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 CORPORATE GOVERNANCE AND RISK MANAGEMENT On July 30, 2003, SOX went into full effect in the United States. This regulation had several important practical implications: (CFOs) and (CEOs) must personally verify and certify the accuracy of financial filings with the Securities and Exchange Commission (SEC).  CFOs and CEOs must attest that all disclosures provide an accurate picture of the firm.  Certain internal controls (e.g., board of director and audit committee composition) are required, and any deficiencies (including uncovered fraudulent activity) must be promptly and accurately disclosed to investors and regulators.  The firm’s reporting procedures and internal controls must be audited annually.  Audit committee member names must be publicly disclosed, and they must  be able to understand accounting principles,  be able to comprehend financial statements,  and have audit experience. key lessons learned from risk management failures during th...

 CREDIT RISK TRANSFER MECHANISMS Credit default swaps (CDSs) are financial derivatives that pay off when the issuer of a reference instrument (e.g., a corporate bond or a securitized fixed income instrument) defaults. This is a very direct way to measure and transfer credit risk. These derivatives function like an insurance contract in which a buyer makes regular (quarterly) premium payments, and in return, they receive a payment in the event of a default. Advantages of CDSs include: Spur innovation . This enables them to fund riskier opportunities  Cash-flow potential. CDS sellers create a stream of payments that could be a significant source of cash flow. Theoretically, they can diversify the CDS contracts  across industries and geographies such that defaults in one area should be offset by fees from CDSs that have not been triggered through default. Risk price discovery. The use of a CDS enables price discovery of a specific credit risk. A CDS is a pure play on ...

 Enterprise Risk Management (ERM) One risk type can affect another, and risks (or their hedges) can be offsetting if viewed from the perspective of the entire company. Treating each primary risk type in isolation ignores these interdependencies and can result in inefficient and costly overhedging of risks at the firm level. In addition, the various functional units responsible for evaluating and measuring risks may all use different methodologies and formats in their risk measurements. Without a centralized risk management system, a company’s senior management and its board of directors will receive fragmented information from the various units, each potentially utilizing different measurement methods.  benefits of an ERM approach to managing risks ERM helps managers define the risk appetite of the entire enterprise and helps firms adhere to the constraints put on risk. It allows managers to focus on the largest threats to the firm, threats to the firm’s survival, rather than ...

 PRINCIPLES FOR EFFECTIVE DATA AGGREGATION AND RISK REPORTING According to the Basel Committee on Banking Supervision, r isk data aggregation means “defining, gathering and processing risk data according to the bank’s risk reporting requirements to enable the bank to measure its performance against its risk tolerance/appetite.”  The aggregation process includes breaking down, sorting, and merging data and datasets benefits of effective risk data aggregation and reporting systems increased ability to anticipate problems In times of financial stress, effective risk data aggregation enhances a bank’s ability to identify routes to return to financial health. Improved resolvability in the event of bank stress or failure. bank is better able to make strategic decisions, increase efficiency, reduce the chance of loss, and ultimately increase profitability Model risks include input risk, estimation risk, valuation risk, and hedging risk. a special subcommittee of the Basel Commi...

  THE FINANCIAL CRISIS OF 2007–2009 In the run-up to the financial crisis of 2007–2009, interest rates in the United States were kept at historically low levels. The cheap cost of money made it easier for people to borrow and acquire real estate property, thus fueling a rapid and unsustainable increase in house prices. Financial innovations, such as securitization, also meant that mortgages could now be easily originated by lenders, repackaged, and sold to investors seeking higher yields—thus, reducing the credit risk borne by the originators. Banks increasingly financed their long-term assets through short-term liabilities. This gave rise to a maturity mismatch between the duration of the assets and the liabilities, which exposed banks to significant liquidity risk. When the crisis struck and house prices stalled, those short-term liabilities could not be rolled over At the peak of the crisis in September 2008, the large U.S. investment bank, Lehman Brothers, declared bankrup...

 Cyber Risk Cyber risk is the risk of financial or reputational loss resulting from a breach in internal technology infrastructures. This risk revolves around a hacker accessing systems that result in theft of money, information, or identity data The SWIFT Case In February 2016, hackers accessed the SWIFT system and stole $81 billion from the Bangladesh Bank (the central bank of Bangladesh). This money was on deposit with the New York Federal Reserve Bank. The access was through the use of employee credentials (how these employee credentials were obtained was never fully resolved) and a series of requests to transfer funds to various locations throughout Asia. The goal was to steal $1 billion, but the Bank of New York stopped all transfers after discovering a typo (“fandations” instead of “foundations”) in one of the otherwise legitimate-looking requests. After the $81 million was transferred to a bank in the Philippines, the hackers used malware to delete the record of the transfe...

 Corporate Governance corporate governance is a system of policies and procedures that direct how a firm is operated.  Governance checkpoints include adequate transparency and accountability, supervision of senior leaders and risk management policies, deploying reasonable diversity, ensuring board member independence, and representation of required skillsets for the company in question Enron The company would routinely purchase gas from various vendors and sell it to a network of customers at predetermined prices.  To cover its risk exposure to gas prices, Enron created a new market for energy derivatives. As a result, Fortune magazine named Enron “America’s Most Innovative Company” from 1995 through 2000. At the end of the year 2000, Enron had 20,000 employees and nearly $101 billion in recorded revenue. Reality caught up with Enron in December 2001, which is when it became the largest bankruptcy in U.S. history.  The various failures are listed as follows: Agency r...

