Enterprise Risk Management: A Financial Industry Perspective

Transcription

1 C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\1 Enterprise Risk Management: Morgan Stanley 5 November 2002

2 Principles: Approach to Risk Management C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\2 Risk-taking is an integral part of financial intermediation Effectively managing the risk associated with a business is understood to be a critical and intrinsic responsibility of management. A focus on risk management by the heads of businesses and trading desks is part of Morgan Stanley s culture and a source of competitive advantage The objectives are for risk-taking to be active (not passive), prudent (e.g., no franchise bets), balanced across asset classes, type, businesses, etc., and commensurate with rewards and Firm s risk appetite Doctrine of No Surprises : Risk management processes are designed to ensure senior management has the information required to achieve these goals. (Risk transparency vs. controls) 1

3 C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\3 Principles: Approach to Risk Management (cont'd) Risk = Potential Loss in Market Value Losses may be caused by adverse market movements (Market Risk) declines in credit worthiness (Credit Risk) operational or process failures (Operational Risk) Drivers of risk: Concentration Illiquidity Poor control environment Effective risk management requires an integrated approach that spans all of the risks to which the firm is exposed. Segmented, partial approaches are less effective 2

4 Firm Risk Management Structure C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\4 Ownership of risk throughout the firm ensures commitment to communication and partnership Organization of risk oversight reflects view that managing risk is a core responsibility of business unit management Board of Directors Management Committee The Management Committee has been authorized by the Board of Directors to establish and review compliance with risk management policies that have been set forth in the Authorizing Guidelines. The Management Committee has delegated its authority relating to specific risk management responsibilities to the Risk Oversight Committees Risk Oversight Committees The Risk Oversight Committees review findings related to general compliance with the policies in the Authorizing Guidelines, make recommendations for improved compliance, and request specific briefings from business units or Independent Risk Oversight Departments Division Head Independent Risk Oversight Departments The Independent Risk Oversight Departments participate in the management and monitoring of certain aspects of the risk profile of the Institutional Securities business. Firm Risk Mgmt. Mkt. Risk Dept. Credit Dept. Internal Audit Law, Compliance and Governmental Affairs Controllers Treasury Operations Information Tech. Tax 3

5 C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\5 Fixed Income Division Risk Management Structure Business Units have strong risk management and ownership of risk control. They have established an internal risk management structure which is independent of the risk takers Independent Risk Oversight Departments Division Head Operating Officer/Risk Manager Business Head Business Risk Manager Communication between traders, management and risk oversight departments is critical Division Operating Risk Manager Division Market Risk Manager Sub-Business Manager The Division Operational Risk Manager is responsible for identifying and addressing nonmarket risk as well as ensuring that non-market risk is appropriately considered in the decision making process The Division Market Risk Manager monitors the division s overall risk profile, reviews new trading strategies and initiatives, and communicates to the Firm Risk Manager significant market risk management issues. Desk Manager Trader 4

6 Risk Oversight Framework Reflects an Integrated Approach to Risk Management C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\6 Credit Department Direct Credit Risk Credit Equivalent Exposure Settlement Risk Credit Risk Operations, Controllers, IT, Tax Dept., Facilities, Human Resources Transaction Risk System Risk Operation Control Risk Taxation Risk Disaster Risk Operating Risk Funding Risk Risk Committee Market Risk Legal Risk Market Risk Department Equity Risk Correlation Risk Interest Rate Risk Currency Risk Commodity Risk Market Liquidity Risk Business Risk Treasury Liquidity Risk Law, Compliance, Government Affairs Enforceability Risk Regulatory Risk Legislation Risk 5

