ALGO CAPITAL, ALGO COLLATERAL, ALGO CREDIT, ALGO MARKET, ALGO OPVANTAGE, ALGO OPVANTAGE FIRST, ALGO RISK,

and ALGO SUITE are trademarks of Algorithmics Trademarks LLC.

© 2010 Algorithmics Software LLC. All rights reserved. ALGO, ALGORITHMICS, Ai & design, ALGORITHMICS & Ai & design, KNOW YOUR RISK, MARK-TO-FUTURE, RISKWATCH, ALGO RISK SERVICE,
JUNE 2010

99
SURVEY O
SAYS!
WHEN O
Tracking the evolution
of Credit Value
IS
NOT

WHEN 99% IS NOT ENOUGH

Adjustment

ENOUGH
THE BIG Exploring the
PICTURE gap between
confidence and
Establishing a certainty
National
Institute of
Finance

THE
SOLVENCY
Not all risks are worth taking. SCENARIOS
Measuring risk along individual business lines can lead to a distorted picture of exposures. At Algorithmics, Four perspectives on
we help clients to see risk in its entirety. This unique perspective enables financial services companies to compliance
mitigate exposures, and identify new opportunities that maximize returns. Supported by a global team of
risk professionals, our proven, enterprise risk solutions allow clients to master the art of risk-informed IN
decision making through the science of knowing better.
LIVE LONG REVIEW
Proven Risk Management Solutions algorithmics.com
AND PROSPER
JUNE 2010

Understanding Whole
The beauty of
Enterprise Risk art as investment
Credit Value
Adjustment
The changing environment for pricing
and managing counterparty risk

Download our latest whitepaper at

http://www.algorithmics.com/en/CVA.cfm

© 2010 Algorithmics Software LLC. All rights reserved.

As the world’s leading provider of enterprise risk solutions, Algorithmics conducts ongoing research
into industry trends and challenges. Our latest white paper on Credit Value Adjustment (CVA) contains
survey results based on in-depth interviews with a cross-section of financial institutions that actively
manage counterparty credit risk. These interviews reveal how CVA is being measured, where CVA fits
into systems today, and how CVA practices are expected to evolve. Download your free copy at
http://www.algorithmics.com/en/CVA.cfm

Proven Risk Management Solutions algorithmics.com

 WHEN 99% IS
22 NOT ENOUGH
What financial risk
management can
learn from the
nuclear energy and
demolition industries

LIVE LONG
40 AND PROSPER
How risk
management tools can
help financial
institutions extend
their lifecycle

THE BIG

34 PICTURE
Profiling Allan
Mendelowitz and
the Committee to
Establish a National
Institute of Finance

ENABLING
INTUITION
How replicating
portfolios can
improve the
effectiveness of
firm-wide risk
management

44 THE LAST
WORD
Portfolio updates
in Haiku? On a
smartphone,
anything is possible
 CONTENTS
JUNE 2010
THE SOLVENCY
28 SCENARIOS
Best practices
approaches on the
road to Solvency II
compliance
17
READING SURVEY SAYS!
10 ROOM
Paul Samuelson,
economic calamities,
In-depth interviews
reveal changing
attitudes towards
Credit Value
financial models, Adjustment (CVA)
zombies and more and the pricing and
managing of
counterparty risk

12
DEPARTMENTS
04 OPENING BELL
The pieces and puzzles of ERM

05 IN CONVERSATION:
JOHN MACDONALD
Algorithmics’ Executive VP on the
realities of counterparty risk, technology
and the “Basel Billions”

08 IN REVIEW
Art and the emergence of an alternative
investment

10 READING ROOM
New and noteworthy titles for the
practitioner’s bookshelf

44 THE LAST WORD

Risk management apps we’d like to see
for our smartphones
 OPENING BELL

Like an intricate jigsaw puzzle, financial markets

contain a number of smaller pieces whose relationships to each
other may not be obvious. The difference between the puzzles lies
in our expectations. We expect jigsaw puzzles to fit together neatly.
We may look inside the box or check around our feet for missing
pieces, but as long as a blank area remains we don’t wonder if the
puzzle is irrational or if we have relied too heavily on historical
analysis. With financial markets, we strive to fill in as many of
these blank spaces as we can, but, due to the complexity of the
subject matter, we know in advance we will not end up with a com-
plete image. What we know is that the more pieces we assemble
the more insight we can gain, and that all these pieces matter.

Welcome to the fourth issue of THINK, an Algorithmics publication created by and for risk practitioners. As
industry thought leaders, we devote a great deal of our energy to engineering and assembling different pieces
that will create more effective enterprise risk management solutions. This curiosity is reflected in “When 99%
is not enough,” this edition’s cover story, in which risk management practices between the social and physical
sciences are compared.

Another puzzle considered in this issue is how to prevent future instances of systemic risk. The Committee to
04 Establish a National Institute of Finance (NIF) believes the answer lies in the collection and analysis of granular
transaction and position data. The NIF and Committee co-founder Allan Mendelowitz are profiled in “The Big
Picture.” Other featured content includes a look at how banks can benefit from the use of replicating portfolios,
JUNE 2010 THINK

the evolving role of Credit Valuation Adjustment, and an intriguing look at how risk management tools can
enhance the lifespan of financial institutions.

Acquiring accurate data remains an important component of risk management. But each time risk professionals
interact with a piece of this puzzle, we have the opportunity to ask ourselves how it fits into the larger picture
and whether prior assumptions are still relevant. Establishing this discipline can only help risk management
play a larger and more meaningful role within the financial services industry.

As always, your comments and feedback regarding THINK are welcome.

Dr. Michael Zerbs

President and Chief Operating Officer

Algorithmics

PUBLISHER CONTRIBUTORS PRODUCTION AND CONTACT INFORMATION

John Macdonald Jeremy Asprey DISTRIBUTION Algorithmics
Andrew Aziz COORDINATOR 185 Spadina Avenue
EDITORIAL DIRECTOR Andrew Barrie Nalinie Sharma Toronto, Ontario, Canada
M5T 2C6
Maria Raposo Bob Boettcher
416-217-1500
Curt Burmeister ART DIRECTOR
EDITOR-IN-CHIEF Penny Cagan & DESIGN think@algorithmics.com
Erin Williams Jon Gregory Ma design Studio www.algorithmics.com/think
Mario Onorato
CONTRIBUTING Diane Reynolds
EDITOR Inga Rottmann
David Bester Fraser Schad
Michael Zerbs

© 2010 Algorithmics Software LLC. All rights reserved. You may not reproduce or transmit any part of this document in any form or by any means, electronic or mechanical, includ-
ing photocopying and recording, for any purpose without the express written permission of Algorithmics Software LLC or any other member of the Algorithmics group of companies.
The materials presented herein are for informational purposes only and do not constitute financial, investment or risk management advice.
IN CONVERSATION:
JOHN MACDONALD
John Macdonald, Executive Vice
President, Sell-Side Business and
Marketing at Algorithmics, shares
his thoughts on the nature of
banking, the “Basel Billions” and
the evolution of technology.
THINK: Many banks are cautiously optimistic about a
return to stability. Is that a fair characterization?
John: Yes. I think that there is a clear understanding emerg-
ing of what regulations are coming and the impact they will
have. This awareness enables banks to anticipate and focus
their energies on which practices must be modified or
changed in light of the financial crisis and concerns about
capital markets. They are also seeing an increase in business
volumes, suggesting that there are promising opportunities
ahead for the banks that want to win them. A better under-
standing of risk is certainly helping banks to price and assess
transactions in ways that really weren’t being done before.
THINK: Can you give an example of where you are seeing
a change in practice?
John: Counterparty risk remains a high priority issue that
banks are looking to minimize across the board. One idea
gaining traction, particularly among regulators and policy
makers, is the introduction of central counterparties (CCP).
A CCP can help reduce the volume and severity of counter-
05
party risk in OTC derivatives markets. CCPs are complex
JUNE 2010 THINK
entities however, and if they are not properly implemented,
they could produce their own set of all too familiar problems.
THINK: Let’s start with the benefits. What advantages can
a CCP provide?
John: A CCP can improve market resilience by reducing the
potential harm from a major dealer’s failure. Through the
use of multilateral netting, CCPs offer banks enhanced flex-
ibility to enter into new transactions and end existing ones.
The multilateral aspect and its support for anonymous
trades can reduce barriers to market entry and mitigate
counterparty risk, leading to greater liquidity.
Centralizing counterparty transactions through CCPs auto-
mates the clearing process, which helps to prevent
confirmation backlogs. Consolidation would require stan-
dardized rules and mechanisms, which can reduce the risk
of legal disputes from unconfirmed trades, enhance trans-
parency and deliver operational efficiencies.
Size plays a role as well. A CCP can create best practices and
procedures in partnership with regulators more efficiently
than institutions working individually or in alliance.
THINK: What are the disadvantages?
John: A centralized clearing function requires a certain
degree of product conformity. Yet OTC products can be
heavily customized, limiting their ability to be cleared
through an automated system. Standardizing some product
elements, such as valuation approaches and documentation,
may be required, but this aspect has not been needed in
 bilateral markets. In bilateral markets dealers compete for
business, to a certain extent, on their capabilities of manag-
ing counterparty risk. Without this level of competition, the
motivation to accurately price and manage counterparty risk
when entering a trade is reduced.
I had mentioned that size plays an advantageous role in the
benefits a CCP can provide, but it is also a concern. Should
regulators favor a particular CCP, this could induce institu-
tions to enter into trades with less accurate pricing of
06 counterparty risk, leading back to market instability.
Amidst all the talk of institutions that are too big to fail, it is
JUNE 2010 THINK
interesting that CCPs are being cited as an improvement
because their size would bring added stability to the process.
We know that even with supervision and strict capital
requirements, no institution is invulnerable to unforeseen
circumstances.
THINK: How can banks navigate between these benefits
and challenges?
John: The form CCPs will take is still unknown, but they do
reflect the growing presence of automated transactions
across the banking landscape. Banks will need to develop
scenarios and run simulations on margin calls generated
through a CCP. Market changes will impact the size and tim-
ing of margin calls and, effectively, this form of risk replaces
some of the counterparty risk that they hold today.
By taking these steps, banks can prepare themselves and
leverage technology to integrate their infrastructure and
develop more innovative and sophisticated products with
this emphasis on automated transactions in mind.
THINK: Where will the next generation of technology
solutions come from: internal development or solution
providers?
John: Banks are major consumers of technology, so the
ongoing answer will likely be a combination of both.
Leveraging vendor technology can deliver a savings of
costs and scale, and deliver quick wins for organizations
seeking to demonstrate compliance or transparent
processes. In many cases, it lets a bank optimize its own
IT resources on creating software or tools which give it
proprietary advantage over rivals; that’s adding value to
the business, not just a cost.
Keeping ahead of the competition requires continuous
improvements to infrastructures, a constant pressure to
speed up trading processes and their associated checks, and
the maintenance of data that seems to constantly increase in
volume and importance. In today’s climate the speed of
response, not just through use of technology but also of deci-
sion making, is crucial to effective management.
THINK: Speed of response is linked to real-time analysis.
Where does acquiring on-demand analytic capabilities fit
within a bank’s priorities?
John: The knowledge and technology to support real-time
analysis exists. As the trend to transform credit risk into
tradable market risk grows, the ability to accurately price
and understand the risk and return at the time of the trans-
action becomes paramount. I like to think of “Right Time”
rather than real time alone as what is needed. The essence
of a “Right Time” approach is to make sure that an inte-
grated infrastructure of data, technology and applications is
able to deliver the right information to the right person
when they need it.
So, it is not necessary or even desirable to have everything
in real time. Like all things in life, the latest and greatest
technology comes with a price. This cost can be more easily
justified for certain aspects, less so for others. At a decision-
making level, the question needs to be asked: “Is there a
logical fit here between need and application?”
There has to be an ongoing, internal dialog within banks to
ensure that resources are diverted to the areas that will deliver
the best return on their risk investment. After living through
the “Basel Billions,” banks are justifiably cautious about mak-
ing an extensive investment in their risk infrastructure without
having a clear picture of what the returns will be beyond sat-
isfying the regulator reporting requirements.
THINK: The “Basel Billions?”
John: It’s an informal reference, but banks individually
invested millions of dollars into their compliance programs.
And what did they get for it?
Now, let me qualify this by saying, outside of compliance,
the investment in a risk infrastructure itself offers its own
rewards. Senior Supervisor’s Reports have been quite clear
that in the wake of the financial crisis: those banks that
relied on a broader range of risk measures and challenged
some of the assumptions underlying their methodologies,
tended to do better than those institutions that viewed their
risk infrastructure purely as a means to address compliance.
Following the credit crisis, a consensus has developed among
regulators, political bodies and investors that additional
transparency is required. This relates particularly to exotics
and securitization. And so the Liquidity & Capital Require-
ments Directive is being revised, which will likely affect
compliance requirements. As an organization, you certainly
want to take any steps you can to ensure stability. But at the
same time, you don’t want to be in a position where the
costs to take these steps are unclear or difficult to quantify.
THINK: Regulators are certainly concerned about trans-
parency, but perhaps even more so about liquidity. How
high a priority is it for banks to address liquidity risk?
John: Unlike efforts to address counterparty risk, there’s no
visible cliff where systemic failure occurs; no signpost that
an institution can see and say: “Yes, we are now protected.”
The interconnected nature of global markets and by exten-
sion institutions is a factor when addressing liquidity risk,
but what system could one bank put into place that provides
a benefit? What would it cost? What actionable information
could it provide? On this issue it is best to let regulators and
governing bodies take the lead. On an institutional level, it is
better to put resources towards systems that can deliver on
a cost/benefit analysis.
THINK: Where should these resources be focused?
John: Any investment in a risk infrastructure that can give
future flexibility is a positive one. An advanced risk frame-
work can be a competitive differentiator for banks. One area
that provides the greatest benefit is the ability to acquire
data and make it available across the organization. A phi-
losophy of “acquire once, add value and then use many
times” is the best way to ensure that decision makers within
the bank can access data and use it as required.
This must take place at a deep level of granularity. Provid-
ing decision makers with the information they need is not
the same as handing over all the data at once. It becomes
meaningless. An overload of data is counterproductive, or
may even provide a false sense of security. It goes back to the
idea of getting quality information at the right time to the
right place. This need to acquire and analyze data will only
increase as the diversity of instruments continues to grow.
THINK: That seems to lead us towards the future. What steps
can banks take to position themselves for long-term success?
John: To ensure stability and lay the groundwork for prof-
itability, banks need to ensure that they have a thorough
understanding of the real drivers deep in their business
model. They must also have a firm grasp of the constraints
they have to operate under to meet the capital adequacy
goals set out both internally and by regulators. We now have
a better understanding of the nature and challenges of man-
aging liquidity, so banks will be much more cautious about
the potential of overextending themselves in the market and
to other institutions.
These issues can be supported to an extent by technology.
The ability to outsource transactional processing solutions
may provide some relief. But given the speed at which the
industry evolves, leadership and organizational structure
will play an even larger role in determining the success of
technology-based projects. Frequent reorganizations and
consolidation can make it challenging to sustain multi-year
strategies. Banks with the vision to implement solutions and
maintain the high-level support required to see them through
will be more likely to enjoy a successful outcome.
So technology is important, but is really secondary to
vision. High-level dialog and a willingness to engage on
all aspects of the bank’s risk policy will be even more
important to ensure that the bank’s strategic and business
goals are met. 07
THINK: We have discussed a number of shifts in thinking
JUNE 2010 THINK
about risk in the banking industry, from basic compliance to
technology and its role in maximizing the availability of use-
ful information. Has the sum of these changes altered the
nature of banking?
John: The nature of banking hasn’t changed – only its com-
plexity. In a theoretical world, a bank would lend and
borrow money on the same terms; by that I mean the same
amount over the same period of time. But in the real world
this happens rarely. There are more variations on timing,
currency, product type, methods of transacting and other
characteristics of a product or trade. Each time a new
instrument or approach is introduced – which is demanded
by a competitive market place – new correlations need to
be examined and understood. A greater emphasis on the
continuity of risk planning, closely tied to the bank’s tradi-
tional business model, is required as these new
opportunities are pursued.
Algorithmics has evolved in a similar way. We have always
advocated the benefits of measuring and managing risk on
an enterprise level. Sharing consistent and accurate risk
information across the organization has been proven to be
a more effective approach than trying to manage risk by
components through a silo-based mentality. But as the
market place and the corresponding needs of banks
evolve, new techniques and business solutions are required
to support them. As vendors in an enduring partnership
with our clients, we continue to research, innovate and
engineer solutions that will help banks to better under-
stand and manage the actual risks associated with the
known challenges of today and the emerging opportuni-
ties of tomorrow.
 IN REVIEW
No. 5, 1948
ART AS INVESTMENT Sold for
For centuries, art has had a profound
impact on viewers around the world. $140 million
Over the last few decades, many of November 2006
these spectators have become
speculators that view art as an asset
class with its own unique risk and
return measures.

