Enterprise-Wide Risk Management

Firm-Wide Risk Management

Philippe Jorion 1

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Enterprise-Wide Risk Management

Philippe JorionUniversity of California at Irvine

July 2004

© 2004 P.JorionE-mail: [email protected]

Please do not reproduce without author�s permission

Integrated Risk Management

! "Firm-wide risk management",! "Enterprise-wide risk management" (ERM),! "Integrated risk management",--all mean:

A coordinated process for managing risk on a firm-wide basis, across types of risk, locations and business lines


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Why Integrated Risk Management?The Positive View

��the common framework for risk management revolves around the efficient use of capital.�

Prakash Shimpi, Integrating Corporate Risk Management

Why Integrated Risk Management?The Sarcastic View

�Is it an accident that banks are now looking for growth in areas where they do not directly allocate capital and where risk is difficult to manage, rather than in basic trading and lending where businesses now have to pay their own way?�

Anonymous quote reported in Euromoney (September 1996)


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Integrated Risk Management:Plan

(1) Firm-wide risk identification(2) Integrated risk measurement(3) Integrated risk management(4) Benefits from integrated risk management(5) Conclusions


(1)Firm-Wide Risk Identification


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Types of Firm-Wide Risks! Business risks: risks the corporation willingly

assumes to create shareholder value» symmetrical (can create gains and losses)» corporations are �paid� to take business risk

! Financial risks: risks due to the effect of financial variables» often symmetrical (can create gains and losses)» corporations are �paid� to manage financial risk

! Event risks: risks due to other, outside events» asymmetrical (can only create losses)» corporations �pay� to mitigate event risk

Risk Management - Philippe Jorion

over-erm at 180%

Business risk

Business environment

Financial risk

Firm-wide risks

Non-business risk

Other risks

Credit risk

Operational risk

Market risk,incl. liquidity

Strategic risk

Regulatory, political risk

Business decisions

Reputational risk

Product,Marketing,Organization

Competition,Technology

Macro-economic



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ERM-risk.swf

Types of Financial Risks

! Market risk: arise from movements in the level or volatility of financial prices

! Credit risk: arise when counterparts may be unwilling or unable to fulfill obligations

! Operational risk: risk of direct and indirect loss resulting from failed or inadequate process, systems, or people and from external events



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Market Risk Credit Risk Operational Risk Define risk categories

Interest rate Equity Currency Commodity

Default Downgrade

Processes People Systems External events

Measure risk factors

Volatility Correlations

Default Loss given default

Loss frequency

Measure exposure

Duration Delta Mapping

Current and potential exposure

Loss distribution

Calculate risk

Market VAR Credit VAR Expected loss

Operational VAR Expected loss

Measuring Financial Risks


Interaction of Firm-Wide Risks:Operational Risk

! Marking-to-market (resettling) OTC contracts: lowers credit exposure, but creates operational and liquidity risk

! Narrow focus on RAROC-risk-adjusted return on capital (Bankers Trust): by giving incentives to maximize RAROC only, financial risks may be controlled, but can create reputational risk



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Interaction of Firm-Wide Risks: Market and Credit Risk

! LTCM: the firm tried to control market risk but ended up creating asset/funding liquidity risk » the positions ($1.2 trillion) were so large that the

portfolio could not be adjusted(see LTCM paper on my web site�published in Eur. Fin. Mgt 2000)

! Lenders to LTCM: brokers had controlled separately market risk and credit risk» CMRA survey of financial institutions about

integration of market and credit risk functions:Pre-October 98, 9% have integrated functionsPost-October 98, 64% have integrated functions


Interaction of Firm-Wide Risks: �Wrong Way� Trades

! Credit and market risk amplify each other! Asian currency swaps (1997 crisis): U.S.

banks lent to Asian companies in dollars, but the devaluation led to a contraction in Asian business activity, creating credit risk

! Syndicated Euroloan (sovereign lending in 1980s): U.S. banks wanted to limit market risk, by using short-term loans in dollars, but higher U.S. interest rates caused borrowers to default, creating credit risk



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Interaction of Firm-Wide Risks: Hedgers and Speculators

! Pay fixed oil price swap with airline: if oil price goes up, swap in-the-money but airline more likely to default

! Receive fixed oil price swap with drilling co: if oil price goes down, swap in-the-money but co more likely to default

! Pay fixed swap with highly leveraged co: if rates go up swap in-the-money, but hedge fund more likely to default

