The Ripple Effect: How Basel II Will Impact Institutions of All Sizes
ERisk, white paper, July 2005
This paper explores the impact that Basel II will have on all kinds of financial institutions from an enterprise risk management and economic capital perspective – and discusses how Basel II investments in risk modeling and data gathering can be leveraged into ten key improvements in business management. The paper looks at how to overcome the key challenges of implementing Basel II, including improving the credit rating process, accurate risk factor estimation, sound approaches to operational risk, and the development of an overarching economic capital framework. It also sets out a seven-step route to the efficient implementation of Basel II that will allow banks to gain immediate business benefits from their longer-term investments in Basel II compliance programs.

Stress Testing Housing Loan Portfolios: A Regulatory Case Study
Neil Esho et al, Australian Prudential Regulation Authority, 9 September, 2005
Over the last few years, there have been sharp rises in house prices in economies such as the United States, United Kingdom and Australia. Whether these price rises can be sustained is a significant concern for many banks with growing residential mortgage portfolios. Here, the Australian Prudential Regulation Authority conducts a stress test to see how robust 120 Australian banks might be to a 30% price fall, plus increasing default and loss rates. It turns out that all the institutions remain solvent in the face of these market conditions, but 11 break their minimum regulatory capital ratios.

Stress Testing at Major Financial Institutions: Survey Results and Practice
BIS Committee on the Global Financial System, January 2005
The application of stress tests has grown from analysis of exceptional but plausible events to a range of applications including the allocation of economic capital, limit setting and the exploration of business risks. This report is the most up-to-date synthesis available on how stress testing is used in the banking industry, using survey responses from 64 banks. The report also notes some of the tricky challenges facing banks in the future. These include stress testing whole loan portfolios, how market liquidity is affected by stressful market conditions, and fully integrated stress testing.

How do Banks Make Money? The Fallacies of Fee Income
Robert DeYoung and Tara Rice, Chicago Fed – Economic Perspectives, November 2004
Over the last few decades fee income has become ever more important to banks, in comparison to their more traditional sources of income (especially lending). Fee income looks very attractive to bankers because it seems more stable – it does not attract heavy credit losses during the trough of the credit cycle and is less affected by interest rate volatility. For the same reason, fee businesses have traditionally not attracted much in the way of regulatory capital charges. The authors of this paper, however, puncture some of the myths. They find that, though fee income is becoming more important to banks, at many smaller banks it is payments fee income – a traditional form of bank income – that accounts for much of the rise. They also find that fee income can make bank earnings more, not less, volatile. This is because fee-income customers are much more fickle than borrowers, and because fee-income businesses tend to lead to an increase in staffing costs that may not be easy to reverse if business volumes fall (i.e., operating leverage risk). Fee income can also make banks “riskier” in another important way. The authors say that because banks incur low regulatory capital charges for fee businesses, any shift to fee income business allows a bank to increase its financial leverage.

Evaluating Design Choices in Economic Capital Modeling: A Loss Function Approach
Nicholas Kiefer and C. Erik Larson, OCC working paper, September 2004
The way in which credit exposures are segmented and aggregated can affect total economic capital allocation and its attribution back to individual bank activities and business lines. This technical paper examines this problem and looks at the trade-off between the advantages of combining data (which increases sample size) and the danger that this will lead to a characterization of heterogeneous assets with the same default probability.

Making Sense of Risk: The Role of Internal Audit in Enterprise-Wide Risk Management (download page)
Institute of Internal Auditors, position paper, 27 September 2004
Many different parties within a bank are interested in the concept of enterprise risk management – from the risk management function, to top executives, to internal and external auditors. But in this fast emerging field it is not always clear how the roles of all these players should be defined. This paper defines ERM in a way that is in line with the new COSO framework and goes on to discuss the proper role for internal auditors in any ERM activities. The paper is particularly keen to preserve the independent “watchdog” or assurance role of the auditor. Internal auditors should therefore help a firm evaluate how well it is reporting risks from an ERM perspective, but they should not get involved in determining the firm’s risk appetite or in specific risk management activities. Auditors, who report largely to the Audit Committee, must keep a distance between their ERM activities and those of the risk modeling and risk management functions of the firm (who report largely to executive management).

