The Failure of the Royal Bank of Scotland

Financial Services Authority Board Report (2011)

Quite reasonably people want to know why RBS failed. And they want to understand whether failure resulted from a level of incompetence, a lack of integrity, or dishonesty which can be subject to legal sanction.
This Report aims to provide that account. It identifies the multiple factors which combined to produce RBS’s failure. It describes the errors of judgement and execution made by RBS executive and management, which in combination resulted in RBS being one of the banks that failed amid the general crisis. These were decisions for whose commercial consequences RBS executive and Board were ultimately responsible. It sets out the FSA’s Enforcement Division’s assessment of whether any management and Board failures could be subject to regulatory sanction. It also describes deficiencies in the overall global framework for bank regulation which made a systemic crisis more likely, and flaws in the FSA’s approach to the supervision of banks in general and RBS in particular which resulted in insufficient challenge to RBS.

 

This Time is Different

Eight Centuries of Financial Folly

Carmen Reinhart and Kenneth Rogoff (2011)

Throughout history, rich and poor countries alike have been lending, borrowing, crashing–and recovering–their way through an extraordinary range of financial crises. Each time, the experts have chimed, “this time is different”–claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. With this breakthrough study, leading economists Carmen Reinhart and Kenneth Rogoff definitively prove them wrong. Covering sixty-six countries across five continents, This Time Is Different presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes–from medieval currency debasements to today’s subprime catastrophe. Carmen Reinhart and Kenneth Rogoff, leading economists whose work has been influential in the policy debate concerning the current financial crisis, provocatively argue that financial combustions are universal rites of passage for emerging and established market nations. The authors draw important lessons from history to show us how much–or how little–we have learned.

Using clear, sharp analysis and comprehensive data, Reinhart and Rogoff document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts–as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to recur.

 

Models. Behaving. Badly.

Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

by Emanuel Derman (2011)

Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs, one of the financial engineers whose mathematical models became crucial for Wall Street. The reliance investors put on such quantitative analysis was catastrophic for the economy, setting off the ongoing string of financial crises that began with the mortgage market in 2007 and continues through today. Here Derman looks at why people– bankers in particular –still put so much faith in these models, and why it’s a terrible mistake to do so.

Though financial models imitate the style of physics and employ the language of mathematics, ultimately they deal with human beings. There is a fundamental difference between the aims and potential achievements of physics and those of finance. In physics, theories aim for a description of reality; in finance, at best, models can shoot only for a simplistic and very limited approximation to it. When we make a model involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper.  It doesn’t fit without cutting off some of the essential parts. Physicists and economists have been too enthusiastic to acknowledge the limits of their equations in the sphere of human behavior–which of course is what economics is all about.

 

APPLICATION OF RISK THEORY TO INTERPRETATION OF STOCHASTIC CASH-FLOW-TESTING RESULTS

Edward L. Robbins, Samuel H. Cox,  and Richard D. Phillips

This paper offers practical guidance to actuaries who are seeking ways to evaluate and manage the output from the stochastic cash-flow-testing process. A commonly expressed opinion about the stochastic approach is that almost all the results are successes, whereas the adverse scenarios are arguably the ones of major interest. This paper responds to the following question: “Given that I have run a large number of stochastic cash-flow-testing scenarios resulting in only a very small number of scenarios landing in the adverse area, or “ruin tail,” how can I use the results of the entire set of observations to better estimate the area under the ruin tail?

We begin the paper with a discussion of the types of variables that could be investigated by using the output from typical simulation models. The choice of variable worth examining appears flexible and could include the accumulated surplus at the end of the time horizon of the scenario, the present value of the accumulated surplus discounted to the beginning of the time horizon, or the lowest risk-based capital (RBC) multiple realized during the time horizon. We use the present value of accumulated surplus in this study.

 

Enterprise Risk Management – Integrated Framework

COSO (2004)

In response to a need for principles-based guidance to help entities design and implement effective enterprise-wide approaches to risk management, COSO issued the Enterprise Risk Management – Integrated Framework in 2004. This framework defines essential enterprise risk management components, discusses key ERM principles and concepts, suggests a common ERM language, and provides clear direction and guidance for enterprise risk management. The guidance introduces an enterprise-wide approach to risk management as well as concepts such as: risk appetite, risk tolerance, portfolio view. This framework is now being used by organizations around the world to design and implement effective ERM processes.