! Generally, when counterparty �speculates�Risk Management - Philippe Jorion

Risk Management-Philippe Jorion

Commercial bank

Investment bank

Treasurymanagement

Retail broker

Assetmanagement

Market

Credit

Percentage of Total Risk Capital

Operational

Credit


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! In September 1996, Deutsche Morgan Grenfell (DMG) suspended a star fund manager, Peter Young, for European equity funds, worth $2.2b

! Peter Young had breached the limit of 10% in unlisted securities; the funds ranked dead last in their category in 1996 H1

! Deutsche Bank, the German owner of DMG, agreed to compensate the shareholders in the funds; it later announced it had to pay $640 million in damages

Operational Risk in Asset Management: DMG

Risk Management-Philippe Jorion

Operational Risk in Asset Management: Unilever

! Oct 15, 2001: pension-fund trustees for Unilever sue Mercury Asset Management (MAM), now Merrill (MLIM), for negligence in handling of £1 billion of active equities

! Between Jan 97 and March 98, the fund underperformed the benchmark by 10%

! MAM was terminated in 1998! Dec 6, 2001: Merrill agrees to pay $105m! No legal precedents have been set since

settled out of courtRisk Management-Philippe Jorion


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Interaction of Firm-Wide Risks:Conclusions

! Risks cannot be viewed in isolation! Market, credit risk, and operational risk can

be naturally correlated! Worse, focusing too much on one type of risk

may create exposure to other, more subtle risks

! Therefore, it is important to identify all risks, which leads to firm-wide risk management


Steps in Firm-Wide Risk Management

(1) Identification of risks» financial risks easy to identify» business risks more difficult to identify

(2) Measurement/assessment of risks» VAR methods for financial market risks» extend to firm-wide risks» identify natural hedges

(3) Management of risks» control or monitoring» retain or insure/hedge



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(2)Integrated Risk Measurement

Integrated Risk Measurement! How do we compute combined capital

charge across risk categories?! First, choose same horizon (even though

time for corrective action may differ)! Adding risk charges is conservative:

it assumes a worst-case scenario in all markets at the same time » quantile risk measure is not necessarily �coherent�» coherence is only true for elliptical distribution, however;

it may not hold for some distributions! Ideally, take into account correlations



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Integrated Market and Credit Risk: Simulations

! Standard models do not allow for integrated risk management» e.g., CreditMetrics has fixed market risk factors

(term structure and spreads)! Simulations must model stochastic process:

» n market factors,» m credit events, from a credit index (hazard rate)» model correlations across risk factors » allow for conditional correlation between market

factors and hazard rates


Large-Scale Simulations (1)! Number of random variables is very large! Generally impossible to model joint

distribution, unless multivariate normal but� (KMV and CM assume multivariate normal)

! Steps:» select and estimate separate (marginal)

distributions for each variable (e.g. Student-t, GARCH, jump-diffusion)

» combine marginals into a joint distribution using �copulas�



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Large-Scale Simulations (2)! �Copulas�: multivariate functions that couple

marginal distributions into a joint distribution! Steps:(1) Generate non-independent uniforms using

a copula (e.g., t copula, which has more extreme tail dependence)

(2) Generate random variables by transforming uniforms into marginals


Large-Scale Simulations (3)! Examples of more realistic dependence

structure generated by different copulas

Source: Frey, McNeil, and Nyfeler, �Copulas and credit models,� RISK, October 2001



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Market and Credit Risk: Example

! Consider a portfolio of n zero-coupon bonds with one market risk factor

! Over the horizon, the portfolio is subject to market and credit risk» simulate r(t), h1(t), �,hn(t)» reprice the portfolio at the horizon

! Example: One-factor model, 6 bond portfolio» initial 5-year maturity; rated Aaa, Aa, A, Baa, Ba, B» zero correlation of credit indices with market riskKijima and Muromachi, Journal of Risk, 2001


Market and Credit Risk (1):No Market Risk

» Two peaks: no default, 1 default�» Movements due to changes in credit spreads» 99% VAR=8.2% of expected value

Value At Risk-Philippe Jorion


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Market and Credit Risk (2):Mild Market Risk (σ=0.5%)


» Peaks are more blurred» 99% total VAR is 9.7%

Market and Credit Risk (3):Market Risk (σ=1%)


» Distribution much smoother but wider» 99% total VAR is 11.4% (credit 8.2+mkt 8.8=17.0%)


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Risk Distributions: Types

Source: Rosenberg and Schuermann, 2004, A General Approach to Integrated Risk Management

KurtosisSkewnessVolatility

HighAverageLowHighAverageZeroLowAverageHighOperationalCreditMarket

Risk Distributions: Example


-0.54%-0.37%-1.79%-2.05%99.9% Quant69.5%

35.3-4.5

0.04%Oper.

