.

Risk professionals will always use the caveats listed above, and warn against assuming VaR as the worst-case, or even the advisability of relying on a simple number that is statistically generated. With your continued involvement and comments, let us talk some more about VaR, Models, Stress-Tests…

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Posted by Jaidev Iyer, MD, GARP at 9:47 AM 21 comments

Recent crises have highlighted many failures in managing risk, including at the Board, senior management, regulator, and rating agency levels. But Risk Management failed too…

In measuring risk

• Risk models misused or specified incorrectly
• Lack of understanding or attention to issues of liquidity, correlation
• Ineffective use of stress testing

In mitigating risk

• Hedges viewed in isolation
• Concentrations of risk ignored, not understood
• What-if scenarios and stress-testing inadequate

(And almost above all) in communicating risk

• Not being proactive enough, just reactive
• Not ‘managing’ Risk as much as playing to some nebulous ‘support’ and ‘control’ roles
• Not ensuring an audience (exacerbated by the CRO not being truly in the C-suite)

As discussed under “The CRO of Tomorrow” the fundamental role of the risk manager is to oversee and continually test for “compatibilities” of a firm’s risk-taking with:

• Its risk appetite (contextualized for the legal-regulatory environment)
• Products and markets through which risk is taken
• Returns for taking such risks

As a primer, the fundamental questions for Risk Management should be:

• Do we know what bet/s we are making?
• Are our bets those that we can afford to make?
• Do limits reflect business strategy, risk-tolerance & appetite, our markets?
• Are positions within established limits?
• Is the risk/reward ratio appropriate?
• Is our risk-taking on purpose: do we know the unusual, the unintended, and the unacceptable?
• Do the right people discuss the risks…and watch over them?

The financial meltdown shows that among the many contributing failures, Risk Management didn’t sufficiently manage risk. Were Risk Managers constrained by the C-suite who wouldn’t hear the warnings, or were Risk Managers not answering (not able to answer) the Fundamental Questions? Either way, Risk Management has some soul-searching to do.

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Posted by Jaidev Iyer, MD, GARP at 9:30 AM 17 comments

On Tuesday (July 28) the Commodity Futures Trading Commission (CFTC) announced the agency is considering setting limits on speculative trading on energy futures.

Topping out at $147/barrel, 2008 saw record oil prices, and many blame speculators for the spikes. Consumers and businesses suffered when prices for gasoline soared to above $4/gallon. Now, it seems, the blame-game has a new head of steam. Testifying before the CFTC, Representative Bart Stupak (MI) said, “The crises in the oil and financial sectors have shown us what happens when speculators control our markets. Less than a year ago, the CFTC was denying excessive speculation was contributing to high energy costs. Under new leadership, the Commission acknowledges it is a problem and is looking for ways to address it. This progress is good news for consumers, and I remain committed to working with the CFTC and the Obama Administration to create a strong regulatory system that protects American consumers.”

Stupak notes that although prices have come down, speculation is still driving the cost of oil. According to his testimony, domestic oil supplies are at a 20-year high while oil demand is at a ten-year low, yet oil is still trading at $70/bbl. “Gas prices, home heating oil, natural gas and other energy prices should be based on supply and demand,” Stupak said. “Not speculation by price manipulators.”

It appears with a new Administration in the White House the CFTC is changing its tune. Under the Bush administration the agency “found that fundamental supply and demand factors provide the best explanation for the recent crude oil price increases.” With Obama at the helm, however, the tremendous price swings will be blamed on Wall Street (the report is due next month).

What about this 180 degree turn? In a statement, Bart Chilton, Commissioner of the CFTC, admitted, “Quite candidly, last year the agency did not perform its due diligence function with as much zeal as it should have, and I am pleased to see that we’re finally on the right road.”

Much of the debate revolves around the closure of the so-called “Enron Loophole,” an exemption granted by the CFTC to Enron’s now defunct online trading platform, Enron Online. Even though Enron Online is dead and gone, the exemption for the online trading platform lives on, most notably for the Intercontinental Exchange (ICE). NYMEX, for its part, is advocating for the same regulation of online exchanges by which physical floors are governed.

