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ERM > Lam - ERM Textbook > Flashcards

Lam - ERM Textbook Flashcards

1
Q

What is the overall risk portfolio of a company?

A

It is the collective build-up of individual business decisions and risks, which results in a unique risk profile.

Principal Terms

Lam - ERM Textbook - pg. 4

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2
Q

What does a company’s risk profile determine?

A

It determines the company’s earnings and earnings volatility.

Principal Terms

Lam - ERM Textbook - pg. 4

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3
Q

What are the key components of risk management?

A

1) Using a portfolio approach
2) Establishing control systems
3) Having the right people and risk culture
4) Reducing downside potential
5) Increasing upside opportunity

Principal Terms

Lam - ERM Textbook - pg. 4

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4
Q

How is the relationship between risk and return often misunderstood?

A

Many believe no risk = no return and high risk = high return, viewing it as linear, but it is better to view it as a parabolic relationship focusing on risk-adjusted return.

Principal Terms

Lam - ERM Textbook - pg. 4

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5
Q

What does NPV stand for?

A

Net Present Value.

Principal Terms

Lam - ERM Textbook - pg. 5

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6
Q

What does EVA stand for?

A

Economic Value Added.

Principal Terms

Lam - ERM Textbook - pg. 5

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7
Q

Why should a company develop an integrated approach to measuring and managing risk?

A

To optimize its risk/return profile.

Principal Terms

Lam - ERM Textbook - pg. 6

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8
Q

What are the four main reasons that risk management should be important to the management of a firm?

A

Managing risk …
1) is management’s job
2) can reduce earnings volatility
3) can maximize shareholder value
4) promotes job and financial security

Principal Terms

Lam - ERM Textbook - pg. 6

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9
Q

What knowledge is required for effective risk management? Who is responsible for risk management?

A

1) Knowledge of historical data (risk/return results, volatility, correlations)
2) Current risk exposures
3) Future business plans
The average investor does not have the knowledge or expertise, so it is management’s responsibility to manage the firm’s risk.

Principal Terms

Lam - ERM Textbook - pg. 7

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10
Q

What proof do we have that risk management works and is important?

A

1) A study showed that gold producers that hedge more tend to have larger asset values.
2) Many executive lost their jobs in the 2008 financial crisis due to poor risk management performance.

Principal Terms

Lam - ERM Textbook - pg. 8

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11
Q

How can improvements to shareholder value be achieved through risk management?

A

In short, it reduces the cost of capital and reduces the uncertainty of commercial activities.
1) Establish target returns
2) Allocate capital to attractive projects (based on risk-adjusted returns)
3) Align performance metrics with risk objectives
4) Give the company the skills to manage risks (like large financial losses or reputation damage)
5) Incorporate risk when making key decisions such as mergers and acquisitions

Principal Terms

Lam - ERM Textbook - pg. 8

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12
Q

What types of risks are interdependent? Give an example.

A

Financial risk, business risk, and operational risk. Within financial risk, market, credit, and liquidity risks are also interdependent.
Ex: The quality of loan documentation is usually considered an operational risk. If the loan is performing, the documentation has no real economic impact. But if the loan is in default, the quality of the loan documentation can have a significant impact on loss severity, with respect to collateral and bankruptcy rights.

Principal Terms

Lam - ERM Textbook - pg. 10

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13
Q

Why is a silo-based risk management strategy inferior?

A

1) It does not account for interdependencies between risks and may overlook the big picture.
2) It is difficult to aggregate risk exposure across an organization if business units use different methodologies and systems.

Principal Terms

Lam - ERM Textbook - pg. 10

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14
Q

What have studies shown are the root causes when publibly traded companies suffer significant market value declines?

A

Strategic risks represented approximately 60 percent of the root
causes, followed by operational risks (approximately 30 percent) and financial
risks (approximately 10 percent)

Principal Terms

Lam - ERM Textbook - pg. 11

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15
Q

What is funding risk?

