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A Risk Professional’s Survival Guide

Applied Best Practices in Risk Management

CLIFFORD ROSSI





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To Linda; with this adventure astern,
may calm winds carry us toward new horizons.

Preface

The intent of this book is to provide the next generation of risk leaders, as well as current practitioners of financial risk management, a handy reference of techniques and concepts for identifying, measuring, and mitigating the major risks facing financial institutions. Risk management has evolved over the past decade into a highly quantitative field, drawing on increasingly complex mathematical and statistical concepts to portray a variety of traditional risks such as credit, counterparty, market, and interest rate risk. At the same time, the financial crisis of 2008–2009 laid bare the limitations of sophisticated quantitative analysis. Advances in quantitative risk management will continue; however, risk managers must be mindful of the “art” of risk management, namely judgment and experience that augments the “science” of risk management. Many risk management books focus on the quantitative aspects of the field rather than explore the importance of the qualitative side of risk management. This book is an attempt to bring both perspectives together in a cohesive fashion.

Another feature of this book is to provide readers with a framework for thinking about risk not as a singular outcome, but one that has consequences that may ripple across other parts of the business or risks. Leveraging experience from the crisis and afterward, the book follows the events of SifiBank, a stylized significantly important financial institution that provides the common thread of risk management practices throughout the course of the book. In that regard, this book represents a significant departure from other risk management books in that it is effectively a case study of one large complex commercial bank. To bring that story alive, a synthetic balance sheet is constructed within which specific positions, portfolios and loans are created. This information is then used in a series of Excel/VBA workbooks to provide the reader a hands on companion to the text discussion of key concepts and models.

The structure of the book starts by providing background on SifiBank, an imaginary institution that serves as an example throughout the chapters, and its historical roots, organizational and regulatory structure, competitive landscape, and markets. The reader is then guided through a risk taxonomy and governance discussion followed by a chapter introducing the reader to value-at-risk (VaR) and risk-adjusted performance metrics in light of the importance of such metrics for measuring a broad variety of risks.

Following these foundational chapters, the book delves into specific risk types, with an emphasis on identifying and measuring risk. Following each risk the reader is introduced to techniques and structures for mitigating major risk types. The book also presents chapters on operational, model, regulatory, reputation, and legal risk, all of which are of increasing importance for financial institutions following the financial crisis. Finally, the book ends with a look at integrated risk management and how risk managers should be thinking holistically across risks and the firm in performing their risk assessment.

The book is designed for a variety of readers. Readers with technical backgrounds will be able to delve into details surrounding a number of key quantitative concepts and techniques such as Monte Carlo simulation, Principal Components Analysis, copula methods, and econometric models for estimating default risk, to name a few. The Excel/VBA workbooks will be useful to such readers to reinforce concepts and allow sensitivity analysis to be performed. At the same time, readers with an interest in obtaining a basic understanding of key concepts rather than implementing risk models can review the chapter discussion to gain an overall understanding of a particular risk issue.

At the university level, the book is targeted to advanced undergraduate or graduate students in risk management, business, finance, and insurance. The book provides material for a semester long course in financial risk management or bank management or can be easily adapted for a two-course sequence. End of chapter questions provide students an opportunity to test their understanding of important concepts covered and the Test Bank provided to instructors contains ready-made examinations that can be used directly in class. Further, a set of comprehensive PowerPoint instruction slides is provided for each chapter, tying directly to the material discussed in the chapter. Instructors are invited to visit www.wiley.com for additional materials.

As a former senior risk executive at several large financial institutions, my staff and I were always looking for useful references on risk management that could help us improve our understanding of applied risk management concepts and methodologies. In that spirit, this book is meant to fill a gap in this field that provides a comprehensive applied reference for risk managers, now and in the future.

Acknowledgments

While my name appears on the cover of this book, this project could not have been completed without the direct and indirect support from a number of people critical to the process. First, and foremost, Jim Thompson, a colleague of mine from a former workplace is credited with putting together the Excel/VBA workbooks contained in this book. Jim’s exceptional work, particularly evidenced in the Market Risk, Interest Rate Risk, and Consumer Credit Risk chapters provides readers with user-friendly tools, allowing them to test highly complex risk methodologies easily. These Excel tools bring the story of SifiBank alive and without this material the utility of this book would be severely limited.

Linda Rossi, my wife, not only endured the writing and editing process, but also volunteered her time to take on the role of project manager and jack-of-all-trades in manuscript preparation and version control. Without her assistance and moral support throughout the project, this process would have been significantly more difficult for me.

Finally, a number of people have provided reviews and support along this path. Professor Larry Gordon, from the Robert H. Smith School of Business, University of Maryland, provided guidance and insight on the book-writing process from his own experience, motivating me to take on this project. Likewise, Dean Alex Triantis, Robert H. Smith School of Business, University of Maryland, provided support and an introduction to Bill Falloon at John Wiley & Sons. Bill’s support of the concept for the book provided the catalyst for it to become something more than just an idea. Thanks also go out to Meg Freeborn and Vincent Nordhaus whose editorial skills greatly enhanced the end product while keeping me on schedule. Finally, I would like to thank the MS Finance students taking my Corporate Risk Management course at the Robert H. Smith School of Business, University of Maryland, who provided feedback and critical input on the materials during the project.

To all of you go my sincerest thanks for your patience and understanding. Your support enabled the book to come to fruition, and any remaining errors and omissions are solely my own.

About the Author

Dr. Rossi is Professor-of-the-Practice and Executive-in-Residence at the Robert H. Smith School of Business, University of Maryland. Prior to entering academia, Dr. Rossi had nearly 25 years’ experience in banking and government, having held senior executive roles in risk management at several of the largest financial services companies.

His most recent position was Managing Director and Chief Risk Officer for Citigroup’s Consumer Lending Group. He also served as Chief Credit Officer at Washington Mutual (WaMu) and as Managing Director and Chief Risk Officer at Countrywide Bank. Previous to these assignments, Dr. Rossi held senior risk management positions at Freddie Mac and Fannie Mae. He started his career during the thrift crisis at the U.S. Treasury’s Office of Domestic Finance and later at the Office of Thrift Supervision, working on key policy issues affecting depositories. Dr. Rossi was also an adjunct professor in the Finance Department at the Robert H. Smith School of Business for eight years and has numerous academic and nonacademic articles on banking industry topics. Dr. Rossi is frequently quoted on financial policy issues in major newspapers and has appeared on such programs as Fox News, Canada’s BNN, C-SPAN’s Washington Journal and CNN’s Situation Room. He also has a weekly column, Risk Doctor, in the American Banker on risk and regulatory reform issues. Dr. Rossi serves as an advisor to a number of banks, federal regulatory agencies, private equity investment companies, and hedge funds on banking and regulatory topics, and founded Chesapeake Risk Advisors, LLC, a financial risk management consulting practice. He received his PhD from Cornell University.