The British Rail Pension Fund was the

first institutional investor to treat art
as an investment vehicle. In 1974, the
fund dedicated around 3% of its
holdings (approximately $70 million)
Eight Elvises
to a diversified collection of pieces Sold for
including Impressionist paintings,
rare books, Old Master drawings and
$100 million
African tribal art. These pieces were December 2009
ultimately sold in the late 1980s,
delivering an annual compound
08 return of 11.3% to the fund.
JUNE 2010 THINK

Since the British Rail Pension Fund

tested the waters with their art Andy Warhol
escapade, a number of art funds have
followed suit with mixed results. But
the interest in art continues to grow.
Many financial institutions now offer
specialized art advisory and
For the
insurance services. Corporate art
collecting has grown substantially,
Love of
and a number of banks have taken a
leading role in amassing the most
God
impressive collections, Deutsche Sold for
Bank, Progressive Insurance and $100 million
UBS in particular. August 2008
The attraction to art is easy to
understand. Original art pieces are Damien Hirst
unique objects that support
diversification strategies while adding
great prestige and beauty to a
portfolio. The potential to realize
extraordinary returns is also hard to
ignore. Over the past few years, a
successive stream of pieces has Walking Man
shattered individual records for art
sales. The extensive media coverage Sold for
garnered by these sales keeps the $104.3 million
spotlight on art as investment, February 2010
making it likely that the audience of
institutional art investors will
continue to grow.
 BREAKING THE BANK
RECORD-BREAKING ART SALES RAISE EYEBROWS AND EXPECTATIONS AMONG COLLECTORS,
INVESTORS AND CONNOISSEURS. HERE IS A LIST OF 8 NOTABLE TRANSACTIONS FROM RECENT YEARS.

Woman III
Sold for
$137.5 million
November 2006

Jackson Pollock

Willem De Kooning
Boy with
a Pipe
Sold for 09
$104 million

JUNE 2010 THINK

May 2004

Pablo Picasso

Jeff Koons Hanging

Heart
Sold for
$23.6 million
November 2007
Titian
Diana and
Actaeon
Sold for
$91 million
January 2009

Alberto Giacometti
 A ROUNDUP OF
RECENTLY RELEASED AND
NOTEWORTHY TITLES.
10 An Engine, not a Camera:
How Financial Models Shape
Markets
JUNE 2010 THINK
Author: Donald MacKenzie
Milton Friedman famously referred to
economic theory as an engine intended to
analyze the world, not a camera expected to
faithfully reproduce its every detail. Donald
MacKenzie tweaks the meaning of this phrase
in the title and content of An Engine, not a
Camera. He argues that the engine of modern
finance theories have actively transformed the
environment around them, affecting markets
in fundamental ways.
MacKenzie suggests that the emergence of
Nobel Prize-winning theories, based on
elegant mathematical models of markets,
were not merely external analyses but
intrinsic parts of economic processes. In
1970, there was almost no trading in financial
derivatives, such as futures. By 2004, $273
trillion in derivatives contracts were
outstanding worldwide. MacKenzie proposes
that this growth could not have occurred
without the development of theories that
legitimized derivatives and explained their
complexities.
The role of finance theory in the stock market
crash of 1987 and the market turmoil tied to
the fall of Long-Term Capital Management in
1998 is also examined. MacKenzie points out
that these scenarios took place during a
period when an authoritative theory of
financial markets emerged, and questions
whether these events could have occurred
without the availability of such a theory. If the
impact of finance theories is not appreciated
among most individuals, as MacKenzie
suggests, it becomes easier to understand
why many businesses struggle to effectively
manage risk, despite the availability and
variety of information age tools.
Donald MacKenzie is Professor of Sociology
at the University of Edinburgh. His work in the
social studies of finance will interest anyone
who wants a better understanding of how
American financial markets have evolved into
their current form.
How Markets Fail: The Logic
of Economic Calamities
Author: John Cassidy
For 50 years or more, economists have been
busy developing elegant theories of how
markets facilitate innovation, wealth
creation and the efficient allocation of a
society’s resources. But what about when
markets don’t work? What about when they
lead to stock market bubbles, glaring
inequality, real estate crashes and credit
crunches?
In How Markets Fail, John Cassidy seeks to
answer these questions by connecting two
storylines. The first recounts the history of
modern economics. The second details the
recent financial crisis and how it was shaped
by what he calls “utopian economics.” For
Cassidy, utopian economics involves turning
a willful blind eye toward the behavior of
real people and the possibility that an
unregulated free market can produce
disastrous and unintended consequences.
Cassidy argues that, over the course of a
generation, utopian economics have become
accepted mainstream theory for
policymakers and investors. However, he
argues that markets are “rationally
irrational” and can fail to capture all the
information necessary to sustain the
assumptions required by utopian economics.
This disconnect can lead to a host of
individual behavioral biases, from
overconfidence to envy, copycat behavior and
myopia, which give rise to market bubbles
and crashes. These failures remain
unexpected behavior to those who believe in
a purely efficient market.
Cassidy, an economics writer for The New
Yorker, combines on-the-ground reporting
with historical analysis to make his point
that conforming to antiquated orthodoxies
isn’t just misguided: in today’s economic
crisis, it’s dangerous. How Markets Fail
offers a new, enlightening way to
understand the force of the irrational in our
volatile global economy.
This Time is Different: Eight
Centuries of Financial Folly
Authors: Carmen M. Reinhart,
Kenneth S. Rogoff
For This Time is Different, economists
Carmen Reinhart and Kenneth Rogoff have
compiled financial data covering 66
countries over 8 centuries to study financial
crises and analyze their causes. Preceding
almost every crisis was a common belief

that conditions at the time were unique, and
that potential risks had been properly
identified and managed. The repeated
inability of governments and market
participants to recognize analogies and
precedents was so frequent that the authors
name the blind spot as the “this-time-is-
different syndrome.”
Reinhart and Rogoff define what constitutes
a financial crisis, explain the various forms a
crisis can take (for example, sovereign debt,
exchange rate crashes, inflation crises,
banking crises, currency debasement or the
bursting of asset price bubbles) and
emphasize that the different types of crises
tend to occur in clusters. The last
observation leads the authors to suggest
that it may be possible to have a systemic
definition of crises that would improve our
ability to recognize conditions and identify a
potential crisis.
The authors’ analysis sets guidelines for
conditional thresholds that must be weighed
in the context of historical time periods,
when smaller historical movements
constituted huge surprises and were
therefore hugely disruptive. In more recent
times where there is an international
dimension to markets, new methods are
needed to identify potential surprises, gauge
their intensity and their transmission, and
attempt to define the most relevant
parameters that contribute to a global
financial crisis.
We are left with the message that we must
resist the temptation of “this-time-is-
different syndrome” if we are to reduce the
risk of future financial crises or better
manage catastrophes when they do happen.
Paul Samuelson: On Being an
Economist
Authors: Michael Szenberg,
Aron Gottesman, Lall Ramrattan
THINK invites Algorithmics thought leaders
to review titles of interest from their own
bookshelves. This issue’s contribution is by
Dr. Andrew Aziz, Executive Vice President,
Buy-Side Business.
As author of the bestselling economics
textbook in history (Economics) and the first
American to win the Nobel Prize in
Economics, Paul Samuelson maintained both
a popular and influential platform to share
his views and enthusiasm for neoclassical
economics. Samuelson, who passed away in
December 2009, considered himself the last
generalist in a discipline that was gradually
taken over by specialists. Over seven
decades, his research and ideas spanned
trade, public finance, business trends and
consumer behavior, and his early work on
speculative pricing covered ground that
eventually produced the efficient markets
hypothesis in financial theory.
Part of Samuelson’s appeal was his spirited
writing. His legacy and engaging personality
are documented in On Being an Economist, a
concise profile of an original thinker and one
of the great economists of the 20th century.
The book traces Samuelson’s career from his
When Zombies Attack!
I
n the movie Zombieland only a handful
of humans remain to fight a world
overrun by flesh-craving zombies.
The film takes a light-hearted if gory
approach to surviving a zombie attack. For
those craving a more intellectual
perspective, a group from the University of
Ottawa and Carleton University have come
to the rescue with When Zombies Attack!:
Mathematical Modelling of an Outbreak of
Zombie Infection.
READING ROOM
days as an undergraduate at the University of
Chicago through his evolution as a
theoretician, a magazine columnist and the
architect of the influential economics
department at Massachusetts Institute of
Technology. The book balances personal
anecdotes from his colleagues and students
with a functional overview of his philosophies
and the mathematical language of his
methodology. His theories and methods,
celebrity, “wise sayings” and role as a mentor
are also covered.
Over 90% of Samuelson’s published work
appeared after he turned 50. This prolific
output later in life is impressive, particularly
in the sciences, where it is generally
assumed that all of a person’s good work
takes place in their 30s. Shortly before his
death at 94, the Annual Review of Financial
Economics published Samuelson’s brief
memoir, An Enjoyable Life Puzzling Over
Modern Finance Theory. In the article
abstract, Samuelson wrote: “Because
economic history at best obeys only quasi-
stationary probabilities, no sure-thing
formulas will ever be definable. Excess
returns – excess ’alphas’ – can result
only from early new ’insider’ knowledge,
11
however acquired – legally or illegally.
JUNE 2010 THINK
Boo hoo.” His oversized wit and intellect
deserve to be remembered and celebrated.
Paul Samuelson: On Being an Economist
is a fine starting point for practitioners and
general interest readers.
Dr. Andrew Aziz
Zombieland images courtesy of Columbia Pictures Industries, Inc.
All rights reserved.
Authors Philip Munz, Ioan Hudea, Joe
Imad and Robert J. Smith? introduce a
basic model for zombie infection,
determine equilibria and their stability, and
illustrate the outcome with numerical
solutions. The model is then modified to
introduce a latent period of zombification,
whereby humans are infected, but not
infectious, before becoming undead.
For more information on When Zombies
Attack! and to download a copy, visit
www.mathstat.uottawa.ca/~rsmith/
 12

ENABLING
JUNE 2010 THINK

INTUITION
HOW REPLICATING PORTFOLIOS CAN HELP
FINANCIAL INSTITUTIONS IMPROVE THE
EFFECTIVENESS OF RISK MANAGEMENT AT
THE ENTERPRISE LEVEL
by Michael Zerbs
I
he recent financial crisis has unambiguously

T demonstrated the importance of and need for

effective firm-wide risk management that builds
on responsive risk analysis and informative risk
reporting. Financial institutions are making con-
siderable investments in their risk infrastructure to allow for the
comprehensive aggregation and monitoring of exposures across
counterparties, businesses, risk strands and other dimensions to
improve their overall risk capabilities and processes.