Not all agree closing this loophole is the answer. Blaming the Enron Loophole on sky-high oil prices is a red herring, says Platts’ John Kingston. Congressional attempts at closing it call for stricter regulation only on individual contracts serving “significant price discovery” functions on online platforms. “The biggest target right now is ICE's financial Henry Hub swap contract,” writes Kingston. “So far, it seems that will be the only one that will fit the definition of a ‘significant price discovery’ contract per a loose set of prerequisites (volume, arbitrage, whether the exempt contract can influence the NYMEX contract price, etc.) proposed by the CFTC and adopted in the government's language.” In other words, the finger-pointing here is merely a political scapegoat.

Among the speculator defenders is Jon Birger of Fortune, who argues speculators “cannot have a material impact on the price if they’re never taking physical delivery of the commodity.” Still, anti-speculation advocates are no lightweights. A broad coalition of businesses including airlines and storage and transportation companies are behind Stop Oil Speculation Now, a lobby aimed at reining in oil speculation in the markets.

“We are in the business, however, of ensuring that actions of market participants, individually or as a group, aren’t having unintended or uneconomic effects on our markets or on prices,” says Chilton. “A delicate balancing act? Yes, but that’s what we get paid for—that’s our job.” Whither energy speculation regulation? Stay tuned…

US Rep Stupak’s Statement on Energy Speculation

http://www.youtube.com/watch?v=9y4DBzKeSJo

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Posted by Shaun Randol at 1:18 PM 1 comments

The Chief Risk Officer is the individual (and leader of the function) that defines the firm’s risk appetite and tolerance, and helps maintain operations within the dimensions of such appetite.

The CRO is talented and experienced of course. But critically, she (read interchangeably with ‘he’) understands that a pro-active approach with a commitment to value-added perspective creates a leadership role for Risk Management in the firm and a ‘seat at the table’. We have to say adieu to the days of Risk being a ‘control’ or a ‘support’ function or a ‘let’s just keep the Regulators happy’ strategy – that can only happen if Risk steps up to the plate.

1. Vital to ensuring the CRO’s inclusion at the governance level is that she

a) Defines and dimensions the firm’s risk appetite and tolerance/s, and creates the mechanisms to articulate and communicate this across the firm.

b) Provides strategic perspective with direct lines of communication to the Board and the CEO on what’s going on in markets, businesses and the legal-regulatory environment (and what is on the horizon) that impacts risk levels and the risk appetite of the firm holistically. Specifically, she relates the growth and business of a firm to the evolution of its risk appetite.

c) Stays on point with the risk function, meaning she does not get bogged down in other board business! She is simply the lead advocate for responsible risk management across the firm.

2. Tactically, as the manager of an independent and objective risk organization of the firm, the CRO implements its risk appetite and tolerance through an infrastructure of people, technology and dynamic communications across all stakeholders. The fundamental role of the risk manager is to oversee and continually test for “compatibilities” of a firms risk-taking with

i. Its risk appetite (contextualized for the legal-regulatory environment)

ii. Products and markets through which risk is taken

iii. Returns for taking such risks

The CRO lays down the principles, policies and practices that benchmark the business-as-usual and the “unusual, unintended, and unacceptable” risk-taking in the firm. She simultaneously implements measurement and management practices that ensure reconciliation with the top.

3. As custodian of risk appetite, the CRO dynamically redeploys the Economic Capital of the firm(it is time we got the CFOs out of this role) among various competing business units process of doing so computes and compares risk-adjusted performances across the firm using RAROC, RORAC, RORC, NIACC or any of such measures as long as consistently applied (anything but

ROE as long as C figures in it, please !!)

Simple? No

Critical for survival? Maybe

At least a key differentiator with some promise of resilience? Yes

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Posted by Jaidev Iyer, MD, GARP at 9:28 AM 5 comments

In recent weeks, several banks have revamped their Boards. Some new Directors even have the word “risk” feature in parts of their Resumes. That’s very nice. Now what?

The current crisis has revealed that many banks’ boards (and executive management) failed in their risk oversight responsibilities. Not only do many lack board-level risk committees, but those that have risk committees do not meet regularly nor do they have the functional feedback necessary for meaningful governance.

It is time Boards of Directors become pro-actively committed to risk management. It is time Regulators focus keenly on risk governance in their analysis of the health of banks. And it is time investors and shareholders and customers differentiate banks on this basis.

So, with so many stakeholders looking over its shoulders, what’s a Board to do?

• Start with a holistic approach. Align practice with strategic objectives by issuing a well developed top down statement of risk appetite. It is high time we moved away from cliché in this regard. Risk appetite need not be all quantitative. And it is unlikely to be static. And it is always relative. Boards must not only understand current business risks but assess the changing marketplace, identify new risks, monitor the business and be prepared to respond rapidly.

