Webinar Slides 16mar Final Changing Financial Landscape

The Changing Financial Landscape: Lessons Learned, Impact of Financial Reform, and

Hot Topics Surrounding Risk and Corporate Governance

PRESENTER

Thomas Day

Vice-Chairman, PRMIA Board of Directors and Managing Director of Risk Solutions and Policy, SunGard

16 March 2011

Risk & Performance Management

Standard Disclaimer

The views, expressions and ideas of this presentation are those of the author(s) and do not necessarily reflect the views and opinions of SunGard

Thank you to SunGard and all the participants on the call..

We are going to strive to be thought-provoking and conversational as we proceed through the presentation.

We invite you to submit questions as we proceed through the presentation. We will leave time for Q&A at the end.

Agenda

1. Current State. How did we get here?

2. How has the financial and regulatory landscape shifted?

3. What are the key lessons learned and how do we create value in the new financial landscape?

4. Areas of focus for risk management and corporate governance.

Agenda

1. Current State. How did we get here?

2. How has the financial and regulatory landscape shifted?

3. What are the key lessons learned and how do we create value in the new financial landscape?

4. Areas of focus for risk management and corporate governance.

So What Happened?ANS: A Systemic Failure Due to our “Home Ownership is a Right” National Policy Goals + Poor Monetary Policy

“To those of you who have not yet reached President's Club, I want each and every one you to believe you have the potential to achieve this great reward. Now is the time to really kick it into high gear and drive for attending this awesome event! Rankings are updated and posted monthly... I'm especially pleased with your ability to change with the market and responsibly sell more higher-margin product - Option ARM, Home Equity, Non-prime, and Alt-A.” - November 2006, WaMu Internal E-mail

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Risk Adjusted Returns (in

Basis Points)

1. Can’t compete head-to-head with GSEs. A funding curve we can’t match.

Improperly priced credit derivatives & taxpayer funded dividends.

2. Cheap credit: A “glut” of liquidity

3. Incentive Plans: Focus on today’s GAAP earnings, not value-creation

4. Poor risk-controls: growth, concentrations, funding

5. Lack of transparency

6. New and untested product(s)

So What Happened?ANS: …. + Poor Monetary Policy

From October of 2001 through September of 2005, the average spread between 10-year UST and 3-mo UST was 262bp

Coincident with the “removal” of this spread via the curve flattening which began in ~ Summer 2004, the market for “opacity” picked-up. Reminiscent of the 1992-1994 structured note boom, but on houses (whose values never decline!)

In the search for yield, opacity/complexity pays (sell-side reigns)o CDO, PLRMBS, CDS, CLO, SCDO,

CDO^2, LCDS, CMBS, CCOs, etc.

Oct-0

0

May

-01

Dec-0

1

Jul-0

2

Feb-0

3

Sep-0

3

Apr-0

4

Nov-0

4

Jun-

05

Jan-

06

Aug-0

6

Mar

-07

Oct-0

7

May

-08

Dec-0

8

Jul-0

9

Feb-1

0

Sep-1

0

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4 10 Year less 3-Month CMT

10 Year less 3-Month CMT

Period

of r

apid

SIV g

rowth

…and poor corporate governance

Bonuses:2006 = $60 billion

2007 = $66 billion

2008 = $72 billion

2009 = $90 billion

• Compensation should be based on value-creation, not the ability to manufacturer short-term, GAAP (or IFRS) earnings; however, many compensation packages are based solely on ROE.• The market should discipline rent-seekers. Equity is meant to be “owned”

not merely traded, and certainly not manipulated. • Like getting married. Should feel the full weight of “I Do.”

Bonuses paid to the top 5 financial firms in

the U.S. Can anyone guess if these are

“risk-adjusted” bonuses?

Summary Point: Not a lack of Regulation

Misguided public policy in the form of directed credit and capital to the housing industry spurred on by an aggressive curve slope for an “extended period”

1. USG writing mispriced credit derivatives on housing should come to an end. Dealing with housing policy should be the national priority, not simply the mortgage interest deduction as discussed in the 1-Dec-2010 National Commission on Fiscal Responsibility and Reform Report

2. USG writing of other guarantees should stop, or be accounted for via GAAPo Sidebar: Should USG finances be GAAP-based? According to shadow stats, debt using

GAAP is ~$70.7 trillion in 2009, or approximately ~5x GDP

• Poor incentive structures within firms and a “sell-side”, “HFT”, “make a quick buck” (i.e., “Noise”) mentality to equity ownership. This institutional arrangement fosters rationally unsavory capital allocation decisions in the pursuit of EPS.

• It raises profound questions about the corporate structure itself, and especially corporate governance.

