role of data science in erm @ nashville analytics summit sep 2014

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The Role of Data Science in Enterprise Risk Management By John Liu, PhD, CFA

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An overview of how organizations can leverage data science and predictive analytics to improve enterprise risk management. Applications for risk identification, mitigation and management will be discussed, as well as methods to facilitate strategic integration across an organization.

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Page 1: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

The Role of Data Science in Enterprise Risk Management By John Liu, PhD, CFA

Page 2: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Question of the Day ¡ How do you tell the difference between a

Bayesian Statistician and Data Scientist?

¡ Answer: What’s the p-value?

Page 3: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Big Data: Big Risks ¡ Healthcare

¡ Financial Services

¡ Insurance

¡ Transportation

¡ National Security

¡ Dating

Page 4: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Key Takeaways ¡ What is Enterprise Risk Management

(ERM)?

¡ What is the Role of Data Science in ERM?

¡ What Data Analytics are used for ERM?

Page 5: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

What is Enterprise Risk

Management?

Page 6: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

What is Risk Management? ¡ A structured approach to manage uncertainty

¡ Management strategies:

Risk Avoidance Risk Transfer Risk Mitigation

Page 7: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Risk Management - Defense Insurance Approach

Reward

Probability of Success

Do Nothing

Page 8: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Risk Management - Offense Opportunistic Approach

Reward

Probability of Success

Carpe Diem

Do Nothing

Page 9: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

What is ERM? ¡ Risk-based approach to managing an enterprise

¡ Risk-aware: every major tangible and intangible factor contributing toward failure in every process at every level of the enterprise

¡ Enterprise value maximized with optimal balance between profitability/growth and related risks

¡ Management better prepared to seize opportunities for growth and value creation

Page 10: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

ERM Components

Identify

Quantify

Respond

Monitor

Comprehensive Approach To

Managing Uncertainty

Identify/Assess Internal and External Risks

Risk Scoring & Modeling

Respond and Control

Monitor & Report Effectiveness

Page 11: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

ERM Goals ¡ Provide holistic view across an organization

leveraging firm experience and knowledge

¡ Provide greater transparency to factors that can impair value preservation and business profitability

¡ Understand & test assumptions & interpretations in business decision-making

Page 12: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

ERM Risk Types ¡  • Resource Capital Management

• Business Disruption, IT Operational

• Credit Exposure • Exchange Rate, Cash flow, Funding Financial

• Privacy, Security, Safety • Regulatory and Statutory Compliance

• Financial Reporting • Regulatory Reporting Reporting

• Natural Catastrophe • Market Panics Hazard

• Business Planning • Marketing, Reputation Strategic

Page 13: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

RM vs ERM HQ: EUR exposure Subsidiary: USD exposure

Sells EUR, Buys USD Sells USD, Buys EUR

RM: Subsidiaries/Business Units manage risks separately

ERM: Manage NET exposure across entire enterprise

Page 14: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Data Science and ERM

Page 15: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

ERM Framework

Compliance

Financial

Compliance

Reporting

Hazard

Strategic

Entity W

ide

Divisio

n

Busin

ess U

nit

Enterprise Structure, Risks Objectives & Components Comprehensive Approach Leverage Data & Analytic Resources Predictive Modeling

Page 16: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Common Challenges ¡ Data warehousing & sharing across entity

¡ Prioritization methodology

¡ Consolidated reporting

¡ Timeliness

¡ Data security

¡ The risk management process itself!

Page 17: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Role of Data Science ¡ Data science methods provide: ¡  Enterprise Data Management

¡  Comprehensive warehousing

¡  Data quality and abundance

¡  Risk Analytics ¡  Predictive Modeling

¡  Loss Distributions

¡  Reporting ¡  Real-time visualization, dashboards

¡  Regulatory requirements

Reporting

Page 18: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Typical Corporate EDW

¡  Big data warehouse ≠ useful data (quite the opposite)

Page 19: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Data Management ¡ Comprehensive data warehouse ¡ Coherent data collection (maybe)

¡  Facilitate data sharing across entity

¡ No useful analytics without abundant, high quality data

Data Big Data

Excel BigTable

PostgreSQL Cassandra, HIVE, HBase

MongoDB Vertica, KDB

Page 20: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Risk Analytics ¡ Benefits beyond Business Intelligence

¡ Newest: cognitive analytics = What is the best answer?

Descriptive Analytics

Predictive Analytics

Prescriptive Analytics

What happened? What’s likely to occur? Why would it occur?

Hindsight Foresight Insight

Summary Statistics Data mining Heuristic Optimization

web analytics, BI, inventory reporting

credit scoring, trend analysis, sentiment

operations planning, stochastic methods

Page 21: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Rich Set of Visualization & Reporting Tools

Aggregate Risk Dashboards Continuous & Comprehensive Risk Monitors

Source: IBM Cognos

Page 22: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Data Analytics Applications for ERM ¡  • Scenario Analysis & Stress Testing Operational

• Credit Scoring Financial

•  IT Security Anomaly Detection Compliance

• Risk Dashboard Reporting

• Catastrophe & Market Risk Hedging Hazard

• Marketing Analytics Strategic

Page 23: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Data Analytics for ERM

Page 24: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Definition of Risk ¡ Risk = Frequency of Loss x Severity of Loss

¡ Loss Distribution

Unexpected Loss

Page 25: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Traditional ERM ¡ Analytic Methods ¡  Closed-form solutions (…just like most things in life)