7 Communicating and Measuring Risk C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\7 No one summary measure or sufficient statistic exists for any category of risk => adopt multiple measures to highlight risk profile Risk monitoring and measurement: identify changes in risk profile Review positions and changes in risk profile Measure exposure sensitivity to changing market conditions Position/risk sensitivity reports. Identify and quantify risk concentrations VaR Stress Tests P&L/Risk Identify and quantify limit usages and overages Risk dialogue and communication Daily discussion with trading desks Weekly FRB report and Risk Committee meeting Quarterly and annual risk reviews and regulatory reporting Daily Reporting I. Market Conditions Price/Rates Volatility Liquidity Trends III. Measure Risk Exposure VaR Stress Tests P&L Sensitivity Limit Usage Weekly Presentation Risk Committee Business Heads Trading Desks Annual Report II. Key Risk Drivers Outright exposures Spread exposures Credit Risk Asset Liquidity Concentrations Quarterly Disclosure IV. P&L Risk/Return Daily Cumulative Sources 6

8 Risk Controls C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\8 Policies and procedures for managing the risks associated with trading activities are specified in the Firm s Authorizing Guidelines and Risk Management Procedures Mark to Market Discipline Ensures revenues more closely track economics Critical components: Independent reviews by Controllers P&L Explain by Controllers New Model Approval Process New Product Review Processes Limits 7

9 Market Risk Limits C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\9 Market-risk limits are set and monitored at various levels within the Fixed Income Division: Trading Division, Business Units, Trading Desks, Trader. Limits generally serve to ensure that a material change in risk taking sparks a discussion between the trader or trading desk and management. Types of Limits: Price Exposure/Sensitivities: DV01, Delta Value, etc. Option Limits: Kappa, Gamma, Stress Limits Scenario Limits: Aggregate limits on the consequences of historical or hypothetical scenarios, or statistical scenarios (VaR) Liquidity Single-Name Concentration Limits Gross Limits Position as a % of daily trading volume 8

10 Summary C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\11 Culture and incentives matter: Risk Management works best when the Firm s risk appetite is clear and when Business managers possess a strong risk management culture and own the risk There is no single summary measure of risk. Multiple, complementary measures that provide different views of risk work best. Mark to Market is an important risk management discipline. Operational risk can be significant, but is amendable to management. Remote trading locations require special focus. 9

11 C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\12 Appendices

12 Value at Risk Methodology C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\13 Parametric Multivariate Normal Advantages: Methodological Simplicity, Embeds Covariance Structure Disadvantages: Does not reflect excess Kurtosis present in financial data Other Distributions Mixtures of Distributions Non-Parametric Historical simulation, bootstrapping Advantages: Embeds covariance structure and correct higher order moments Disadvantages: Time varying covariance structure requires parametric overlay 10

13 Morgan Stanley's Value at Risk Methodology C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\14 Model characteristics: Historical Simulation for market factors > 1500 factors All markets All Asset classes Monte Carlo Simulation for issue specific factors 99% confidence interval 1 and 10 day VaR Revaluations through interpolation Implementation Issues: Conditional vs. Unconditional Distribution 11

14 What is Meant by Stress Tests C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\15 Examination of low probability events that could result in extraordinary losses or gains 12

15 Stress Testing C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\16 Pre-established shifts in pricing variables Typically, parallel shift of all yield curves by x% Usually ignore implications for other variables Statistically generated shocks Search for worst case shock 10-day VaR as a stress test Sensitivity over time ("Heat Graphs") Search for P&L holes or Gamma troughs Micro Analysis 13

16 Scenario Analysis C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\17 Guidelines for creating scenarios Risks involved are material Probability of event occurring is non-trivial Three approaches Use events from history to simulate impact on current portfolio Construct Hypothetical Scenarios Hybrid Approach Advantages/Disadvantages Historical appeals to intuition Scenario allows tailoring but is difficult to obtain consensus 14

17 C:\!Today\44288.ppt\A2\04 NOV 2002\9:56 AM\18 Valuation/Sensitivity Measurement and Model Risk All models are inaccurate. The relevant question is the degree of inaccuracy, which should be evaluated within the context in which the model will be employed Materiality of positions Price discovery vs. risk management Model development errors Specification of pricing/payoff function Omitted variables Functional specification Implementation errors Coding Calibration Controls Model vetting Pre-testing vs. verification Ensure performance of boundaries Identify appropriate/inappropriate market environments Independent mark reviews P&L explain Limits 15