To dissuade some that view this as a new or radical idea:

“But as longer-term commitments have come to dominate tax and spending decisions, such cash accounting has been rendered

progressively less meaningful as the principal indicator of the state of our fiscal affairs. An accrual-based accounting system geared to

the longer horizon could be constructed with a reasonable amount of additional effort.” “An accrual system would allow us to keep

better track of the government's overall accrued obligations and deferred assets. Future benefit obligations and taxes would be

recognized as they are incurred rather than when they are paid out by the government.” - Alan Greenspan, February 11, 2003

- http://www.federalreserve.gov/boarddocs/hh/2003/february/testimony.htm

The Truth About Regulation

Charter shopping has been common for many years. One of the best storied examples may be Colonial Bank, which failed on August 14, 2009.

• Goal: Which regulator will be most useful for me, the “constituent”?o Some regulators, in their “relationship” management capacity, fancy

themselves as consultant/advisors, not beat-cops. Very few risk-focused exams that labor on the USC and CFR. TBTF or TCTM?

• However: Weak regulation didn’t “cause” the problem. Moreover, adding more of what didn’t work won’t fix the structural issues that continue to exist. Thus, Answer #1 – regulators and ineffectual regulation - is wrong. Contributors? Sure. Foremost to blame? Not a chance.

“Kerry Killinger, the CEO of Washington Mutual (WaMu) will be in town Friday and wants to have a

lunch meeting. He’s my largest constituent asset wise.”

– May 2007, OTS internal e-mail

The Truth About Regulation

The regulators have had sufficient authority to clamp down on excesses for a long time. We all know this fact.

A strong approach didn’t happen for a large # of reasons:o Charter shopping and “functional regulation”:

1) Divide and conquer, a good war-plan. Fighting battles on many fronts has never had much success.

2) A Congress eager to appease and “tear down those walls”o “Ability” to supervise versus “Will” to supervise

1) “The banks are always two steps ahead of us.” Why? This is fixable. However, in the years of enlightened regulation, it was assumed proper and fitting.

o APA (P.L. 79-404) and the PRA (P.L. 96-511)

1) Good examples of how to institutionalize poor agility, flexibility and timeliness

"Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion.“

- James Gilleran

We may be tempted to chuckle and point a finger. Truth is that all danced to the

deregulation, light-touch, non-intrusive, risk-scoping and ‘exam-vetting’ piper.

IMF’s Lessons for us?

Worth reviewing:1. Good supervision is intrusive

2. Good supervision is skeptical but proactive

3. Good supervision is comprehensive

4. Good supervision is adaptive

5. Good supervision is conclusive

To achieve these elements you need adequate resources, clear strategy, robust internal organization, effective working relationship with other agencies (e.g., umbrella supervision) and the willingness to act.

According to Oliver Hart of Harvard and Luigi Zingales of the University of

Chicago, SIFIs could borrow at 29bps beneath small banks prior to the crisis;

today the SIFIs can borrow at 78bps below. According to their analysis, this

amounts to a $34.1 billion subsidy courtesy of our unusual and exigent

circumstances. As an economist colleague said to me recently: “Not only are

we all Keynesians. It seems we are all Frenchmen too.”

“In addition to the broad issues of capital and liquidity, I also argue that the doctrine of ‘too big

to fail’ (or, more appropriately, ‘too interconnected to be liquidated quickly’) cannot be allowed

to stand.” “I agree with Gary Stern, the former President of the Federal Reserve Bank of

Minneapolis, who has long held the position that ‘. . . creditors will continue to under-price the

risk-taking of these financial institutions, overfund them, and fail to provide effective market

discipline. Facing prices that are too low, systemically important firms will take on too much

risk.”

- Alan Greenspan, FCIC, April 7, 2010

Said differently: Is it necessary for the market to see Title II of the DFA in action?

Agenda

1. Current State. How did we get here?

2. How has the financial and regulatory landscape shifted?

3. What are the key lessons learned and how do we create value in the new financial landscape?

4. Areas of focus for risk management and corporate governance.

Do you recognize this quote?

1. “On March 31, 1980, President Carter signed into law the Depository Institutions Deregulation and Monetary Control Act of 1980, the most important federal legislation relating to the financial community since the 1930s. The act has nine titles covering a wide range of subjects, including reserve requirements, access to and pricing of Federal Reserve services, a phase-out of Regulation Q and new powers for thrift institutions.” – Frank Morris, Former President, FRB Boston

2. “Last year the Financial Modernization Act of 1999 (FMA) was signed into law. Also known as the Gramm-Leach-Bliley Act, this statute represents the single most important set of regulatory reforms since the Glass-Steagall Act of 1933.” - James Thompson, FRB Cleveland, 15-April-2000

This is “…the most important federal legislation

relating to the financial community since the 1930s.”