What Determines How Much Capital is Held by UK Banks and Building Societies
Isaac Alfon et al.,  Financial Services Authority, Occasional Paper Series, July 2004
All banks hold risk capital above and beyond the strict regulatory minimums required by their regulators. But it is not always clear how banks determine how much “excess” capital they should hold above the minimum. It is also not clear that banks should increase their total capital if minimums are increased, given that they usually maintain a large buffer of capital – yet many do, at least to some extent. This paper discusses the various reasons why banks hold excess capital, notably the need of management to be certain the bank will not “accidentally” break regulatory minimums and their need to maintain the confidence of rating agencies and the wider market. The paper concludes that peer group levels of capital are an important influence, perhaps because of a market discipline effect.

A General Approach to Integrated Risk Management with Skewed, Fat-Tailed Risks
Joshua Rosenberg and Til Schuermann, Federal Reserve Bank of New York, May 2004
One of the most important technical challenges in calculating enterprise-wide economic capital is the problem of how to aggregate risk and capital numbers across a bank’s different activities and risk types. The aggregation problem is exacerbated by the different natures of the loss distributions in risks such as market, credit and operational risk. For example, operational risk calculations depend more than market risk calculations on the susceptibility of the firm to low-frequency but very severe risks. This paper offers an accessible introduction to the aggregation challenge, as well as some leading-edge technical analysis. The paper finds that given a risk type, total risk is more sensitive to differences in business mix than it is to differences in inter-risk correlations.

Bank Failures in Mature Economies
Basel Committee on Banking Supervision, April 2004
What actually makes banks fail? This lengthy survey of the historical evidence looks at many banking system and individual bank failures around the world over the last few decades. It seems that systemic failures can, almost always, be laid at the door of credit risk – with real estate lending and overly concentrated portfolios being the principal specific mechanisms of failure. The historical record also shows that failures tend to happen after a period of financial liberalization and are exacerbated by poor bank supervision. The authors wonder if bank failures caused by market and liquidity risk – at present, quite rare phenomena – might become more common as banks come to depend on the financial markets for more of their funding.

Trends in Risk Integration and Aggregation
Basel Committee on Banking Supervision, Joint Forum working group report, August 2003
This report, based on a survey of 31 financial institutions in 12 jurisdictions, identifies and describes two key trends in the management of risks in the banking, insurance, and securities sectors: (1) greater emphasis on the management of risk on an integrated firm-wide basis and (2) related efforts to “aggregate” risks through mathematical risk models. The report does not attempt to define best practice and offers only limited quantitative data about industry practice, preferring to make a series of more general, qualitative statements in this emerging area of risk management. However, it offers a timely characterization of industry trends and many hints on regulatory thinking, as well as clear introductions to some of the key conceptual tools surrounding risk integration and economic capital.

Assessing the Strength of UK Banks Through Macroeconomic Stress Tests
Glenn Hoggarth and John Whitley, Bank of England Financial Stability Review, June 2003
This paper describes how the Bank of England devised a series of stress tests for UK banks. The tests included a fall in equity prices; unexpected sterling depreciation; an increase in wages; and a fall in house prices. The paper also describes another approach to stress testing: re-running the more general effects of the early 1990s recession on today’s banks. The stress tests revealed that credit risk remains the most important risk class for major UK banks, and that the banks would indeed be able to weather the selected scenarios. But the paper’s conclusion highlights the limitations of such stress testing: the short time horizon specified in the tests (one year); the necessary assumptions about monetary policy; and the unpredictabilitiy of market reactions to counterparty concerns.

Framework for the Assessment of Bank Earnings
Rodrigo Luis Rosa Couto, Banco Central do Brazil, Financial Stability Institute 2002 Award Winning Paper
This award-winning paper offers an analytical framework that helps answer three very important questions about a bank: What are the banks expected results considering the available information and a given set of business conditions? How does it generate its income? What is the sensitivity of its earnings to changes in interest rates, spreads, loan volumes, delinquency and other banking business factors? The authors contend that reported bank earnings are not necessarily a good guide to future bank earnings, particularly in developing economies. Their proposed new framework – developed in Brazil and already applied there by regulators – attempts to separate out reliable indicators of future income from accounting items that can confuse forward-looking earnings estimations. In particular, it separates out items such as provisions and tax credits (subject to management estimation), treasury dealings (volatile and non-core), income from securities holdings, and the effects of foreign exchange exposure.