Undoubtedly, these investments will help financial institutions

advance the quality of their risk measurement. What is less clear
though is whether those changes will truly improve corporate
risk governance. In a January 2008 interview with the Wall
Street Journal, Merrill Lynch CEO John Thain explained one of
the reasons why the company had suffered substantial losses in
the previous year: “Merrill had a risk committee. It just didn’t
function. So now when we have a weekly meeting, the head of
fixed income and equities show up. I show up, and the risk
heads show up. Thain further stated that once these and other
changes had been made, “it [the risk committee] functions and
functions across the business.”

Thain’s statement was made before the full impact of the finan-
cial crisis was understood. Yet it does not appear that additional
hindsight has inspired institutions to take a deeper look at their 13
risk practices. As a somewhat discouraging example, supervi-
sors continue to see insufficient evidence of board involvement

JUNE 2010 THINK

in articulating and monitoring institutions’ risk appetite more
than two years after the onset of the financial crisis. Where such
processes exist, they are often fragile and not actionable.
Recently, the Senior Supervisors Group re-iterated those con-
cerns in their updated October 2009 report, “Risk Management
Lessons from the Global Banking Crisis.”

MUCH EFFORT, LITTLE BENEFIT

It would be disappointing and in fact highly dangerous to the
future stability of the financial system if the many improvements
that have been recommended and are now being implemented
ultimately fail to enhance risk governance in a meaningful way.
Regrettably, such an outcome is entirely possible. There is one
fundamental reason for my pessimism, which is insufficient
focus on how boards and senior decision makers can make
sense of the risk analysis and reports they receive in order to for-
mulate actionable responses. Institutions face a difficult
dilemma: they are asked by regulators and industry working
groups alike to provide multiple relevant measures of risk “to
develop a range of perspectives and consider a broad distribu-
tion of possible outcomes,” yet it may well be that enhanced
transparency in the form of more and at times conflicting infor-
mation will overwhelm the consumer of information. In other
words, details may obscure the bigger picture.

A POTENTIAL OUT-OF-THE-BOX SOLUTION

Replicating portfolios, which have been adopted widely in
the insurance industry as a computationally efficient and
robust proxy for complex and unwieldy liability portfolios, can
help the broader financial services industry resolve this
dilemma. Properly constructed, replicating portfolios can
provide a succinct and intuitive representation of large and
multi-dimensional portfolios, allow for responsive, on-demand
risk analysis, enable actionable hedging strategies and facilitate
14
Concise replicating portfolios
JUNE 2010 THINK
allow for the rapid evaluation
of the implications of changing
market conditions and the
assessment of alternative
scenarios in an on-demand
mode of operation.
the articulation of a firm’s overall risk appetite. The concept
is particularly applicable to the risk analysis and manage-
ment in the very banks that are strongly encouraged by
supervisors to redouble their efforts to address critical areas
for continued improvement resolutely.
SMALL IS BEAUTIFUL
The main idea is simple: replicating portfolios are hypothet-
ical, small portfolios of financial instruments that have been
constructed to have essentially the same risk characteristics
in a risk model as actual large and complex portfolios over
a range of scenarios and multiple time periods. In other
words, they “replicate” or mimic the risk of the large port-
folio for the purposes of risk analysis. Typically, scenario
optimization techniques are used to identify effective repli-
cating portfolios. The benefits of replication are directly
related to the concise representation of large portfolios –
interpretation, analysis, decisions and hedging all become
much more straightforward when the modeled portfolio is
a slimmed down version of an actual “enterprise” portfolio.
In its communication objectives the approach is similar to the
concept of a “risk equivalent” position that has been popu-
lar since the 1980s. For example, complex interest rate books
would have been expressed in two-year or five-year govern-
ment bond futures positions with the same local interest rate
sensitivity as the original book. Equity portfolios would have
been expressed as beta-weighted positions in a general mar-
ket index. In both cases, the objective was to find a simple
and intuitive way to communicate risk information about
complex portfolios, which is the same objective as in repli-
cation. In contrast to such earlier approaches, replication can
capture a much richer set of risk characteristics, as the abil-
ity to identify a portfolio of replicating instruments offers
greater flexibility for matching non-linear behavior over mul-
tiple scenarios and across several risk factors.
Where strategic risk management is focused on major
threats at the enterprise level, for example the adequacy of
risk capital in a market-wide Black Swan scenario, replica-
tion would be used primarily to ensure risk equivalence for
a range of general market or systemic stress tests. Tactical
risk management, on the other hand, would require replica-
tion that encompasses both systemic and idiosyncratic risks.
This discussion is focused on replication in the context of
market-wide Black Swan events rather than idiosyncratic
events. The approach naturally extends to more granular
risk analyses as well.
SUCCINCTNESS AND INTUITION
Replicating portfolios use different semantics with different
intuitive associations than traditional risk reports. Whereas
traditional risk reports typically show the “worst case loss”
at a certain probability threshold, for instance using VaR
or shortfall measures, replicating portfolios translate risk
 THE ART AND SCIENCE OF
REPLICATING PORTFOLIOS
While replication has many potential
benefits, it is not a panacea for reducing
complexity and enabling effective risk
management decisions based on
informed risk assessment. It must be
ensured that replicating portfolios are
accurate and reliable, and encourage
intuition that is aligned with the
underlying risk characteristics.
Algorithmics has published a number of
papers that provide additional insight into
the effective creation and usage of
replicating portfolios.

15

Replicating Portfolios in Algo Risk

JUNE 2010 THINK

exposures into succinct portfolios of well-understood plain This paper offers a high-level overview of the
vanilla instruments that support robust intuition. replicating portfolio construction process available
within Algo Risk.
Probabilistic assumptions have a great capacity to be mis-
understood. Statements like, “You can expect to lose more http://www.algorithmics.com/EN/publications
than this amount less than once in a hundred years,” with /whitepapers
all the assumptions that are left unsaid and the many incor-
rect inferences that can be made by non-experts are replaced
The practice of portfolio replication
with a statement such as, “Fundamentally, you should think
This excerpt from the Algo Risk Quarterly reviews the
of your market exposure as a short call option on the equity
basic principles behind replication and several practical
market combined with a long commodity position and an
examples of its application.
interest rate spread position.” When markets are in free fall,
the “short call” representation of risk tells us more than a
http://www.algorithmics.com/EN/publications
VaR representation with probabilistic assumptions that have
/whitepapers
been overtaken by events does, exactly when they are needed.
Similarly, it is easier to explain risk exposures in terms of
plain vanilla representative positions in, say, Eurostoxx or Strength in Numbers
Euribor futures or options than to disclose detailed tables of In this article, the authors consider how employing a
deltas, gammas, rhos and other greeks or PV01s. closely related series of replicating portfolios can
benefit insurers.
RESPONSIVE, ON-DEMAND RISK ANALYSIS
Running firm-wide risk analyses is a major computational http://www.algorithmics.com/think/dec09
challenge. Even with advanced hardware and risk architec- /strength1.html
tures that have been optimized for performance,
comprehensive risk reports can take several hours of simu- Building the Perfect Beast
lation time on grids with hundreds of CPUs. This timeframe In this article, the authors provide a detailed insight
is not fast enough when risk management needs to be into the mechanics of building a dependable replicating
responsive to market shocks that may be developing rapidly portfolio.
throughout the day.
http://www.algorithmics.com/think/January09
Concise replicating portfolios allow for the rapid evaluation /beast.html
of the implications of changing market conditions and the
assessment of alternative scenarios in an on-demand mode
of operation. As turnaround times shrink from hours to

One area where
fundamental change
is needed is in the
delivery of complex
information to enable
the meaningful
articulation of risk
appetite and the
effective oversight of
risk by non-expert
stakeholders.
minutes, replicating portfolios change a reactive reporting
perspective that often lags events to a pro-active and interac-
tive mindset that enables risk managers to participate with
fresh and relevant information in the decision making process.
The approach can also be used to effectively reprice large
portfolios during times of high market volatility, without
16 waiting for a full revaluation of each individual position. As
institutions monitor collateral thresholds, counterparty
JUNE 2010 THINK
exposures, capital buffers and risk limits tightly and in near
real time during periods of market turmoil, the ability to
revalue a proxy portfolio within minutes can provide invalu-
able information to traders and risk managers alike.
HEDGING AND CAPITAL MANAGEMENT
Replication can be used to identify effective hedging strate-
gies. The request “show us the combination of five plain
vanilla instruments that best represents the main risks in our
proprietary trading book” is closely related to the question
“out of the following ten highly liquid instruments, which
five can we choose to hedge our exposure to a particular set
of potential Black Swan events?” The methodology natu-
rally accounts for liquidity constraints and transaction costs.
This is particularly important when hedging strategies bump
against liquidity constraints due to the absolute size of cer-
tain markets even in normal market conditions, but
especially when conditions are not normal. In periods of
market stress, the desire for a perfect hedge that is finely
tuned to each risk sensitivity of a portfolio quickly gives way
to a desire to hedge “at least” some of the major exposures
to key market factors. For example, at the height of the
recent market turmoil there were only a handful of hedging
instruments globally that had meaningful liquidity. Replica-
tion can make the best of such constrained situations and
can help in the quantification of trade-offs. Examples of
trade-offs that need to be considered include the following
questions: Is it better to buy more protection at a higher cost
or less protection at a lower cost? How robust are different
hedging strategies under different unexpected scenarios? Is
it more effective to hedge with three highly liquid and trans-
parently priced products or five less liquid and less
transparently priced products?
Replication under tight liquidity constraints is important
when hedging large enterprise risks, as well as when hedg-
ing specific trading books in smaller and less liquid markets.
Specifically, replication has also been used successfully to
hedge bond trading exposures in certain local government
bond markets with limited market depth.
Because the hedging strategies that replication produces are
often non-intuitive to other market participants, they have
the potential to change the dynamics between protection
buyers and sellers. The buyer’s strategy is no longer obvious
to the seller, which can make a critical difference to the
buyer’s ability to hedge effectively and at a reasonable cost,
especially in times of market turmoil.
As another application of the same concepts, replicating
portfolios provide useful insights in the management of risk
capital. Business and hedging strategies can be tuned to
reduce or cap exposures to specific scenarios that drive risk
capital consumption. The approach can distinguish naturally
between acceptable risks under normal market conditions,
which can remain unhedged, and unacceptable tail expo-
sures which drive capital consumption and free up risk
capital if reduced.
A CALL FOR REVOLUTION, NOT EVOLUTION
Supervisors and government alike have stated repeatedly
that a “revolution” (U.K. Financial Services Authority
Chairman Lord Turner) and “fundamental change” (U.S.
Treasury Secretary Timothy Geithner) are required to create
a financial system that is truly robust and sustainable. While
these comments were made in the context of supervisory
reform, they apply equally to the change in industry practice
that is required to improve risk management substantively.
As the Senior Supervisors Group noted in their recent report:
“[We] remain unconvinced that firms are undertaking the
full scope and depth of needed improvements. Further, if left
unaddressed, certain gaps could potentially undermine the
[…] progress already made.” In other words, incremental
improvement along the same trodden path won’t do, and
radically different approaches have to be considered.
One area where fundamental change is needed is in the
delivery of complex information to enable the meaningful
articulation of risk appetite and the effective oversight of
risk by non-expert stakeholders. Communicating at an intu-
itive level is especially important when the target audience
includes senior executives, board members or even other
stakeholders who are not experts in finance or quantitative
risk management. Replicating portfolios can serve to high-
light the key bets that have been taken and in this way
complement other probabilistic risk measures or detailed
sensitivity reports.
“More of the same”, in the form of expanded disclosure and
deeper transparency, won’t suffice by itself. It needs to be
complemented by succinct out-of-the-box communication
methods that relate to the audience’s learned concepts and
experiences in all of their natural richness and suggestive
power. Replicating portfolios are innovative constructs that
are well placed to rise to the challenge and provide action-
able risk insights.
 V
SU E
RY
SA S
Y
... 17

JUNE 2010 THINK

by Jon Gregory
The market volatility experienced during the
COUNTERPARTY RISK financial crisis has driven many firms to review
AND THE EMERGENCE their methods of accounting for counterparty
credit risk (CCR). Credit Value Adjustment
OF CREDIT VALUE (CVA) offers an opportunity for banks to move
ADJUSTMENT beyond the control mindset of credit limits by
dynamically pricing counterparty credit risk
directly into new trades. As part of ongoing
research, Algorithmics conducted in-depth
interviews with a cross-section of financial
institutions to gain insight into their
approaches to emerging opportunities for CVA.