…and here we are, once again, with the most important federal legislation since the 1930s: The Dodd-Frank Act (DFA),

B3, and the G-20 reform agenda. Collectively, it seems we have a rather short memory. History is important. More of us

should study it.

What Really Happened?

According to the media and, to some degree, the DFA itself (and too many academics it seems):

Answer #1: The regulators failed to control the excesses of the now infamous

“banksters”. Therefore, we need more and better regulation. Thus, the Dodd-Frank Act (DFA) will protect us from the next crisis because we’ve fundamentally addressed the problems that created the global financial crisis.

Banksters? Irregulators?

DFA DFA

We take this Commercial Break to Set the Record Straight: It’s About Incentives

Without the direct influence of congressional

action(s), the breadth, depth, duration, and

scope of the financial crisis could never have

happened. This crisis is a direct consequence

of legislative ineptitude and an almost complete

absence of timely and responsible action by our

legislature.

We continue to possess a patchwork of regulatory

agencies, even if we have vested one agency with

more power than any other – the Fed. While the

number of supporting characters is vast, the fault

rests squarely with our legislators – which means

it rests with the American people. What happens

when the sovereign becomes the greatest sources

of systemic risk?

Broad Principles:Robustness, Transparency, Resilience

Robust Transparent Resilient

• FSOC

• Resolution Authority

• Office of Fin’l Research

• Volker Rule

• Routine stress-testing

• Non-bank Fis

• Growth restrictions

• Redefine capital

• CCPs

• CFTC (from 14 to 20)

• FMUs

• Improved disclosures

• OFR

• CFPB

• FIO (“US Solvency 2”)

• Countercyclical capital

• Contingent capital

• FDIC assessments

• Basel-3

quality & quantity of capital

liquidity standards

International Harmonization and Coordination

ESRB FSB G-20 CEBS BCBS IOSCO(…)(…)

[NOTE: Insert Miracle Here]

Regulatory Reform: Timeline to the Current State

Regulatory Considerations

Despite our best attempts, human behavior is difficult to regulate completely

Although we must strive to improve our abilities to see around corners, we must not fool ourselves into believing we know how to identify bubbles and prevent systemic risk events

A number of policies and practices at financial institutions were inherently pro-cyclical, further magnifying effects during the boom and bust

Incentives are important to regulating behavior, however, establishing strong risk discipline at financial institutions is genetic; and something not mandated through regulatory edict

Key Questions and Themes

• The financial crisis precipitated the most expansive set of regulation of global financial services in history

• The recent crisis exposed significant management, process, regulatory and governance deficiencies across the industry

• Has this new regulatory regime focused on the right things to be effective at preventing a future crisis?

• Dodd-Frank and Basel III address a number of critical pressure points in financial markets and governance

• The regulations, however, offer a false sense of hope regarding the ability to avoid future bubbles and systemic market crises

Other Areas of Impact

Enterprise Risk Management Expect a greater emphasis on enterprise risk management, a deeper analysis

of processes, need for adherence to established best-practice, and Board level risk-committee structure(s) [culture not compliance]

Executive and Incentive Compensation Expect your risk management group to be part of these discussions

Consumer Protection Rules

Liquidity and Capital

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking,

contributing to bank losses and financial instability.” – Chairman Ben Bernanke, October 2009

Agenda

1. Current State. How did we get here?

2. How has the financial and regulatory landscape shifted?

3. What are the key lessons learned and how do we create value in the new financial landscape?

4. Areas of focus for risk management and corporate governance.

Financial Crisis Inquiry Commission: Lessons Learned

It always bugged us that DFA was issued in July 2010 and the FCIC report was issued in January 2011. Does this seems problematic to you?

• Conclusions:• Avoidable• Regulation and supervision (blame the cops for the crime?) (#4?)• “Dramatic” failures in corporate governance and risk management (#2?)• Leverage, opacity, and lack of disclosure (#3?)• Poor government preparedness • Breakdown in accountability and ethics (#1?)• Failure in OTC and rating agency oversight

In the FRS Holding Company Manual corporate governance – while referred to repeatedly

in §1050 – is never defined; however, if one takes from the text the intended theme, it

seems that corporate governance is predominately concerned with treasury, audit,

Sarbanes-Oxley §404, and corporate finance. This is inconsistent with a multiplicity of

definitions available in the marketplace that suggest a much richer definition and scope; a

scope that includes notions of strong and active board culture, business savvy, ethics and

fair business conduct, accountability, integrity, a concern over capital stewardship and

value, incentive compensation, and other principle-based statements. Note that the FRB’s

Handbook didn’t include any procedures relating to incentive compensation, other than for

retail non-deposit investment products, until July 2010.

