Building Confidence Post-Crisis: Challenges and Solutions for Implementing a Risk Framework

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Building Confidence Post-Crisis Challenges and
Solutions for Implementing a Risk Framework

• Chad Burhance, Managing DirectorGlobal Risk
  Services
• State Street Investment Analytics
• September 2009

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Goals of Presentation

• Review contributing factors to recent financial
  crisis
• Communicate emerging view that there was
  insufficient risk management practices across the
  investment process
• Evaluate challenges that current risk management
  practices have in accurately detecting the many
  facets of risk
• Explore potential new methods and techniques to
  address risk management challenges
• Encourage how to better incorporate these
  practices into an overreaching risk management
  framework and culture

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Post Crisis ReviewRearview Mirror of Causes

• Some things are debatable
• No single cause led to the global financial
  crisis
• Issues were myriad
• Overabundance of credit/leverage
• Lack of regulatory oversight
• Overreliance on financial modelsvs. common sense
  and due diligence
• Overaggressive appetite for risk
• Concentration risk too many assetsin to few
  players

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Post Crisis ReviewRearview Mirror of Causes

• Others are not debatable
• Inadequate investment in risk management
  infrastructure
• Need strong tools and expertise to properly
  analyze increasing investment complexity
• Misalignment of risk management within the
  investment process
• There is no return without risk
• But there is risk without return
• Not enough transparency
• Into what is owned, how it is structured and its
  economic behavior
• Overreliance on risk and asset allocation models
  with flawed assumptions

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Post Crisis ReviewRearview Mirror of Causes

• Behind AIG's Fall, Risk Models Failed to Pass
  Real-World Test
• In a 2006 SEC filing, AIG said none of the swap
  deals now causing it pain had ever experienced
  high enough defaults to consider the likelihood
  of making a payout more than remote, even in
  severe recessionary market scenarios. - Wall
  Street Journal, 31 October 2008

Why Toxic Assets Are So Hard to Clean Up
Securitization was maddeningly complex.
Mandated transparency is the only
solution. Each time these tranches were mixed
together with other tranches in a new pool, the
securities became more complex. Assume a
hypothetical CDO2 held 100 CLOs, each holding 250
corporate loans -- then we would need information
on 25,000 underlying loans to determine the value
of the security. But assume the CDO2 held 100
CDOs each holding 100 RMBS comprising a mere
2,000 mortgages -- the number now rises to 20
million! - Wall Street Journal, 21 July 2009

• Some Funds Stop Grading on Curve
• Recent history would suggest such meltdowns
  aren't so rareInvestors using standard
  asset-allocation approaches have been hammered.
  Last year, all their supposedly diversified
  investments plummeted in unison. In short, the
  underlying assumptions failed.
• FiLife, a Wall Street Journal Partner, 8
  September 2009

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Coming out of the CrisisBuilding Confidence
Broad Themes to Protect Portfolios

• Qualitative
• Increased transparency
• Increased due-diligence
• Risk as part of the investment process A
  framework is needed to
• Mitigate risk
• Manage risk
• Make better portfolio decisions
• Solve business problems

• Quantitative
• Independent valuation
• Calculation of risk drivers
• Understanding of interdependencies within the
  portfolio
• Undiversified measures
• Correlation dependencies
• Identification of the worst cases scenarios

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Building Confidence in the Investment Process

• Improving transparency across the investment
  spectrum
• What do we own?
• What is it?
• How does it pay out?
• What is worth?
• Hard to price / illiquid?
• Hard to model?
• What is its risk?
• What drives its risk characteristics?
• What could hurt this position?
• Who are WE doing business with?
• Who are THEY doing business?

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Risk Information Flows

• Good decisions stand on many shoulders

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Portfolios Are Complex and Multi-Faceted

• Risk is multi-dimensional
• There is no single risk measure
• Multiple views of risk must be understood
• Market
• Interest rate
• Currency
• Counterparty
• Liquidity
• Credit

"We got blindsided by some developments that
weren't accounted for by the models we were
using - A well know pension manager.
Source WSJ 9/10/2009
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Lessons LearnedRisk Measurement Is Not Just
about Value-at-Risk (VaR)

• Lessons from 2008 panic
• VaR is a tool, not a panacea
• Normal vs. extreme tails confidence intervals
• Short- vs. long-term volatility
• Stress tests as valuable tool
• Diversification can fail
• Unlikely, but possible, scenarios should be
  tested
• Important to plan for recovery events in
  additionto downside events
• Liability-centric measurement of risk
• Balance needs to exceed hurdle rates vs. riskin
  a low interest rate environment
• Asset / liability matching Surplus at risk

• Stress testing
• Event explanation?
• Risk mitigation?
• Likely vs. unlikely events?
• Market factors as well as economic factors?
• Opportunity identification?
• Single factor vs. multifactor?

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Lessons Learned from the CrisisBack Testing

• Back testing should not only be a post-crisis
  task
• Helps ensure risk projections and modeling are
  consistent with the risk experienced
• Is the test calibrated correctly?
• Are there assumptions that could improve the
  results and predictive capability?
• Is it being budgeted appropriately?
• If and where did it breakdown?
• Provides a self assessment
• How are we doing?
• Passing or failing grade?

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Understanding the Risk Quadrants

• Where are the Risks?
• Concentrations and Exposures
• Whats in my portfolio?
• What do I own in both public and private markets?
• Direct and commingled with others.
• Incomplete picture without entire portfolio.
• Does not tell me size or sensitivity.
• Market Value-, NPV

• Whats the Quality of Risk?
• Upside vs. Downside
• Diversification vs. Contribution
• VaR / ETL / CVaR
• Relies on correlations.
• VaR, ETL, Downside TE
• Does not tell me impact of changes in
  correlation?

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2

• What is the Size of the Risk?
• Price it and determine Risk characteristics
• React to changes in underlying
• Sensitivity to different factors
• Does not tell me interrelationships with rest of
  portfolio
• StDev, TE, Delta, Stand Alone VaR

• What is the Extreme Risk?
• Undiversified Risk?
• What happens when correlations fail?
• What is the Perfect Storm?
• Disaster scenario
• Stress Tests Historical and Predictive
• VaR100 / ETL 100

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Risk FrameworkImplementation Considerations

• Four basic elements
• People
• Process
• Technology
• Governance

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Risk FrameworkImplementation Considerations

• Data is the primary focus Without the accurate,
  reliable data, no process can be successful

TechnologySupports the Entire Process
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Thank You