4.85.23.9Kurtosis

Weights

SkewnessVolatility

100.0%26.4%4.1%

-1.0-1.10.00.13%0.41%0.64%

TotalCreditMarket

! Annual data, fraction of total assets! Normal copula, correlations of 0.5, 0.2, 0.2


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ERM VAR Approximations! Define α as the standardized quantile that

corresponds to the confidence level c! Copula VAR! Additive VAR assumes perfect correlations

! Hybrid VAR accounts for different distributions

! Normal VAR assumes normal distributions


2 2 2 21 1 2 2 1 1 2 2H-VAR 2α σ α σ ρ α σ α σ= + +

1 1 2 2Add-VAR α σ α σ= +

2 21 2 1 2N-VAR 2Nα σ σ ρ σ σ= + +

VAR p pα σ=

ERM VAR Approximations: Example


-42%N-VAR+9%H-VAR

Add-VARVAR

+45%0%

Error

Conclusions:(1) Additive VAR overestimates risk by >40%(2) Hybrid VAR close to actual, and conservative(3) Normal VAR too small


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VAR with Increasing Market Risk

0%

10%

20%

30%

40%

50%

60%

70%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Share of market book (vs. credit book, operational book constant)

OperationalCreditMarket

VAR with Increasing Operational Risk

0%

10%

20%

30%

40%

50%

60%

0%

10%

20%

30%

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50%

60%

70%

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100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Fraction of market and credit book shifted to operational book

OperationalCreditMarket


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Conclusions from ERM VAR Analysis

Conclusions:(1) Diversification effects are important(2) Most important factors are choices of business lines, or breakdown of risk types(3) Correlations across risk types less important(4) Choice of copula less important



(3)Integrated Risk Management


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Passive:

Defensive:

Active:

Controlling risk:setting risk limits (desk level and firm-wide)

Allocating risk:performance evaluation capital allocation strategic business decisions

Reporting risk:disclosure to shareholders management reports regulatory requirements

Evolution in Applications of VAR


Integrated Risk Management:Rationale

! Enterprise-wide Risk Management aims at managing the overall risk of the institution across all risk categories and business lines

! Motivated by the search for better risk/return decisions



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Integrated Risk Management:Benefits

! Better use of capital» total capital is less than capital for different

categories, due to diversification» key to merger decisions

! Cheaper hedging:» cost reduction from insuring as a group, rather

than individual risks (e.g. lower transaction costs)» integrated view may reveal �natural� hedges

! Better control over risks:» avoids �shifting� of risk from some areas to others


Operational risk (25%)

Total charge for financial risk

Credit risk(60%)

Market/liquidity risk (15%)

Diversification effect

Firm-Wide Charge for Risk



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Bank Regulatory Requirements and ERM

! ERM should lead to lower capital chargesExample: capital charge for AA corporate bond

Cr GARP 99

Basel 88 Basel II ERM

Standardizedmodel Internal

model


Basel Capital Adequacy! Total capital > MktRC + CrRC + OpRC! Adding risk charges is conservative! Internal Model Approach for market risk:

allows diversification effects! Ratings-based Approach for credit risk:

does not give incentives to diversify risk across borrowers nor risk factors

! Advanced Measurement Approach for operational risk: allows diversification effects



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Deutsche Bank: Economic and Regulatory Capital (in � millions)

22,42616,674Total Economic Capital Usage2,4492,282Operational Risk 1,9781,117Business Risk 8,2924,940Nontrading Market Risk(2)

765972Trading Market Risk(1)

9,0575,912Market Risk 8,9427,363Credit Risk 20022003

12.6%13.9%Capital ratio (Tier I + II + III) 9.6%10.0%Core capital ratio (Tier I)

29,86229,871Total regulatory capital��Available Tier III capital

7,1208,253Supplementary capital (Tier II) 22,74221,618Core capital (Tier I)

237,479215,672Risk position 6,2179,530Market risk equivalent(1)

�231,262�206,142Risk-weighted positions �Very severe�means a 0.02% probability that our aggregated losses within one year will exceed our economic capital for that year.


