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Enterprise Risk Management in Finance is a guide to measuring and managing Enterprise-wide risks in financial institutions. Financial institutions operate in a unique manner when compared to other businesses. They are, by the nature of their business, highly exposed to risk at every level, and indeed employ their own risk management functions to manage many of these risks. However, financial firms are also highly exposed at enterprise level. Traditional approaches and frameworks for ERM are flawed when applied to banks, asset managers or insurance houses, and a different approach is needed. This new book provides a comprehensive, technical guide to ERM for financial institutions. Split into three parts, it first sets the scene, putting ERM in the context of finance houses. It will examine the financial risks already inherent in banking, and then insurance operations, and how these need to be accounted for at a floor and enterprise level. The book then provides the necessary tools to implement ERM in these environments, including performance analysis, credit analysis and forecasting applications. Finally, the book provides real life cases of successful and not so successful ERM in financial institutions. Technical and rigorous, this book will be a welcome addition to the literature in this area, and will appeal to risk managers, actuaries, regulators and senior managers in banks and financial institutions.



1. Enterprise Risk Management

Living and working in today’s environment involves many risks. The processes used to make decisions in this environment should consider the need both to keep people gainfully employed (through increased economic activity) and to protect humanity from threats arising from human activity. Terrorism led to the gas attack on the Japanese subway system in 1995, to 9/11 in 2001, and to the bombings of the Spanish and British transportation systems in 2004 and 2005 respectively. But nature has been far more deadly, with hurricanes in Florida, tsunamis in Japan, earthquakes in China, and volcanoes in Iceland. These locations only represent recent, well-publicized events. Nature can strike at us anywhere. We need to consider the many risks that exist, and to come up with strategies, controls, and regulations that accomplish a complex combination of goals.

Desheng Dash Wu, David L. Olson

2. Enron

One of the primary reasons for the current emphasis on ethical business practice has been the history of the Enron Corporation. Enron was founded in 1985 to manage a natural gas pipeline. It expanded operations to include trading not only natural gas but also other energy commodities, including gas and electricity. This trading included derivatives on the price of gas, to hedge risk. Enron participated in a joint venture creating an online trading operation offering options and other derivatives to traders in the gas industry. By 2000 it was well known as a trading pioneer in that field, and this led to its stock doing well on Wall Street; in 2001 it was rated as 7th on the Fortune 500.

Desheng Dash Wu, David L. Olson

3. Financial Risk Management

Traditional risk management focuses on risks stemming from physical or legal causes such as natural disasters or fires, accidents, death and lawsuits. Financial risk management deals with risks that can be managed using traded financial instruments. The events of the 21st century have made it even more critical. Top business management came under suspicion after the scandals at ENRON, WorldCom, and other business entities. In recent times, many investors have experienced difficulties from bubbles. The most spectacular failure in the late 20th century was probably that of Long-Term Capital Management,1 but that was only a precursor to the more comprehensive failure of technology firms during the dotcom bubble around 2001. The global financial community suffered the 2007 subprime crisis of the banking industry, the Fannie Mae and Freddie Mac crisis in secondary US mortgage markets, Lehman Brothers’ failure, Merrill Lynch’s takeover by Bank of America, and industry-giant AIG applying for emergency financial support from the Federal Reserve. The financial world’s failures include the Barings Bank collapse in 1995, as well as the Long-Term Capital Management and subprime mortgage bubble implosion already mentioned.

Desheng Dash Wu, David L. Olson

4. The Real Estate Crash of 2008

The current population of the United States has grown up with what seemed to be a steady and reliable increase in value of homes. Owning one’s own home is one of the signs of a prosperous and successful culture. In the 1930s, many people lost title to their homes during one of the greatest failures of human economic systems known. In response, banks and mortgage lending were regulated, bank deposits insured up to a level covering what most people had, and stock-trading practices ostensibly controlled. True, very old people could remember a time when the price of housing dropped, but with the inevitable passage of life with time, this group grew smaller and smaller, and older and older, and less relevant. There also were anomalies in local areas where, for whatever reason, home prices might negatively fluctuate. Reinhart and Rogoff have described five such anomalies, all associated with banking crises (Spain in 1977, Norway in 1987, Finland and Sweden in 1991, and Japan in 1992).1 But house price decline occurred very rarely, and nobody really noticed.

Desheng Dash Wu, David L. Olson

5. Financial Risk Forecast Using Machine Learning and Sentiment Analysis

There is a widespread need for effective forecasting of financial risk using readily available financial measures, but the complicated environment facing financial practitioners and business institutions makes this very challenging. The concept of financial volatility, a required parameter for pricing many kinds of financial assets and derivatives, is critical, because it is widely expected that financial volatility implies financial risk. Therefore, accurate prediction of financial volatility is extremely important. Efficient prediction of financial volatility has been an extremely difficult task, but we can now offer a scalable and customizable mathematical model to achieve this goal, employing two approaches to forecast the volatility using financial information available online. First, we carry out a comparative study between two different machine-learning techniques — artificial neural networks (ANN) and support vector machines (SVM) — to forecast trading volume volatility. Second, we utilize semantic techniques to probe correlations between information sentiment and asset price volatility.

