Internal Control Requirements - a
glance at recent Joint Forum
findings
for the EFCC - Roundtable of
08/09/2008
Jeroen Lamoot
1
Overview of recent market events

A systematic credit event spread through the financial
markets, affecting many different business lines and
activities within the fico’s:





Severe drop in investor demand for any form of securitized
product.
Resulted in drawdowns of back-up lines to support SPVs and
orginating companies.
Build-up of concentrated exposures from assets in the
wharehouse pipeline, or (structured) assets that were brought
back on balance sheet.
Collateral requirements challenged the liquidity positions further.
Concentrated exposures also emerged as hedging strategies
failed or could not be continued.
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Overview of recent market events

Con'd:
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


The liquidity squeeze, the higher sensistivity to credit risk and
elevated concerns regarding the institutions' health spread to the
interbank markets.
The losses on and the extensive downgrading on the ABS
affected the monoline insurance companies and the
municipalities market
The events showed a risk management failure in
different areas.
Should evolve to an active, group-wide and integrated
risk management.
3
Active, group-wide and integrated risk
management

"Active" implies:
A
constant monitoring and understanding of the
evolution (and underlying drivers) within the markets.


Forward-looking approach
Evolution of the business(es) and review of strategies
IIF « Review with senior management how the firm’s strategy is evolving
over time and to what extent the firm is deviating from that strategy »
4
Active, group-wide and integrated risk
management

Active cont’d:
A
constant identification and measurement of the
potential emergence of concentrated exposures
within the firm.


Identify and measure new and evolving exposures, potential
interacting exposures, etc. (i.e. “identification function”).
Go further than first-order observations and potential risk
exposures
IIF « Support senior management by identifying developing risks,
concentrations and other situations that need to be examined via stress
testing and other techniques »
Active, group-wide and integrated risk
management

Active cont’d:
A
constant assessment and updating of the risk
methods and the parameters given the changing
environment.


The risk management methods should follow the evolutions
in the markets and products.
Know the weaknesses of the methods and incorporate them
in the risk management.
IIF « In a market environment that can produce unprecedented price moves
and significant tail risks, seemingly robust risk management tools and
frameworks can prove inadequate »
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Active, group-wide and integrated risk
management

Active cont’d:
 And


active management of the risk exposures
As a market player, active management of the risk exposures
is a necessity.
However, active management may lead to additional and
sometimes difficult to measure and manage risk exposures.
Active, group-wide and integrated risk
management

"Group-wide" implies:
 A fico should have a firm-wide view of the extent that
a certain scenario (single or multiple risk factors) may
affect its different business lines and activities.


Events clearly showed that different activities may be
affected at the same time, potentially compounding the
exposures at the different entities.
First requirement to assess the risk exposures of the fico.
IIF « The lack of a comprehensive approach to firm-wide risk management
often meant that key risks were not identifed or effectively managed »
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Active, group-wide and integrated risk
management

"Integrated" implies:
A
risk management system well entrenched within the
overall management that ensures that the potential
risks it runs are embedded within the risk and firmwide management (decisions).
IIF, the crisis events showed the « need to strengthen the risk management
organisational structures »
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Active, group-wide and integrated risk
management

"Integrated" cont’d:
 It
concerns the integration of the risk management:



along the (sectoral) business units of the group
along the different risk categories (go beyond silo approach)
with the overall management strategies and practices
IIF « The cultivation of a consistent risk culture throughout firms is the main
enabling tool in risk management »
IIF « Eschew the silo approach towards risk management and take a
comprehensive approach to risk (integrating strands such as credit, market,
operational, liquidity and reputational risk) »
IIF «Ensure that the firm’s risk level is consistent with its risk appetite,
providing a thoughtful, integrated view of the overall risks the firm faces »
Important sources for the discussion
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"Cross-sectoral review of group-wide identification and
management of risk concentrations", The Joint Forum,
April 2008
"Final report of the IIF Committee on Market Best
Practices", IFF, July 2008
"Containing systematic risk: The road to reform", The
report of the CRMPG III
"Credit Risk Transfer - developments from 2005-2007",
The Joint Forum, July 2008
"Report of the Financial Stability Forum on Enhancing
Market and institutional resilience", The FSF, April 2008
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The current practices - economic capital models
and stress testing

Economic capital models:



For going-concern / day to day management
Focus lies on calculation of potential diversification effects
Stress testing and scenario analysis:




Advantages are flexibility and potential forward-looking feature
Firms were quite reluctant to develop stress test exercises to
integrate risk exposures and obtain a more firm-wide perspective
Current exercises should be made more realistic (e.g. towards
management buy-ins, issues of market liquidity, second-order
effects)
Will remain a complementary tool
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