The Institutional Memory Hypothesis and the ProCyclicality of Bank Lending Behavior
Allen N. Berger and Gregory Udell, Board of Governors of the Federal Reserve System, Indiana University, December 2002
This paper advances the hypothesis that the ability of loan officers to select strong credits deteriorates over a bank’s lending cycle, giving rise to an easing of credit standards and helping to cause “procyclicality” at an industry level. Specifically, lending institutions tend to forget the lessons they learned from their problem loans as time passes from their last loan “bust”, due to a proportional increase in officers that have never experienced a loan bust, the atrophying skills of experienced officers, and increasingly inefficient internal monitoring systems (loan review) as time passes since the bank’s last bust. The authors find support for their general hypothesis in a test that employs data on commercial loan growth, interest rate premiums on loans, credit standards and loan spreads.

Global Evidence on the Equity Risk Premium
Elroy Dimson, Paul Marsh, and Mike Staunton, London Business School, IFA working paper, summer 2003
The magnitude of the equity risk premium – the difference between the return on risky stocks and the return on safe bonds or bills – is one of the most important issues in corporate finance. The equity risk premium drives future equity returns and is a key determinant of the cost of capital (and bank “hurdle rates”). Yet it is not clear how big the equity premium has been in the past or how large it is today. In response, the authors examine equity returns in 16 different countries over the 103-year period from 1900 to 2002. This “big picture” view of the equity risk premium suggests that a plausible, forward-looking risk premium for the world’s major markets is around 3% on a geometric mean basis, while the corresponding arithmetic mean risk premium would be around 5% – lower than historical premiums quoted in most textbooks or academic surveys. The new numbers represent the authors’ best estimate of the equity risk premium for corporate capital budgeting and valuation applications.

The HIH Royal Commission Report
Justice Neville Owen, HIH Royal Commission, 16 April 2003
On 15 March 2001 the major part of the HIH Insurance group was placed in provisional liquidation with deficiencies later estimated at between $3.6 billion and $5.3 billion – one of the largest corporate failures Australia has endured to date. This three-volume report offers exhaustive evidence on the causes of the disaster. It finds that the debacle was not caused by wholesale fraud, setting aside any misconceived desire to paper over the ever-widening cracks in the company. Instead, a deficiency of several billion dollars arose because claims arising from insured events in previous years were far greater than the company had provided for. This ‘under-reserving’ or ‘under-provisioning’ arose in turn through mismanagement and a business culture epitomised by a lack of attention to detail, a lack of accountability for performance, and a lack of integrity in the company’s internal processes and systems. Combined, these features led to a series of business decisions that were poorly conceived and even more poorly executed. In the words of the presiding judge: “Risks were not properly identified and managed. Unpleasant information was hidden, filtered or sanitised. And there was a lack of sceptical questioning and analysis when and where it mattered.” Risk professionals too busy to read the whole report should read the ‘Reasons for the Failure’ section of the official summary, available here.

Managing Risk: Practical Lessons from Recent ‘Failures’ Of EU Insurers
William McDonnell, FSA Occasional Papers, December 2002
In this report a working group of supervisors from 15 European countries dissect recent experiences of failed insurance companies and ‘near misses’across the life and non-life sectors since 1996. The report also assesses supervisory practices aimed at prevention and advance detection. It concludes that internal management problems appear to be the root cause of every failure or near failure; firms need to anticipate how risks can interact in complex ways, including causal links between different types of risk (for instance operational risks and underwriting risk or claims evaluation risk) and unexpected correlations (particularly between certain asset and underwriting risks); and that it is important to strike the right balance between prescriptive rules, principles, incentives and diagnostic tools.

Derivatives Risk in Commercial Banking
Alan C. Puwalski, FYI (FDIC electronic bulletin), 26 March 2003
This regulatory overview paper looks at the operational, market and credit risks posed by derivatives to commercial banking in terms of three activities: hedging, trading and speculating. It notes the overwhelming importance of a few major dealers in some derivatives markets, saying that an erosion of confidence in any one of the major dealers could result in a rapid change in its risk profile and cause market disruptions. But the real danger lies in immature derivatives markets where margins are temptingly high, but risks might not be fully understood.