A

the risk that positions may be profitable in the long run, but bankrupt
a company in the short run

Principal Terms

Lam - ERM Textbook - pg. 16

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16
Q

What is strategic risk?

A

the risk that business strategies (mergers, acquisitions, growth strategies, product innovations) are flawed or ineffectively executed

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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17
Q

What is business risk?

A

the risk that annual financial and operating results may not meet management and stakeholder expectations

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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18
Q

What is market risk?

A

the risk that prices and rates will move in a way that has negative consequences for a company

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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19
Q

What is credit risk?

A

the risk that a customer, counterparty, or supplier will fail to meet its obligations

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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20
Q

What is liquidity risk?

A

the risk that a company cannot raise cash to meet its requirements in a timely and cost-effective manner

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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21
Q

What is operational risk?

A

the risk that people, processes, or systems will fail, or that an external event (e.g., earthquake, fire) will negatively impact the company

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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22
Q

What is compliance risk?

A

the risk that the company may violate laws and regulations

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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23
Q

What is reputation risk?

A

the risk that a company’s brand and reputation may be negatively impacted

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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24
Q

What is a second-order risk?

A

A risk that is a consequence of other primary factors. (Reputation risk)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

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25
Q

What are the pros and cons of making risk management a part of every employee’s job responsibility?

A

Pro: employees know the risks of their work activities best
Pro: risk is managed throughout the company
Con: substantial training and education is required

ERM concept, framework, and process

Lam - ERM Textbook - pg. 32

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26
Q

What are the risk concepts?

A

1) Exposure
2) Volatility
3) Probability
4) Severity
5) Time Horizon
6) Correlation
7) Capital

ERM concept, framework, and process

Lam - ERM Textbook - pg. 32

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27
Q

What is risk exposure? How is it measured?

A

The maximum amount of damange that will be suffered if some event occurs.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

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28
Q

How is risk exposure measured?

A

Exposure measurement is quantitative for credit and market risk, but may be qualitative for others like operational and compliance risk.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

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29
Q

What is risk volatility?

A

The variability of potential outcomes.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

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30
Q

How is risk volatility measured?

A

Volatility risk is quantitative for some risks. For example, for market risk, it is the standard deviation of returns. Other risks need to be considered too like an increase in the turnover rate of programmers could negatively affect a company’s technology initiatives.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

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31
Q

Why is commercial real estate considered riskier than credit card business?

A

Commercial real estate has a much more volatile loss rate. Higher risk volatility.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

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32
Q

What is risk probability?

A

The likelihood that some event will occur

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

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33
Q

What is risk severity?

A

How impactful the event is likely to be.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 34

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34
Q

What is a risk’s time horizon?

A

How long the company is exposed to the risk.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 34

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35
Q

Explain the focus of risk time horizon for financial vs operational risks.

A

For financial risks, the key issue is the liquidity of the position affected by the risk event.
For operational risks, time horizon can be thought of as the time required to recover from the risk event (like a fire).

ERM concept, framework, and process

Lam - ERM Textbook - pg. 34

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36
Q

What is risk correlation?

A

The relationships between risks

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

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37
Q

How is correlation risk managed in financial and operational risks?

A

Financial: diversification can be achieved through risk limits and portfolio allocation targets to reduce risk concentrations.
Operational: diversification can be achieved through separation of operational units.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

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38
Q

What is economic capital?

A

Capital that a company holds for the following 2 reasons:
2) 1) To meet cash requirements like costs of investments and expenses.
2) To cover unexpexted losses arising from risk exposures.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

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39
Q

What is a credit rating?

A

An estimate of how likely a company is to fail

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

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40
Q

How does a company decide how much capital to hold?

A

The company decides how high it wants its credit rating to be. More capital = higher rating.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

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41
Q

Why do companies have to allocate capital to its business units?

A

1) It explicitly links risk and return
2) It allows the profitability of all business units to be compared on a consistent risk-adjusted basis

ERM concept, framework, and process

Lam - ERM Textbook - pg. 36

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42
Q

What is an internal capital market?

