Canadian Annual Derivatives Conference of the Montral exchange

Characteristics of Superior Risk Management Solutions

Fairmont Le Chateau FrontenacQuebec, CanadaFriday, August 19, 2005 9:40 am 10:20 am Dr. Robert M. MarkBmark.blackdiamond@tmo.blackberry.net925 299 6859

Dr Bob Mark

A significant challenge is to stay on top of a complex combination of Characteristics which are at the Core of Superior ERM Solutions*CustomersInvestors*Markets*RegulatorsRating AgenciesEquity AnalystsFinancial Risk-Market Risk-Credit RiskNon Financial Risk-Operational Risk-Business RiskInfrastructurePoliciesMethodologiesThe ability to efficiently integrate all the components of risk on a *portfolio basis as well as to effectively operate in complex *markets while serving *customers as well as satisfying *regulators is a direct function of the quality of the policies, methodologies and infrastructure

Dr Bob Mark

Basel has driven a significant spend on risk management Minimum Capital RequirementThree Basic PillarsSupervisory Review ProcessMarket Discipline Requirements

Dr Bob Mark

Superior ERM SolutionsINCREASING KNOWLEDGE REQUIRED+ Monitor+ Value at Risk + Facilitate Pricing+ Economic (Risk) Capital+ Stress Test & Scenario AnalysisIdentify & Avoid= Portfolio Mgmt Limit ManagementRisk Analysis The ability to proactively manage risk on an integrated portfolio mgmt* basis:stems from having several sophisticated layers of functionality . is based on a relentless commitment toward superior analytics and infrastructure

+ Accounting Capital+ Performance Measurement+ Regulatory Capital (Basel)

Manage Reserves and Capital

Dr Bob Mark

Example 1: The Credit Portfolio Management Group(CPMG) proactively manages credit risk on an integrated* basis

Dr Bob Mark

A significant challenge is to build a Superior ERM Solution in partnership with the C Suite whose Characteristics can be benchmarked in terms of:

Dr Bob Mark

Characteristics of Policies at the Core of Superior ERM Solutions These include:The tolerance for risk (financial and non financial) is integrated and consistent with the Business Strategies (and visa versa)

Risk measures are backtested, authorities are expressed in meaningful terms and reflect a desired tolerance for risk

Risk is properly disclosed (e.g. Chinese walls may exist) internally and externally on a drill down and integrated portfolio management * basisDisclosureAuthoritiesRisk ToleranceBusinessStrategiesIndependentSuperior ERM Solutions

Dr Bob Mark

Risk DisclosureKey characteristics of disclosure include having the ability to provide disclosures such as:Slicing and dicing the risk in real time (or near real time) by risk type, asset class ,business, product, industry, country, etcmark-to-market (mark- to-model) vs. cash flow viewsGAAP vs. Economic viewCapital (e.g. GAAP Capital vs. Economic Capital vs. Basel Capital) the main drivers of riskDisclosureAuthoritiesRisk ToleranceBusinessStrategiesIndependentSuperior ERM Solutions

Dr Bob Mark

Disclosing the main drivers of financial and non financial risk would include answering such questions as :What are the top risks in the trading book and banking book (i.e. a literal hit parade of risks)Where are the concentrations of risk (e.g. hot spots)How often the list of main risks changeHave the forecasts of the top financial and operational risks (e.g. stress tests) been predictive? Have any of the top risks listed caused management to take action to alter them in any way? If so, how?What financial risks keep management up late at night?

Dr Bob Mark

Example 2: August 1998:

Equity prices dropped sharply

Equity Volatility increased

Liquidity dried up (Flight to quality)

Correlations broke down

Credit spreads widened

Credit quality deterioratedWide Credit SpreadHigh VolatilityLow LiquidityAugust 98

Dr Bob Mark

Example 3 :Certain types of backtesting disclosure have become standard (e.g. market risk).Ultimately,similar disclosure will become standard across all risk types C$ MillionsALCO Limit - Upper BoundaryALCO Limit - Lower BoundaryPotential Predicted Positive RevenueDaily Net Trading RevenuePotential Negative Revenue PredictedNov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct August 27, 1998

Dr Bob Mark

Characteristics of Methodologies at the Core of Superior ERM SolutionsThese include: VaR and Stress Test methodologies are predictive of the actual losses and integrated across all risks and all books of businessOngoing dedication toward first class risk methodology researchMathematical models are properly vetted.Positions are properly valued (and becomes a bigger deal with SOX).Risk methodologies are tied into pricing and performance measurement.IndependentFirst-ClassProactive RiskManagementPerformanceVetting &ValuationStress TestsVaR