The Economics of the Bank and of the Loan Book
Stephen Kealhofer, Moody’s KMV, 2002
This paper explores how the profitability of a loan can be measured more accurately by decomposing the performance of the loan into two parts, one attributable to the underwriting activity, and one attributable to the subsequent performance of the loan (ie portfolio management activities). The underwriter’s revenue is the difference between the funds extended and the value of the loan held by the bank – assessed using external market valuations of similar instruments – minus the costs of the underwriting operation. Meanwhile, portfolio management can be evaluated relative to the performance of a well-constructed portfolio formed from the same universe of potential assets. The paper looks at how this argument relates to RAROC profitability measures, discusses approaches to loan valuation, and explores the meaning of “mark to market” in the context of the credit portfolio.

Incentive Features in CEO Compensation in the Banking Industry
Kose John and Yiming Qian, New York University and University of Iowa, Federal Reserve Bank of New York Economic Policy Review, April 2003
Should corporate governance and incentive compensation at a bank try to align executive interests with those of shareholders, or with the interests of other key stakeholders? This paper looks at the CEO pay-performance sensitivity of the banking industry using 1992-2000 data, finding that bank executive pay is less sensitive to performance than is the CEO pay at other corporations. The authors put this down to the highly regulated and leveraged nature of banks, and the important responsibilities they hold to depositors (as well as shareholders). The paper offers an up-to-date review of the theory governing how executive pay might affect bank risk and reward management decisions.

Is Corporate Governance Different for Bank Holding Companies?
Renee Adams and Hamid Mehran, Federal Reserve Bank of New York, Economic Policy Review, April 2003
The authors analyze a range of corporate governance variables in a sample of bank holding companies and manufacturing firms. They find that banks have larger boards, more committees and a relatively high percentage of outside directors. Conversely, the proportion of CEO stock option pay to salary plus bonuses, as well as the percentage and market value of direct equity holdings, is smaller for banks. Furthermore, fewer institutions hold shares in banks relative to shares of manufacturing firms, and the institutions hold a smaller percentage of bank equity. The differences, the authors argue, suggest that governance structures are industry-specific. They might result from differences in the investment opportunities of firms in the two industries, as well as from the presence of regulation in the banking industry.

Taming Uncertainty: Risk Management for the Entire Enterprise
PricewaterhouseCoopers/Economist Intelligence Unit, July 2002
This briefing looks at the trend towards a holistic approach to risk management in financial institutions. It summarises three key ‘enablers’ for enterprise risk management: board-level support; management processes that make the whole enterprise aware of risk; and putting the right people and systems in place to make sure risk-aware decisions can be taken. The briefing also sets out ten attributes of a world-class risk management culture, summarises UBS’s approach to ERM in new product approval, and offers a broadbrush framework for the ERM process.

The Challenges of Risk Management in Diversified Financial Companies
Christine M. Cumming and Beverly J. Hirtle, Federal Reserve Bank of New York, Economic Policy Review, March 2001
This paper is notable as one of the first explicit attempts by regulatory thinkers to address the managerial attempt to build enterprise-wide risk management structures in the banking industry. The authors acknowledge that, in recent years, financial institutions and their supervisors have placed increased emphasis on the importance of measuring and managing risk on a firmwide basis – a process that this paper refers to as ‘consolidated risk management’. The authors, prominent regulatory thinkers, say that while the benefits of this type of risk management are widely acknowledged, few if any financial firms have fully developed systems in place today. This suggests that significant obstacles have led institutions to manage risk in a more segmented fashion. The authors examine the economic rationale behind consolidated risk management, while also confronting key problematics for bank supervisors and practitioners in developing consolidated risk management systems.

Enterprise Credit Risk Management (registration required)
Scott Aguais and Dan Rosen, Algorithmics, 2001
This paper, the introduction to a complete electronic book on credit risk measurement from risk software company Algorithmics, discusses how to build a framework for integrating credit risk and reward across a financial enterprise. It emphasizes four fundamental modelling requirements: the simultaneous use of various credit risk models; the accurate modelling and valuation of individual credit risky instruments; the integration of market and credit risk; and the construction of effective tools not only to measure risk, but also to manage and optimize risk and reward. In so doing, the paper highlights the challenges many institutions face in breaching the ‘risk silos’ that dominate conventional treatments of credit risk measurement.