Lessons Learned

• Overreliance on performance metrics not properly adjusted for risk

• Data and analytical limitations leading to underestimation of risks

• Cognitive biases among senior management leading to:• Lower aversion to risk due to perceptions of continued low losses

based on prior experience• Poor risk management culture and stature and uncertainty bias• Herd behavior in development and expansion of riskier products

• Possible regulatory capture and resource/complexity issues of regulators

Procyclicality and Regulation

• Interconnectedness of several procyclical policies and procedures at banks exacerbated the effects of the crisis – what are these?

• Loan Loss Reserves

• Bank Capital Requirements

• Liquidity

• Deposit Insurance Premiums

• Fair Value Accounting (Level III assets)

Loan Loss Reserves

• Incurred Loss model under FAS 5 (GAAP) accounting policies

• Banks slow to buildup credit reserves during good economic times, must accelerate buildup as markets deteriorate

• Inability to apply forward-looking metrics handicaps process

Countercyclical Capital Buffers

SCAP stress test results revealed procyclical effects of bank capital - $185B capital deficiency

• Basel risk-weighted capital ratios introduce procyclical effects by underestimating credit risk in good times, leading to lower capital requirements

• But are proposals such as countercyclical capital buffers an effective mechanism to address this problem?

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Liquidity

• Liquidity crisis in 2007-2008 of several firms led to liquidity contagion

• Responses and outcomes are detrimental to financial system

• Asset dumping at firesale prices• Credit tightening

• Are Basel liquidity ratio requirements the right answer?• Net Stable Funding• Liquidity Coverage Ratio

Deposit Insurance Premiums

• As bank failures have risen, FDIC reserve fund has come under pressure

• Deposit insurance premiums tied to Bank Insurance Fund (BIF) reserve levels• BIF Reserve/Bank Deposits >1.15%, only riskiest banks required to

pay premiums• When ratio <1.21%, all firms must pay in accordance with FDIC

premium schedule

• Deposit premiums thus tend to rise at the worst time for the bank and the premium assessment process is thus highly procyclical as shown in the next slide

Procyclicality of Deposit Insurance Premiums

A better approach would be to devise a long-term moving average, actuarially fair pricing methodology

Regulation, Procyclicality & Governance

• Regulations address procyclicality in piecemeal, incomplete fashion

• Remedies not always an improvement • Countercyclical capital

• Other remedies await important players• FASB for fair value accounting and loan loss reserve policy

• Regulations also miss key contributing factor of the crisis• Poor risk governance• Limited reliance of robust risk-adjusted performance management

capabilities

Agenda

1. Current State. How did we get here?

2. How has the financial and regulatory landscape shifted?

3. What are the key lessons learned and how do we create value in the new financial landscape?

4. Areas of focus for risk management and corporate governance.

Areas of Current Risk Focus: Hot Topics

The search for earning assets Beware the rise of Interest Rate Risk

Balance sheet management New volumes – credit spread, risk and duration Funding and deposit strategies (preparations made?) Capital planning, including focus on non-organic growth (M&A

should pick up) Balance between liquidity and need for spread

Profitability, margin-protection, and efficiency Financial risk and corporate governance Regulatory preparedness

Many Opportunities for Improvement

CRO Attestation to Internal Risk Management Practices Developing a Uniform Set of Risk Management Standards

Principles, not rules. THIS IS A RISK MANAGEMENT IMPERATIVE

Continued development of “specialists of the whole” “On a Global Foresight Commons”, Carol Dumaine, 23-Nov-2010 Unwinding Orthodoxy, the Value of Heresy, learning to “…profoundly challenge

the status quo.”

The US is only “now” joining the International Association of Insurance Supervisors (see FIO)

Expert needs around stress-testing Subjectivity, Risk Imagination, and Expert-Based Systems SME Swarming, Risk Mash-ups, Network Sensors, COEs (industry,

regulatory, intelligence industry, other?)

Impact of reform on risk management

• Risk Management Impact?

• Full employment at:

Deloitte, KPMG, PwC, BAH, Promontory

Have regulatory experience, will hire

• Major areas of need:

Infrastructure issues

ERM is “for keeps”

Massive need for education

Collaboration and Situational Awareness is Critical

Our success throughout the reform process will be a function of effective collaboration.

– paraphrase of Neal Wolin

“…global policy cooperation is fracturing at best.” - John Lipsky, IMF

Markets remain fragile and it’s imperative we avoid sliding into financial protectionism

http://www.riskmanagementcommunity.com

Site will be live by June 2011

The Changing Financial Landscape: Lessons Learned, Impact of Financial Reform, and

Hot Topics Surrounding Risk and Corporate Governance

PRESENTERS

Thomas Day

Vice-Chairman, PRMIA Board of Directors and Managing Director of Risk Solutions and Policy, SunGard

16 March 2011

Risk & Performance Management

Thank You!