Boombust Can we avoid history repeating itself

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Boom-bustCan we avoid history repeating itself?
Financial Services

• January 2008

CONFIDENTIAL www.oliverwyman.com
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To avoid repeating the recent boom-bust pattern
in the future, banks must build a more balanced
partnership between risk management and the front
office
Risk Mgmt
Origination
Boom-bust model
Risk Mgmt
Origination
4.50
4.00
3.50
3.00
2.50
Share price
2.00
1.50
1.00
Time
Sustainable growth model
4.50
4.00
3.50
3.00
Share price
2.50
2.00
1.50
1.00
Time
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Key success factors for building a sustainable
partnership between risk management and the front
office
Challenges for Front Office
Challenges for Risk Management

• To act as first line of defence for risk
  management
• Incentives tied to medium-term performance
• Allocation of front-office budget to improving
  risk management
• Hiring/training of risk-literate people
  rotation of staff through risk management
• Greater ownership/input into risk management
  methodologies

• Articulate risk appetite using quantitative
  metrics need to know when risk appetite has
  been exceeded
• Closer dialogue with front office on recent
  innovation and risk management challenges
• Greater clout at all levels stemming from
  stronger representation at board level
• Healthy suspicion of businesses that generate
  huge rewards with apparently little risk
  (particularly complex mechanisms/vehicles)
• No compromise on underwriting standards

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In order to ensure that risk management carries
the appropriate weight, it is vital that the
board is engaged in a risk appetite discussion
which can be cascaded down
Group/board-levelrisk dashboard
2. Translate into risk appetite into measurable
metrics and limits
1. Articulate risk appetite
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• Needs to be comprehensive across risk types
• Include top-down and bottom stress tests linked
  to plausible scenarios

Losses no greater than XMM in 1-in-10 quarters
Able to pay dividendin 1-in-25 quarters
Ensure target solvency
5. Cascade limits
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4. Editorship of dashboards and funnelling of
information
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3. Specify BU level dashboards
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The Originate-to-distribute model was at the
heart of the recent credit boom but also the root
cause of the recent market turmoil

• Basic philisophy was to allow originators to
  increase volume by repackaging and distrbuting
  the risks to 3rd party investors and also tap
  into alternative sources of funding
• Supposedly a win-win-win originators
  increased volume and lock into profits/fees by
  removing balance sheet contraints investment
  banks thrived on repackaging fees investors
  gained access to new asset classes and exotic
  investment opportunities (CDO, CDO-squared, etc.)
• The risks of this model are now apparent
• Originators have a reduced incentive to maintain
  tight underwriting standards and to monitor risks
  of off-balance-sheet assets (relative to assets
  held on balance sheet)
• The pacakaging and re-packaging of risks greatly
  reduced the transparency for end-investors
  leading to over-reliance on rating agencies
• Even investment banks found it difficult to
  understand the risks of the most complex products
  leading some large misplaced bets
• The main question is whether there is still a
  future for this technology going forward?
• This presentation argues that some variations of
  this model have a future providing some minimum
  criteria are met
• Despite the bursting of the internet bubble, the
  technology is still flourishing today

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Some variations of the originate-to-distribute
model are still viable if a number of minimum
criteria are met
Originate-to-hold
Loans
Portfolio management model
Investment Bank
Portfolio Management
Origination
Distribute
Loans
Pure originate-to-distribute model
Bank
Arms-length Origination
Investment Bank/Conduit
Retention
Distribute
Loans
Collateral Manager
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Minimum requirements for operating an
originate-to-distribute model
Quick wins
Description
Potential challenges
Underwriting Standards

• Bank needs a minimum set of underwriting standard
  even if assets are held off-balance sheet even
  if there is no recourse there is significant
  brand risk and the risk that a vital funding
  source will be eliminated

• In arms-length origination, if the bank is unable
  to obtain sufficient information to underwrite
  the loans then the model is not viable

Transparency

• All risks at each point in the value chain need
  to be understood by the bank regardless of
  whether the bank is isolated from the risk

• Some complex mechanisms are so difficult to
  unravel that they may have no future

Evaluation

• The bank needs to evaluate whether the business
  model creates sustainable value given all of the
  possible risks and downside

• It is some times difficult to distinguish a
  sustainable growth opportunity from a short-term
  gain

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Wrap up Threats and opportunities coming out of
recent events

• Threats
• Banks depleted capital ratios could lead to
  reduced activity creating a vicious circle of
  reduced profits and further capital depletion
• The real economy most losses to date have been
  MtM losses, but we could see some actual defaults
  materialise if credit remains tight
• Property prices a repeat of the US experience in
  Europe is a real possibility (UK, Ireland and
  Spain are particularly vulnerable)
• Investment banks could suffer a triple whammy
  direct losses from market events reduced
  volume due to lack of liquidity reduced
  margins due flight to simplicity
• Opportunities
• Some acquisition targets now look cheap (but only
  capital-rich banks can take advantage of the
  opportunities)
• Chance for risk management to demand some budget
  to bring capabilities and systems in line with
  front-office capabilities

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