Dr Bob Mark

Example 4: A key characteristic of superior market risk methodologies is to realistically capture liquidity riskTradingRulesInitialPositionDataResultsScenariosData}

Dr Bob Mark

Example 5:A key characteristic of superior credit risk solutions is to build a robust Risk Rating Process that enables you to calculate the PD, LGD ,attribute capital and price credits

Transaction StructureCollateralMaturity of TransactionThird Party SupportManagerial Capability,Competitive Position Quality of Financial Information, Country RiskFinancial Assessment(Floor on obligor rating)ObligorRating

Dr Bob Mark

A term structure of risk is calculated over multiple time periodsThe term structure of PDs (from the obligor rating) and RRs (from the facility rating ) is typically applied to price as well as determine the capital for credit riskEXPOSURERECOVERIESDEFAULTS0TIMECREDIT LOSSPROBABILITYEXAMPLE

Dr Bob Mark

Credit risk models (eg Mertons model) have also become deeply practical for the purposes of predicting such things as:Distribution of asset values at maturity of the debt obligationAssets ValueVTV0Probability of defaultTimeTFProbability of default (PD)

Dr Bob Mark

Example 6: A key characteristic of superior credit risk stress test solutions is to arrive at reasonable paranoia stress testsStressing the boundaries of credit riskCredit risk factors may be shocked . . .. . .To produce perturbations of combined distributions of simulated future credit lossesEXPOSUREDEFAULTSRECOVERIES0TIMECREDIT LOSSPROBABILITYShocksEXAMPLE

Dr Bob Mark

Example 7:A key characteristic of being able to calculate credit risk is to be able to calculate a joint PDF for such things as credit grade migrationJoint migration probabilities (%) with zero correlation for 2 issuers rated BB and AObligor #2 (single-A)Obligor #1AAAAAABBBBBBCCCDefaultBB0.092.2791.055.520.740.260.010.06AAA0.030.000.000.030.000.000.000.000.00AA0.140.000.000.130.010.000.000.000.00A0.670.000.020.610.400.000.000.000.00BBB7.730.010.187.040.430.060.020.000.00BB80.530.071.8373.324.450.600.200.010.05B8.840.010.208.050.490.070.020.000.00CCC1.000.000.020.910.060.010.000.000.00Default1.060.000.020.970.060.010.000.000.00

Dr Bob Mark

.which includes being able to calculate meaningful estimates of correlation between asset returns

-Typical assumption is that the joint normalized return distribution for the assets is a bivariate normal PDF Note: Equity returns are sometimes used as a proxy for asset returns.

Dr Bob Mark

Example 8: A key characteristic of superior methodologies is that they are used to price market, credit and operational risk. For example, a Credit Derivative can be modeled as a put

Dr Bob Mark

and can be used to calculate expected credit spreads (CS). Liquidity is a key element

Dr Bob Mark

Sources: British Bankers Association 2001-2002 Credit Derivatives Survey and Standard and Poors Financial Institutions: Demystifying Banks Use of Credit Derivatives (December 8, 2003)The Credit Insurance market has exploded Global Credit Derivatives Volume now over 5 trillion US$($ in billions)

Dr Bob Mark

Chart2

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668

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($ in billions)

5,000+

Sheet1

($ in billions)

1997180

1998350

1999668

20001,009

20011,280

20022,097

Mar-033,000

2004E5,068

Sheet1

0

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($ in billions)

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Credit ScoreGood AccountsBad AccountsCut-off ScorePercent of AccountsExample9: A key characteristic of superior retail methodologies is that credit scoring analytics can be supplemented with sophisticated analytics..The presumption underlying credit scoring models is that there exists a metric that can divide good credits and bad credits into distinct distributions

Dr Bob Mark

lowhighhighE [ Volume ]Low cutoffsHighcutoffs.. which can be used to construct an efficient frontier so as to optimally make market share vs. risk tradeoff decisions

Dr Bob Mark

Significant progress has been made in measuring market risk and credit risk . with some early success at measuring operational risk buthaving a a highly reliable unified measure of risk inside of a common risk architecture is at the core of superior ERM solutions

Dr Bob Mark

Valuation and PerformanceKey Characteristics includes an ability to :accurately vet and value transactions (e.g. loan valuations and derivative valuations) appropriately (e.g. traditional RAROC is flawed) quantify the return to risk relationships of the individual as well as portfolio of transactions