A

An internal capital market is a market created within one company when economic capital is allocated to business units. Business units that produce the best risk-adjusted returns will thrive while other phase out.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 36

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43
Q

What are the 3 steps in the risk management process?

A

1) Promote risk awareness
2) Measure risk
3) Control risk

ERM concept, framework, and process

Lam - ERM Textbook - pg. 36

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44
Q

What are 4 ways to deal with a risk?

A

1) Do nothing
2) Limit the risk
3) Reduce the risk
4) Transfer the risk

ERM concept, framework, and process

Lam - ERM Textbook - pg. 37

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45
Q

What is the goal for promoting risk awareness?

A

To ensure everyone within a business is:
1) Proactively identifying the key risks for the company
2) Seriously thinking about the consequences of the risks for which they are responsible
3) Communicating up and down the organization those risks that warrant others’ attention

ERM concept, framework, and process

Lam - ERM Textbook - pg. 38

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46
Q

What are the top 5 ways to promote risk awareness in a company?

A

1) Set the tone from the top
2) Ask the right questions
3) Establish a risk taxonomy
4) Provide training and education
5) Link compensation to risk

ERM concept, framework, and process

Lam - ERM Textbook - pg. 38

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47
Q

Why is it important for a company to set the tone for risk awareness from the top? (Senior management and especially the CEO?)

A

Some aspects of risk management are not instinctual. For example, people are eager to talk about their company’s successes, not actual or potential losses. It is crucial that senior management shows their commitment to risk management through words AND actions!

ERM concept, framework, and process

Lam - ERM Textbook - pg. 38

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48
Q

How can senior management ask the right questions when it comes to risk management?

A

Use the RISK acronym.
Return: What are the expected returns on the risks?
Immunization: What risk limits are in place?
Systems: Do we have appropriate systems to track and measure risk?
Knowledge: Do we have the right people and skills for effective risk management?

ERM concept, framework, and process

Lam - ERM Textbook - pg. 39

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49
Q

Why is it important for a company to establish a risk taxonomy?

A

Risk communications can be misunderstood easily without a risk taxonomy: a common structure for describing the categories and sub-categories of risks, as well as the tools, metrics, and strategies for risk management.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 39

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50
Q

Why is it important for a company to provide training and development for risk management?

A

Employees need the skills and tools to manage the risks for which they are responsible.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 40

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51
Q

Why is it important for a company to link risk and compensation?

A

People pay more attention to what their own responsibilities and how their financial incentives are tied to their performance. Risk management should be tied to compensation for employees at all levels. Otherwise, employees will stop paying attention.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 40

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52
Q

What items should be included in every risk report?

A

1) Losses
2) Incidents
3) Risk assessments
4) Key risk indicators

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

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53
Q

What should be included in the Losses section of a risk report?

A

Only overall levels of loss and important trends should be reported to senior management.
Ex: losses above thresholds, actual vs expected

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

54
Q

What should be included in the Incidents section of a risk report?

A

List the major risk incidents for the period whether they were financial losses or not. Include the potential impact, root causes, and business response. Highlight any patterns.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

55
Q

What should be included in the Risk Assessments section of a risk report?

A

Advance assessment of potential risks. Ex: absence of key staff, product launches, new technologies, etc.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

56
Q

What should be included in the Key Indicators section of a risk report?

A

Quantifications of important trends and risk exposures for the company that can serve as early warning signals.
Financial risk ex: VaR, P&L, credit exposure vs limit
Operational risk ex: errors, customer complaints

ERM concept, framework, and process

Lam - ERM Textbook - pg. 42

57
Q

How does the self-correcting feature of the risk report work?

A

Losses and incidents are captured easily. Management may notice that losses and incidents are coming from risks that are not discussed in risk assessments or key indicators. Action can be taken to improve the risk report going forward.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 42

58
Q

What are the 3 ways to control risk that has not yet been taken on?

A

1) support business growth through capital allocation (to areas with best risk-adjusted return)
2) support profitability through risk-adjusted pricing
3) control downside risks by setting limits

ERM concept, framework, and process

Lam - ERM Textbook - pg. 44

59
Q

What’s wrong with the NPV and EVA techniques for evaluating new investments and business performance?