Desheng Dash Wu, David L. Olson

6. Online Stock Forum Sentiment Analysis

Over the past few decades, behavior finance and risk management have attracted a great deal of attention from both researchers and practitioners seeking to explain investor sentiment behavior, risk and loss perceptions, factors affecting investment strategy and investor behavior related to ongoing market trends.1

Desheng Dash Wu, David L. Olson

7. DEA Risk Scoring Model of Internet Stocks

In financial markets, there are many kinds of investments, with stock the most popular. When investors choose which stock to invest in, they may expect high returns from investing in high performance companies. However, the greatest concern for investors is whether their investment has the potential for high returns, and whether the high performance companies will always yield high returns.

Desheng Dash Wu, David L. Olson

8. Bank Credit Scoring

The concept of enterprise risk management (ERM) developed in the mid-1990s in industry, expressing a managerial focus. ERM is a systematic, integrated approach to managing all risks facing an organization.1 It has been encouraged by traumatic recent events such as 9/11/2001 and business scandals, including Enron and WorldCom. Consideration of risk has always been with business, manifesting itself in 17th-century coffee houses such as Lloyd’s of London spreading risk related to cargoes on the high seas. Businesses exist to cope with specific risks efficiently. Uncertainty creates opportunities for businesses to make profits. Outsourcing can offer many benefits, but also has a high level of inherent risk, and ERM seeks to provide means to recognize and mitigate risks. The field of insurance developed to cover a wide variety of risks, both external and internal, covering natural catastrophes, accidents, human error, and even fraud. Financial risk has been controlled through hedge funds and other tools over the years, often by investment banks. With time, it was realized that many risks could be prevented, or their impact reduced, through loss-prevention and control systems, leading to a broader view of risk management.

Desheng Dash Wu, David L. Olson

9. Credit Scoring using Multiobjective Data Mining

The technique for order preference by similarity to ideal solution (TOPSIS) is a classical method first developed by Hwang and Yoon,1 subsequently discussed by many.2 TOPSIS is based on the concept that alternatives should be selected that have the shortest distance from the positive ideal solution (PIS) and the longest distance from the negative ideal solution (NIS), or nadir. The PIS has the best measures over all attributes, while the NIS has the worst measures over all attributes.

Desheng Dash Wu, David L. Olson

10. Online Banking Efficiency and Risk Evaluation with Principal Component Analysis

Online banking has always been important from different stakeholder perspectives.1 Improving the efficiency of Internet banking is now considered to be important. Banks hope that internet banking will help them maintain profitable growth by enabling them to automate work, reduce costs, and retain customers simultaneously.2 Internet banking may help reduce expenditure on ‘bricks and mortar,’ and reduce capital expenditures.3 Internet banking can give customers 24-hour access, and provide convenience for customers. Cost-effective use of the internet can attract many users to online banking services, but there has been little research examining the superiority of banks providing online banking services over those that do not. The role of online banking in leading to better decisions and creating more profit needs study.

Desheng Dash Wu, David L. Olson

11. Economic Perspective

An early economic view of risk was addressed by Frank H. Knight,1 who focused on the difference between uncertainty (a domain evading accurate measurement: ‘cases of the non-quantitative type’) and risk: (‘a measurable uncertainty, or “risk” proper’). Risk applied to cases where knowledge is available about future outcomes and their probabilities, while uncertainty applies to cases where there is knowledge about future outcomes but not about their probabilities. Risk was viewed as important, drawing upon Courcelle-Seneuil’s view2 that profit is due to the assumption of risk, compatible with von Thünen’s view3 that profit was, in part, payment for certain risks. This was also expressed by F. B. Hawley,4 who argued that risk-taking was the essential function of the entrepreneur. Knight viewed risk as the objective form of the idea, and reserved subjective elements to uncertainty. Since risk was measurable, those things to which it applied had statistical distributions available.

Desheng Dash Wu, David L. Olson

12. British Petroleum Deepwater Horizon

The Macondo well, operated by BP, aided by driller Transocean Ltd. and receiving cement support from Halliburton Co., blew out on April 20, 2010, leading to 11 deaths. The subsequent 87-day flow of oil into the Gulf of Mexico dominated news in the US for an extensive period of time, polluting fisheries in the Gulf as well as the coastal areas of Louisiana, Mississippi, Alabama, Florida, and Texas. The cause was attributed to defective cement in the well.

Desheng Dash Wu, David L. Olson

13. Bank Efficiency Analysis

In today’s economy, the banking industry is of great importance. With the availability of new technology and the internet, more and more organizations are entering some aspect of the banking business and this results in intense competition in the financial services markets. Major domestic banks continue to pursue all the opportunities available to enhance their competitiveness. Consequently, performance analysis in the banking industry has become part of their management practices. Top bank management wants to identify and eliminate the underlying causes of inefficiencies, thus helping their firms to gain competitive advantage, or, at least, meet the challenges from others.