Despite all that has been written about ERM, COSO recognized a need for:

• A broadly accepted ERM framework in order to establish common definitions
• A direction for organizations to use in determining how to enhance their risk management
• Criteria to enable them to evaluate whether their risk management is effective

Initiated in 2001, the project included significant primary and secondary research, extensive analysis of alternative approaches and consideration of comments received during a comprehensive public comment period.  Enterprise Risk Management is one of the few ERM frameworks that has gone through such a rigorous public review process.

Enterprise Risk Management details:

• The essential components of ERM
• The context in which they are effectively implemented
• Key concepts that relate to effective application of the components such as establishing an ERM philosophy, a risk appetite and a portfolio view of risk

The ERM framework builds on COSO’s previously issued framework, Internal Control — Integrated Framework, and identifies the interrelationships among ERM, internal control and entity management.

This two-volume set includes:

• Executive Summary and Framework
• Application Techniques

All individuals who work with governance, risk management or compliance matters will benefit from this important resource.

 

 

 

Enterprise Risk Management: A Methodology for Achieving Strategic Objectives

Gregory Monahan (2008)

Written for enterprise risk management (ERM) practitioners who recognize ERM’s value to their organization, Enterprise Risk Management: A Methodology for Achieving Strategic Objectives thoroughly examines operational risk management and allows you to leverage ERM methodology in your organization by putting author and ERM authority Gregory Monahan’s Strategic Objectives At Risk (SOAR) methodology to work.

 

ENTERPRISE RISK AND RETURN MANAGEMENT FOR FINANCIAL INSTITUTIONS

Mark Griffin and Rick Boomgaardt

It is important to include both risk and return in finding the optimal balance of assets and liabilities for financial institutions. Insurance companies, with their range of sophisticated assets and liabilities, are perhaps the best example of the value of such an approach. Examples in the paper refer to the insurance industry, but parallels to other types of financial institutions are easily drawn. The analysis in the paper shows that a comprehensive approach to risk and return produces some interesting conclusions with respect to asset allocation, active versus passive asset management, and the mix and pricing of liabilities.

 

Embracing Enterprise Risk Management: Practical Approaches to Getting Started

Mark L. Frigo and Richard J. Anderson (2011)

This COSO thought paper describes how an organization can start to move from informal risk management to ERM.  We discuss the increasing importance of and focus on ERM and the need for all types of organizations to understand and embrace ERM.  And, we examine perceived barriers to starting ERM and working through those barriers.  The approaches described in this document are based on successful practices that organizations have used to develop an incremental, step-by-step methodology to start ERM. While this is not the only way to start an ERM initiative, this incremental approach is designed to be very adaptable and flexible. We suggest specific, tangible actions that organizations can use to get started in this thought paper’s three sections:

I. K eys to Success – Overarching themes to provide management with a strong foundation for an effective ERM program as they develop and tailor their specific approach to implementing ERM.
II . Initial Action Steps – Action oriented, “how to” steps to implement an initial ERM effort. These steps support development and implementation of a tailored ERM initiative.

II. Continuing ERM Implementation – Next steps to further develop and broaden the organization’s initial ERM effort.

 

Enterprise Risk Management: A Manager’s Journey

Spencer Pickett (2006)

With the release of the new COSO ERM guidelines, many managers are being asked to implement Enterprise Risk Management (ERM) with very little understanding of the full implications for their business and customers.

In Enterprise Risk Management, A Manager’s Journey, you’ll learn the A-to-Zs of ERM by walking in the shoes of Bill Reynolds as he goes from zero understanding of ERM to becoming fully versed in what ERM is, what it can do for his company, and how to successfully implement it within his organization. Through Bill’s enlightening business trip to London, you will discover how to manage risk across all parts of your business.

 

 

RISK MEASURES AND EFFICIENT USE OF CAPITAL

PHILIPPE ARTZNER, FREDDY DELBAEN AND PABLO KOCH-MEDINA

This paper is concerned with clarifying the link between risk measurement and capital efficiency.  For this purpose we introduce risk measurement as the minimum cost of making a position acceptable by adding an optimal combination of multiple eligible assets.  Under certain assumptions,it is shown that these risk measures have properties similar to those of coherent risk measures.  The motivation for this paper was the study of a multi-currency setting where it is natural to use simultaneously a domestic and a foreign asset as investment
vehicles to inject the capital necessary to make an unacceptable position acceptable.  We also study what happens when one changes the unit of account from domestic to foreign currency and are led to the notion of compatibility of risk measures.  In addition,we aim to clarify terminology in the field.