THINK asked Dr. Jon Gregory, a consultant

specializing in the area of counterparty risk, to
summarize the interview results and share his
analysis of evolving CVA practices.
 “I think our CVA
calculations follow an
80/20 rule in that 80% of
the risk resides in the 20%
of the products we don’t
yet capture properly.”

I A
A Q
he new millennium has been disastrous for

T
AQ
derivatives and financial risk management.
Some financial institutions have declined or
failed, such as the high profile bankruptcy of
Lehman Brothers; and even more would
have folded were it not for government aid. To address
today’s considerable financial challenges, an area that needs
particular and urgent attention is that of counterparty credit

A
risk. When asked about CCR, the majority of interview sub-
jects reported that the attitude in their institution had
18 changed dramatically in the last two years. No respondents
indicated that attitudes remained the same, and these results

Q A
are hardly surprising. The credit crisis brought CCR to the

A Q
JUNE 2010 THINK

forefront of people’s thinking in a similar way that VaR did

13 years ago.

Furthermore, institutions no longer take the concept of “too

big to fail” for granted. Common products like credit deriv-
atives, which were thought to be relatively straightforward,
have been shown to contain huge elements of CCR, some-
times to the extent that the product itself can be worthless.
As a result, CCR has rapidly become a problem for all finan-
cial institutions, big or small.

When asked which elements of CCR had become more

important as a result of the recent crisis, collateral was the
most common answer. This response was also to be
expected. Although improving the measurement and man-
agement of CCR is critical, updating approaches and
analytics can be part of a long-term overhaul, while collat-
eral requirements can be tightened up almost immediately.
In less liquid markets, institutions do not always get cash
guarantees. Securities or bonds can present additional
problems when used as collateral because of their com-
plexity. To reduce the chance of significant losses, many
institutions indicated that they are only willing to enter
into daily collateral agreements, with cash as a highly pre-
ferred form of collateral. Many counterparties, particularly
corporates, cannot handle the operational workload of
daily margining. It would appear that the era of banks call-
ing every two weeks to review terms on collateral is, for the
moment, behind us.

Recognizing the source of CCR is a first step toward con-

trolling risk in this changing environment. Most institutions
(81%) cited interest rate products as contributing the most
to their overall risk. This answer demonstrated that institu-
tions are gaining awareness of their true exposures. While
interest rate swaps may carry a maximum exposure that is
a small percentage of their notional value, the sheer size of
that value suggests that CCR lurks beneath the surface.

In contrast, foreign exchange and credit derivatives, which

were ranked the second and third largest contributors to
counterparty risk, carry a smaller notional exposure but can
be more toxic in terms of their CCR. It could be argued that
credit derivatives actually pose a greater threat than interest
rates due to the hidden nature of the risk they contain. How-
ever, that these products were selected as the top three
responses indicates that institutions are looking in the right
direction as they attempt to better measure and manage CCR.

A VALUE-BASED ADJUSTMENT
Setting limits against future exposures and verifying poten-
tial trades against these limits is the traditional approach
financial institutions have used to control CCR. This prac-
tice is consistent with portfolio diversification and generally
permits trades that moderately reduce or increase exposure;
but this traditional approach risks rejecting trading oppor-
tunities with large exposures that exceed set limits.

Credit Value Adjustment is the fair value price of CCR. 19

Therefore, banks are able to price CCR directly into trades,
fully accounting for the cost of carrying or hedging the

JUNE 2010 THINK

risk. Firms that adopt CVA also gain a metric to measure
Jon Gregory is a consultant specializing in the
trading desk performance, and can use CVA to create
area of counterparty credit risk, previously
incentives for individuals and departments to choose the
working for Citigroup, BNP Paribas and
most appropriate trades.
Barclays Capital. His latest book,
Counterparty Credit Risk: The new challenge
Interview results indicated that most institutions currently
for global financial markets (Wiley, 2009), has
use CVA for accounting purposes. Fair pricing of new trades
been described as “(a)n excellent
was the second most popular response, followed by reducing
practitioner’s guide and required reading for
reliance on credit limits and charging for unexpected losses.
all risk managers.”
The first three answers are somewhat complementary. Many
institutions are required to employ CVA for reporting pur-
poses, and these same organizations benefit from the utility
of CVA, which helps reduce the reliance on older practices.

The frequency of calculating CVA provides additional “Our credit derivatives

insight into the motives behind its usage. Half the institu-
tions surveyed indicated that they calculate CVA for all
counterparties on a monthly basis. The remaining institu-
counterparty risk was
tions were evenly split (25% each) into daily and pre-deal
calculations. almost completely
Combining this stated usage with the frequency of calcula-
tions suggests that interest in CVA is being driven by ignored prior to 2007,
accounting rules, but that a trend is emerging to use incre-
mental CVA for the fair pricing of new business. These
drivers can be seen as related as they both provide benefits,
now it is the key
but to what degree is likely determined by the relative inter-
ests of each institution. focus.”
SYSTEMS AND CALCULATIONS
CVA is traditionally defined as the difference between the
risk-free and risky value of one or more trades, or the
expected loss arising from a future counterparty default. The
 “We will not trade with
anyone without daily
margin calls on
collateral.”

components for a successful CVA system are scenario gen-

eration, pricing and valuation, aggregation and post trade
processing, and databases. The main challenge in comput-
ing CVA arises from the impact of netting, which means that
the total CVA for a counterparty is not the sum of its parts
(the individual transaction CVAs). This means that the incre-
mental CVA of a potential new deal must be calculated with
reference to all other existing deals that could be netted with
this deal in the event that the counterparty defaults.

20 Nearly half of respondents compute CVA through simple

add-ons, such as lookup tables or formulas. A small number
of around 20% calculate CVA more accurately on a prod-
JUNE 2010 THINK

uct-by-product basis but still ignore netting. The remaining

third utilize a full Monte Carlo system incorporating netting.
Critically, only a quarter of all respondents indicated that
they have the infrastructure to calculate incremental CVA on
an intra-day basis (pre-deal CVA). To achieve this requires
the implementation of a highly efficient Monte Carlo simu-
lation that can calculate CVA numbers “on-the-fly”.
Although CVA offers a more advanced approach to CCR
than transitional credit limits, it does not seem to be replac-
ing this more historical approach. This can be seen from the
result that CCR pricing works exclusively on an expected
loss basis as less than 10% of participants reported that their
CVA calculation includes a charge for unexpected losses.
It is important to understand where CVA resides within
the systems of an institution. Trading systems cannot eas-
ily be extended since the calculation of CVA is often an
order of magnitude more complex than that of the under-
lying product, such as in the case of interest rate swaps
from a yield curve. Arriving at a value for CVA is always
more complex than valuing the underlying instrument as,
by definition, the more complex the instrument, the more
complex the CVA becomes. Furthermore, the calculation
of a CVA incorporating netting becomes a multi-asset cal-
culation. One respondent made an interesting point,
referring to an 80/20 rule with CVA: that 80% of the
products are captured very easily but this only represents
about 20% of the risk involved. This anecdotal response,
taken with answers on frequency of pre-deal CVA calcu-
lations, suggests credit derivatives haven’t been properly
incorporated into these systems because they have only
become prominent over the last few years.
“The top priority is
to have a real-time CVA
calculation for all
derivatives trades.”
WHO’S MINDING – AND HEDGING – THE STORE
When asked who in their organization is responsible for the
management of CVA, a single front-office group was the
most popular response (58%). Multiple groups were cited
by 25% of respondents and the remainder indicated a single
risk group. These responses are in keeping with current
practices, as most large users of derivatives either already
have CVA groups dedicated to controlling CCR for their
business lines or are quickly developing such groups. These
institutions, which tend to be big banks, have an individual
running a CVA or CCR team from the front office to com-
plement an environment of fairly active traders.
Among less technically advanced institutions, it is more
likely that a risk management group or an individual from
a market risk or credit risk department is tasked with CVA
management. As institutions become more sophisticated
about counterparty risk, it is natural to centralize the man-
agement of CVA as a typical counterparty can be linked
across numerous business areas and trading desks. CVA
desks can charge all risk takers consistently for the incre-
mental risks they add and are therefore able to manage the
overall volatility of CVA within the institution.
Establishing such a specialized group can add enormous
value to an institution’s ability to manage risk. Not only can
they improve the competitive advantage within transactions,
but just as importantly, they can realize when it is best to
walk away from a transaction with another counterparty.
CVA desks can also increase the level of business with a reli-
able counterparty and reduce concentration risk by
diversifying credit exposure. These specialized CVA groups,
similar to front-office trading desks, are increasingly seen as
being well positioned for such management. However, some
institutions manage CVA with risk management teams, while
others have no single dedicated group for managing CCR.
Firms that are facing issues of CCR have many options
available to manage their overall exposure, and the key to
remaining competitive in a changing environment is intelli-
gent planning and decision making at all levels. In the short
term, an increasing number of financial institutions are tak-
ing steps to control wrong-way risk and tighten collateral
management parameters in an effort to reduce exposure and
increase profitability. In the long term, major institutional
developments are underway to enhance existing CVA sys-
tems or to design new ones with the capacity for real-time
calculation, incorporation of debt valuation adjustment and
better handling of credit derivative products. In the coming
years, the implementation of in-house and third-party CVA
systems will clearly be a key objective for banks and other
financial institutions.

Since CVA is presented as a price for CCR, it is natural to

ask what the associated “hedge” is. Without the ability to
hedge, enterprises may find themselves severely limited in
the type and amount of transactions they can take and the
counterparties with which they can trade. Furthermore, an
institution’s total CVA may exhibit severe volatility and,
therefore, potentially lead to large losses.
21
The most common instrument used to hedge CVA is single
name credit default swap (CDS), cited by just over half of

JUNE 2010 THINK

respondents. Other instruments that received multiple men-
tions are futures/forwards, options/swaptions, CDS indices,
correlation products and contingent credit default swaps
(CCDS). Hedging CCR poses many challenges due to the
number of market variables involved and the linkages
between them, however the range of instruments from these
answers makes sense. The key issue for CCR is what might
happen if someone defaults or their credit quality deterio-
rates, and CDS does offer the most logical protection.

To some extent, this volume of hedging may be inflated

because people understand that CCR should always be
hedged, not that it always is. Some participants suggested
that hedging was active and continuous with no significant
> VISIT THINK ONLINE
residual risks, a qualification that is not surprising since no TO READ THE CVA WHITE PAPER
trader likes to brag about their unmanaged risks. CVA desks IN ITS ENTIRETY
effectively run multi-asset books and are therefore exposed to
many underlying risk factors and their cross-dependencies.
Furthermore, the credit market is a relatively crude asset
class and it is impossible to hedge it extremely well – it’s just
not liquid enough. Algorithmics’ white paper, Credit Value
Adjustment and the changing environment for
THE FUTURE OF COUNTERPARTY RISK pricing and managing counterparty risk,
Institutions were asked to choose the most critical aspect of contains detailed insights into how CVA is
CCR going forward from a short list of choices. Wrong-way currently being measured, where CVA fits into
risk received the most responses (just over 50%), followed by institutions’ systems, and how CVA practices are
collateral, more toxic areas and exposure generation. Inter- expect to evolve.
estingly, central counterparties, which are often proposed by
regulators as “the solution” to counterparty risk, received the To access your copy today, visit THINK online at:
fewest votes. This is an indicator that, despite the enthusiasm www.algorithmics.com/think
of regulators, institutions view central counterparties as a
solution that re-introduces the concept of “too big to fail” and
may end up creating its own set of problems.
WHEN
99% IS
NOT
ENOUGH
EXPLORING THE GAP
BETWEEN CONFIDENCE
AND CERTAINTY
22
JUNE 2010 THINK

In the world of financial engineering, risk measures are used to estimate the
probabilities of unexpected outcomes. VaR is commonly utilized to calculate the
worst loss an institution can experience within a certain timeframe up to a
confidence level of 99%. For some businesses however, a measure that only
covers 99% of any variable is simply unacceptable. THINK takes a closer look at
the demolition and nuclear power industries to understand how risk is managed
when anything less than a perfect outcome can be a catastrophe.

by David Bester & Michael Zerbs

 CONTROLLED DEMOLITION

A When a financial institution is destroyed,

something terrible has happened. When
Controlled Demolition, Inc. (CDI) destroys
something, it means everything has gone
according to plan. CDI is an American company that demol-
ishes structures with the kind of precision and planning
usually associated with their creation. For over 60 years,
3 generations of the Loizeaux family have created a com-
mercial explosives demolition industry through innovation,
expertise, leadership and a methodology designed to guar-
antee complete predictability. This history includes the
implosion of the Kingdome in Seattle, which holds the Guin-
ness World Record for the largest structure by volume ever
felled with explosives.