Creating Value Through Enterprise Risk Management – A Practical Approach for the Insurance Industry
Tillinghast-Towers-Perrin, 2001
This long and ambitious concept paper by consultants at Tillinghast-Towers-Perrin looks at how enterprise risk management can be defined for insurance firms and offers a detailed framework for implementing ERM. It discusses the differences between banking and insurance ERM and offers a guide to developing ERM in the insurance industry. It discusses many of the specific problematics such as risk mapping, prioritisation techniques such as heat mapping, and compares the main risk modeling techniques. The paper also compares financial risk modelling techniques developed in the banking industry, such as value at risk, to insurance industry techniques such as probability of ruin. It offers a five-step process to ERM strategy building and concludes with some illustrative vignettes on ERM in practice.  Also from TTP, note this survey from 2000 that helped benchmark corporate attitudes to enterprise risk management.

Integrated Risk Management: A Holistic Risk Management Approach for the Insurance Industry
Working paper, Dr. Andreas Müller, Munich, 1999
This paper takes a look at holistic risk management from a reinsurance perspective. It argues that, ultimately, an integrated risk management strategy will enhance shareholder value at insurance joint-stock companies. The paper claims that the field of 'integrated risk management' opens up an opportunity for reinsurers to effectively position themselves in the market. It also argues that integrated risk management solutions are a fundamental pre-condition for the design of efficient insurance coverage – particularly as risks grow steadily more complex.

Survey on Enterprise Risk Management
Casualty Actuarial Society, 2001
This survey took the temperature of knowledge about enterprise risk management in the insurance industry. It found a lack of knowledge of important tools and concepts such as economic capital, Economic Value Added, Expected Policyholder Deficit, Extreme Value Theory, options pricing theory, Risk Adjusted Return on Capital, risk mapping and Value at Risk (even among those respondents who rate themselves as expert in or highly familiar with ERM).

How Safe is Safe Enough: An Introduction to Risk Management
Angela Darlington et al., Staple Inn Actuarial Society, June 2001
This easy-to-read overview of problems and issues in holistic risk management is aimed primarily at actuaries, and offers a summary of the key themes and practices employed in risk management. A specific discussion of enterprise risk management (pages 26-32) defines ERM as ‘the process of systematically and comprehensively identifying critical risks, quantifying their impacts, and implementing integrated risk management strategies to maximise enterprise value’. The paper includes a table that lays out the difference between traditional ‘insurance-led’ risk management and ERM, and concludes by asking how actuaries can add value to the ERM discussion.

The Corporate Governance of Banks
Jonathan R. Macey and Maureen O’Hara, Federal Reserve Bank of New York, Economic Policy, 2001
This paper examines the special corporate governance concerns at banking institutions, arguing that the officers and directors of banks should be given a special duty to maintain ‘safety and soundness’. In particular, those in control of banks owe special duties to creditors (as well shareholders) and should take solvency issues specifically into account when taking risky decisions. The authors point out that legal precedent suggests that bank boards might be unlikely to be personally liable for the institution’s failings unless they fail utterly in their duty to provide a system of oversight. The authors argue that this does not set the bar high enough for the boards of banks. Instead, bank boards should have ‘a continuing obligation to develop and maintain a detailed and elaborate system of monitoring and oversight’.

Corporate Governance: A Mandate for Risk Management?
Lynn T. Drennan and Matthias Beck, Glasgow Caledonian Business School
This paper looks at the ‘corporate governance revolution’ in the UK since the 1990s. With some specific reference to financial institutions, the paper clearly lays out the main elements of this revolution and looks at the likely implications in terms of corporate risk management. It takes a particular look at the seminal UK Turnbull report in the UK, which emphasized that risk management and control should be embedded in business processes. The authors say that the Turnbull report has therefore been interpreted as involving three steps: board identification of key risks and an assessment of how they have been evaluated and managed; assessment of the effectiveness of the internal control system in place (with a particular focus on trouble spots); company reporting of all aspects of the risk control system.

Incentives for Effective Risk Management
Jon Danielsson, Bjorn N. Jorgensen and Casper G. de Vries, LSE, HBS, Tinbergen Institute, September 2001
So far, the debate about Basle Capital Reform has skirted round the problem of how the various options within the regulators’ proposals might interact with self-interested decision-taking by various agents within a financial institution. This Tinbergen Institute discussion paper opens up that discussion with an examination of the principal–agent relationship between regulator, board of directors and risk manager. It models the strategic choice between alternative risk management strategies and finds that there are some conditions under which the bank chooses a better risk management system when left to itself than it does when supervised. The paper also points out that most banks carry considerably more capital than their regulators stipulate, perhaps because banks are in fact riskier than regulatory models imply: how might this complicate decision-making?