A

These tools are usually based on book capital, which typically doesn’t fully capture expected loss, much less unexpected loss, and thus does not correspond to economic capital. Therefore, these methods tend to overstate the profitability of risky business and understate the profitability of low-risk business.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 45

60
Q

How can a company determine its risk appetite?

A

It depends on the human, financial, and technology resources available. Risk appetite can be expressed in terms of the amount and likelihood of actual and potential loss.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 46

61
Q

What limits should a company set to control downside risks?

A

1) Use stop-loss limits to control the actual amount of loss it takes.
2) Use sensitivity limits to control the potential losses it may take.
3) Use exposure limits
In all cases, when limits are reached, management actions and decisions should be triggered.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

62
Q

What does TQM mean?

A

Total quality management

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

63
Q

What are the 3 ways to control risk that have already been taken on?

A

1) Understand the risks through risk analysis
2) Understand which risks offset and exacerbate each other
3) Transfer risk when time, resources, or flexibility are scarce

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

64
Q

What is duration matching?

A

A common risk management technique under which a financial institution matches the interest rate sensitivities of its assets and liabilities to make sure that their prices change in the same way when interest rates change. (The prices offset)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

65
Q

Why can risk be thought of as a bell curve?

A

The mean of the bell curve represents the expected performance. The objective of risk management is to optimize the shape of the bell curve (improve the expected performance and narrow the distribution of potential outcomes).

ERM concept, framework, and process

Lam - ERM Textbook - pg. 48

66
Q

What risk variables can increase/decrease strategic risk?

A

1) Macroeconomic conditions
2) Competitive actions
3) The company’s effectiveness in formulating and executing its strategic plan

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

67
Q

What does EPS mean?

A

Earnings per share

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

68
Q

What risk variables can increase/decrease business risk?

A

These risks could drive earnings volatility.
1) market share
2) new customers
3) pricing margings
4) cost management

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

69
Q

What risk variables can increase/decrease financial risk?

A

Using interest rate risk as an example:
1) asset/liability duration mismatches
2) interest rate levels
3) pricing spreads

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

70
Q

What risk variables can increase/decrease operational risk?

A

Using IT as an example:
1) single points of failure (SPOFs) that could bring down critical systems
2) cyber security exposures

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

71
Q

What does IT mean?

A

Information technology

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

72
Q

What risk variables can increase/decrease regulatory risk?

A

1) new regulations that the company is not prepared for
2) new employees who are not trained in the company’s compliance procedures

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

73
Q

What are 5 questions that senior management should be able to answer regarding risk management?

A

1) What are the company’s top 10 risks?
2) Are any of our business objectives at risk?
3) Do we have key risk indicators that track our critical risk exposures against risk tolerance levels?
4) What were the company’s losses and incidents, and did we identify these risks in previous reports?
5) Are we in compliance?

ERM concept, framework, and process

Lam - ERM Textbook - pg. 52

74
Q

What is the definition of ERM?

A

Risk is a variable that can cause deviation from an expected outcome. ERM is a comprehensive and integrated framework for managing key risks in order to achieve business objectives, minimize unexpected earnings volatility, and maximize firm value.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 53

75
Q

ERM is all about integration in what 3 ways?

A

The following items are requred:
1) A centralized risk management unit (like a CRO) to oversee all aspects of risk in the organization.
2) Integration of risk transfer strategies. Transfer only residual undesirable risk, after accounting for offsetting risks.
3) Integration of risk management throughout business processes like risk-adjusted pricing and capital allocation.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 54

76
Q

What are the 3 major benefits of ERM?

A

1) increased organizational effectiveness
2) better risk reporting
3) improved business performance (reduced losses, lower earnings volatility, increased earnings, and improved shareholder value)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 54

77
Q

What does RAROC mean?

A

risk-adjusted return on capital

ERM concept, framework, and process

Lam - ERM Textbook - pg. 57

78
Q

What is a CRO responsible for?