“Once we decide that we can safely perform a project from

a technical standpoint, the first risk we manage is that of our
client,” says CDI’s President, Mark Loizeaux. “We need to 23
understand their perspective, their position in the industry
and what they have to lose. Our solution to their problem

JUNE 2010 THINK

needs to embrace those points, as well as those related to
CDI’s scope of work and task at hand.”

CDI begins with engineering to see if the numbers match the

company’s intuitive analysis for the likelihood of success,
based on their experience in the demolition of thousands of
structures. Not everything CDI does can be proven mathe-
matically, because even with a set of original, as-built
blueprints, a finite structural analysis would need to be per-
formed to fully trust the data plugged into structural
engineering formulas. “In order to achieve this level of trust,
we would have to de-build the structure. Once this is done,
there would be no need to implode it!” Mark points out.
The next step is to break the demolition down into a series
of sequential tasks, with critical path management at each
level, to ensure absolute control over the project’s successful
outcome. This requires tremendous experience, extraordi-
nary observation and management skills, and the ability to
communicate clearly with not only the client, but also every
single team member involved.
“We become the core clearing house for decision making,
communication and performance. If we aren’t permitted
this role, then we aren’t interested in the project,” states
Mark. CDI takes this position because under common law
in the United States, explosives-handling operations fall
under strict or absolute liability. This means that operators
are not considered innocent until proven guilty in the court’s
eyes. Rather they are guilty until they can demonstrate their
innocence. This puts CDI at extraordinary risk with regard
to litigation, as the company’s insurance and reputation are
first in line for claims.
EXPLOSIVE RELATIONSHIPS
Historically, the relationship between regulators and the
demolition industry has been a tenuous courtship. “Regula-
tors are accustomed to industries that rely on mathematical
analysis and computer programs memorialized in technical
publications and books,” observes Mark. While construc-
tion disciplines are taught in universities and there is a
well-documented history of how to control a design/build
process when a structure is erected, the same can’t be said
for taking a structure apart. This is largely because the data
on what actually exists in older, fatigued structures is too
uncertain, and there is no large body of data or industry-
sponsored groups to vouch for the data, as is the case in the
construction industry. As a result, the National Demolition
Association spends a great deal of money to educate regula-
tors and maintain clear lines of communication.
“Regulatory agencies in our field don’t know as much about
what we are doing as we do, particularly with regard to new
and cutting-edge concepts. As a result, regulators tend to be
more reactive than proactive, and show up once a problem
has been identified at a demolition project. Prior to an
 of cubic feet of air from the structure to safely bring it down while preventing damage to 100-year old historic structures directly across the street.
The Kingdome’s unique post-tensioned construction to support the largest concrete dome on earth necessitated a whole level of dynamic control never needed on previous CDI projects. CDI needed to create controlled venting of millions
accident, regulators tend to rely more on the individual rep-
utations and track records of companies requesting permits.
This is why CDI treasures and protects its reputation so
aggressively,” says Mark.

Defense of this reputation extends to the company’s work as

consultants. “The problem with many consultants is that
they prognosticate from lofty ivory towers with either no
hands-on experience or, if the consultant is long retired from
the demolition industry, outdated data. A consulting opin-
ion without a commitment to stand behind same is almost
useless.” To maintain its reputation and support its mandate
to understand client needs, CDI offers to perform the work
at a future date, up to five years out, for every consulting
project they handle. With this cost certainty in place, a devel-
oper wanting to borrow $100 million from a major U.S.
bank for a new development can move forward knowing
they can rely on a fixed price from a solvent, well-insured,
internationally-recognized demolition company.

A POWERFUL REACTION
Gee Sham is a Senior Engineer in the Canadian nuclear
industry, where the concept of 99% is not enough is often
used in seminars and presentations. “A safety system in a
nuclear power plant is in place to prevent a core meltdown.
24 Having a safety system is insufficient; it must be able to actu-
ate in response to a large coolant loss,” says Gee. In the
nuclear industry, the target for safety system unavailability
JUNE 2010 THINK

is generally between six and eight hours per year. If only

99% system availability is achieved, that facility’s license
would be taken away. These standards are in place to pre-
vent an incident like the Three Mile Island accident, where a
partial core meltdown resulted in the release of a substantial
volume of radioactive gases in 1979.

Probabilistic risk assessment and project risk management

are the two main approaches used by the nuclear industry.
“A fault tree analysis is a requirement for regulators. For
any operational system, we are required to model every
component down to the level of every single switch and
relay, or even a spring within a switch, that could contribute
to a system failure,” states Gee. He offers the example of a
pump, which is vital to coolant injections. “The pump can
fail, so we need to identify what could lead to this failure.
One way to mitigate a pump fail is to install a secondary
pump. But this might also fail. So we install a third pump.
Every piece of equipment that has the potential to fail must be
modeled probabilistically. We then assign a probability of fail-
ure to each individual component, which forms the fault tree.”

Within the tree framework, engineers know whether an indi-

vidual component needs to be tested on a daily, weekly or
monthly basis. These elements form the industry’s proba-
bilistic risk model, which dictates how testing, maintenance
and replacements are performed.

Channelization and duplicate redundancies are used to fur-

ther improve system reliability. “We use sensors to detect
low pressure in the Primary Heat Transport system. The sys-
tem requires one sensor, but what happens in the case that
this one sensor is not operating properly? We address this
“Regulatory agencies in
our field don’t know as
much about what we are
doing as we do, particularly
with regard to new and
cutting-edge concepts. As
a result, regulators tend to
be more reactive than
proactive.”
variable by using three sensors. Instead of one pump, we will
have two or three in operation. Through this process we
have protected ourselves against potential channel rejec-
tions. Channelization also reduces the possibility of
generating a spurious signal because it requires two out of
three channel logic to make it a true signal,” says Gee.
Taking a reactor offline is expensive, so maintenance is
scheduled when demand is low. All risks of overrunning the
schedule and exceeding the maintenance budget are logged
through a risk register, which ties realistic numbers to spe-
cific components based on operating experience. To
minimize risk that a project runs over time, repairs and
maintenance variables are addressed in great detail. If a
maintenance or refurbishment project involves opening up
a major piece of equipment, the potential to encounter
unforeseen problems must also be taken into account. Addi-
tional parts and engineering support must be secured on a
cost/benefit analysis, as acquiring additional spares and
maintaining engineering resources on standby for every con-
ceivable situation is not feasible.
SHARED BORDER, DIFFERENT APPROACHES
There is a marked difference between nuclear oversight in
the U.S. and Canada. In the U.S., the Nuclear Regulatory
Commission specifies how each utility must operate in each
power plant. The risk of each component is dictated by the
agency and compliance is enforced. Canadian regulators,
who oversee a smaller number of plants that operate in dif-
ferent fashions, provide directives and it is up to the
Canadian plants to demonstrate compliance. “Let’s say there
is one type of valve that is known to be problematic,”
explains Gee. “The manufacturer sends out a bulletin and
the U.S. regulator would specify what should be done. In
25
Canada the regulator would ask, ’What are you going to do
JUNE 2010 THINK
to demonstrate that this is under control?’”
Operators on both sides of the border share one goal: a tar-
get of Zero Defect and Zero Tolerance. This extends to
accident rates as well. Gee relates that at his plant, “We have
achieved 6.5 million hours without any lost time accidents.
We would normally complete between two and three million
hours without an incident so we have achieved well above
99% in this area. But the target remains zero, and this
applies to cut fingers, back injuries and anything that is an
outcome of work-related injuries. Most nuclear and utility-
related industries are on this track, and considering the
volume of people working 40+ hours per week, our results
are quite an achievement.”
PARALLEL LINES
How can regulators acquire higher quality information to
make better assessments of the true risks facing institutions?
One analogy can be drawn between the concepts of guilty
until proven innocent cited by CDI and the growth in
investor suitability testing in financial services. Prior to the
credit crisis, the onus was generally on corporate or individ-
ual investors to ensure that they understood the risks of
financial products, subject to fairly basic risk disclosure
requirements. Today investor suitability testing is being
demanded in much more depth, an indication that the indus-
try has moved from a position that things are fine until there
is a problem to a more proactive stance.
The issue of regulators in bordering countries bringing a dif-
ferent approach to industry oversight was referenced for the
nuclear industry. The Markets in Financial Instruments
Directive (MiFID) and the latest update to Undertakings for
 A rigorous and disciplined
approach to the implementation
and interpretation of several
redundant measures is one way
in which the financial risk
community could learn from
other disciplines.
26
Collective Investment in Transferable Securities (UCITS IV)
attempt to provide harmonized regulations for investment
JUNE 2010 THINK
services across various borders of the European Union.
These principles seek to deal with the European problem of
connecting common passport rules with different perspec-
tives on the nature and objectives of regulation that can vary
from country to country.
Under common passport rules, Iceland’s Icesave bank was
allowed access to the British market without much oversight
by the FSA. More than 400,000 depositors from the UK and
the Netherlands deposited funds into Icesave’s high interest
accounts, but the credit crunch exposed the failings in the
Icelandic banking model. It became clear that oversight by
the Icelandic regulator was insufficient. Icesave is a good
example of where innocent until proven guilty would have
been the standard approach at one time, while today the
host regulator would probably insist on its supervision com-
plementing the home regulator’s supervision to a much
greater extent.
One outcome is clear from all three industries: if regulators
become aware of a problem only once something has blown
up, they have become involved too late.
TOP TO BOTTOM, BOTTOM TO TOP
Within risk management and finance there is a debate
whether you can go top down or bottom up: is it good
enough to have some high-level assumptions about how the
system in the aggregate behaves, or do you need to look at
each individual position and model it?
One luxury the physical sciences have is that they are typi-
cally modeling processes with stable, well-defined properties.
In social sciences, models are built to approximate how the
human mind works, but we don’t understand human behav-
ior to the same degree as we understand the physical
properties of steel, or the pressure required to cause concrete
columns to collapse. Trying to build a set of models with sta-
ble statistical properties over a baseline of assumptions is a
more complex proposition.
Similar to the concept of redundancies in nuclear engi-
neering, how can an organization know with certainty
how much capital is enough when there isn’t enough cer-
tainty that their risk model captures the relevant range of
outcomes effectively? To make matters more challenging,
what is enough during normal market conditions often
isn’t enough during periods of turmoil. Financial institu-
tions need enough liquidity and risk capital to withstand
large losses and must have the additional liquidity and loss
bearing capacity to carry on with their business. With this
additional liquidity in place, firms can maintain full mar-
ket confidence, even when they can’t raise more capital
and their balance sheet has large positions in illiquid and
complex assets.
Many banks faced this problem during 2008 and 2009,
when they had enough capital to make up for the initial
wave of losses but were perceived to be left with insufficient
funds to run a business or protect the bank in the event of a
second wave. So how much redundancy is needed? One
approach is to increase the availability and quality of capital
and liquidity in case there is a large problem. A comple-
mentary approach is to utilize multiple redundant measures
to better understand where problems could develop early on
even if any specific model fails. A rigorous and disciplined
approach to the implementation and interpretation of sev-
eral redundant measures is one way in which the financial
risk community could learn from other disciplines.