IndependentSuperior ERM SolutionsPerformanceVetting &ValuationStress TestingVaR

Dr Bob Mark

Example 10:A key characteristic of superior solutions is that all models to measure risk are fully vettedDeal DatabaseModel nModelCalibrationModel 1Model NDeal ValuationHedging ModelsHedging RiskModel Risk(valuation)InputRiskStatisticalToolsVendors ofparametersMarket DatabaseEstimation Risk

Dr Bob Mark

Key Characteristics of Infrastructure at the Core of Superior ERM Solutionsincludes having:

The appropriate people in place

A single enterprise wide risk and data architecture

A integrated risk architecture which incorporates and replaces many of the mid office functions (e.g. valuing deals)

Single integrated risk engine

Real time access to data (e.g. market data,transaction data,legal data,etc) Periodic Change initiativesAccurateDataOperationsPeople(Skills)IndependentSuperior ERM SolutionsTechnology

Dr Bob Mark

Building the infrastructure to support an Independent and Integrated Comprehensive ERM integrated framework istough ,efficient (e.g. replaces mid office costs) and effective (e.g. for direct risk takers) and has become a competitive necessity

Direct Risk TakersAnalyze Deal Price Deal Compare Risk to Limit Execute Confirm/ Settle Manage Business Unit RiskCredit RiskMarket RiskOperational RiskBusiness RiskIncremental RiskTotal RiskPoliciesMethodologiesInfrastructure FrameworkRisks

Dr Bob Mark

Appendix

Operational Risk Matrix (Basel II)

Dr Bob Mark

Appendix

Dr Bob Mark

Appendix

Dr Bob Mark

Appendix

Dr Bob Mark

Crouhy,Galai and Mark Co-Authoreda leadingRisk ManagementBook. ThisBook is considered the Risk Managementbenchmark for technical and practicalRisk Management strategies.

Dr Bob Mark

700 pages

ISBN: 0-07-135731-9

$70.00

To Order Call:

1-800-2-MCGRAW

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1-614-755-5645

Chapter 1: The Need for Risk Management Systems

Chapter 2: The New Regulatory and Corporate Environment

Chapter 3: Structuring and Managing the Risk Management Function

Chapter 4: The New BIS Capital Requirements for Financial Risks

Chapter 5: Measuring Market Risk: The VaR Approach

Chapter 6: Measuring Market Risk: Extensions of the VaR Approach and Testing the Models

Chapter 7: Credit Rating Systems

Chapter 8: Credit Migration Approach to Measuring Credit Risk

Chapter 9: The Contingent Claim Approach to Measuring Credit Risk

Chapter 10: Other Approaches: The Actuarial and Reduced-form Approaches to Measuring Credit Risk

Chapter 11: Comparison of Industry-sponsored Credit Models and Associated Back-Testing Issues

Chapter 12: Hedging Credit Risk

Chapter 13: Managing Operational Risk

Chapter 14: Capital Allocation and Performance Measurement

Chapter 15: Model Risk

Chapter 16: Risk Management in Nonbank Corporations

Chapter 17: Risk Management in the Future

Michel Crouhy, Ph.D., is senior vice president, Global Analytics, Risk Management Division at Canadian Imperial Bank of Commerce (CIBC), where he is in charge of market and credit risk analytics. He has published extensively in academic journals, is currently associate editor of both Journal of Derivatives and Journal of Banking and Finance, and is on the editorial board of Journal of Risk.

Dan Galai, Ph.D., is the Abe Gray Professor of Finance and Business Administration at Hebrew University and a principal of Sigma P.C.M. Dr. Galai has consulted for the Chicago Board Options Exchange and the American Stock Exchange and published numerous articles in leading journals. He was the winner of the First Annual Pomeranze Prize for excellence in options research presented by the CBOE.

Robert Mark, Ph.D., is senior executive vice president at the Canadian Imperial Bank of Commerce. Dr. Mark is the chief risk officer at CIBC. He is a member of the senior executive team of the bank and reports directly to the chairman. In 1998, Dr. Mark was named Financial Risk Manager of the Year by the Global Association of Risk Professionals (GARP).

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Risk Management

Michel Crouhy, Dan Galai,

and Robert Mark

The All-in-One Banker's and

Financial Manager's Guide for Implementing ( and Using ( an

Effective Risk Management Program

In todays world of multibillion-dollar credit losses and bailouts, it has become increasingly imperative for corporate and banking leaders to monitor and manage risk(on all fronts. Risk Management introduces and explores the latest financial and hedging techniques in use around the world, and provides the foundation for creating an integrated, consistent, and effective risk management strategy.