A

1) Providing leadership for ERM
2) Integrating risk management frameworks across the organization
3) Setting risk appetite (through risk limits)
4) Implementing risk indicators and risk reports
5) Allocating capital to business activities based on risk
6) Communicating the company’s risk profile to key stakeholders
7) Developing the systems to support the risk management program

ERM concept, framework, and process

Lam - ERM Textbook - pg. 58

79
Q

Why is it important for risk managment to have an independent voice? How can it be achieved?

A

In extreme circumstances like CEO/CFO fraud or excessive risk taking, the CRO may fear for their job security. Communication between the CRO and the board or board risk committee should be established in advance to ensure that risk management concerns are heard.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 59

80
Q

What 5 qualities should a CRO have?

A

1) Leadership skills to hire and retain talented risk professionals
2) Skills to overcome resistance from business units
3) Ability to safegaurd the company’s financial and reputational assets
4) Technical skills in strategic, business, credit, market, and operational risks
5) Ability to educate the board, senior management, and business units

ERM concept, framework, and process

Lam - ERM Textbook - pg. 61

81
Q

What are the 7 components of ERM?

A

1) Corporate governance
2) Line management
3) Portfolio management
4) Risk transfer
5) Risk analytics
6) Data and technology resources
7) Stakeholder management

ERM concept, framework, and process

Lam - ERM Textbook - pg. 61

82
Q

What is the role of corporate governance in ERM?

A

Establish top-down risk management.
It ensures that the board of directors and management have established the appropriate organizational processes and corporate controls to measure and manage risk across the company

ERM concept, framework, and process

Lam - ERM Textbook - pg. 62

83
Q

What is the role of line management in ERM?

A

Business strategy alignment.
The risks of business transactions should be fully assessed and incorporated into pricing and profitability targets in the execution of business strategy.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 63

84
Q

What is the role of portfolio management in ERM?

A

Management should act like a fund manager by setting portfolio targets and risk limits to ensure appropriate diversification and optimal portfolio returns. Portfolio management provides a direct link between risk management and shareholder value maximization.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 64

85
Q

What is the role of risk transfer in ERM?

A

To reduce undesirable risks, management should evaluate derivatives, insurance, and hybrid products on a consistent basis and select the most cost-effective alternative.
Ex: swap undesirable risk exposure for desirable risk exposure through a derivative contract.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 64

86
Q

What is the role of risk analytics in ERM?

A

Develop advanced analytical tools to consistently quantify and manage risk. For example, the results can be used to:
1) decide whether or not to transfer risk by comparing cost of transfer and cost of retention, for example.
2) support strategic planning by analyzing the probabilities and outcomes of different business strategies.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 65

87
Q

What is the role of stakeholder management in ERM?

A

Improve risk transparency for key stakeholders such as the board of directors, regulators, and rating agencies.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 66

88
Q

What are the 3 main reasons that operational risk management is important?

A

1) Investigations of major financial disasters over the past few decades have identified operational risk issues as the main culprits in most cases.
2) Operational risks are often correlated with credit and market risks. Operational failures during stressed market conditions can be very costly.
3) If operational risk is not managed as a distinct discipline of risk, it tends to be managed differently across the company. This leads to inconsistencies and inaccurate information fed to senior leaders.

Risk measurement and assessment

Lam - ERM Textbook - pg. 238

89
Q

What 3 benefits are achieved with successful operational risk management?

A

In short, it helps management achieve business objectives.
1) Reduce day-to-day losses and potential losses for major incidents.
2) Frees management’s time to focus on revenue-generating activities instead of dealing with operational crises.
3) Strengthens the enterprise risk management system. Incorporates correlation between operational, credit, and market risks.

Risk measurement and assessment

Lam - ERM Textbook - pg. 240

90
Q

What are the 5 risks that make up operational risk?

A

1) process risk
2) people risk
3) system risk
4) event risk
5) business risk

Risk measurement and assessment

Lam - ERM Textbook - pg. 241

91
Q

What is process risk?

