Risk Minds USA 2013 Risk Governance and Risk

Risk Minds USA 2013 Risk Governance and Risk Management: Oxymorons? J. V. Rizzi June, 2013 Macrostrategies, LLC 1

Table of Contents � Introduction � Decisions � Governance � Why Change � Conclusion Macrostrategies, LLC 2

Introduction Macrostrategies, LLC 3

Introduction Risk governance worked, except for “rare” exceptions… ◦ Never attribute to malice or stupidity that which can be explained by moderately rational individuals following incentives in a complex system of interactions. – Douglas Hubbard ◦ Purpose of governance is to protect the institution from being driven by the narrow interests of an individual or group of individuals. ◦ Absent governance, the institutional imperatives takes hold: 1) an institution will resist any change in its current direction; 2) business cravings of the leader(s), however foolish, will be supported by detailed rate-of-return and strategic studies prepared by his troops; 3) behavior of peer companies will be mindlessly imitated. – Warren Buffett Role of the Board is to understand monitor senior management behavior to protect shareholder interests… …like financial crisis, MF Global, London Whale…ha. Macrostrategies, LLC 4

Introduction Continued Process (Governance Puzzle: How to resist excessive risk e. g. JPMC Big Whale… Governance (Board) Montoring & Rebalancing Investment Strategy & Risk Appetite Performance (Asymmetric information) …taking in benign market(s). Macrostrategies, LLC 5

Decisions Macrostrategies, LLC 6

Social Decision Making (The birds do it, the bees do it… � Herding ◦ Safety in Numbers ◦ Peer Comparisons ◦ Cycle Amplifications �Momentum �Liquidity �Leverage � Information Cascade ◦ Feedback Loops ◦ Self-fulfilling Prophecies …everyone is doing it. ) Macrostrategies, LLC 7

Statistical Bias (Risk as a challenge to overcome… � Fooled by Randomness ◦ The star banker problem ◦ Risk vs. uncertainty � Extrapolation ◦ Historical experience ◦ Mean reversion � Model Struck: illusion of knowledge ◦ Market efficiency ◦ Liquidity ◦ Rational Participants …or an uncontrollable chance outcome? ) Macrostrategies, LLC 8

Disaster Myopia (The influence of Risk Management… Defined: underestimate the impact of low probability high impact events. � Psychological ◦ Availability ◦ Threshold � Reinforced Basis by internal accounting & bonus schemes ◦ Line managers ◦ Breakdown of pricing ◦ Herding � Impact …decreases by the square of the time since the last crisis. ) Macrostrategies, LLC 9

Group Think (If it cannot go wrong – it will. ) � Group Think: Shared Reasoning Deficiency ◦ Sources �Conformity �Organizational Pressures and Optimism �Expert Illusion ◦ Results �Married to positions �Absence of critical thinking �Lack of exit or downside plan �Denial (Fools are always certain, while the wise are doubtful. ) Macrostrategies, LLC 10

Decisions at Risk (DAR) (Who decides… Uncertainty & Asymmetric Information Beyond the data events: - Experiences - Exposures Black Swans Adverse Selection Moral Hazard Behavioral Bias Over Confidence Illusion of Control Hindsight Bias Anchoring Amplifiers Incentives Bureaucracy Opaque Accounting Leverage Complexity Control Internal - Board monitoring - Incentives - Sanction External - Regulators - Rating Agencies - Marked for Control …how do they decide? ) Macrostrategies, LLC 11

Governance Macrostrategies, LLC 12

Governance Failure (We do not need better models… � Unnoticed Risk Appetite Change � Failure to understand Risk Implications of Strategy � Inconsistent capital Structure and Stakeholder Communications � Top management and Board failed to understand arcane models � Entering new activities can misalign incentives requiring organizational, compensation and control structure changes …we need better governance. ) Macrostrategies, LLC 13