(4)Benefits from

Integrated Risk Management


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ERM: Examples! BP reviewed its portfolio of risk and

decided to self-insure, except when required by law

! Honeywell entered an insurance program that covers currency risk, property, and liability coverage» saved 25% on premiums

! Programs called �holistic risk�, �enterprise risk�, �insuritization risk�


Why Manage Risk?! Without market �frictions�, financial policies

of the corporation cannot add value (M-M theorem): » hedging lowers the volatility of values but not

the mean (provided financial contracts are fairly priced): on average, the value of the firm is the same

» investors may buy oil companies to acquire exposure to oil prices

! Hence, risk management is irrelevant...Risk Management - Philippe Jorion


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-$100m 0 $100m $200m $300mValue of cash flows

Probability distribution

After hedging

Before hedgingVAR=$145m

VAR=$70m

Why Hedge?


Why Hedge?! Conditions under which hedging matters:

(1) Hedging lowers costs of financial distress, which is valuable if distress has deadweight

costs(2) Hedging lowers taxes, when the firm�s tax

function is convex (e.g. no tax refund when loss)(3) Hedging lowers agency costs, as investors can

evaluate managers better when earnings are not too volatile due to external factors

(4) Hedging facilitates optimal investment, due to the need to have steady investment in R&D and limited access to external capital markets



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Why Hedge?Empirical Evidence

! Large literature on determinants of hedging: (1) Large firms hedge more, reflecting economies of

scale(2) Firms with greater growth opportunities hedge

more, reflecting the need for steady investment! But, does hedging increase market value?


Benefits of Hedging?Empirical Evidence

! Recent study by Allayannis and Weston (Review of Financial Studies, 2001) considers the relationship between market values and foreign currency hedge programs for a sample of 720 U.S. non-financial firms

! Firms that hedge have market values of 5% higher than others on average (after controlling for other effects)» with median market value of $4b, this gives a

benefit of $200mRisk Management - Philippe Jorion


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Risk Management

(5)Conclusions

Risk Management

(5)Conclusions


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What is the Most Important Function as Treasurer/CFO?

! It has to be managing risk, whether it be financial, currency, interest-rate, refinancing, commodity or others. I spend about 25% of my time on this. Up to now, risk management has been event- and transaction-driven. Now we are trying to comprehend the total picture. We hope to have an enterprise risk solution in place by the end of the year

-- Susan Stalnecker, treasurer, DuPont ($27.9b)! Integrating the treasury staff into the business of the whole

company. Our goal is to reduce the volatility of the company�s earnings

-- Gian Camuzzi, treasurer, Gillette ($9.8b)

Integrated Risk Management! ERM is still in its infancy but attracting

increasing attention! ERM brings substantial benefits

» ERM reveals natural hedges, allow better use of capital due to diversification effects

» because of its company-wide, centralized nature ERM can potentially affect strategic decisions

» there is tentative evidence that market values are enhanced through active management of financial risks



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Challenges of Risk Management in Diversified Financial Companies! Adding up risk charges for various risk

categories should be conservative! However, there may be situations where total

risk is greater then the sum:» liquidity effects, when combined positions are

large and activity can move markets» reputation effect, due to erosion of customer trust

(revenues), or when problems in one unit may affect confidence in other parts of the firm (funding costs)


Bibliography! Basel Committee on Banking Supervision, 2004,

International Convergence of Capital Measurement and Capital Standards: A Revised Framework

! Christine M. Cumming and Beverly J. Hirtle, 2001, The Challenges of Risk Management in Diversified Financial Companies, FRBNY Economic Policy Review 7 (March) » www.ny.frb.org/research/epr/01v07n1/0103cumm.html

! Joshua Rosenberg and Til Schuermann, 2004, A General Approach to Integrated Risk Management, FRB New York n. 185» www.ny.frb.org


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References! Philippe Jorion is Professor of Finance at the Graduate

School of Management at the University of California at Irvine! Author of �Value at Risk,� published by McGraw-Hill in 1997,

which has become an �industry standard,� translated into 7 other languages; revised in 2000

! Author of the �Financial Risk Manager Handbook,� published by Wiley and exclusive text for the FRM exam; revised in 2003

! Editor of the �Journal of Risk�! Some of this material is based on the online "market risk

management" course developed by the Derivatives Institute:for more information, visit www.d-x.ca, or call 1-866-871-7888

Phone: (949) 824-5245FAX: (949) 824-8469

E-Mail: [email protected]: www.gsm.uci.edu/~jorion

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