• Transparency is crucial. Set the trend by actively disclosing risk appetite and tolerance to all stakeholders for critique and comment.

• Mandatorily disclose the available risk architecture that reconciles bottom-up business and risk management practices and output, with target appetite, tolerance, and results.

• ‘Stakeholders’ necessarily includes the internal organization. Are all employees aware of the statement of risk appetite, can they find it, have they read it? Does the statement of risk appetite describe what is expected insofar as the unusual, the unintended, and the unacceptable? Does the firm have a meaningful way to aggregate, understand, and respond to risk? Are all staff able to articulate the parameters of their own risk responsibilities?

• Define a meaningful relationship between the risk function and the Board. Equip and empower the CRO and the risk management organization, with clarity in culture, role, and accountabilities.

More on this soon

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Posted by Jaidev Iyer, MD, GARP at 9:27 AM 0 comments

Compensation has been brought to task as a major contributor to the global financial crisis. Chasing short-term positive results, failing to implement a robust internal control environment, not fully understanding the risks of financial instruments being sold, or, in many cases not caring, simply to pad personal compensation resulted in a major disconnect between company and shareholder interests and the interests of the individual whose contracts provided for incentives tied to profit making. Government initiated “thinking” such as that set out by the Sir Warren in his recent report issued in the United Kingdom , many in the United States Congress and various other country legislative bodies suggests compensation should be more highly controlled, directly or indirectly by the government.

The problem with dealing with compensation and incentives is obvious, it goes against most all notions of capitalism and free markets, and having the government involved in setting compensation policy is generally not considered a positive move in the right direction.

But the way forward is not at all clear. If compensation controls are implemented, or “suggestions” made by regulators that cannot go ignored, e.g., governments providing disincentives through taxation policies mitigating against personal wealth creation, one result is that individuals will simply forum shop, moving to another location to practice their craft. Of even greater concern is that a wrong policy or incentive structure will stifle innovation and initiative will diminish - not a good thing. Regulators have a tendency to overreact in times of stress, and may not necessarily look at an issue as volatile and complex as compensation in a forward thinking and objective manner.

An approach to this issue would be for companies to proactively establish compensation policies tied to long-term incentives and other risk-based compensation methodologies. The financial industry taking a proactive approach would keep governments out of the highly personal compensation issue.

Questions:

1. Is there really a compensation solution that is politically viable and commercially acceptable?
2. How can compensation policies be linked to the risks a person takes?
3. Is this really much to do about nothing in that the problems we’re now dealing with were really only marginally linked to banking compensation and because it is perceived to be generous it has become an easy target?

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Posted by Rich Apostolik at 11:46 AM 6 comments

The independence of the chief risk officer (CRO)

It is imperative that a CRO be insulated from business line, or other, pressures that would cause him or her to give biased, incorrect, or incomplete information to the board. While various methods can be proposed for accomplishing this, the review suggests that the CRO should report directly to the risk committee (with an internal reporting line to the CEO), and be completely independent of the business lines. Additionally, removal of the CRO and the CRO’s compensation would be subject to approval by the board. This arrangement will provide a degree of independence for the CRO, although dual reporting responsibilities will make it difficult to prevent the CRO from being completely insulated from pressure by the CEO.

Additionally, the review was largely silent on the issue of the process for hiring the CRO. If the hiring is done by the CEO, either from internal or external candidates, some degree of the wanted independence may be lost. However, if the board is in charge of the hiring (or has approval power over the hire), current boards may not feel up to the task of rigorously evaluating the credentials of a CRO candidate and may rely heavily on senior management’s recommendations - again possibly losing a degree of the sought-after independence. Hopefully, over time, as board’s skills and confidence in risk management improve, this may become less of an issue.

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Posted by William May, Senior Analyst at 2:13 PM 2 comments

The role of the risk committee

While the specifics of committee structure should remain the responsibility of individual boards, the review’s recommendations concerning the need for a separate risk committee warrants serious consideration. Risk should be a consideration in board’s forward-looking considerations; not as a backward-looking measure - a tendency which may exist when handled under another committee, such as audit. Separating risk from other committee structures should help foster the development of a risk management-prism through which many business decisions – acquisitions, new product and market development, remuneration, etc. – can be viewed.
Having a competent risk committee, however, will require boards to critically evaluate their skill and experience needs and to consider any shortcomings when they develop recruitment and training plans. An empowered risk committee may also encounter resistance at the board level as it involves itself with issues that are typically the purview of other committees (such as compensation). The board chair will be important in this period of transition as he or she will need to lead the board forward in the process of giving the risk committee sufficient breadth of responsibility to not only advise on the development of the bank’s risk appetite but to play an active role in the creation of policies that seek to align employee behavior with it.