 Reputation Risk Reputation risk is the potential for negative operational outcomes due to a poor public perception (ESG or otherwise). The three big constituents to watch are customers, regulators, and shareholders Volkswagen In September 2015, the U.S. Environmental Protection Agency (EPA) announced that Volkswagen (VW) had been unethical in its environmental responsibilities. It violated the ESG ethos by programming the software on its vehicles to only control emissions during regulatory tests. Between 2009 and 2015, this software management affected over 10 million cars worldwide The reputational damage to VW was fast and furious. Its share price was cut by one-third as the scandal unfolded. Volkswagen faced billions of dollars in potential fines on top of decreased sales as consumers responded to the allegations by switching brand loyalty to other vendors.

 Financial Engineering The building blocks for financial engineering are forwards, futures, swaps, options, and securitized products. By using these tools, a risk manager could hedge either a granular risk exposure or a basket of risk exposures Risk managers need to be careful about which goal a hedging strategy is pursuing. In its purest sense, a hedging strategy can be used for risk mitigation. Alternatively, some firms have used hedging strategies to enhance returns. This second strategy usually adds more layers of risk rather than mitigating current exposures. Bankers Trust In the early 1990s, Proctor & Gamble (P&G) approached BT to help manage interest rate risk in both U.S. dollars and deutsche marks (the German currency at the time). After discussion with Bankers Trust, P&G decided to bet on an interest rate decline using complex leveraged swaps At one point, it was leveraged 20:1 in a series of swaps where BT would pay P&G a fixed rate in return for a floati...

 Rogue Trading Leeson’s role expanded to conducting proprietary arbitrage trades exploiting perceived pricing differentials on futures contracts listed concurrently on the largest stock exchange in Japan (i.e., the Nikkei) and the second largest stock exchange in Japan (i.e., the Osaka Securities Exchange).   Leeson decided to take the rogue action of speculating in a directional move by only buying one asset without an offsetting short position. Leeson also controlled the back-office accounting of his own trades, and he managed the reporting through a hidden reconciliation account that was never reported to the home office. What appeared to be a £102 million profit in 1994 was actually a £200 million loss.  In late 1994, the risk managers at Barings Bank grew curious about the unusual gains that Leeson was producing relative to the types of trades he was making. Risk managers continued their interest when, in January 1995, Leeson reported an unusual profit of £10 mi...

 Liquidity Risk  Liquidity risk is the risk that an entity might not be able to meet short-term cash requirements.  This risk can materialize from external market conditions, from internal operational issues, from structural (i.e., balance sheet) challenges, or from a mix of these three Lehman Brothers In the early 2000s, it invested heavily in securitized U.S. real estate assets.  This company was very active in the process of sourcing loans, repackaging them as securitized assets, and selling them to investors. All banks use leverage where they source new assets (i.e., loans or securitized loan products) and often use debt to fund the new assets rather than customer deposits or internal capital. By 2007, Lehman Brothers had leverage (an asset-to-equity ratio) of 31:1. Its core funding strategy was to borrow in the short-term (i.e., daily repo) markets and use these short-term borrowings to fund the long-term and relatively illiquid securitized assets. The housing b...

Interest Rate Risk Interest rate risk is the potential for loss due to fluctuations in interest rate levels.  The degree of sensitivity to interest rate risk is classically measured with duration. 1980s savings and loan crisis in the U.S All commercial banks, S&Ls included, accept s hort-term demand deposits from customers and use those funds to make long-term loans.  Their goal is to capture the spread between the rate paid for short-term deposits (liabilities from the bank’s perspective) and the rate received on longer-term loans (assets from the bank’s perspective).  During the late ‘60s and early ‘70s, the yield curve was upward sloping, which meant that short-term rates (a cost for S&Ls) was much lower than longer term rates (a profit center for S&Ls). In the late 1970s, inflation surged and the Federal Reserve responded by raising interest rates. This reality weakened strong lending margins to the point where losses began to mount. This situation could ...

Arbitrage Pricing Theory Multi-factor model for asset pricing which relates various macro-economic (systematic) risk variables to the pricing of financial assets. Proposed by economist Stephen Ross in 1976 APT is founded upon the law of one price, which suggests that within an equilibrium market, rational investors will implement arbitrage such that the equilibrium price is eventually realised. APT assumes that there are no available arbitrage opportunities, and that if one does exist, it will very quickly evaporate due to the trading actions of market participants. Ri = E(Ri ) + β1F1 + β2F2 + ... + βkFk + ei  where: Ri = the actual return on stock i E(Ri ) = the expected return on stock i  β1 = the beta (factor sensitivity) for factor 1  F1 = the first in a series of risk factors that could add return deviation from the expected return -systematic factor (macroeconomic or company-specific factor) βk = the beta (factor sensitivity) for factor k  Fk = the las...

 Modern Portfolio Theory Also called as mean-variance analysis Created by Harry Markowitz - 1950s (later awarded a Nobel Prize in Economic Sciences) It is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk.  It is a formalization and extension of diversification in investing, the idea that owning different kinds of financial assets is less risky than owning only one type.  Its key insight is that an asset's risk and return should not be assessed by itself, but by how it contributes to a portfolio's overall risk and return. Assumptions Capital markets are perfect -  investors do not pay taxes, commission all traders have free access to all the information there is perfect competition between market participants Investors are rational and risk-averse Markowitz defines a rational investor as someone who seeks to maximize utility from investments. Furthermore, when presented with two investme...