The financial industry accepts a certain risk tolerance.
What practitioners can observe and perhaps learn from
how this tolerance is defined in industries with physical
properties is that operating with a 1 in 1,000 chance that
unemployment doubles and the budget deficit goes up to
12% is not good enough. On a relative basis we should try
to rethink what an acceptable risk tolerance is and try to
move toward that line.
NORMALIZATION OF DEVIANCE
About a year before the credit crisis a small episode took
place in the CDO market. There was a worry that the debt
ratings on Ford and GM would be dropped below invest-
ment grade, causing a massive realignment of correlations.
Some instruments were subsequently priced far outside of
what the models had predicted. For a few weeks the market
was quite concerned about these implications, but, ulti-
mately, the expected downgrade did not occur and the
market moved on.
Periodically situations like this occur where a small market
disturbance suggests an underlying issue of model failure.
Since no bank went under in these transactions and markets
returned to normal, the models were not examined further.
One possibly harmful outcome from the continued use of
these models was that a false sense of security took hold, a
behavior that practitioners in social and physical sciences
must seek to avoid.
In the nuclear industry this phenomenon is referred to as
normalization of deviance. Gee cites an example from the
aerospace industry that underscores the potential damage a
false sense of security brings. “NASA was using foam insu-
lation to protect space shuttles from the heat caused by
reentry into the earth’s atmosphere. The foam was known
27
to come loose and damage the craft’s thermal protection sys-
tem. This had happened four or five times and NASA
JUNE 2010 THINK
management was aware of it, but it did not lead to a change
in behavior.” As a result, a deviance occurred and became
accepted as normal until an eventual catastrophe occurred
and a shuttle disintegrated during reentry.
A similar normalization of deviance took place during the
Three Mile Island accident, when a control panel light was
known to malfunction. The operators got used to it and
thought it was okay, but accepting this scenario as normal ulti-
mately became a contributing factor in the reactor’s meltdown,
as that light was designed to convey important information.
“When I go into a reactor I take a gamma meter and if that
meter goes off I back out even if everything appears perfectly
normal. It’s easy to accept small modifications in protocol, but
the stakes are too high to allow any deviance to go unchal-
lenged. No matter how small the problem appears to be, it
must be reported and it must be reviewed,” says Gee.
As a final question, Gee was asked what the financial indus-
try could learn from his work. “Identify deviations.
Challenge them. If you give high-risk mortgages and accept
that they should be treated the same as other mortgages
because everyone else is doing it, or because you believe the
housing market is on a continual upswing, you have
accepted deviance as normal. Once we start believing that
this deviance will lead to predictable behavior it is the same
thing as waiting for an accident to happen.”
The same question was asked of Mark at CDI, who had a
slightly different take. “I think it is more appropriate to say
that what I learned from the financial industry is what I
apply to the demolition industry: never risk more than
you’re prepared to lose.”
28
JUNE 2010 THINK

THE SOLVENCY
SCENARIOS
FOUR PERSPECTIVES ON
SOLVENCY II COMPLIANCE
by Andrew Barrie & Curt Burmeister

hat is the best-practice approach for
W implementing a Solvency II solution?
This question may apply to all Euro-
pean Union insurers, but the answer
depends on the preferences of the
individual institutions. Under Solvency II insurers
must implement a risk-based system that aligns
capital requirements with the true underlying risks
of the company. Unlike other regulations, Solvency
II’s principle-based system requires companies to
take ownership of their positions and be able to jus-
tify them under regulatory scrutiny.
This form of compliance will require significant
rethinking by institutions of how they treat risk, and
how they acquire, audit and utilize data. Senior man-
agement decisions, from high-level strategy down
to a granular level of calibrations and approxima-
tions, must be reflected across the organization. In
this article, the authors consider four perspectives
on Solvency II, representing different entry points
and levels of preparedness, to help insurers deter-
mine where to focus their regulatory energies.
#1: VISION
The first step for any organization is for senior management
to create and articulate a clear vision. Is Solvency II solely
about calculating metrics, such as the Solvency Capital Re-
quirement (SCR), or does it also involve a deeper re-engi-
neering of key business processes? A successful vision must
address how risk will be measured and managed in a holis-
tic, consistent way across all of the organization’s business.
The vision will have implications that go beyond systems
and technologies. It will affect elements as varied as how to
consistently consider mismatched risk, monitor the risk
being taken by the asset managers, establish product pricing
principles for guarantees, and communicate both product
benefits and product risks to customers.
Two determining factors for creating a vision are the size
and resources of an organization. Solvency II will be a
significant undertaking for all insurers. For larger
firms, the process of valuing their liabilities in a mar-
ket-consistent fashion has been underway for many
years and these newly established processes will be
a useful step towards a Solvency II implementation.
This is particularly true in the U.K., where historic
regulatory practice have required companies to in-
vest a great deal of time and effort into the con-
struction of valuations under both base and
stressed scenarios. Many multinationals have
made significant advances in their risk meas-
urement methodologies over the past few years.
However, even for the institutions that are
already valuing liabilities in a market consis-
tent manner, the scope of Solvency II goes well
beyond existing capabilities.
It is likely that smaller or less complex firms that either do
not want to, or cannot, reengineer their processes will try to
steer themselves toward a compliance-based solution. Firms
that fall in the middle may have the most options and choices
to make. Their decisions will ultimately reflect a balance of
cost and internal resources with the commercial or manage-
ment benefits that can be derived from the solution they se-
lect. It will be interesting to see whether evolving solutions
are utilized to address common standards or support a wider
range of diverse approaches.
Viewing Solvency II as an opportunity, and not merely an
exercise in regulatory compliance, provides organizations with
a greater degree of flexibility in how their risk appetite will be
defined. However, this approach also demands a greater level
of responsibility to ensure this appetite is well understood, ob-
served and managed. This can present a significant challenge
because of the scope of the problem and the number of inte-
grated and interdependent components. Because it is unrea-
sonable to expect any one individual to understand or oversee
the detail for all the moving parts, Solvency II solutions are
often linked into enterprise risk management (ERM) frame-
works. At an ERM level, the salient information can be dis-
tilled and analyzed in an appropriate manner that allows
strategic, competitive and business decisions to be more eas-
ily embedded in all facets of an organization. An ERM frame-
work with the capacity to adapt to evolving standards and
 Viewing Solvency II as an
opportunity, and not merely
an exercise in regulatory
compliance, provides
organizations with a
greater degree of flexibility
in how their risk appetite
will be defined.
O
SI
VI
30
JUNE 2010 THINK
strategic plans is the most reliable way for insurers to support
their vision and ensure that compliance and governance can
be managed and demonstrated throughout their organization.
#2: THE STANDARD FORMULA VS.
INTERNAL MODELS
Solvency II offers insurers the option of using a Standard
Formula or an approved internal model to calculate SCR.
The Standard Formula is easier and possibly less costly to
implement but may require additional management time and
may negatively affect market perceptions about an organi-
zation’s commitment to understanding its risks. Internal
models are more complex and require a higher up-front in-
vestment but are expected to deliver long-term capital ben-
efits and help embed risk awareness throughout an
organization’s business.
The Standard Formula has advantages that are easier to
communicate and may be more readily apparent than those
of the internal model. Because the regulator provides the for-
mula, the project risk of acceptance is virtually non-existent.
Implementation will require less time, less work, less ex-
pertise and a lesser investment. The Standard Formula will
also provide faster insight into initial capital requirements,
and may make preparing for a “known” value easier than
preparing for an “unknown” value. The general nature of
the Standard Formula may also help by preventing insurers
from regarding formula results uncritically or treating them
in a “black box” fashion.
N
Internal models promise a greater range of advantages to
insurers. It is generally accepted that internal models will
track risk more accurately, possibly leading to a reduction
in capital requirements. Lower capital requirements lead
to a host of benefits, including a lower cost to acquire cap-
ital, the opportunity to deploy capital more effectively
throughout the organization, a competitive advantage
through more accurate pricing of products, and the repu-
tational rewards of demonstrating transparency to in-
vestors and regulators.
One barrier for firms considering an internal model ap-
proach may be the technological requirements. An internal
model is essentially a huge Monte Carlo simulation that re-
quires precise data management and the processing of tens of
thousands of scenarios. This approach has historically been
time consuming, expensive and computationally demanding,
but new options, such as curve fitting and replicating port-
folios, offer dramatic performance improvements at a more
acceptable cost.
Curve fitting is a technique to approximate the value of an
instrument over scenarios based on a limited amount of
data. Curve fitting enables insurers to value a liability using
a formula that calculates values of the instrument over a fit-
ted curve, taking into account the values of other risk fac-
tors. Under this approach, Monte Carlo or stochastic
scenarios are not required for recalculating the market con-
sistent valuation of liabilities.
 D A
S
O L
EL
M MU
A R
N O
R DF
L
TE R
N A
. I ND
VS A
ST
Portfolio replication is another technique that can be used
to reduce model run time. A replicating portfolio is a port-
folio of financial instruments chosen to match a portfolio of
insurance liabilities as closely as possible. Replicating port-
folios, once derived, replicate or mimic the risk of the larger
portfolios for the purpose of risk analysis. These smaller
replicating portfolios can be quickly revalued using analyti-
cal models, eliminating the need for stochastic pricing mod-
els and therefore enabling faster response times for risk
monitoring, performance measurement and analysis.
It seems clear from Solvency II’s focus on risk-based systems
that insurers are being encouraged to go the route of inter-
nal models. Many larger institutions have already commit-
ted significant resources to this path. For organizations that
deal exclusively in vanilla products, the decision to use the
Standard Formula will be a natural one. Institutions who
find themselves between these two positions will have to
weigh their needs against the known and hidden costs of
their choice. These organizations may find new techniques
like curve fitting and replicating portfolios make internal
models a more attractive option than previously thought.
#3: THE USE TEST
For firms choosing a partial or full internal model approach,
the Solvency II Use Test promises both technical and cultural
challenges. According to the requirement, “the internal model
is widely used and plays an important part in [the insurer’s]
system of governance.” The Committee of European Insur-
31
JUNE 2010 THINK
ance and Occupational Pensions Supervisors explicitly lists
which uses must be incorporated. Many of the items on this list
entail capital allocation or an equivalent form of risk-adjusted
performance measurement that will extend the requirements of
the internal model. For example, incorporating support for
Business and Strategic Planning will introduce a multi-year
projection requirement that goes far beyond the base internal
model requirement of just establishing a current valuation ca-
pability. New techniques, such as curve fitting and replicating
portfolios, can support these additional requirements and
make a comprehensive internal model a practical proposition.
Bringing this level of consistency into practice begins with
deriving data from models at a speed sufficient enough to
provide decision makers with relevant, accurate information.
Strict governance is also required to ensure that the data
platform is up to regulatory standards. A similar standard
of ownership will need to be demonstrated at every point
where data is captured, stored or analyzed.
Under Solvency II, there will be an increased demand for his-
torical data to support SCR calculations and model verifica-
tion. While actuarial teams have traditionally searched for data
on an as-needed basis, this method will no longer be feasible.
From pricing a product to reinsurance, effective management
decisions, performance management, mergers and acquisitions,
portfolio management and business planning, insurers will be
required to demonstrate how data has been reconciled from
multiple sources into an approved analytical process.
 ST
TE
SE
U
32
JUNE 2010 THINK

Once this data is acquired in a timely, auditable fashion,

It seems clear from it is expected to support risk-informed decision making.
But will board members have enough insight into the
Solvency II’s focus on models and data to effectively challenge results or rely on
them to make strategic decisions? Will definitions of risk
be clearly understood and shared across multiple business
risk-based systems that lines, regions and geographies? For these issues to be
solved effectively and ensure that the spirit and details of
insurers are being the Use Test are met, firms will have to determine what
shape future processes will take and the cultural implica-
encouraged to go the route tions they may present.

of internal models. The title – Use Test – is quite literal in meaning: management
will need to demonstrate to regulators that data has been
used and tested in an appropriate and consistent fashion,
and that results gained from internal models are actively
used to make real business decisions. For those firms who
go through the steps to engineer internal models, these obli-
gations will have been fulfilled. If the proper due diligence is
not undertaken, insurers will find meeting the Use Test to be
a cumbersome process.

#4: IMPLEMENTATION AND BEYOND

With a vision, model determination and usage process in
place, insurers still face a number of questions regarding the
operation of their Solvency II framework. Dave Matcham,
Chief Executive of the International Underwriting Associa-
tion believes that modernization and Solvency II are connected

issues: “On the face of it they are separate initiatives – one is
regulatory, the other technology and process change…
however I believe that they are not mutually exclusive.”
Insurers must determine how to implement the components
required to address Solvency II relative to existing systems and
processes. It may be tempting to rip up existing systems and
start from scratch – the benefits of working with a brand new
system designed to connect all aspects of an organization has
its advantages – however this approach will likely generate
more pain and expense than can be justified in the short term.
Organizations seem to be trending toward creating a Sol-
vency II system and wrapping it around existing processes.
Determining what to keep and what to dispose of, what
should link into this new layer and what must be treated as
a standalone application presents a significant challenge that
management must be able to share internally, with vendors
and with solutions providers. A clear methodology must be
in place to ensure the integrity of data gathering and sharing.
The joint aspects of technology and process change highlight
one of the main differences between Solvency II and the
Basel II process experienced by the banking sector. When
Basel II requirements were unveiled, there were fewer and
more limited existing processes. In the European Union
many of the larger insurance companies have already been
moving to value their liabilities in a market-consistent way.
N
O
TI
TA
EN
EM
PL
IM
33
JUNE 2010 THINK
What the directive provides is the requirement to extend these
valuations from limited usage to the entire organization.
Organizations must be prepared to accept that certain chal-
lenges and costs will only emerge during the implementation
phase. Prior to the acquisition of an ERM system, an or-
ganization would rely on individual people and groups who
understood each part of the system and had an intuitive un-
derstanding of whether things were working as expected.
With an enterprise-wide system, having one person who un-
derstands the entire process is unrealistic. The scope of the
system and the “whole is greater than the sum of the parts”
aspect of ERM requires a series of audits and checks. En-
suring that the time, resources and understanding of this
phase are in place is required to make sure that the systems
speak to each other, people are speaking to each other and
all efforts are directed toward a commonly understood goal.
The need to properly implement a Solvency II solution is cru-
cial for firms of all sizes. Smaller firms that rely on the Standard
Formula will still have to prove they are embedding processes
and methodologies into their overall business. Larger firms that
choose a more customized approach to Solvency II will not
only have to defend their position to regulators, but also to live
with it as part of their organizational DNA. Only by ensuring
that the vision, models and usage are properly implemented
can insurers benefit from more accurate SCR calculations and
the insights afforded by a risk-based system.
THE
BIG
PIC-
TURE
ALLAN MENDELOWITZ AND
THE NATIONAL INSTITUTE
OF FINANCE

by David Bester
 n the aftermath of the financial crisis, a general con-

I sensus emerged among business leaders and

lawmakers that reforms were necessary. More than
a year after the near collapse of the financial indus-
try, the nature of these reforms is coming into focus.
The U.S. House of Representatives passed a bill in December
2009 designed to impose more oversight and stronger capital
requirements on large American banks and investment firms.
The bill contained provisions for a new Consumer Financial
Protection Agency and a new Financial Services Oversight
Council (FSOC). Proponents for the FSOC contend that one
reason the credit crisis occurred was the absence of an agency
focused primarily on systemic risk. The FSOC, which is
intended to remedy this omission, would be responsible for
identifying emerging risks in financial markets and interven-
ing when a “too big to fail” bank is considered to pose a
great danger to the economy as a whole.

