How to Develop a Strong Risk Culture within Financial Institutions Leveraging on an Economic Capital Framework and BASEL III

By Aurle M. Houngbedji, Ph.D. GARP Chapter Meeting Washington DC, December 19, 2011

Biography
Dr. Aurle M. Houngbedji is a Senior Risk Management Officer at the International Finance Corporation (IFC), a member of the World Bank Group in Washington DC. He is responsible for developing new methodologies for modeling Economic Capital (EC) and its applications for strategic business decision making and portfolio risk management. Prior to joining the World Bank Group in January 2005, Dr. Houngbedji was a Quantitative Analyst in the Capital Markets Department at AmTrust Bank. He was responsible for developing mortgage pipeline hedging models; risk based pricing models, delinquency analysis models, valuation models for the banks loans, servicing assets, and other hedging instruments and assets. His research interests include economic capital management, risk strategy, risk culture, credit risk modeling, Monte Carlo simulation methods, Mortgage Backed Securities (MBS) risk management and pricing financial derivatives. Dr. Houngbedji is an industry expert and professional lecturer of risk management. He is an adjunct professor of risk management & quantitative finance, in the McDonough school of business at Georgetown University, and the Johns Hopkins Carey Business School. Dr. Houngbedji holds a Ph.D in Mathematical Finance from the University of Pittsburgh; he is a certified Financial Risk Manager from both the Global Association of Risk Professionals (GARP) and the Professional Risk Managers International Association (PRMIA). Dr. Houngbedji is a Charter Member of Risk Who's Who Society. Dr. Houngbedji is the regional director for the GARP Washington DC Chapter.

Disclaimer
The views expressed in this presentation are mine and only mine and do not reflect in any way those of the IFCs Integrated Risk Management Department.

Agenda
Definition of risk culture
Why a strong risk culture in a financial institution?

Key Elements of a strong risk culture

How to develop a strong risk culture in a bank?

How can Economic Capital and BASEL III help?

Conclusion

Definition of Risk Culture

The norms of behavior for individuals and groups within a bank that determine the collective ability to identify and understand, openly discuss and act on the banks current and future risks*

A system of values and behaviors present throughout a bank that shape risk decisions

* Source: IIF & McKinsey, December 2009

Why A Strong Risk Culture? (1/3)

A Strong Risk culture is:
Critical to a successful risk management Centered on human judgment and human interaction in day-to-day business decisions Powerful offensive and defensive tool, and must take into account holistically all material risk related interactions that happen inside the bank Significant shift in mindsets, policies, processes, making risk everyones business Last line of defense in market stressed situations

A recent IIF/EY industry survey indicated that 92%*of firms interviewed reported an increase in senior management attention on strengthening the risk culture
* Source: IIF and Ernst & Young: Making strides in financial services risk management, 2011

Why A Strong Risk Culture? (2/3)

A strong risk culture reinforces
Clear and well communicated risk strategy and risk appetite High standards of analytical rigor & information sharing across bank Rapid escalation of threats and concerns

Example:
During the 2008 global crisis, most of existing risk management frameworks became unreliable, major banks experienced numerous limit breaches in several business lines Few banks were able to properly identify, escalade, address risks promptly, effectively because of their strong risk culture

Why A Strong Risk Culture? (3/3)

A strong risk culture
Helps ensure that the focus on risk-based decision making becomes sustainable over time Critical to ensure that doing the right thing wins over doing whatever it takes Influences the decisions of management and staff A fundamental building block of strong ERM practices

Key Elements of Strong Risk Culture (1/9)

Strong support from the Board & Management Accountability and Ownership Risk Transparency Communication & Training Risk-Adjusted Return on Capital Optimization Partnership & Collaboration Strong Integrated Risk Management Framework

Key Elements of Strong Risk Culture (2/9)

A strong risk culture requires
Full support of the board and senior management Setting the stage for the culture change Establishing the vision and firm wide rules and guidelines related to risks Clearly defines roles and responsibilities Strengthen and clarify roles and responsibilities of the: Board Senior management team (CEO, CFO, CRO) Business units leaders

Key Elements of Strong Risk Culture (3/9)

Accountability & Ownership
Management & Board have to set risk appetite Engage management and business leaders in franc dialogue on risk implications of business strategies Adhere to clear communication and understanding of business expectations, performance measurements and compensation implications Consider risk in the hiring, compensation, promotion process Enhance risk awareness through training

Key Elements of Strong Risk Culture (4/9)

Adhere to the three lines of defense model
Governance : Board & Risk Committee
1st line: Management
Ownership,

2nd line: Risk Oversight Risk & Compliance Functions

Corporate Risk Management

3rd line: Corporate Audit Group

Independent assessment by

Accountability, and responsibility for risk Business leaders, operation groups adopt strategies to identify business opportunities and optimize return on capital and create value

Group, independently work with all business lines Establish & recommend risk management policies, infrastructure, & processes Provides the framework and infrastructure to facilitate risk management

internal & external auditors Monitors the effectiveness of operational functions, reliability of financial reporting, compliance with policies & regulations

Key Elements of Strong Risk Culture (5/9)

Risk Transparency
Ensure that risk positions are consistent with risk appetite and are well understood by risk takers Improve risk reporting, risk dashboard, stress testing framework, back testing process and risk analytics Create risk advisory/discussion/forum/ at senior management level to step up the firm wide risk discussions