A

An element of operational risk that arises from ineffective and inefficient processes. The key is to balance efficiency and effectiveness of business processes.

Risk measurement and assessment

Lam - ERM Textbook - pg. 241

92
Q

What is people risk?

A

An element of operational risk that arises from staff constraints, incompetence, dishonesty, and a corporate culture that does not cultivate risk awareness.

Risk measurement and assessment

Lam - ERM Textbook - pg. 243

93
Q

What is system risk?

A

An element of operational risk that arises from system availability, data integrity, systems capacity, data security, business recovery from contingencies, faulty financial models, programming errors, etc.

Risk measurement and assessment

Lam - ERM Textbook - pg. 244

94
Q

What is event risk?

A

An element of operational risk that arises from single, unlikely, major incidents like natural disasters.

Risk measurement and assessment

Lam - ERM Textbook - pg. 245

95
Q

What is business risk (within the operational risk context)?

A

An element of operational risk that arises from unexpected…
1) changes in the competitive environment
2) trends that damange the franchise and/or operating economics of a business.
It is the risk that revenue will not cover costs within a given period of time.

Risk measurement and assessment

Lam - ERM Textbook - pg. 246

96
Q

What are the steps to managing operational risk?

A

1) risk policy and organization
2) risk identification and assessment
3) capital allocation and performance measurement
4) risk mitigation and control
5) risk transfer and finance

Risk measurement and assessment

Lam - ERM Textbook - pg. 246

97
Q

What should be included in an operational risk management policy?

A

1) Management principles for operational risk
2) Definitions and taxonomy
3) Objectives and goals
4) Processes and tools
5) Organizational structure
6) Roles and responsibilities

Risk measurement and assessment

Lam - ERM Textbook - pg. 247

98
Q

In an operational risk management policy, roles and responsibilities should be defined for…

A

1) Operational risk management overall to ensure the framework is established
2) Strategic planning to ensure risks are addressed in plans and reviews
3) Finance and accounting to ensure accuracy of records and profitability models
4) Legal to ensure activities are in compliance
5) IT to ensure information security
6) Corporate security to ensure corporate assets are protected

Risk measurement and assessment

Lam - ERM Textbook - pg. 248

99
Q

What is a key issue to consider when assigning roles and responsibilities in an operational risk management policy?

A

Determine which groups are consultants, checkers, or both. For example, typically, operational risk management groups are consultants, audit groups are checkers, and legal groups are both.

Risk measurement and assessment

Lam - ERM Textbook - pg. 248

100
Q

What are the 4 main risk identification and assessment tools used for managing operational risk?

A

1) Loss-incident database. Every loss and incident represents a learning opportunity. The database supports root-cause analysis and risk mitigation strategies.
2) Control self-assessment. Each business unit assesses their own key risks, controls, and management implications which fosters ownership and an idea of how to proceed.
3) Risk mapping. Management ranks key risk exposures with respect to probability and severity (supported by the control self-assessments).
4) Risk indicators and performance triggers

Risk measurement and assessment

Lam - ERM Textbook - pg. 249

101
Q

What does MAP mean?

A

minimum acceptable performance

Risk measurement and assessment

Lam - ERM Textbook - pg. 250

102
Q

What are the most common methodologies for the capital allocation and performance measurement step of operational risk management?

A

1) Top-down models
2) Implied-capital model
3) Income-volatility model
4) Economic pricing model
5) Analog model
6) Bottom-up (Loss Distribution) Model

Risk measurement and assessment

Lam - ERM Textbook - pg. 250

103
Q

What is a top-down model in regards to operational risk management?

A

1) A model for capital allocation and performance measurement.
2) It involves leveraging sophisticated methodologies already developed for credit and market risk to calculate the overall implied operational risk by using data that is usually readily available.
3) Examples are the implied-capital model, the income-volatility model, the economic-pricing model, and the analog model

Risk measurement and assessment

Lam - ERM Textbook - pg. 250

104
Q

What is an implied-capital model in regards to operational risk management?

