Understanding and Managing Risks

In a Volatile Environment

Prepared for: Delaware Bankers Association

Thursday, January 22, 2009

University & Whist Club | Wilmington, DE

Agenda

• Quick Introductions – Our Qualifications• Overview of Current Environment – Setting

the Stage• The Challenges & Opportunities• Final Conclusion & Possible Next Steps• Open Q&A

Quick Introductions – Our Qualifications

Richard P. Eckman

Richard P. Eckman is a partner in the Wilmington office of Pepper Hamilton LLP. He is a finance and transactional lawyer and chairs the firm’s Financial Services Practice Group. Mr. Eckman’s transactional practice focuses on representing financial institutions, corporations and other entities in complex financing transactions, including mergers and acquisitions, asset securitizations and other lending and venture transactions.

Mr. Eckman was one of the drafters of Delaware’s landmark Financial Center Development Act that attracted over 25 financial institutions to Delaware, many of whom he represents. He was chairman of the Commercial Law Section of the Delaware Bar Association from 1989-1991 and of its Banking Law Committee from 1984-1992. He has been counsel to the Bank of Delaware, now PNC Bank; was a founder of and vice president and general counsel for The Chase Manhattan Bank (USA), N.A.; and was a director and secretary of FCC National Bank, headquartered in Wilmington.

Mr. Eckman is a fellow in and former regent of the American College of Consumer Financial Services Lawyers and a member of the Lawyers Committee of the Consumer Bankers Association. He is also an adjunct professor at the Villanova University School of Law where he teaches financial institution law. He is active in and held leadership positions on the Consumer Financial Services Committee of the Business Law Section of the American Bar Association and currently serves as editor-in-chief of its e-newsletter. Mr. Eckman was a founder and president of the Delaware Entrepreneurs’ Forum. Mr. Eckman is also a member of the Editorial Board of the Journal of Payment Systems Law.

Richard P. Eckman302.777.6560 – Direct302.421.8390 – Fax eckmanr@pepperlaw.com

Mr. McTaggart started his legal career in the Legal Division of the Board of Governors of the Federal Reserve System and is now is a partner in the Washington, D.C., office of Pepper Hamilton LLP. He focuses his practice on bank and financial services regulatory matters. He also has significant experience handling transactional, enforcement and legislative matters for financial services clients. Earlier in his career, Mr. McTaggart served as the Delaware State Bank Commissioner (1994-1999) and as counsel to the U.S. Senate Banking Committee (1991-1994).

Mr. McTaggart has represented financial services companies, foreign banks, investor groups, bank trade associations, investment firms and retailers in connection with issues such as Internet banking, state and federal financial regulation, government-sponsored enterprise matters, and privacy and data safeguard issues. Mr. McTaggart also has represented clients before the federal bank regulatory agencies, including the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision and the Board of Governors of the Federal Reserve System, as well as various state banking departments across the country.

As the Delaware State Bank Commissioner, Mr. McTaggart supervised and set policy for retail banks, trust companies, wholesale banks, credit card banks, saving banks, mortgage companies and other financial services companies with operations in Delaware and across the nation. He also was responsible for administering escheat laws and the bank franchise tax applicable to all financial institutions operating in Delaware.

Timothy R. McTaggart202.220.1210 – Direct202.220.1665 – Fax mctaggartt@pepperlaw.com

Timothy R. McTaggart

Mr. Noring is a Managing Director in the Finance and Accounting practice in the Washington DC office. He leads NCI’s Financial Risk Management Advisory Practice, which includes the Internal Audit Services, Sarbanes Oxley Services, Financial Risk Management, Credit Risk Management, Model Risk Management, and Servicing Operations Risk Groups.

Mr. Noring has extensive experience in capital markets operations, mortgage banking, securitization transactions, derivative risk management operations, auto finance, best practice environments surrounding financial instrument accounting, fair value measurements and allowance for loan loss methodologies.

Mr. Noring has over 21 years of professional services experience and is a former partner at PricewaterhouseCoopers where he spent 18 years serving large multinational financial services clients. Prior to joining Navigant Consulting, he was Senior Vice President of Finance at Fannie Mae, responsible for financial reporting, tax and the business unit controller’s function as well as leading key restatement efforts.

Mr. Noring joined Navigant Consulting in June 2006 and since then has lead three significant restatement projects involving a major multi-family real estate finance company, a leading auto lender, and a government sponsored agricultural mortgage guarantor. Key restatement issues involve FIN 45(R), FAS 133, FAS 140 as well as other financial instrument and real estate accounting pronouncements.

Most recently, Mr. Noring has led a detailed servicing operations review at a top 10 mortgage servicer on behalf of the trustee for the entity’s private label securitizations. In addition to covering all servicing functions, the review placed extra emphasis on the servicer’s loss mitigation and loan modification activities.

