Risk Governance and Risk Management: Oxymorons?

J. V. RizziJune, 2013

Macrostrategies, LLC

1Macrostrategies, LLC

Introduction Decisions Governance Why Change Conclusion

2Macrostrategies, LLC

Macrostrategies, LLC 3

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 and monitor senior management behavior to protect shareholder interests…

…like financial crisis, MF Global, London Whale…ha.

Macrostrategies, LLC 4

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

Macrostrategies, LLC 6

(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

(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

(The influence of Risk Management…

Defined: underestimate the impact of low probability high impact events.

Psychological Basis◦ Availability◦ Threshold

Reinforced 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

(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

(Who decides…

Uncertainty & Behavioral Bias Amplifiers ControlAsymmetric Over Confidence Incentives InternalInformation Illusion of Control Bureaucracy - Board monitoringBeyond the data Hindsight Bias Opaque - Incentivesevents: Anchoring Accounting - Sanction- Experiences Leverage External- Exposures Complexity - RegulatorsBlack Swans - Rating AgenciesAdverse Selection - Marked for

ControlMoral Hazard

…how do they decide?)

Macrostrategies, LLC 11

Macrostrategies, LLC 12

(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

(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

(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

(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

(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

(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

(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

Macrostrategies, LLC 20

(Beware turning risk management and governance…

CAMELS: management “m” to include Board competence and engagement

Dodd Frank◦ Risk committee requirement: $10B ≤ assets < $50

Chaired by independent direction; one risk management professional◦ Chief Risk Office requirement: assets ≥ $50B

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

(Change before…

Just one crisis away from shareholder action◦ JPM◦ Goldman◦ Non-banks

Activists Supporters

◦ Advisors◦ Pensions

…being changed.)

Macrostrategies, LLC 22

Macrostrategies, LLC 23

(Purpose of governance is to protect institution from being…

Role of Board: understand and 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