Key Elements of Strong Risk Culture (6/9)

Strong Communication & Training
Communicate risk appetite across the institution for a better understanding of risks pursued by risk takers at the bank Develop a good stakeholder management process by improving quality and timeliness of risk information & interaction with stakeholders Risk & HR functions can jointly create workshop programs to increase knowledge and understanding of risk throughout the banks

Key Elements of Strong Risk Culture (7/9)

Risk-Adjusted Return on Capital Optimization
Optimize risk-return trade offs at transaction and portfolio levels Improve EC and other risk models, allocate capital, monitor capital usage & performance on capital Improve risk based pricing models and practices Engage management to put risk at the center of discussions during periodical strategic planning Consider risk-return as an integral part of decision making

Key Elements of Strong Risk Culture (8/9)

Partnership & Collaboration
Improve cooperation and dialogue with risk takers to enable the pursue of sustainable profitable growth opportunities Work proactively with businesses to establish trust and open conversion about risks related issues Ensure that consistent risk information is shared with all business lines Establish risk champions (CRO & Risk Head) for the firm & major business lines Share rewards by celebrating success

Key Elements of Strong Risk culture (9/9)

Strong Integrated Risk Management Framework
Enhance processes, skills, education, models, technologies that support risk management activities Develop a firm wide models risk management framework Establish core competency in risk management function Establish a firm wide IT risk Architecture & central risk database Remove silos and replace by an integrated risk management framework Embrace the strategic view of risk management turning it into a strong competitive advantage Align risk appetite and strategy Leverage BASEL III and Economic Capital framework to improve risk management processes and practices

How to develop a Strong Risk Culture?

Begin a dialogue at management level on risk culture Create a team to lead the process Conduct a complete assessment of existing culture Develop a diagnostic report with a set of tangible recommendations Determine what the desired risk culture should look like Design and implement an action plan based on the recommendations to build the new risk culture Communicate changes and secure buy in from all stakeholders Establish a process to evaluate the changes and make necessary adjustments

How can Economic Capital help?

Economic capital framework can fully integrate material risks into the decision making process and support the implementation of a strong risk culture
Strategic Planning
Risk-Based Business Decision Making Risk-Based Pricing Capital Adequacy Risk-Based Limits Setting Concentration Management Performance Measurement

Risk IT Infrastructure, Portfolio Risk Analytics, Stress Testing & Scenario Analysis

Risk Culture, Communication & Training

Risk Measurement
How Much Risk does and should Bank have?

Risk Control
How can Bank control Unexpected Loss?

Risk/Return Optimization
How can Bank optimize Capital Utilization?

How can BASEL III help? (1/2)

Regulations such as BASEL can drive changes in risk management leading to culture change

Global Financial Stability

BASEL (2006,2009,2010): Three-Pillar Architecture
Pillar 1 Minimum Capital Requirements
Capital Requirements for:
Credit Risk Standardized Approach Foundation IRB Approach Advanced IRB Approach Market Risk Standardized Approach Internal Var Models Operational Risk
Basic Indicator Standardized Approach Advanced Measurement Approaches

Pillar 2 Supervisory Review Process

Framework for Banks (ICAAP) Qualitative Supervisory EC and Stress testing Risk oversight, risk concentrations, off-balance-sheet exposures Providing incentives for banks to better manage risk and returns over the long term Sound compensation practices Reputational risk Supervisory Framework Evaluation of internal Systems of Banks Assessment of risk profile Review of compliance with all regulations Supervisory measures

Pillar 3 Market Discipline

Disclosure Requirements for Banks Transparency for Market participants concerning the banks risk position Increase transparency for securitizations, off-balance-sheet exposures and trading Reduce uncertainties about the ability to trade in volatile Markets Pipeline and warehousing risks with regard to securitization Exposures Enhances comparability among banks

Strengthen capital requirements Risk weight of resecuritization Exposures

Market Risk Capital Requirements Credit Conversion Factor (CCF) for liquidity facilities More rigorous credit analysis of externally rated securitization exposures Prohibition to use ratings based on self-guarantees

How can BASEL III help? (2/2)

BASEL III addresses jointly capital, leverage, buffer, liquidity The Internal Capital Adequacy Assessment Process (ICAAP) in pillar 2 is a process to ensure that management:
Identify, measure, aggregate, and monitor adequately the banks risks Hold adequate internal capital with respect to the bank's risk profile Use sound risk management systems and develop them further

ICAAP is a key integrated risk management tool Pillar 2 processes enhance link between banks risk profile, risk management, risk mitigation systems, and its capital BASEL III and ICAAP implementation can help instill a strong risk culture in a financial institution

Conclusion
Risk culture has to be at the top of the agenda for senior management in all banks Financial Institutions need to develop a strong risk culture that is focused on optimizing well calculated and well understood risk return trade-offs within a well defined firm wide risk strategy leading to a consistent value creation for shareholders Develop a strong risk culture is a journey, a long process of consistent communication, education, and management Implementation of EC framework and BASEL III can help instill a strong risk culture Some professional risk organizations and financial services providers can help create a culture of risk awareness within firms, from entry level to board level, making risk everyones business

Q&A Thank You!