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Enterprise Risk Management: From Incentives to Controls, 2nd Edition


Praise for Enterprise Risk Management, Second Edition

“The concept that it takes a lifetime to build a company but that it takes moments to destroy it is a very valuable mantra for business leaders. The impact of the recent financial crisis brought that perspective into sharp and, for some, painful relief. Companies, however, need to innovate and grow and to take appropriate risks to do so. The joy of James Lam’s new book is that it recognizes the need for innovation and growth but also acknowledges in a very practical way the role of the ever-evolving risk framework around that growth. The book offers a credible and implementable nexus between growth and risk control, and as such, will be a highly valued tool for boards and management everywhere.”
—Rodger A. Lawson, Chairman of the Board of Directors, E*TRADE Financial, Member of the Board of Directors, UnitedHealth Group, Retired President, Fidelity Investments

“All too often, organizations focus on the process of risk management at the expense of incorporating risk management principles into the governance, leadership, and management of their enterprises. James Lam is a long-time leader in risk management and his substantial experience has enabled him to produce a comprehensive and practical guide for anyone committed to creating an organization capable of effectively evaluating risks versus returns.”
—Matthew R. Feldman, President and Chief Executive Officer, Federal Home Loan Bank of Chicago

“A key success factor in any ERM program is practical and effective implementation. In order to provide sustainable, long-term enterprise value, risk management must be integrated into an organization’s governance model, business analytics, strategic and tactical decisions, and dashboard reporting. Based on his hands-on experience, James Lam has very clearly outlined and articulated the best practices and implementation requirements for ERM. I highly recommend this book to anyone who is engaged in ERM oversight and implementation.”
—Paymon Aliabadi, Executive Vice President and Chief Risk Officer, Exelon Corporation

JAMES LAM is widely recognized as the first ever Chief Risk Officer and a pioneer in the field of enterprise risk management. In a Euromoney survey, Mr. Lam was nominated by clients and peers as one of the world’s leading risk consultants. He currently serves as President of James Lam & Associates and Director and Chairman, Risk Oversight Committee of E*TRADE Financial. Previously, he held positions including Partner of Oliver Wyman, Founder and President of ERisk, Chief Risk Officer of Fidelity Investments, and Chief Risk Officer of GE Capital Markets Services, Inc. In 1997, Mr. Lam received the inaugural Risk Manager of the Year Award from the Global Association of Risk Professionals. Treasury & Risk magazine named him one of the “100 Most Influential People in Finance” in 2005, 2006, and 2008.

Preface xiii

Acknowledgments xvii

Section One Risk Mangement in Context 1

Chapter 1 Introduction 3

The Benefits of Risk Management 6

Integration Adds Value 9

Cautionary Tales 12

Chapter 2 Lessons Learned 21

Lesson #1: Know Your Business 23

Lesson #2: Establish Checks and Balances 24

Lesson #3: Set Limits and Boundaries 25

Lesson #4: Keep Your Eye on the Cash 26

Lesson #5: Use the Right Yardstick 27

Lesson #6: Pay for the Performance You Want 27

Lesson #7: Balance the Yin and the Yang 28

Chapter 3 Concepts and Processes 31

Risk Concepts 32

Risk Processes 36

Risk Awareness 38

Risk Measurement 40

Risk Control 42

Risk Is a Bell Curve 48

Chapter 4 What Is ERM? 51

ERM Definitions 53

The Benefits of ERM 53

The Chief Risk Officer 57

Components of ERM 61

Section Two The Enterprise Risk Management Framework 67

Chapter 5 Corporate Governance 69

Codes of Conduct 71

Best Practices 72

Linking Corporate Governance and ERM 77

Chapter 6 Line Management 83

The Relationship Between Line and Risk Functions 84

Key Challenges 89

Best Practices 92

Chapter 7 Portfolio Management 99

The Theory of Active Portfolio Management 100

Benefits of Active Portfolio Management 102

Practical Applications of Portfolio Management 105

Chapter 8 Risk Transfer 111

A Brief History of ART 112

Advantages of ART 116

Pitfalls of ART 119

A Look to the Future 122

Case Study: Honeywell 124

Case Study: Barclays 124

Chapter 9 Risk Analytics 127

Risk Control Analytics 128

Risk Optimization Analytics 133

Market Risk Analytics 135

Credit Risk Analytics 138

Credit Portfolio Models 141

Operational Risk Analytics 142

GRC Systems 143

Chapter 10 Data and Technology 147

Early Systems 147

Data Management 149

Interface Building 151

Middleware 152

Distributed Architectures 153

Key Factors for a Successful Implementation 154

Chapter 11 Stakeholder Management 157

Employees 158

Customers 161

Regulators 164

Rating Agencies 166

Shareholder Service Providers 167

Business Partners 169

Section Three Risk Management Applications 173

Chapter 12 Credit Risk Management 175

Key Credit Risk Concepts 176

The Credit Risk Management Process 184

Basel Requirements 192

Best Practices in Credit Risk Management 196

Case Study: Export Development Corporation (EDC) 200

Chapter 13 Market Risk Management 209

Types of Market Risk 210

Market Risk Measurement 211

Market Risk Management 224

Best Practices in Market Risk Management 227

Case Study: Market Risk Management at Chase 230

Chapter 14 Operational Risk Management 237

Operational Risk--Definition and Scope 240

The Operational Risk Management Process 246

Best Practice in Operational Risk Management 257

Emerging IT Risks 259

Case Study: Heller Financial 264

Chapter 15 Business Applications 271

Stage I: Minimizing the Downside 271

Stage II: Managing Uncertainty 272

Stage III: Performance Optimization 274

The Further Evolution of Risk Management 275

Chapter 16 Financial Institutions 277

Industry Trends 278

Risk Management Requirements 283

Systemic Risk 287

A Look to the Future 289

Case Study: CIBC 292

Chapter 17 Energy Firms 297

Industry Trends 298

Risk Management Requirements 301

A Look to the Future 310

Lessons Learned from Enron 313

Lessons Learned from the BP Oil Spill 314

Chapter 18 Non-Financial Corporations 317

Risk Management Requirements 317

Best Practices in Corporate Risk Management 326

Case Study: Microsoft 333

Case Study: Ford 335

Case Study: Airbus and Boeing 336

Section Four A Look to the Future 339

Chapter 19 Predictions 341

The Profession of Risk Management 342

Technology and the Convergence of Risk Management 345

Ten Predictions 348

2013 Looking Back 353

Chapter 20 Everlast Financial 357

Section Five ERM Implementation 361

Chapter 21 ERM Implementation 363

Benefits of Corporate Governance and ERM Practices 364

ERM Implementation Requirements 366

ERM Maturity Model 373

Other ERM Maturity Models 377

Risk Culture 378

Chapter 22 Role of the Board 381

Board Oversight Requirements 381

Current Board Practices 383

Case Study: JP Morgan Chase 386

The Last Line of Defense 388

Chapter 23 Risk Assessment 399

Risk Assessment Methodology 401

Best Practice Case Studies in Risk Assessment 414

Appendix: Risk Assessment Self-Evaluation Checklist 415

Chapter 24 Risk-Based Decision Making 423

ERM Decisions and Actions 423

Creating Value through ERM 427

Case Study: Duke Energy 437

Chapter 25 Dashboard Reporting 439

Traditional versus Dashboard Reporting 441

General Dashboard Applications 442

ERM Dashboard Implementation 444

Evolving Best Practices 450

Notes 451

Index 465