Paul A. Norig, CPA703.734.5912 – Direct703.734.5970 – Fax pnoring@navigantconsulting.com

Paul A. Noring, CPA

Overview of Current Environment –Setting the Stage

Despite the implemenation of new methodologies, modeling techniques and supporting technologies, significant “long tail” events continue to take the industry by surprise

The Risk Management Challenge

Risk Tolerance

Risk

Appetit

e

Ton

e

at th

e

Top

Regulatory Oversight Managemen

t Experti

se

Tech

. Fra

mew

or

k

Risk Modeling

Limitations

Risk Modeling

Limitations Resource Hiring &

Investments

Constraints

Resource Hiring &

Investments

Constraints

Increased Complexity in Products & Services

Increased Complexity in Products & Services

Revenues & Earnings Pressures

Revenues & Earnings Pressures

Governance Governance & &

Risk Risk CultureCulture

Governance Governance & &

Risk Risk CultureCulture

Organizational Roles &

Responsibilities

Misaligned Performance & Compensation

Plans

Willingness to accept risk in the normal

course

Willingness to pursue risk for reasonable

returns

Level of influence exerted by Oversight

groups

Understanding complex transaction

risks

Systems capabilities & constraints

Articulated & demonstrated

Commitment & Ethics

The environmental factors surrounding the execution of Risk Management activities can significantly impact the overall effectiveness of such efforts

In order to survive and thrive in this environment, FSO’s must proactively respond & adapt to the new business reality

Pursue revenue generation opportunities

WHAT CAN AND SHOULD WE DO?

Assess & balance resource needs

Assess & mitigate embedded risks Ensure the

integrity of Governance & Controls framework

Mitigating Risk In a Volatile

Environment Seek out & implement process efficiencies

It is incumbent upon Executive Management to pursue all opportunities to preserve franchise value in times of extraordinary pressures

» Confirm that all controls are in place and effective» Mitigate credit losses to the extent possible» Improve processes to support expense containment» Continue to drive revenues in a risk appropriate manner

The Challenges & Opportunities

Credit Risk

Arises from the potential that a borrower or counterparty will fail to perform under the contractual terms of an obligation.

Mitigating Risk In a Volatile

Environment

- Underwriting

- Off balance sheet exposures (guarantees / SPV's and SIV's / commitments)

- Covenant and Collateral Protection

- Portfolio Correlation / Concentration

- Continuous Risk Rating / Risk Mitigation

- Transparent Risk Analytics / Reporting

- Stress Testing

- Reserving

- Workout / recovery

Market Risk

The risk to a financial institution's condition resulting from adverse movements in market rates or prices, such as interest rates foreign exchange rates, or equity / prices. - Proprietary Trading Desks and Strategies

- Investment & Liquidity Portfolio (realized versus unrealized)

- Derivative and FX dealing (matched book versus market making activities)

- Securitization Residuals (subordinated tranches and MSRs)

- Principal Investing

- Collateral values

- Refinancing options (ties into credit risk

Operational Risk

Arises for the potential that inadequate information systems, operational problems, breaches in internal controls, fraud or unforeseen catastrophes will result in unexpected losses.

- Fraud / Unauthorized Activities

- Accounting Processes (trade capture / payments / reconciliations)

- Financial Restatements

- Merger Integration

- Unauthorized access to data

- Business Continuity / Disaster Recovery

- New Product Approval (ties into all risk categories)

Other Key Risk Categories

Liquidity Arises from the potential inability to meet obligations when due because of inadequate funding or an inability to liquidate assets, or in cases where exposures cannot be unwound or offset without significantly lowering market prices because of inadequate market depth or market disruptions.

Legal

Arises from the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or conditions of a banking organization

Reputational Arises from the potential that negative publicity regarding an institution's business practices whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.

Enterprise Risk Management (“ERM”) is focused on the minimization of earnings volatility, and effective implementation is considered a critical element in value creation

"…a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives."