The Board and Risk Management (Ignorance is not bliss… Although 90% of directors say they understand the risk implications of the current strategy… ◦ Only 77% of directors say they understand the risk/return tradeoffs underlying the current strategy. ◦ Only 73% of directors say their companies fully manage risk. ◦ Only 59% of directors understand how business segments interact in the company’s overall risk portfolio. ◦ Only 54% have clearly defined risk tolerance levels. ◦ Only 48% of boards rank key risks. ◦ Only 42% have formal practices and policies in place to address reputational risk. Source: The Conference Board …it is rot. ) Macrostrategies, LLC 14

Governance Culture (I admire individuals unafraid to speak their minds… � Rewards for Risk Taking � Acceptance of Bad News � Internal Competition Level � Performance Pressure � More than Compliance � Hero Worship and the Great Man Problem � Succession Plan …even if it costs them their job. – L. B. Mayer) Macrostrategies, LLC 15

Information Management (Risk management as… � � � Organizational and Transaction Complexity and Transparency. Diagnostic Performance Gaps Extent of Decentralization: decisions made without direct senior management oversight. Board Awareness/Board Understanding Judgment vs. Models ◦ Illusory profits given inadequate reserving ◦ Ability to put organization at risk ◦ Speed � Financial risks are opaque and do not immediately manifest themselves ◦ Track records of limited use ◦ Difficult to distinguish luck vs. skill …exposure measurement and accounting. ) Macrostrategies, LLC 16

Board Focus (In God we trust… � Risk Appetite ◦ Relative to capital � Limit Setting � Monitoring � Discipline � Reward � Succession Plan � Annual Independent Assessment of Risk Governance Framework …every else must bring the data. ) Macrostrategies, LLC 17

Board Independence and Quality (Do you want to believe what you see… � � � � Size Outside to Inside Ratio Lead Director Dedication: limit number of directorships Splitting CEO – Chairman Roles Meeting Frequency Experience Compensation ◦ Financial commitment: eat own cooking � Selection and Tenure ◦ Limit tenure � Chair Board Committees with Independent Directors ◦ Risk ◦ Compliance ◦ Compensation …or what I am telling you? ) Macrostrategies, LLC 18

JPM Chase 2012 Management Discussion Whale Lessons Learned (Now they tell us… Fight Complacency: do not assume tomorrow will look like today, especially after a long period of good times. � Overcome Conflict Avoidance: ask hard questions. � Control Must Match the Size of the Risk Involved: big bet your bank type risk exposures require rigorous review process � Trust but Verify: make them verify their plans – do not blindly assume they are correct. � Do Not Shoot the Messenger: encourage surfacing problems before they become fatal. � …do they believe it, and if so for how long? ) Macrostrategies, LLC 19

Why Change Macrostrategies, LLC 20

Regulatory (Beware turning risk management and governance… CAMELS: management “m” to include Board competence and engagement � Dodd Frank � ◦ Risk committee requirement: $10 B ≤ assets < $50 � Chaired by independent direction; one risk management professional ◦ Chief Risk Office requirement: assets ≥ $50 B � Reports to risk committee and CEO � Components ◦ Risk Appetite: policies and processes for risk oversight ◦ Monitoring: management compliance with risk limits ◦ Control: management of risk exposures and controls …into a compliance and audit function. ) Macrostrategies, LLC 21

Shareholder Activism (Change before… � Just one crisis away from shareholder action ◦ JPM ◦ Goldman ◦ Non-banks � Activists � Supporters ◦ Advisors ◦ Pensions …being changed. ) Macrostrategies, LLC 22

Conclusion Macrostrategies, LLC 23

Conclusion (Purpose of governance is to protect institution from being… � Role of Board: understand monitor senior management to protect shareholder interests � Beware of Bias � Judgment vs. Model � Risk Appetite � Risk Management vs. Risk Measurement � Duty of Care …manipulated towards narrow management interests. ) Macrostrategies, LLC 24