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Posted by William May, Senior Analyst at 9:35 AM 0 comments

On Thursday, Sir David Walker, a former chairman of Morgan Stanley International issued a report (at the behest of the UK Prime Minister) entitled “A review of corporate governance in UK banks and other financial industry entities”. This review covers a wide range of issues and offers thirty-nine recommendations in total. While many of the issues addressed in the report warrant comment, over the next few days, I will focus on three:

1. The “specialness” of banks and the primary responsibility of bank boards to shareholders
2. The role of the risk committee, and
3. The independence of the chief risk officer (CRO).

Bank “Specialness”

The special role of banks in the economic and social order introduces unique challenges for a board. As deposit holding, loan granting institutions that retain only a small fraction of the deposits entrusted to them, modern banks are inherently highly leveraged institutions for which the management of financial risk is a fundamental - as opposed to an ancillary or derivative - aspect of their business model. Through their role in trade finance and business and personal credit creation, banks are connected and interconnected in ways that other, non-bank, institutions are not. The failure, or partial failure, of a bank can have a significantly greater impact on the society and economic system in which it exists than, say, the demise of an industrial firm. The possibility of these negative public interest externalities puts significantly greater pressure on bank boards to properly steward their operations.

Despite the important role of banks, the growing pressure from some corners to charge bank boards with statutory responsibilities beyond those owed to shareholders – to include employees, depositors, and/or taxpayers - is rejected in the review. While I do understand the idea that protecting the interests of depositors, taxpayers, and other non-shareholders is an important issue, I agree with Walker that this protection must be attended to via other means and that in order to function effectively a bank board must be explicitly charged with only one master – the shareholder. How then to attend to the proper protection of depositors – and by extension in many cases – to taxpayers?

Improved risk management practices certainly can be expected to afford depositors added protection. If the actions of the board are driven by a desire to benefit shareholders, however, the achieved level of protection may be less than that desired by a depositor. In many modern economies this issue is largely handled through deposit insurance - which has the effect of shifting the ultimate risk in many cases to the taxpayers and renders the depositor as somewhat indifferent to the risk management activities of a given bank. As the discussions of how to improve the risk management of banks, both individually and systematically, advance, it may be beneficial to include in these an evaluation of deposit insurance – the rationale for it, the moral hazards and behavioral effects it introduces, and its proper pricing. Perhaps an improved risk pricing mechanism associated with either public or private deposit insurance could serve a useful purpose in aligning board actions with depositor and taxpayer objectives.

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Posted by William May, Senior Analyst at 1:18 PM 0 comments

1. Everything is standard; the burden of proof is on the institution to prove otherwise. - I have to presume that markets are in fact in favor of central counter-parties, to help mitigate credit risk and operational risk (the system does take new concentration risk). Meanwhile, ensuring that “non-standard” contracts are at least as stringently regulated as standard ones should mitigate incentive to innovate around the regulations.
2. Institutions must be asked to decompose their “products” into underlying “factors of risk exposure”.
   All exposures, however complex, can be broken down into underlying Market Factors, Terms & Conditions determining payoffs, and Time (this is Derivatives 101).This way, we will get out of the confusing product jargon. A uniform market model for breaking down risk into components means that it can be communicated and aggregated easily across institutions, and across the market as a whole.
3. A College of Regulators -While the Federal Reserve seems ready to take on the driving regulatory role, there are alternatives with unique merits. A college of regulators could have the mandate to collect and examine inventories and exposures in the market at factor, instrument, product, and player levels, and set alerts to determine how much gross and net exposure warrants attention. This would be a “heat map” of risk levels fed by regular scenario analysis and stress-testing against liquidity, correlations, market risk factor, and macro-economic considerations.
4. But empower one regulatory voice for the global dialogue -Our financial solutions seek to address issues nationally but the markets and risk are global. The US must appoint one regulator, to be its voice at the international table of regulators. A new systemic regulator is a redundancy. Having said that, the Fed (if it is the chosen one) needs some cultural transformation from the micro to the macro, and in resolving the conflict between monetary policy and supervision, and between regulation of a firm versus the market.
5. Create additional sharp focus on Liquidity - Liquidity risk remains very little understood and the least developed of all Risk-types. At the height of a crisis, Liquidity risk creates binary outcomes…here today, gone tomorrow. The Regulatory College must develop good perspective for liquidity in markets as a whole.
6. But above all, smart principle-based Regulation, please - Do recognize there are no guarantees. Smart regulation will not allow players to abdicate risk responsibility to the regulator and the politician. It will instead put the onus firmly on institutions to establish complete and transparent principles, practices, and policies. It is high time that Boards and CEOs, with their CROs, define and articulate their risk appetite (it doesn’t have to be all quantitative); and then prove they have the architecture to implement, support and manage actual risk exposure against appetite & tolerance.

