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1 Senior Supervisors Group: Observations on Risk Management Practices During the Recent Market Turbulence Jon Greenlee Associate Director, Risk Management Division of Banking Supervision and Regulation Federal Reserve Board June 5, 2008
2 Agenda Senior Supervisory Group (SSG) Effort SSG Conclusions: Three Business Lines where Varying Practices Differentiated Performance Four Factors that Differentiated Performance Regulatory Response: Primary Supervisor Focus Strengthening Supervisory Oversight of Relevant Areas 2
3 Senior Supervisors Group Effort Convened in September 2007 to assess whether shortcomings in risk management may have contributed to losses. Met with senior management at selected organizations in mid-to-late November Met with industry representatives on February 19, 2008 in NYC. Shared updated report with the Financial Stability Forum Working Group on Market & Institutional Resilience on February 25, Released report on all SSG members external websites on March 6,
4 SSG Conclusions Three business lines where varying practices differentiated performance included: CDO structuring, warehousing, and trading businesses Some firms did not consider that the positions might be of poorer credit quality than the external credit rating indicated. Some firms also did not consider that even senior tranches could lose market value if the underlying collateral suffered losses (or was downgraded) or if market liquidity receded for this product. Syndication of leveraged financing loans Some firms did not properly account for the price risk inherent in the pipelines. Some firms did not consider the importance of marking positions to market. Conduit and SIV businesses Several firms did not properly recognize or control for the liquidity risk in their conduit businesses or recognize the reputational risks associated with the SIV business. 4
5 SSG Conclusions Four firm-wide risk management practices that differentiated performance are: 1. Effective firm-wide risk identification and analysis; 2. Consistent application of independent and rigorous valuation practices across the firm; 3. Effective management of funding liquidity, capital and the balance sheet; and 4. Informative and responsive risk measurement and management reporting and practices. 5
6 SSG Conclusions 1. Effective firm-wide risk identification and analysis Successful firms: Emphasized a comprehensive, firm wide look at risk. Across business units, activities, risk types Disciplined culture and well-established process for routine discussion of current and emerging risks across the business lines, risk management, and finance. Made decisions about aggregate firm-wide exposures and risk mitigation (e.g., hedging) rather than rely solely on judgment of business lines. Less successful firms: Business lines were siloed in their view of risks and made decisions in isolation. Did not make decisions on consolidated views. 6
7 SSG Conclusions 2. Consistent application of independent and rigorous valuation practices across the firm. Successful firms: Emphasized mark-to-market discipline. Invested in the development of independent pricing models and staff with specialized expertise. Skeptical of and less reliant on external ratings. Less successful firms: Did not place as strong an emphasis on market prices. Adopted relatively passive approaches of observing prices and using external assessments of value. Treated positions as par assets. 7
8 SSG Conclusions 3. Effective management of funding liquidity, capital and the balance sheet. Successful firms: Disciplined in measuring and limiting these risks. More agile in reducing/hedging exposures. Strong processes around allocation and internal pricing of liquidity and capital. Less successful firms: Not focused on consolidated positions. Weak or missing controls, particularly around contingent liquidity needs. 8
9 SSG Conclusions 4. Informative and responsive risk measurement and management reporting and practices. Successful firms: Used a wide range of informative risk measures to discuss and challenge views on credit and market risk broadly across different business lines within the firm in a disciplined fashion. Notional and gross measures, market sensitivities of derivative exposures, notional limits, VaR, static single-factor stress tests, and forward-looking scenario analysis. Understood the limitations of individual risk measures Adaptable MIS Less successful firms: Dependent on a single methodology, limited set of tools, or inflexible applications that could not be adjusted in a crisis. Tended to apply a mechanical risk management approach. 9
10 SSG Key Observations - Summary Senior management oversight The balance between risk appetite and controls The role of senior management in understanding and acting on emerging risks The timing and quality of information flow up to senior management The breadth and depth of internal communication across the firm Liquidity risk management Planning and managing internal pricing for contingent events Funding liquidity management during the stress event Contingency funding plans Credit & market risk management Credit underwriting and reporting Valuation practices Risk measures Stress-testing and scenarios-analysis Hedging and counterparty risk management 10
11 SSG Industry Roundtable Discussion Broadly supported the SSG s overall conclusions. Provided additional context for some of the SSG s observations, such as the following: The equal importance of communication and analysis across business areas at every level of the firm, not solely at senior management executive level; The risks and moral hazard associated with firm-wide macrohedging or macro-overlay strategies that were originally mentioned favorably in the SSG s observations; Their general agreement that counterparty positions and their valuations drove the liquidity strains rather than concerns about balance sheet capacity; and The balance firms seek between continually developing new scenarios versus relying on repeated use of similar shocks over time in stress testing to provide senior management with insight into the sensitivity of the firm s risk profile. 11
12 Supervisory Response Primary Supervisor s Focus Supervisors are critically evaluating the efforts of the individual firms they supervise to address weaknesses in risk management practices. Each supervisor is ensuring that its firms are making appropriate changes in risk management practices, including addressing deficiencies in: Senior management risk oversight, The use of risk measurement techniques, Stress testing, and Contingency funding planning. 12
13 Supervisory Response Agency Principals Focus Define an agenda for strengthening supervisory oversight that supports the following: The efforts of the Basel Committee on Banking Supervision to strengthen the efficacy and robustness of the Basel II Capital framework; Enhance the incentives for firms to develop more forward-looking approached to risk measures (beyond capital measures) that fully incorporate expert judgment on exposures, limits, reserves and capital; and Sets sufficiently high standards for what constitutes risk transfer, increases capital charges for certain securitized assets and ABCP liquidity facilities, and provides sufficient scope for addressing implicit support and reputational risks. The need to strengthen the management of liquidity risk; Continue to work directly through the appropriate international forums on both planned and ongoing initiatives. 13
14 Supervisory Response Agency Principals Focus Define an agenda for strengthening supervisory oversight that supports the following: The need to strengthen the management of liquidity risk; and strengthening, as appropriate, of existing guidance on risk management practices, valuation practices, and controls over both; The efforts to address issues that may benefit from discussion among market participants, supervisors, and other key players, including Quality and timeliness of public disclosures Appropriate accounting and disclosure treatments of OBS vehicles Challenges in managing incentive problems created by compensation practices 14
15 Question & Answer Session 15
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