A

1) A model for capital allocation and performance measurement.
2) Capital allocated to operational risk = total risk capital - credit risk capital - market risk capital

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

105
Q

What are the 3 disadvantages of the implied-capital model?

A

1) Total risk capital must be estimated
2) It ignores the interrelationships between operational risk and market and credit risk
3) It doesn’t capture cause-and-effect scenarios for operational risk (it is accounted for only implicitly)

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

106
Q

What is an income-volatility model in regards to operational risk management?

A

1) A model for capital allocation and performance measurement.
2) Operational risk capital depends on income volatility. Volatility due to operational risk = total income volatility - that due to credit risk - that due to market risk.

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

107
Q

What are the pros and cons of the income-volatility model?

A

Pro: It considers the primary determinant of capital allocation: income volatility.
Pro: Data is typically readily available for this method.
Con: It ignores the rapid evolution of industries.
Con: It fails to capture opportunity costs and reputation damage

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

108
Q

What is an issue with all of the top-down model for capital allocation and performance measurement of operational risk?

A

They all fail to capture the low-probability, high-consequence risks

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

109
Q

What is an economic pricing model in regards to operational risk management?

A

1) A model for capital allocation and performance measurement.
2) Assume all market info is captured in the share price. Stock price volatility due to operational risk = total stock price vol - that due to credit risk - that due to market risk

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

110
Q

What does CAPM mean?

A

Capital-asset pricing model. The most widely used economic model for capital allocation and performance measurement of operational risks.

Risk measurement and assessment

Lam - ERM Textbook - pg. 251

111
Q

What are the pros and cons of the CAPM?

A

Pro: It incorporates opportunity costs and reputation damage
Con: It doesn’t provide information about specific operational risks, only an aggregate view of capital adequacy.
Con: Operational risk exposure is not affected by controls and business risk characteristics in this model, so there is not motivation to improve operations
Con: It does not account for the fact that a major incident could completely bankrupt the business (best it does is incorporate tail-end risks)

Risk measurement and assessment

Lam - ERM Textbook - pg. 252

112
Q

What is an analog model in regards to operational risk management?

A

1) A model for capital allocation and performance measurement.
2) Use data on other companies with similar business structures and operations to derive operational risk measures for one’s own company. (This includes analyzing cause and effect of operational losses)

Risk measurement and assessment

Lam - ERM Textbook - pg. 252

113
Q

What are the pros and cons of an analog model?

A

Pro: it is useful for companies that do not yet have a robust database of operational risk losses
Con: It assumes that the data on another company can accurately measure the operational risk of another which is a large assumption

Risk measurement and assessment

Lam - ERM Textbook - pg. 252

114
Q

What is a bottom-up (or loss distribution) model in regards to operational risk management?

A

1) A model for capital allocation and performance measurement.
2) Apply loss and/or causal factors to derive predicted loss expectancies for each category of operational risk that the company faces.

Risk measurement and assessment

Lam - ERM Textbook - pg. 252

115
Q

What are the pros and cons of the bottom-up (loss distribution) model?

A

Pro: the data needed for this model can also be used to derive a business’ risk profile
Pro: Operational risk categories can be tracked over time, increasing awareness and giving opportunities for improvements
Con: Executing the model is complicated. It requires mapping company loss data with industry loss data.
Con: It uses statistical and scenario analysis to make predictions, so it does not perform well on low-probability, high-consequence events. (Few data points)

Risk measurement and assessment

Lam - ERM Textbook - pg. 253

116
Q

What does EVT mean?

A

Extreme value theory: focuses on the extreme event data rather than all the data to make more reliable estimates

Risk measurement and assessment

Lam - ERM Textbook - pg. 253

117
Q

What is scenario analysis in regards to operational risk management?

A

It involves gathering opinions, concerns, and experience of managers and presenting them in a business model. It captures both quantitative and qualitative data.

Risk measurement and assessment

Lam - ERM Textbook - pg. 254

118
Q

What are the pros and cons of scenario analysis in regards to operational risk management?

