An overview of risk management for undergraduates at the University of Wisconsin, Eau Claire. Also includes thoughts on the credit crisis. Preseted on 11.17.09.
2. Risk Management Paradigm My Background
• Graduated from UWEC with Accounting major, 1995
• Public accounting after graduation, mostly with KPMG
CPA (currently inactive)
Two years consulting Credit Suisse on US GAAP in Zurich, Switzerland
• GMAC-RFC, subprime mortgage banking & securitization
Corporate Accounting Director, then VP Risk Management
Implemented Sarbanes-Oxley 404 in 2004, reinvented the wheel
MBA from Duke University while at GMAC
• TPG Credit, hedge fund manager in Minneapolis
Controller there since early 2006, built people, processes, systems, from
ground up
Endured 2008 financial melt down
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3. Risk Management Paradigm Agenda
I. Overview of Risk Management Paradigm
II. Financial Crisis:
− What Happened?
− Risk Managers Contribution to the Problem?
− What can be done?
III. Careers in Risk Management
IV. Further Reading
V. Summary and Recap
VI. Questions
Focus is on Financial Service Organizations (i.e., banks, hedge funds)
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4. Risk Management Paradigm I. Overview
What is Risk Management?
General Definition
Risk management is the identification, assessment, and
prioritization of risks followed by coordinated and
economical application of resources to minimize,
monitor, and control the probability and/or impact of
unfortunate events. 1
Risks can come from uncertainty in financial markets,
project failures, legal liabilities, credit risk, accidents,
natural causes and disasters as well as deliberate
attacks from an adversary.
1 Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to
Fix It" pg. 46, John Wiley & Sons, 2009
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5. Risk Management Paradigm I. Overview
What is Risk Management?
My Definition
Risk management is the identification of events that
could result in unwanted negative consequences or
economic losses and then taking steps to mitigate or
manage those events.
Ultimately risk management is planning for the unlikely
event that could cause harm.
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6. Risk Management Paradigm I. Overview (continued)
What is Risk Management?
Risk Management for Financial Services
Market Risk Credit Risk Operations Risk
Risk of loss from a
Risk of loss from the Risk of loss from a
failure of people,
value change of an borrower or counter-
processes, or
asset or liability party not meeting systems /
obligations infrastructure
Often measured via Involves forecasting Primarily qualitative at
Monte Carlo defaults and severities this point, use tools
simulations (Value at using such as “heat maps”
Risk) using historical historical data etc.
data
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8. Risk Management Paradigm I. Overview (continued)
Bank Loss Reserve Example (same concept as the flood):
Known as a “tail
event” or “black
swan”
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9. Risk Management Paradigm I. Overview (continued)
More Examples:
• GPA Risk Management
− When you take a couple difficult classes in a semester, do you look
for some easier classes to offset?
− If so then you are actively managing your GPA risk
− You might be able to manage all hard classes but why take that risk?
• Career Risk Management
− Did you join SAS just to make or friends or were you looking to build
your resume and network with employers?
• Event Risk Management
− If you needed to be in Minneapolis tomorrow at 10 AM for an
important interview, what time would you leave?
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10. Risk Management Paradigm II. Financial Crisis
US Housing Prices on the Eve of the Financial Crisis, Everyone
Assumed Values Would Always Rise
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11. Risk Management Paradigm II. Financial Crisis (continued)
The Credit Crisis: What Happened?
• After September 11, 2001 and during the subsequent
recession the US adopted a loose monetary policy (keep
America rolling, go out and shop)
Credit became cheap, underwriting standards were loosened, consumers
treated their houses as ATM’s and borrowed against the increase values,
thus increasing consumer spending
Consumer spending is roughly 70% of US GDP
• Complex investments / products were developed and sold
to investors that were based on housing and consumer
credit
Securitization led to wide dispersion of credit risk, the use of credit default
swaps and derivatives exploded, adding further dispersion of risk
These products were highly complex
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12. Risk Management Paradigm II. Financial Crisis (continued)
The Credit Crisis: What Happened?
• Memories were short: things were too good for too long
• Ultimately there was too much leverage in the financial
system / economy as credit risk was drastically
undervalued
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13. Risk Management Paradigm II. Financial Crisis (continued)
The Credit Crisis: How Did Risk
Managers Contribute to the Problem?
• Risk Managers Relied too Heavily on Historical Data
US housing prices never decreased in the past, therefore it was assumed
they would not in the future, this was a critical assumption that did not
come true
• Hubris: Risk Managers Relied too Heavily on Quantitative
Models
• Risk Managers Assumed Individual Risks were not
Correlated
Correlation goes to 1 in a crisis
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14. Risk Management Paradigm II. Financial Crisis (continued)
The Credit Crisis: How Did Risk
Managers Contribute to the Problem?
• Models Became Too Complex
Advancements in computing power resulted in incredibly complex
models, too complex for most people to fully understand
• In short: What Was Deemed Statistically Remote Actually
Happened and Nobody was Prepared for it
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15. Risk Management Paradigm II. Financial Crisis (continued)
Bad Model Assumption: Housing Prices Did Actually Fall, by a lot!
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16. Risk Management Paradigm II. Financial Crisis (continued)
The Credit Crisis: What Can Risk
Managers do Now?
• The good news: we now have a large tail event to include
in our models (the current crisis)
• Ensure proper rewards and punishments, not just rewards
– current bonus structure shares only upside
• Counter balance complexity with simplicity
“Derivatives are financial weapons of mass destruction” Warren
Buffet
• Consider model assumptions and output in the context of
what makes sense, including qualitative considerations
• Push for counter-cyclical loss reserving
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17. Risk Management Paradigm III. Careers
Corporate Functions / Roles
“Everyone is a risk manager”
Operations Risk Market & Credit Risk
Auditing / Risk Underwriting
Controller /
Internal or Treasury / Investing
Accounting Management
Public
Undergraduate Course Work: Statistics, Economics, Finance,
Accounting Degree a Good Start
Graduate School, MBA, Statistics, etc.
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18. Risk Management Paradigm IV. Further Reading
When Genius Failed: The Rise and Fall of Long-Term Capital
Management, Roger Lowenstein
The Black Swan, Nicholas Taleb
House of Cards: A Tale of Hubris and Wretched Excess on Wall Street,
William Cohan
The Economist, best weekly or daily periodical available
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19. Risk Management Paradigm V. Summary and Recap
• Risk management is about preparing for unlikely events
• Reliance on historical data and quantitative models,
coupled with hubris and bad assumptions, greatly
contributed to the current financial crisis
• Common sense and qualitative considerations should
always be layered on top of any model
• Overly complex models can make the situation worse
• Everyone is a risk manager at some level
• There is plenty of good reading out there on risk
management, both case studies and technical analysis
and theories
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