Risk Management presents a straightforward, no-nonsense examination of the modern risk management function and is todays best risk management resource for bankers and financial managers. Its tested and comprehensive analyses and insights will give you all the information you need for:

Risk Management Overview

From the history of risk management to the new regulatory and trading environment, a look at risk management past and present

Risk Management Program Design

Techniques to organize the risk management function, and design a system to cover your organizations many risk exposures

Risk Management Implementation

How to use the myriad systems and products(value at risk (VaR), stress-testing, derivatives, and more(for measuring and hedging risk in todays marketplace

In the financial world, the need for a dedicated risk management framework is a relatively recent phenomenon. But as the recent crises attest, lack of up-to-date knowledge concerning its many components can be devastating. For financial managers in both the banking and business environments, Risk Management will introduce and illustrate the many aspects of modern risk management(and strengthen every financial risk management program.

ANNOUNCING

CONTENTS

ABOUT THE AUTHORS

_1036409678.doc

Bio of Dr. MarkDr. Robert M. Mark is the Chief Executive Officer of Black Diamond which provides corporate governance, risk management consulting and transaction services. He serves on several Boards such as the Fields Institute for Research in Mathematical Sciences, IBMs Deep Computing Institute, Checkpoint Canada, The Royal Conservatory and is an Advisory Director on Entergy Kochs Audit Committee of the Board . He also serves on Checkpoints Investment Committee. In 1998, he was awarded the Financial Risk Manager of the Year by the Global Association of Risk Professionals (GARP). He is the Chairperson of The Professional Risk Managers International Associations (PRMIA) Blue Ribbon Panel

Prior to his current position, he was the Senior Executive Vice-President and Chief Risk Officer (CRO) at the Canadian Imperial Bank of Commerce (CIBC). Dr. Mark was a member of the Management Committee. Dr. Marks global responsibility covered all credit, market and operating risks for all of CIBC as well as for its subsidiaries. Prior to his CRO position, he was the Corporate Treasurer at CIBC.

Prior to CIBC, he was the partner in charge of the Financial Risk Management Consulting practice at Coopers & Lybrand(C&L). The Risk Management Practice and C&L advised clients on risk management issues and was directed toward financial institutions and multi-national corporations. This specialty area also coordinated the delivery of the firms accounting, tax, control, and litigation services to provide clients with integrated and comprehensive risk management solutions and opportunities.

Prior to his position at C&L, he was a managing director in the Asia, Europe, and Capital Markets Group (AECM) at Chemical Bank. His responsibilities within AECM encompassed risk management, asset/liability management, research (quantitative analysis), strategic planning and analytical systems. He served on the Senior Credit Committee of the Bank. Before he joined Chemical Bank, he was a senior officer at Marine Midland Bank/Hong KongShanghaiBank (HKSB) where he headed the technical analysis trading group within the Capital Markets Sector.

He earned his Ph.D., with a dissertation in options pricing, from New York Universitys Graduate School of Engineering and Science, graduating first in his class. Subsequently, he received an Advanced Professional Certificate (APC) in accounting from NYUs Stern Graduate School of Business, and is a graduate of the Harvard Business School Advanced Management Program. He is an Adjunct Professor and co-author of Risk Management (McGraw-Hill), published in October 2000. He also served on the board of ISDA as well as the Chairperson of the National Asset/Liability Management Association (NALMA).

Dr Bob Mark

Entergy-Koch Tradings (EKTs) advantage lies with its organizational structure. Its trading system allows it to attract and retain disciplined, quantitative, and economically driven individuals.The new capital accord would consist of thre basic pillars. Taken together they are seen as essential to the working of an effective regulatory capital framework1) A minimum capital requirement, which seeks to expand on and develop the concept of standardized rules to calculate a minimum level of capital for any institution.2) A Supervisory review of an institutions capital adequacy and internal assessment process. This will seek to ensure that the regulators are comfortable that a banks capital position is consistent with its overall risk profile and strategy. Early intervention is envisaged, if a regulator deems there to be deficiencies in either the level of capital or the internal control mechanisms.3) A Market Discipline pillar, which will act as a lever to strengthen disclosure and encourage safe and sound banking practices. Effective market discipline requires the disclosure of reliable and timely information, so that market participants and creditors can make well founded risk assessments. A significant intention, here, being to lessen the risk of Moral hazard to the local regulator. In th past regulators have often felt compelled to bail out creditors who have claimed that a lack of information and discolors prevented them from understanding the risks they were taking.