¡ Historical ¡  Estimate risk using internal and external loss data

¡ Monte Carlo ¡  Estimate distribution parameters from real data ¡  Monte-Carlo sample distribution ¡  Calculate ensemble measures to estimate overall risk

¡ Simple to implement, aggregate across entity, but make complex assumptions, not robust to outliers

Page 26: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Modern ERM ¡ Data analytics driven

¡ Inference based methods

¡ KRI scoring

¡ Parallelization

¡ Natural applications ¡  credit risk scoring ¡ Anti-money laundering ¡  Fraud

Page 27: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Prediction Methods

Methods

Tail Bayesian Frequentist

Transduction

Extreme-Value Expected Deficit

Naïve Bayes HMMs

Bayes Nets

Regression, Decision Trees

SVM

Ensemble Methods Bagging, Boosting, Voting

Page 28: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Outliers, Inliers, and Just Plain Liars ¡ Prediction problems fall in two classes:

Inliers Outliers

Inherently different problems with different quirks

Page 29: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Main Problems with Inlier Prediction ¡ Parametric model choice

¡ Estimation error for lower moments (mean, s.d.)

¡ Incorrectly conjugating priors

¡ Normal/Gaussian distributions don’t really occur in real life

¡ I.I.D.? Really?

Page 30: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Main Problem with Outlier Prediction ¡ Data Quality and Abundance ¡  To estimate low probability events, big data may not be big

enough

Data: 150 years of daily data

Predictor: 100 year flood severity

Relevant Data: 1 or 2 data points

Page 31: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Value-at-Risk (VaR) ¡ Loss severity measure for a given probability and time

horizon

•  Estimate potential losses (or historical losses)

•  Rank losses based on severity •  95% Value-at-Risk is equal to

the 95th percentile loss •  Interpretation = Losses won’t

exceed 65.2m 95% of time •  Underestimates losses during

the other 5% of time

Rank   Loss  1   -­‐0.1  2   -­‐0.1  3   -­‐0.3  4   -­‐0.6  5   -­‐0.7  6   -­‐0.9  7   -­‐1.1  …   …  91   -­‐59.5  92   -­‐63.2  93   -­‐64.9  94   -­‐65.0  95   -­‐65.2  96   -­‐66.5  97   -­‐67.8  98   -­‐93.9  99   -­‐110.0  100   -­‐273.1  

VaR

Page 32: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Value-at-Risk ¡ Loss severity measure for a given probability and time

horizon

1-day 95% VaR of $1m Expect to lose no more than$1m in 95 out of every 100 days Says nothing about the other 5 days out of 100. Not very reassuring, is it?

Page 33: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Tail Value-at-Risk (TVaR) ¡ Loss severity measure for a given probability and time

horizon

•  Estimate potential losses (or historical losses)

•  Rank losses based on severity •  95% Tail Value-at-Risk is equal

to average of all losses beyond 95th percentile loss

•  Expect to lose on average $122m if losses exceed the 95th percentile

Rank   Loss  1   -­‐0.1  2   -­‐0.1  3   -­‐0.3  4   -­‐0.6  5   -­‐0.7  6   -­‐0.9  7   -­‐1.1  …   …  91   -­‐59.5  92   -­‐63.2  93   -­‐64.9  94   -­‐65.0  95   -­‐65.2  96   -­‐66.5  97   -­‐67.8  98   -­‐93.9  99   -­‐110.0  100   -­‐273.1  

TVaR

Page 34: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Tail Value-at-Risk (TVaR) ¡ Loss severity measure for a given probability and time

horizon

1-day 95% TVaR of $122m Better Measure of Risk Also known as Expected Shortfall, CVaR

Page 35: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Application: Operational Risk Management ¡ Definition: The risk of direct and indirect loss resulting

from inadequate or failed: ¡  Internal processes

¡  People

¡  IT systems

¡  External events

Source: NYFed

Operational Risk

External Criminal Activity

Information security failure

Internal Criminal Activity Unauthorized

Activity

Processing Failure

System Failure

Control Failure

Business Disruption

Workplace Safety Malpractice

Page 36: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Managing OpRisk ¡ One Approach

Source: NYFed

Assess Scorecard Identify

Weakness

Internal Loss Data

Risk Scenarios

Risk Model OpVar

Risk Capital

Page 37: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Methods ¡ Scorecard ¡  KRI scoring models

¡  Useful where no severity data exists

¡ Loss Distribution ¡  Estimation of severity distribution parameters

¡ MLE Not robust – data not i.i.d., biased upwards, subject to data paucity & sparsity

¡  Leads to biased loss exposures and correlation assumptions

¡ Huge opportunity for inference-based analytics

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Impact

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Page 38: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Looking Forward

Page 39: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

ERM Trends

Source: NCSU

¡ Increasing adoption of ERM

Page 40: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Fraud Detection Top Concern

But Low Adoption.

Forensic Data Analytics

Source: Ernst & Young

Page 41: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Promise of Data Analytics ¡ EDW remains a huge issue for most corporations ¡  Legacy zombie systems

¡  IT reporting lines

¡ Increased understanding by senior managers and C-suite

¡ Analytics as a Service: growing competition within consulting industry

¡ Talent Gap – same for anything Data Science

Page 42: Role of Data Science in ERM @ Nashville Analytics Summit Sep 2014

Thank you