But would the FSOC, as envisioned by the House, have the

capacity to prevent a systemic crisis? It seems doubtful. The
next crisis will undoubtedly be just as surprising as the pre-
vious ones. Policymakers will require answers to urgent
questions that cannot be foreseen today. Whatever answers
are supplied will be acted upon in a crisis; getting such
actions wrong can make any crisis much worse. Given that 35
building a data collection system can take years, it would be

JUNE 2010 THINK

too late to initiate such an effort when the need arises.

“The most significant weakness is not a lack of legal author-

ities; it is the absence of necessary data and analytical
capability,” states Allan Mendelowitz, Former Chairman,
Federal Housing Finance Board. “What the industry and the
country really need is a technical agency that can access
granular transaction and position data in order to provide
stakeholders with the insights required to deal with systemic
risk.” Allan is not just observing events from the sidelines;
he is working with an ever-expanding group of finance pro-
fessionals, academics and regulators on a volunteer effort to
bring into being a National Institute of Finance (NIF).

Allan sat down with THINK to discuss the Committee’s

mandate and why the NIF is a critical component of the
upcoming restructuring of financial regulation in the U.S.

COMMITTEE ORIGINS
The Committee to Establish a National Institute of Finance
(CE-NIF or Committee) emerged from an explicit recogni-
tion that there was a need to seriously address the challenge
posed by systemic risk. “As the head of a regulatory agency
I grew frustrated with the traditional way of gathering data.
Examination teams can review the policies of an organiza-
tion, examine training methodologies and procedures, pull
files and test internal controls. But completing an exam once
a year in isolation does not provide the best insight into how
risk develops on an institution’s balance sheet. In addition,
even call data that regulators collect periodically tends to be
accounting data, which is not the best data set with which
to understand risk.”

“What the industry and the
country really need is a
technical agency that can
access granular transaction
and position data in order
to provide stakeholders
with the insights required
to deal with systemic risk.”
36
JUNE 2010 THINK
Allan’s concerns about how systemic risk is measured and
managed developed over a long career within the federal gov-
ernment. While serving as Managing Director at the U.S.
GAO (now known as the U.S. Government Accountability
Office), and through an ongoing association with the Federal
Housing Finance Board, Allan came to believe that, unless the
right data was collected remotely on an ongoing basis and
subjected to analysis it would be impossible for regulators to
see the risks as they developed in the financial markets.
“I developed an explicit recognition that there was a need to
take a different approach if the challenge posed by systemic
risk was going to be seriously addressed. And as it turns out,
I did not come to this conclusion alone.” Following a
research conference in February 2009, a group of three aca-
demics and a financial quant sat down to discuss systemic
risk and the importance of collecting relevant data and
improved analytics. The idea was brought to Allan, who
quickly saw that it addressed many of his own concerns. “I
know how to make this happen,” he said to the group. And
the CE-NIF nucleus was born.
The Committee’s goal to see the NIF become part of the
financial reform bill making its way through Congress has
garnered support from a variety of constituents. Statistical
associations, regulators, solution providers, banking indus-
try leaders and influential academics have endorsed the call
for a National Institute of Finance, including Harry
Markowitz, recipient of the Nobel Memorial Prize in Eco-
nomic Sciences and John von Neumann Theory Prize. In
addition, Professor Markowitz took the lead in organizing
a half dozen Nobel Laureates who were recognized for their
work in financial economics to write to the Senate Banking
Committee calling for legislation to create the National
Institute of Finance.
UNDER PRESSURE
The NIF is a proposed new U.S. government agency that
would act as a resource to gather, clean and provide appro-
priate data for the financial regulatory community. The NIF
would also provide the analytical capabilities to monitor sys-
temic risk, perform independent risk assessments of
individual financial entities, and provide advice
to the federal regulatory agencies tasked with
ensuring the health of the financial system.
The analytic component of the NIF would
also support a sustained research effort
into how financial markets work and the
causes of systemic risk. In this context, the
NIF would fulfill a similar role to the
National Weather Service, an agency that con-
nects a lot of data and develops and applies
complex models to understand and forecast the weather. In
addition, the NIF would play a role similar to the National
Transportation Safety Board in that it would be called upon
to determine the causes of financial disruptions and recom-
mend regulatory responses.
The Committee identified that one of the challenges with
regulations in general is pressure. “An important reason (the
NIF) needs to be an insulated agency is to maintain a suit-
able level of independence so that it can speak truth to
power, rather than act as another regulatory body. Even if
you have the right data and analysis, sound conclusions can
be rejected in the political arena for all kinds of reasons
unrelated to the merits of your case,” explains Allan.
As early as 2005, Allan foresaw a major credit event tied to
housing and finance that would push the U.S. into its worst
recession since World War II. He reasons that had he
attempted to have a conversation with a financial institution
in 2005 and advise them to do X, Y and Z to reduce their
exposures, they would have thanked him for his opinion or
showed him the door. Had a bank listened to him and fol-
lowed his advice, the CEO would likely have been fired
 NOW
SHOWING
GRANULAR
TRANSACTION
AND POSITION
DATA/
JUNE/1-30/
2010
THE NATIONAL
INSTITUTE OF
FINANCE
because the company would have passed up opportunities
for substantial (accounting) profits in 2006 and 2007 as the
housing bubble continued to expand. “It’s not just about
understanding the right thing to do; it’s about trying to exe-
cute the correct strategy in a complex world in which diverse
pressures and incentives are brought to bear,” he continues.
ALL THE PIECES MATTER
One “new” approach to systemic risk is to identify a small
number of systemically important firms and focus on regu-
lating them well enough to contain systemic risk. From the
Committee’s perspective, this approach is fundamentally
flawed. When it comes to systemic risk, the whole is greater
than the sum of the parts. While enhancing the oversight of
these firms is a positive development, it ignores the role of
concentrations of risk and interconnectivity between market
participants that can create systemic risk even in the absence
of large systemically important firms. These risks can only
be understood through the collection and analysis of granu-
lar transaction and position data. Allan provides three
examples from the financial crisis to illustrate his point.
“Data in
the financial
sector is
simply a
disaster.”
The first case is Lehman Brothers and the U.S. government’s
decision not to intervene in the firm’s demise. “It had been
reported, and [Treasury Secretary Henry] Paulson believed,
that the problems at Lehman had been understood by the
market for many months, and that the counterparties had
ample opportunity to adjust their exposures. Well, he was
wrong!” Allan notes that Paulson made a monumentally bad
decision based on a belief, rather than on a clear picture of
what had actually occurred. “He did not have the data that
would have enabled him to see that a Lehman collapse would
lead a large money market firm to ’break the buck’, which
was what spread the crisis across the breadth of the market.”
The second instance is the credit default swaps (CDS) at
AIG. “The threat posed by the CDS book at AIG was totally
hidden from Treasury and the regulatory community. Treas-
ury officials did not realize what was going on at AIG until
the week that Lehman actually went down. If the govern-
ment had collected granular data for the market as a whole,
policymakers would have had the data to see the buildup of
this dangerously large unhedged concentration of risk and
 AIG’s linkages to firms across the market. Action could have
been taken sooner.”
The third issue is forensics. There has been criticism of how
the U.S. Securities and Exchange Commission (SEC) failed
to uncover the Madoff fraud – the largest and longest run-
ning Ponzi scheme in history – despite several investigative
attempts. “With hindsight, it’s easy to say that the SEC sim-
ply did not do its job,” concedes Allan. “But without access
to market-wide transaction data there was no simple way to
easily uncover this fraud which was perpetrated by a ’pillar
of the financial community.’ Madoff’s purported investment
strategy required large numbers of derivative transactions.
If the SEC had access to the granular transaction data as we
propose for the NIF, the SEC would have seen immediately
that no counterparties existed for Madoff’s reported trades
and the fraud would have been laid bare.”
DOUBTS ABOUT DATA
The current state of financial data is problematic. In many
financial firms it is a major weakness and vulnerability.
“Every day institutions reconcile their trades, millions of
trades, and many of them have breaks. Sometimes these
breaks are substantive, such as when each trader has recorded
a slightly different record of the trade price. But a huge vol-
ume of breaks come down to firms using inconsistent data,
38 such as describing the same counterparty differently. These
differences have to be reconciled,” observes Allan.
JUNE 2010 THINK
“Secondly, when different regulatory bodies collect data, it is
through a whole host of different systems with different data
structures – and you cannot use this Tower of Babel of data
to build any kind of meaningful picture of what is going on
in the market as a whole. Data in the financial sector is sim-
ply a disaster. In large part this is because it is hard to focus
attention on and get resources for what is dismissed as a
housekeeping chore that does not generate revenue.”
To do its job, the NIF would have to establish uniform data
standards to assure the accuracy and comparability of the
detailed financial data it collects. The NIF’s first order of
business would be to develop reference databases for finan-
cial entities and financial products. Then the NIF proposes
to securely capture data on contractual terms and conditions
at the most granular level: as attributes of specific legal con-
tracts. This detailed data will provide the flexibility required
to feed a diverse range of risk models and enable new ana-
lytical approaches, such as large network simulations of how
the affects of stress play out in the financial markets. The
resulting insights will be invaluable in identifying future sys-
temic fragilities, whose source cannot be predicted today. At
the same time, all of the reporting firms would benefit from
the standardization of data across the market. Their operat-
ing costs would decline and their ability to understand risk
would improve.
HOME AND ABROAD
Given the globalization of financial markets, analyzing sys-
temic risk data acquired from a multilateral, international
approach would be the ultimate objective. Yet the Commit-
tee is aware of the political realities involved in establishing
global standards: the 2009 Climate Change Conference in
“It’s not just about
understanding the right thing
to do; it’s about trying to
execute the correct strategy in
a complex world in which
diverse pressures and
incentives are brought to bear.”
Copenhagen is a recent reminder that trying to orchestrate
a global framework can drag on for decades with no guar-
antee of success.
With its focus, therefore, on a national agency, the Commit-
tee proposes that the NIF be created with the authority to
oversee the following market components:
• all transactions by American firms
• all transactions that take place in the U.S.
• all transactions that have an American counterparty
These components will generate enough data to have a
material improvement over what is currently available to
regulators and perhaps lay the groundwork for future par-
ticipation from other countries. “At the working level, we
have enjoyed regular ongoing participation from the Euro-
pean side because they are grappling with similar issues and
they appreciate the importance of expanding the range of
data collection. A U.S.-based system will certainly be a good
start towards where everyone should ideally be heading.”
GAINING WIDER SUPPORT
The Board of Directors of the American Statistical Association
(ASA) provided an endorsement of the Committee’s plans,
stating, “a new data and analytic infrastructure is required to
maximize the effectiveness of any financial regulatory system.”
Allan also notes a strong pocket of support from solution
providers. “We are finding enthusiasm for the Committee’s
plans from vendors like Algorithmics who deal with risk all
the time and understand the benefits a higher quality of data
can provide for measuring risk and modeling risk.”
Perhaps the most unexpected response has been the high-
level support received from a small number of financial
institutions, including very active participation from leaders