PSAF, Economic Capital and the New Basel Accord
James Thomson, Federal Reserve Bank of Cleveland, 2001
When setting fees for offering correspondent banking services, reserve banks use a ‘private sector adjustment factor’ as a proxy for the risks and costs that public institutions would incur if they were, in fact, private providers of correspondent banking services. This working paper takes a look at whether that factor is meaningful in terms of economic capital concepts. In doing so it offers a fresh perspective on issues in economic capital calculation, and says that a failure to account for differences in risk across correspondent banking service lines has led to cross-subsidies and distortions in investment and pricing decisions. It looks at the problem of setting single and multiple hurdle rates, and argues that the construction of a better proxy for the private return on capital associated with correspondent banking services is becoming critical.

Combined Market and Credit Risk Stress Testing Based on the Merton Model
Maria Kafetzaki-Boulamatsis and Dirk Tasche, RiskLab, June 2001
This highly technical paper examines the problem of how to combine market and credit risk measures. It points out that the literature on this problem is comparatively sparse, even though there is a wide consensus that market and credit risk should not be regarded separately. It reviews the Merton model as it relates to the problem of stress testing the effects of credit, market and foreign exchange risk on the portfolio of a financial institution; there is no straightforward solution to this problem since the Merton model links only equity and firm value for a single firm, but includes neither interest rate volatility nor foreign exchange rates.

Do Risk-Adjusted Pricing and the New Basel Capital Accord Reinforce the Credit Cycle?
Manuel Ammann, University of California, Berkeley, February 2001
This paper by a Swiss visiting professor at Berkeley discusses how risk-adjusted pricing and RAROC methodologies are likely to interact with the dynamics of the economic cycle. It points out, with some reference to the Swiss credit cycle, that pricing based on long-run default probabilities tends to ‘over price’ for credit during economic booms, and ‘under price’ during economic downturns. This means that customers will be tempted to look outside the banking sector for credit when times are good, and then turn to banks when things get difficult. The paper argues that while risk-adjusted pricing makes sense, it won’t solve the problem of credit cycles. As banks become more sophisticated for competitive reasons they might end up accentuating the effect of cyclical time-varying credit spreads. The paper also relates this problem to the ‘pro-cyclicality’ effects of the proposed new Basle Capital Accord.

The Risk Manager of the Future: Scientist or Poet?
Eric Falkenstein, RMA Journal, February 2001
This very readable article offers a practical philosophy of enterprise-wide risk management for busy professionals and managers. The author concludes that the ideal risk manager of the future will need to understand risk analytics, possess keen skills in data integration and understand how risk measures relate to strategic and tactical business decisions. But such a risk manager will find it hard to keep their hands clean of ‘dirty dealings’ in institutional politics. The author is critical of “unfocused risk management” and says that “while RAROC applied everywhere is a good thing, it leaves a lot of ambiguity as to method, sort of like a manager telling his boxer to knock the other guy out”. He reckons that in the future, ‘quants’ will be hired not on academic qualification but on their ability to explain complex risk measures to senior management.

The Strategic Role of Economic Capital in Bank Management
Jerome Bock, MKIRisk, 2000
This discussion paper from a vice-president of MKIRisk says that one of the most important aspects of change in the financial industries is the drive toward efficiency in the definition and use of capital, notably the strategic role of economic capital. It defines economic capital as the “excess of assets over liabilities, both on a mark-to-market basis, that is necessary from an economic perspective to protect the firm from potential bankruptcy to a level of reliability with which the owners of the firm are comfortable.” It then reviews how economic capital should be determined and reconciles the economic capital concept with that of regulatory capital. A related article presents ideas on how to integrate risk assessment and capital determination for the range of risks faced by a multi-line institution.

The Future of Risk-Adjusted Credit Pricing in Financial Institutions
Scott Aguais and Lawrence Forest Jr, RMA Journal, November 2000
This article offers an interesting critique of risk-adjusted return on capital (RAROC) methodologies. Scott Aguais, of software vendor Algorithmics, and his co-author argue that the time is right for a move away from centralised, portfolio-based RAROC approaches to credit pricing and towards more market-based and arbitrage-sensitive approaches. The paper stresses the roles played by economic cycle, term of loan, loan conditions and optionality in credit pricing, and discusses what a mark-to-market approach might mean in practical terms across institutions. It concludes that an application service provider model might allow the right mix of central control over model parameters while allowing sophisticated mark-to-market pricing to take place closer to loan origination level.