A

Pro: it captures details like exposure, severity, whether there are any controls, and the type of control (damage, preventative, detective)
Pro: Cause-and-effect relationships can be captured
Con: The model is subjective, so data may be recorded inconsistently
Con: Conclusions can be biased

Risk measurement and assessment

Lam - ERM Textbook - pg. 254

119
Q

What are the risk mitigation and control strategies for operational risk management?

A

The key is to understand the root causes of operational risks and focus on corrective actions.
1) Implement a process that identifies actions that will reduce operational losses. Ex: increasing training
2) Implement a process to evaluate and prioritize improvement ideas. (Cost/benefit and readiness assessments are useful here)
3) Establish reserves to cover expected operational losses
4) Adjust prices to incorporate operational risk

Risk measurement and assessment

Lam - ERM Textbook - pg. 255

120
Q

What are the risk transfer and finance strategies for operational risk management?

A

Use a combination of internal controls and risk transfer strategies because the cost of the former reduces the cost of the latter. Ex: implement workplace safety procedures and purchase worker’s compensation insurance.

Risk measurement and assessment

Lam - ERM Textbook - pg. 256

121
Q

What 5 things should a company do to manage operational risk?

A

1) Identify operational risk exposures and quantify their probabilities, severities, and economic capital requirements
2) Integrate operational, credit, and market risks to assess overall risk/return profile
3) Establish operational risk limits
4) Implement internal controls
5) Compare the cost of risk retention vs transfer

Risk measurement and assessment

Lam - ERM Textbook - pg. 256

122
Q

What is the difference between risk transfer and risk finance?

A

Transfer: a 3rd party insurance provider takes on the loss between the deductible and the cap
Finance: a 3rd party insurance provider provides funding, but is reimbursed over time

Risk measurement and assessment

Lam - ERM Textbook - pg. 256

123
Q

How can a company choose between different risk transfer options?

A

When transferring risk, the benefit is reduced expected loss and loss volatility. The cost is the insurance premium and higher counterparty credit risk (risk that the 3rd party will default). Therefore, the company is ceding risk and return, so a ceded RAROC can be calculated for each risk transfer option. Choosing a risk transfer strategy with a ceded RAROC below the firm’s cost of equity would add to shareholder value, and vice versa.

Risk measurement and assessment

Lam - ERM Textbook - pg. 257

124
Q

Describe the differences between basic, standard, and best practices for operational risk management.

A

Basic: the company tracks operational risk losses and reports risk indicators, audit/compliance groups act as checkers, an operational risk policy has been developed
Standard: goals and MAPs are established for the risk indicators, internal database is linked with and industry loss-event database, response plans are developed
Best: quantitative and qualitative tools are used to assess and measure, capital is allocated to operational, credit, and market risk to enable risk-adjusted performance measurement, a full set of early warning indicators is developed

Risk measurement and assessment

Lam - ERM Textbook - pg. 257

125
Q

What are some examples of external risk indicators for operational risk?

A

1) public opinion
2) political uncertainties
3) regulatory changes
4) technology trends

Risk measurement and assessment

Lam - ERM Textbook - pg. 258

126
Q

What are the 3 emerging IT risks?

A

1) cyber security
2) cloud computing
3) social media

Risk measurement and assessment

127
Q

What are the types of cyber attacks?

A

1) ones that steal information
2) DoS (denial of service). Crash the firm’s websites and apps.

Risk measurement and assessment

128
Q

What is the best method for firms to reduce the damage done from cyber attacks?

A

Cooperate with the public sector and other private firms. Transparent communication, revealing security breaches.

Risk measurement and assessment

129
Q

What does ISAC mean?

A

Information sharing and analysis centers. They are government committees integrated in critical industries (like finance, transportation, utilities) to support nationwide defense against cyber crime. (These committees were created because private firms did not want to reveal their security breaches to each other, so they were isolated and vulnerable)

Risk measurement and assessment

130
Q
A

Risk measurement and assessment

ERM (2 decks)

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