CIBCs framework for MRM can be benchmarked in terms of PoliciesMethodologiesandInfrastructure

Risk wears many disguises. One can ensure maximum transparency of risk through implementing an independent first class proactive market risk management program.

ClickIf we put these trading risks together then an increase in equity volatility can sometimes be accompanied by a a widening in credit spreads as well as a drying up of liquidity. This does not always happen. But thats exactly what happened during the 4th quarter.In fact, some commentators have called the 4th quarter a market of firsts as we saw the dramatic coming together of these three separate risks.Specifically, Equity volatility increased which led to material losses in our Equity Derivatives book. The dramatic rise in equity volatility was accompanied by a drying up of liquidity. This flight to quality led to a widening of credit spreads which also hurt our High Yield book.

CLICK

The process works through sovereign and macro-economic issues, industry outlook and regulatory trends, to specific attributes (including quality of management, operating and financial positions) and eventually to issue-specific structure of the financial instrumentThe pace of innovation and the volume of activity in credit derivatives are heating up. These instruments promise to become a significant force in risk management for banks. Over the next decade they will transform credit markets. But as promising as the credit derivatives technology is, it is not yet a panacea for the credit problems of banking systems around the world. It has not yet, as is commonly believed, helped banks avoid meaningful amounts of losses in the credit cycle just ending now. Standard & Poors Rating Services estimates that, as of March 2003, $3 trillion total notional amount of credit derivatives outstanding, but only $100 billion represents a transfer of credit risk from banks lending and trading activities to other market participants. The remainder represents the dealing books of the 15 dealing banks that dominate the business, and to a much lesser extent, investment in credit risks by banks and insurance companies. In any case, the $3 trillion number pales before the aggregate loan and bond portfolios of the global banking system which total approximately $29 trillion and $5.5 trillion, respectively.Today risks that can be protected with credit derivative swaps (CDSs) are largely limited to investment grade names. This appears to have the effect of shifting the remaining risk sin the banking system further toward the riskier, non-investment grade range of the spectrum. For the market to become a significant force in moving risk away from banks, a noninvestment-grade market would have to become deeper. There is some evidence that this is occuring, at leat in the U.S. Insurance companies are reputed to be the end-providers of credit protection. They are indeed net providers of credit protection through CDSs. Most of their exposures, however, tend to be in the form of CDOs and basket trades, but these are almost exclusively of the AAA or so-called super-senior tranches of these structures, the second loss positions or, in the case of the monolines, providers of insurance wrap protection on the senor tranches. Such trances cannot be said to be intended to absorb risk.

Losses, volume and profits are dependent random variables. This graph provides a three-dimensional illustration of the changes in expected profits, expected losses and expected portfolio size. The Efficient Frontiers illustrated in earlier slides are projections in different planes of this three-dimensional drawing.Where can trading losses related to model risk originate? Well, either from the inappropriate use of a model, e.g. using the right model with the wrong volatility parameters, i.e. what I call input risk in the graph shown on the screen, or using the wrong model. In the second case the math may be exact but the premises of the model are wrong. In the following I will illustrate both cases.Computers are now so powerful that there is a temptation to develop more and more complex models which are less and less well understood by management. There is clearly a need for risk management to have a thorough understanding of the pros and limitations of all the models being used within CIBC.Here are three examples of what can go wrong. The first two ones are directly related to model risk. The third one is more subtle and relate to both model risk and financial engineering.When it comes to infrastructure, the most important component is people. Here of course I refer to people throughout the organization, not just those in support functions.

OR

The last component of our integrated market risk management framework is infrastructure. The most important component of our infrastructure is people. It is self evident that a necessary condition to achieve a first class proactive management of CIBCs market risk, as illustrated by the arrow on the screen, is through hiring a highly skilled team of risk management experts.Click

What is the way forward ...

Our risk management plan is to build an independent and integrated business oriented process.

We must develop a bankwide common language of risk. The language must accurately describe the multiple dimensions of risk, as well as accommodate the complexity inherent in restructuring and repackaging risk.

As pointed out earlier, we need to develop policies and methodologies, as well as design an infrastructure which is independent but works in partnership with the risk-takers. For example, we need to appreciate the impact that our measurement of risk will have on the ability of direct risk takers to compete on price.

Direct risk takers are responsible for understanding and pricing the risks they assume in pursuing their business activity. Our direct risk takers will only use measures of risk for pricing if they are based on best practice methodologies with low ivory tower content.