Accounting for Economic and Regulatory Capital in RAROC Analysis
Eric Falkenstein, 1997
This 1997 article offers an introduction of lasting value to key concepts in economic and regulatory capital management. It points out that “bank capital is not a function of [economic and regulatory capital]; it is a function of one or the other, depending on the existing assets and liabilities on and off balance sheet”. This has important strategic implications: if a bank is constrained by regulatory capital, it should use the regulatory capital for assessing a project’s return on equity; if the bank is constrained by economic capital, it should use the economic capital. When banks find that economic capital is well below regulatory capital, this tends to push them into projects where economic capital exceeds regulatory capital. The author suggests this explains various banking industry trends through the 1990s, the ramifications of which continue to play out in 2002 – in particular, moves into sub-prime lending, fiduciary services, and capital markets and out of high quality lending. The need to put economic capital to work might also explain why banks often retain significant interest rate risk, a habit that is otherwise difficult to explain.

Risk Budgeting: Time Wisely Spent?
Richard Boardman, Royal & SunAlliance, undated
This short piece by the director of risk modelling at Royal & SunAlliance explains in simple terms the role of risk management concepts in the context of a pensions fund. It outlines the way in which ‘risk budgeting’ – the definition of a risk profile and therefore risk-taking appetite, and decisions about how this risk capacity is ‘spent’ – can help fund trustees understand how risk interacts with the problem of matching assets and liabilities.

Report of the Corley Committee of Enquiry Regarding The Equitable Life Assurance Society
Actuarial Profession’s Corley Committee, September 2001
This report, commissioned by the actuarial profession, is one of the more useful documents yet published on the risk management lessons to be learned from the Equitable Life saga. It refuses, controversially, to assign blame to individuals, but offers a neutral narrative (points 16 to 81) of how the UK’s oldest life assurance institution came to close its doors to new business in December 2000. Many of its comments shed light on enterprise risk management as a general problem. It is particularly interesting in its comments on combining the role of chief actuary and chief executive, the communication of risk information to stakeholders, and the problem of the “cumulative and compounding effect” of risk as its relates to free capital. It points out that the concentrated nature of the Equitable’s product mix meant that a risk that damaged other institutions turned into a uniquely fatal exposure for Equitable. One key finding is tucked away in point 38: “In the opinion of the Committee, it would have been prudent for the Equitable to [take note of contingent liabilities], even when those liabilities could be treated as unquantifiable or negligible.”

Global Aging – The Challenge of the New Millennium
Watson Wyatt/CSIS report, undated
This HTML report gives an easy-to-read overview, with key data, of one of the key drivers of both risk and opportunity in the world’s financial industries: global ageing. It points out that in every major developed country, the unfunded liability for public pensions alone amounts to 100 to 250 per cent of GDP – more than the total for official public debt. It profiles how the challenge of global ageing will affect government budgets, restructure the economy, reshape the family, redefine politics and even rearrange the geopolitical order over the next century.

Sending the Herd off the Cliff -- 12/2000
Avinash Persaud
Might the kind of market-sensitive risk management systems favoured by today’s regulators actually make markets more prone to crisis? Avinash Persaud makes a case against the herding of quants in this, the First Prize Essay on Global Finance for the year 2000 in the Institute of International Finance competition in honour of Jacques de Larosière.

Enterprisewide Risk Management and the Role of the Chief Risk Officer
James Lam, feature article, 1999
This article looks at why institutions are implementing enterprise risk management and asks how the emerging position of 'chief risk officer' in
fianancial institutions is related to the trend. Lam, a co-founder of ERisk.com, outlines seven key components of ERM from corporate governance through to risk analytics. He looks at why traditional 'management by risk silo' has proved so expensive for financial institutions and maps out some practical steps towards establishing an ERM programme, concluding that the only alternative to ERM is crisis management - which tends to be much more expensive and embarrassing. The article also sums up the key functions of a CRO as an institution attempts to understand and communicate risks that arise and interact across the whole enterprise.

Enterprise-Wide Risk Management and the Impact of XML -- 2/17/00
Amir Khwaja
The advent of XML may provide a solution to many of the problems of implementing enterprise-wide risk management systems. This paper explores the benefits and limitations of XML.

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