of a global financial services firm. The Committee’s issues
went all the way up to the firm’s CEO. “I couldn’t help but
ask why – my view was that their firm’s traders liked selling
opaque products for their large profit margins and big com-
missions. I wanted to know how it could be in his firm’s
interest to support the NIF when the end result could dra-
matically increase transparency in the market.”
A lead executive from the firm answered that there was a big
difference between how a trader and the firm’s leaders view
the market. A trader may prefer opaque products but as an
institution the executive felt that the firm would be better off
doing business in a more transparent and stable market in
which margins might be smaller, but strong profits could be
made off a larger volume of better trades.
“It’s asking a lot for the financial community to endorse the
NIF. It is easy for them to view the NIF as counter to their
financial interests. But this institution’s response and open-
ness to consider the market in a new light is a positive sign
for our ongoing efforts,” says Allan.
STATE OF THE UNION
What the Committee has accomplished in just over one year
is unprecedented for the type of organization it represents.
Commercial interests do not own, control or finance the ini-
tiative. In fact, the Committee has raised no money to
support its efforts. All committee members are volunteers
and are paying out of their own pockets the necessary
expenses to accomplish what they believe to be a reform that
is critical to the future well-being of the United States.
“There are firms and trade associations who spend millions
of dollars every year on lobbying in Washington to try and
make things happen. We, on the other hand, are unique.
With nothing more than personal energy and a strong belief
in the importance of what we are doing, we have worked to
sell a new and important idea based on the strength of our
arguments,” Allan observes.
The Committee’s arguments have even influenced proposed
legislation. In March 2010, Senator Chris Dodd, Banking,
Housing & Urban Affairs Committee Chairman, unveiled
the Restoring American Financial Stability Act of 2010. Title
I of the Act deals with systemic risk and calls for the estab-
lishment of the Office of Financial Research within the
Department of the Treasury. Aside from a proposed name
change, the Office would essentially fulfill all the require-
ments endorsed by the Committee.
The Office is designed to be truly independent in terms of
operations, budget and testimony. It would be headed by a
Director, appointed by the President and approved by the 39
Senate, for a six-year term. The Office would contain a Data
Center and a Research and Analysis Center to support the
JUNE 2010 THINK
work of the systemic risk council. Its budget would be raised
based on industry assessments so that funds could not be
appropriated for other uses or be subject to political pres-
sures. This protection extends to the Director’s testimony.
No one in the U.S. government, including the White House,
shall have the authority to require the Director to submit tes-
timony for approval prior to submitting it to Congress.
The part of the bill that would establish the Office of Finan-
cial Research is supported by both Democrat and
Republican Senators. What happens next will be determined
by what happens to the whole bill on the floor of the U.S.
Senate. Democrats have 59 Senators, which is one vote short
of the number required to pass a cloture vote and end debate
on the bill. The 41 Republican Senators, who so far oppose
the overall bill, may choose to filibuster, preventing the
measure from being brought to a vote. The Chairman’s goal
is to get the Act approved by the end of May, which will
require the support of at least one Republican Senator.
Negotiations between the two sides are ongoing. Whatever
the fate of this bill, the Committee has achieved much by
getting a provision to create an advanced warning system for
systemic risk included in the financial reform bill that
reached the floor of the U.S. Senate. They have laid the foun-
dation to include such a capability in any legislation that
ultimately becomes law.
“As the last year has progressed, we have watched as sup-
port for this idea has become widespread like the ripples
spreading out from a pebble dropped into a still pond,” says
Allan. Now that these ripples have reached the U.S. Senate,
the evolution of the NIF from concept to reality could be
mere months away.
LIVE LONG
AND
PROSPER
UNDERSTANDING WHOLE
ENTERPRISE RISK
40
JUNE 2010 THINK

by Penny Cagan

he human lifespan has a certain predictability.
T
Based on a person’s age and geography, we know
intuitively if his or her life was too short or longer
than average. The demise of several of our most
respected financial institutions during the past
year has led to this consideration of a “corporate lifespan”
and how risk management tools and approaches can assist
with the fulfillment of a long life.
Arie de Geus, author of The Living Company (1997), came
to the conclusion that the average lifespan of a Fortune 500
or equivalent multinational company is only 40 to 50 years.
In his book, de Geus observed that if one studied the audited
statements of corporate “darlings” of the 1970s there would
be no indication of the troubles they would face during the
next decade. For instance, the financial reports filed by Gen-
eral Motors, Philips Electronics and IBM during the mid-
1970s provided no hint of pending problems they would
later face. Countrywide Financials’ stock was characterized
by Fortune magazine as the “23,000% stock” based on the
returns it earned between 1982 and 2003. Fortune magazine
also selected Bear Stearns for its list of “America’s Most Ad-
mired Companies” between 2005 and 2007. And of course,
companies such as Enron were later proven to have released
financials that were designed to hide their true condition by
pushing liabilities and losses off their balance sheets.
Financial institutions generally have longer life spans than
corporations. Their longevity could be a positive conse-
quence of regulation, oversight and their focus on solvency
and capital. Financial firms that were entirely unregulated –
as opposed to the investment banks that were perhaps too
lightly supervised but still regulated – had shorter life spans
that more closely resembled the “corporate” average. Coun-
trywide Financial, for instance, was founded in 1969 and ex-
isted for 39 years before it collapsed under the weight of
nonperforming subprime loans. Another notorious unregu-
lated firm – Bernard L. Madoff Investment Securities LLC –
was founded in 1960 before it was discovered to be a Ponzi
scheme and collapsed in December 2008.
Although financial institutions tend to have a long life, the
length of time they have been in business does not necessar-
ily indicate how long they will survive. Barings Bank, which
was founded in 1762 and was the oldest merchant bank in
England, failed in 1995 after a landmark rogue-trading event
that led to a liquidity crisis for the august institution. In fact,
companies with long lifespans may become too complacent
and not fully understand the risks they face through new
businesses, distribution channels and product innovations.
This was certainly the case with Barings, which continued
to fund Nick Leeson’s trading activities in Singapore despite
lacking an understanding of how much overall risk the bank
had taken on.
The Barings case demonstrates how important it is for a fi-
nancial institution to understand that the “rules of the
game” are always changing. This premise has become espe-
cially true as the modern pace of change resulting from tech-
nology and evolving societal mores can translate into
strategies, risk profiles and business models that need to
adapt along with shorter and more extreme business cycles.
The Great Credit Crisis demonstrated that risk assessments,
strategic plans and capital structures that were designed dur-
ing buoyant market conditions were deficient during such a
protracted and pernicious downturn.
At the heart of fat tail risk scenario exercises is the idea of
corporate longevity; questioning whether a certain risk will 41
occur within a certain time period is essentially asking if this
corporation will be around if a certain severe event occurs.
JUNE 2010 THINK
The analysis of the survival of an individual institution as a
result of one event, a confluence of events or a set of market
conditions, translates into a strategy that considers survival
from an enterprise perspective. It also assists with prioritiz-
ing risks in a concise manner, which leads to the key ques-
tion: What do I have to do to survive?
One of the most strategic exercises a financial institution can
undertake is the construction, translation and adoption of a
catalog of key scenarios that consider an institution’s
longevity. It allows a firm to consider not just “what will
happen if a particular risk event occurs” but also what
would happen if its primary form of income disappears as a
result of a fall in demand for its products, a loss of people or
materials that support those products, or perhaps passage of
regulations that make the sale of such products illegal or im-
practical because of price restrictions.
Information from past events, experiences and market condi-
tions cannot predict the future and ensure corporate longevity.
But such information can certainly inform strategic planning
for the future. The process of constructing scenarios that are
multi-disciplinary and are ultimately understood and adopted
by an institution’s senior management and board of directors
is a powerful and focused method for considering key risks
and the overall risk profile of a financial institution with re-
spect to what matters most: survival.
A continued adherence to silo-driven approaches within risk
management perpetuates the tendency of financial institu-
tions to understand their risks in small, contained units
rather than in aggregate. Managing risk strategically and
across a complex organization involves the construction of
a narrative; the narrative should contain key elements of the
story, an analysis of the different cross currents that led to

10
Managing risk strategically and across a complex organization
involves the construction of a narrative; the narrative should
contain key elements of the story, an analysis of the different cross
currents that led to the event, a dissection of the control failings
and a listing of both direct and indirect impacts. Ultimately, the
42 narrative should be transformed into a scenario that is relevant for
one’s own organization and accounts for what a related event
JUNE 2010 THINK
would look like if it occurred internally.
the event, a dissection of the control failings and a listing of
both direct and indirect impacts. Ultimately, the narrative
should be transformed into a scenario that is relevant for
one’s own organization and accounts for what a related
event would look like if it occurred internally. What controls
would likely fail? What market events would heighten the
severity of the event? What direct and indirect costs would re-
sult from such an event? What could cause a liquidity crisis?
The key to constructing scenarios is to use material from the
past, such as the facts surrounding the failure of an organi-
zation, and making the event one’s own. This can be ac-
complished primarily through a questioning process.
Illustrated below are two excerpts from case studies of op-
erational risk events along with examples of how to con-
struct relevant scenarios through a questioning process.
Case Study One: Failure of Corus Bank
Corus Bank of Chicago, Illinois was closed on September
11, 2009, by the Office of the Comptroller of the Currency,
which appointed the Federal Deposit Insurance Corporation
(FDIC) as receiver. The FDIC entered into an immediate pur-
chase and assumption agreement with MB Financial Bank
to assume all of the deposits of Corus Bank. As of June 30,
2009, Corus Bank had total assets of $7 billion and total de-
posits of approximately $7 billion. The FDIC estimated that
the cost to the Deposit Insurance Fund would be $1.7 bil-
100
70
80
40 90
60
20 50
30
lion. Corus was characterized in numerous press reports as
a poster child for commercial lending in boom-bust markets.
The bank’s failure constituted the third largest of 2009 – a
year in which there had already been 133 bank failures in
the United States. (By the end of the year, the United States
experienced 140 bank failures.)
Corus operated extensively outside its Chicago base and was
one of the largest condominium lenders in South Florida. It
provided $1.2 billion in financing to primarily condominium
development projects in 2008. The bank continued its com-
mitment to financing large condominium projects in the state
of Florida even after the dramatic implosion had started.
Corus was also heavily exposed to commercial real estate
lending in Las Vegas – another victim of the real estate
downturn. Only about five percent of the bank’s outstand-
ing loans were associated with Chicago-area projects. A
lending strategy that includes extending a large portion of
loans outside a bank’s home market can prove to be a risky
endeavor, because the institution may not fully understand
the implications of extending loans to borrowers that are lo-
cated far away.
Following the closures of Guaranty Bank and Colonial Bank
in August 2009, rumors circulated that Corus would be
next. By early June 2009 the bank’s capital base was almost
entirely wiped out by loan defaults; it was operating under
Algo FIRST tracks the end of corporate lifespans
through the indexing term “loss of access to
markets.” The following charts provide a view into
the increase of corporate “deaths” by both number
of events and total loss amount.
regulatory orders to raise additional capital by June 18,
2009, find a new owner, or risk being closed down.
Questions to consider in constructing a scenario using the
Corus Bank case: How cyclical are our investments? How
exposed are we to long-term projects that can be started in
one economy and finished in another? What is the largest
amount we can lose from such a project? Do we understand
our markets? Are we operating in non-core businesses that we
may not understand? How correlated are our businesses?
Could one be hampered by economic conditions while others
remain relatively healthy? What if external fraud is present at
the same time as deteriorating credit conditions and volatile
market conditions? What about a large internal fraud?
Case Study Two: Dwelling House Savings and
Loan Association
Dwelling House Savings and Loan Association of Pittsburgh
was closed on August 14, 2009, by the Office of Thrift Su-
pervision (OTS), which appointed the FDIC as receiver. The
FDIC entered into an immediate purchase and assumption
agreement with PNC Bank of Pittsburgh to assume all of the
deposits of Dwelling House Savings and Loan. As of March
31, 2009, Dwelling House had total assets of $13.4 million
and total deposits of approximately $13.8 million. The FDIC
estimated that the cost to the Deposit Insurance Fund would
be $6.8 million.
An internet fraud that resulted in about $3 million of capi-
tal being stolen from the bank contributed to Dwelling
House’s undercapitalization. The crime went undetected for
more than a year, which was attributed to poor bookkeep-
ing practices. Dwelling House recovered about one-third of
these funds; they had been illegally transferred into accounts
held with 62 financial institutions that had unknowingly
processed electronic checks through an automated clearing
house system. The incident led the OTS to order the bank to
replenish the missing funds, replace top management, tighten
compliance controls and accept supervision from a local
bank that would serve as its mentor.
Questions to consider in constructing a scenario using the
Dwelling House case: Could such a fraud occur within our
organization? How big would it have to be to have an im-
pact on our capital base? Could a smaller fraud occur over
a period of time without detection? Could the improper
withdrawal of small amounts of money over time by em-
ployees or external fraudsters add up to an amount that
would have a notable impact? Could money be siphoned out
of our company without noticing? What control break- 43
downs would have to occur for that to happen? What is the
JUNE 2010 THINK
state of these controls? Are there subsidiaries or branches
within our organization that engage in gray market practices
that might cause concern to the regulators – perhaps in a
very small far away location? Could these practices cause
reputational issues for the parent organization? Could the
impact of a technology breach be magnified by difficult mar-
ket conditions? What conditions could occur to increase the
severity of such an event?
A Scenario for Long Life
Large, complex organizations collect a lot of important data
from a multitude of departments, geographies and risk and
compliance disciplines. This can result in an overwhelming
amount of information, which perhaps provides senior man-
agement with a false sense of security that they truly under-
stand their risks. But understanding individual risks in
isolation of each other may not provide the best window into
what can bring an organization down and result in a trun-
cated lifecycle. Scenarios are a powerful method for bringing
together all the insights that an organization has gained
through data collection, workshops, corporate experience
and wisdom into a singular view of risk.
The good news is that the process of constructing a catalog
of cross-organizational scenarios need not be expensive. And
while it may not be the most expensive risk endeavor that an
organization undertakes, it can certainly be the most pro-
found. Scenarios provide the opportunity for financial insti-
tutions to better understand the true risks that they face and
extend their life expectancy even further beyond those of
their corporate counterparts.
 The last word
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