MeasurementMeasurementRisk Appetite / LimitsRisk Appetite / Limits ReportingReporting

CultureCulture

Structure & RolesStructure & RolesPrinciples & StandardsPrinciples & Standards

Integrated Financial Mgmt Systems

Risk Mgmt Tools

Data Mgmt Standards / Infrastructure

Infrastructure

MeasurementMeasurementRisk Appetite / LimitsRisk Appetite / Limits ReportingReporting

CultureCulture

Structure & RolesStructure & RolesPrinciples & StandardsPrinciples & Standards

Integrated Financial Mgmt Systems

Risk Mgmt Tools

Data Mgmt Standards / Infrastructure

Infrastructure

ERM Framework Components

A working definition for Enterprise Risk Management is ….……

An effective ERM framework: Reflects the risk culture of the

organization Is principles based, providing for

flexibility in execution Requires that Key Risk Metrics

(“KRMs”) be measured, reported & managed

Is based on a base level infrastructure that accommodates the harvesting & analysis of internal risk and financial data

The design of the risk governance framework is critical to the deployment of an effective enterprise wide risk & controls program

Board

Level

Govern

ance

Man

ag

em

ent

Com

mit

tees

Funct

ion

al

Gro

ups

LOB

s

Risk Appetite, Corp. Vision

& Corp. Ethics

Mission Statement, Risk Culture & Policy Setting

Limits & Guidelines

Development, Monitoring

&Tool Deployment

Execution

Market RiskMarket Risk

Credit RiskCredit Risk Loan Approval

Loan Approval

Asset/Liab Mgmt

Asset/Liab Mgmt

Ops Risk Ops Risk

AuditAudit

Credit ReviewCredit Review

Credit Risk Mgmt

Credit Risk Mgmt

Model Mgmt& Review

Model Mgmt& Review

Portfolio Mgmt

Portfolio Mgmt ComplianceCompliance Market

Risk MgmtMarket

Risk Mgmt

Ops Risk Mgmt

Ops Risk Mgmt

TreasuryTreasuryFinanceFinance Office of Gen Counsel

Office of Gen Counsel

Business Unit

Business Unit

Business Unit

Business Unit

Business Unit

Business Unit

Business Unit

Business Unit

Enterprise Risk MgmtEnterprise Risk Mgmt

ComplianceCompliance

Committee Charters Committee Membership Sub-Committee Structures Level of Delegation to Exec

Mgmt Required Reporting &

Communications to be Received

Committee Charters Defined Responsibilities Proper Reporting Lines Defined Scopes of Authority Committee Membership Sub-Committee Structures Level of Delegation to Mgmt Levels of Reporting &

Communications (up & down)

Appropriate Levels of Independence

Proper Reporting Lines Defined Scopes of

Responsibility Proper Goals & Incentives Appropriate Expertise/ Skill

Sets Tools that are Fit for Purpose Reporting & Communications Alignment of Business Goals

with Risk Strategies Tools that are Fit for Purpose

Board of DirectorsBoard of Directors

Risk Committee

Risk Committee

Risk Committee

Risk Committee

Risk Committee

Risk Committee

Risk Committee

Risk Committee

Internal Audit

Internal Audit

SOXSOX

Compliance Challenges Facing Financial Institutions

• Review the Scope and Depth of Your Compliance Program

• Do You have the Right People In Your Compliance Group?

• How Does Your Compliance Group Interact with Management?

• How Do They Interact with the Counsel?• What do the Regulators Say?

Hot Areas for Regulators

• Unfair and Deceptive Practices• Fair Lending• BSA/AML• Privacy/Data Breach

Third Party Relationships

• Need to Negotiate a Contract that Regulators will Love

• Treat Third Parties as Part of Your Company

• Audit Rights - Most Important• Reporting• Penalties and Remedies

How to Avoid Costly Litigation

• Effective Compliance Programs Limit Litigation

• Get Lawyers Involved Early• Use Arbitration Clauses• Try to Resolve Disputes Using Mediation• Hire Good Lawyers to Represent You

Final Conclusion & Possible Next Steps

Current Pressing Events

Mitigating Risk In a Volatile

Environment

- CAPITAL!!!

- Credit         * Allowance for Loan Loss Provisioning         * Portfolio Stress Testing         * Risk Analytics / Reporting         * Covenant / Collateral Protection         * Workouts

- Securities / Derivatives         * Valuation of Financial Instruments         * Impact of credit spreads on matched books         * Impairment

- Loan Modification Programs

- Government Bad Asset Purchase Programs

Need for Change

•Organizations can no longer afford to allow risk oversight practices to operate in their respective silos•Internal as well as external forces are driving the need for change •Management must determine the most effective approach to overcome any obstacles

It is Management’s fiduciary & ethical responsibility to ensure that the governance & risk management framework is sufficiently robust and effective for the levels of risk being undertaken

Drivers of Change: Excessive credit & investment losses

Heightened emphasis on risk mitigation

Increased complexity in products & services

New regulatory requirements

Internal cost reduction initiatives

Internal limitations on hiring & investment

Next Steps …………

Identify areas having potential opportunities for improvement ……..…...

Popularize this approach with business owners & decision makers ..…....

Identify & address any internal impediments to success ………………….

Perform a high level assessment of potential benefits & costs ………..

Develop a road map & prioritize efforts …………………..…………………

Mobilize ………………………………….……….…….……………………….

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Open Q&A