Desheng Dash Wu, David L. Olson

14. Catastrophe Bond and Risk Modeling

On May 12, 2008, the Wenchuan earthquake occurred in Sichuan province of China, killing at least 69,000. This great disaster caused widespread damage to the infrastructure and huge economic losses to Chinese society. The loss to the Chinese insurance sector was in excess of 65 million RMB about 70 days after the quake. Figure 14.1 displays insurance claim payoffs relative to the days elapsing after the Wenchuan earthquake.

Desheng Dash Wu, David L. Olson

15. Bilevel Programming Merger Analysis in Banking

In modern organizations, component elements members are mutually dependent on a common set of finite resources.1 These organizational resources include funds, personnel, time, effort, and information.2 As a result, organizations have been described as large pools of scarce shared resources, for which component elements (subgroups) compete.3 MEI, a global provider of trade promotion management solutions, surveyed 52 consumer packaged goods (CPG) manufacturers in May 2011, finding that ‘Trade promotions budgets do not grow and IT budgets are still clamped down, yet these organizations somehow need to improve promotion effectiveness. They are no longer concerned with streamlining the deduction reconciliation process, but they do want better visibility into where their scarce dollars are being spent.’4 Due partly to pressure from competition and shareholders, many corporations, including banks and other financial institutions, seek ways to rearrange their organizational structure and to widen their geographical reach and product variety. These changes often aim to improve efficiency through potentially higher economies of scale and wider scope. This chapter aims to examine how such merger performance is gauged in the presence of scarce shared resources, using a banking organization as an example. In this evaluation, we concentrate on the within-firm competition for the common resources.

Desheng Dash Wu, David L. Olson

16. Sustainability and Risk in Globalization

We all are aware that we live in a world of change, and that there are many things going on that appear to be problematic. There are islands in the Pacific that are going underwater (well, they aren’t sinking, but the water level is rising). There are glaciers that are disappearing. Europeans spent a good part of the second millennium AD looking for a Northwest Passage to Asia — but nature appears to be providing one for us in the third. Climate appears to be changing, although weather being what it is, long-range trends are elusive at best. But North Dakota might someday be a winter haven, and Omaha might be a seaport. We need to worry about the environment. We will, of course, argue about how to cope. Some want to ban coal and petroleum use NOW. Others prefer to consider moving uphill.

Desheng Dash Wu, David L. Olson

17. Risk from Natural Disasters

Natural disasters by definition are surprises, causing a great deal of damage and inconvenience. Earthquakes are among the most terrifying and destructive natural disasters threatening humans. Emergency management has been described as the process of coordinating an emergency or its aftermath through communication and organization for deployment and the use of emergency resources. This chapter provides the state-of-the-art studies of risk and emergency management related to the Wenchuan earthquake that happened in China in May 2008.

Desheng Dash Wu, David L. Olson

18. Pricing of Carbon Emission Exchange in the EU ETS

Carbon emission exchange originated from emission trading proposed by economists in the 1970s. Carbon trading, an important environmental policy in market economy countries, has emerged as the foremost policy instrument for reducing worldwide greenhouse gas emission. The United Nations Intergovernmental Panel on Climate Change (UNIPCC) passed the United Nations Framework Convention on Climate Change (UNFCC) on June 4, 1992. The Kyoto Protocol, passed in December 1997, the first additional convention, uses the market mechanism as a new way to resolve the issue of greenhouse gas reduction, of which carbon emission is the most prominent. Thus carbon emission rights become a tradable commodity, leading to the emergence of a carbon emission exchange mechanism.

Desheng Dash Wu, David L. Olson

19. Volatility Forecasting of the Crude Oil Market

Risk analysis of the crude oil market has always been a core research problem important to both practitioners and academia. Risks arise primarily from changes in oil prices. During the 1970s and 1980s there were a number of steep increases in oil prices; these price fluctuations reached new peaks in 2007 when the price of crude oil doubled during the financial crisis, and double digit fluctuations continued between 2007 and 2008 for short periods. These fluctuations would not be worrisome if oil was not such an important commodity in the world’s economy. But when oil prices become too high and their volatility increases, they have a direct impact on the economy in general, and affect the government decisions regarding market regulation, thus impacting firm and individual consumer incomes.1

Desheng Dash Wu, David L. Olson

20. Confucius Three-stage Learning of Risk Management

During my class of risk management, I teach a Confucius three-step approach of learning risk management to my students. Students seem to be well-motivated to learn this interdisciplinary course using my approach. Confucius, a philosopher born in 551 BCE during the Chou dynasty, may well be one of the most influential philosophers in history.


He wandered all around China, trying to serve as an adviser to various rulers in the Spring-Autumn period. Confucius, his students and many other followers developed ‘Four Books’ in Confucianism. One of the most significant was ‘The Great Learning’, which addresses classical themes of Chinese philosophy and political issues, and has been extremely popular and very influential in both traditional and modern Chinese thinking. ‘Eight steps’ were developed showing how to ‘investigate things,’ which becomes one of the first stages to understanding ‘The Great Learning’.


Three famous steps are expressed:

Wishing to order well their States, they first regulated their families.

Wishing to regulate their families, they first cultivated their persons.

Their persons being cultivated, their families were regulated.

Their families being regulated, their States were rightly governed.

Desheng Dash Wu, David L. Olson


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