American Bankers Association Risk Management Forum, April 29, 2010. Best Practices: Managing Judgment Risk. Presented by Tyler D. Nunnally, Founder & CEO, Upside Risk

1. ABA Risk Management Forum April 28-30, 2010 Best Practices: Managing Judgment Risk Presented by: Tyler D. Nunnally Founder & CEO Upside Risk

4. PART I: Judgment Risk Key Risk Factors in the Decision-Making Process

5. What is Judgment Risk? Risk Probability of Occurrence Judgment Bias X Severity of Likely Impact Risk Appetite “ JUDGMENT RISK”

8. PART II: Behavioral Economics 101

10. The Way People Make Decisions SYSTEM 1 (Intuitive) SYSTEM 2 (Reason) Automatic Spontaneous Unconscious Instinctive “ Gut feel” Thoughtful Controlled Informed Deductive Analytical

11. Decision-Making Under Risk and Uncertainty Diagnosis: person scans, appraises and questions available information Assessment: risk versus rewards analysis made of available options Action: commitment to chosen course of action Adjustment: evaluate decision outcomes and adjust accordingly Diagnosis ▼ Assessment ▼ Action ▼ Adjustment

12. Behavioral Economics in the Mainstream NY Times Business Best Sellers in 2009 PREDICTABLY IRRATIONAL , by Dan Ariely FREAKONOMICS , by Steven D. Levitt and Stephen J. Dubner SWAY , by Ori Brafman and Rom Brafman NUDGE , by Richard H. Thaler and Cass R. Sunstein

13. “ Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world ” Source: Levitt, Steven and List, John “ Homo Economicus Evolves ,” Science , February 15, pp. 909–10. What the Critics Say…

15. “ Risk management is a form of engineering: it uses science, but ultimately depends on judgement… The ultimate protection against risk is good judgement and alertness: your own and that of your colleagues”. Source: Risk Management, November 2005

16. PART III: Judgment Bias

17. Probabilities & Statistics: Sample Size Bias Suppose the mean credit score of all senior citizens is 650. You have selected a random group of 50 senior citizens. The first person that you review has a credit score of 800. What do you think the mean credit score of this group of 50 senior citizens will be? A. 598 B. 650 C. 653 D. 725

19. Heuristics: Availability Perception of how “risky” something is often determined by how readily examples come to mind from memory. Bias occurs when probability assumptions become inflated by recent events. US AIRLINE INDUSTRY PASSENGER REVENUES 1999-2004 Risk Exposure : - Overly cautious - Lost opportunities - Falling profits

21. Booms and Busts: Subprime Crisis U.S. House Prices: 1988 - 2008 Key Risk Factors : - Time discounting - Confirmation bias - Herding - Overconfidence

22. PART IV: Risk Appetite

23. Risk Preferences A person’s level of comfort in taking risk often determines business decisions Risk Preference ↓ Risk Appetite Risk Averse ↓ Risk Avoiding Risk Neutral Risk Prone ↓ Risk Seeking Conservative Decisions Middle of the Road Decisions Aggressive Decisions

25. Risk Appetite Metrics: Sunk Costs You have a significant sum invested in a project to develop a new product. If successfully completed, the project could have a considerable financial impact on your company. However, the project is overdue and over-budget. To complete the project it will now cost double the original projected cost. You must now decide to make the additional investment in order to complete the project, or to terminate it altogether. To complete the project, what probability of success would be required before you would make an additional investment? Please choose one of the following probabilities: 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

26. Excessive Risk Appetite and Catastrophic Risk FDIC Troubled Bank List: 2007 – 2009

27. Risk Aversion and Falling Profits

30. PART V: Best Practices: Managing Judgment Risk

31. “ The best behavioral risk management strategy is to try and arrest problem development earlier in the behavioral stage”. Source: Rudy M. Yandrick, Behavioral Risk Management, 1996

32. Judgment Risk Indicator: Individual Metrics

33. Judgment Risk Indicator: Organizational Metrics

35. Banking Peer Group Risk Appetite Benchmark

36. Tyler D. Nunnally, Founder & CEO Upside Risk Atlanta, Georgia U.S.A. Phone: +1 (404) 320 6047 Email: tnunnally@upside-risk.com www.Upside-Risk.com