Bottom-line, Regulators must

• Provide principles and incentives that each firm clearly articulates risk appetite and tolerance
• Demand disclosure across all stakeholders, including shareholder, investor, and regulator
• Create aggregate simple metrics for risk at the level of the system
• Require standards as to what firms do warehouse and trade outside of the standard systems
• Require strong independent internal risk management structures for reliable measurement, monitoring, reporting and management
• Provide disincentives to arbitrage out of standardization without curtailing ability to innovate and customize client solutions

It is not going to be easy. There is much rock and many hard places.

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Posted by Jaidev Iyer, MD, GARP at 9:26 AM 0 comments

1. Markets are always smarter than regulators.

Too much regulation spurs bad innovation. If regulation is onerous, costs of adherence are high, and firms perceive a shift in competitiveness, then expect markets (the good guys and the bad guys) to find ways to circumvent it. Also, much of the day-to-day function at Regulators is focused on magnifying-glass level examination of details; whereas the need here is to have a broader macro-perspective of how “it” all fits together, where “it” is much more than any regulatory form, any individual bank and even the banking system.

2. Are the right products regulated? In the right way?

What is a ‘standard’ derivative, in the context of the move to exchanges and clearing-houses? Standard derivatives didn’t cause the crisis at any individual institution. At a systemic level arguably they did, in the volume and liquidity sense. Complex and exotic products, not regulated because nobody has figured out how, are often the serious offenders.

3. There is as yet no way to measure the overall health, and level of systemic risk, in the market.

Ex-ante, who knows what systemic risk is. Regulators are currently unable to even pull together a comprehensive view of the market. And if we do get a market-level aggregate report, when is the light going to turn from orange to red. Some absolute level decided by the Fed? At the level of each instrument? At the change of the light, will the Fed via individual regulators go back to firms and demand action. What action? And so, are we about to see a hitherto undefined conflict between regulation of an institution versus regulation of the market as a whole?

4. National regulators do not talk to each other, not enough, not effectively

One key lesson from the recent crisis seems to be that risk and flows and financial markets are global, whereas most regulation is national and often nationalistic. This brings another central point to the discussion, a single regulator versus a committee of them.

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Posted by Jaidev Iyer, MD, GARP at 9:20 AM 2 comments

A New Regulatory Regime, and no perfect solution for a problem that is not well defined

Do not envy Tim Geithner. There is simply no chance to get it all right all at once – in form, content, and effectiveness. And the critics have it too easy. Some will call new regulations as not far reaching enough and unable to guarantee against future financial meltdowns. Others will want to preserve complete freedom of the derivatives markets and howl about the baby versus the bathwater. And all will wring hands about market constraints and cost.

Do remember that derivatives before they went toxic, were good creative ways to hedge exposures, to isolate asset allocation decisions from risk decisions, to synthetically overcome barriers to market access. Till parts of the market went rogue, and we had too much of a good thing. And, we also found out that self regulation is a myth in competitive markets in the face of “let’s make revenues Monday, manage costs on Tuesday, and oh let’s do get a Risk report on Wednesday; everybody else is doing it”.

Most will agree ‘some’ incremental regulation is needed. What it will look like, how much of it, and how effective it will be has yet to be defined. The challenge is of course in the balance – we want just the right amount to curb bad innovation, to stifle system-wide blowups, and with incentives for organizations to institutionalize solid risk management principles.

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Posted by Jaidev Iyer, MD, GARP at 11:20 AM 11 comments