New Task Force Established to Combat Financial Fraud

Yesterday, the Obama Administration announced the creation of a new task force dedicated to rooting out individuals who participated in fraudulent activities that led to the great financial meltdown of 2008.  The new organization is aptly named the Financial Fraud Enforcement Task Force and is composed of members from over 24 federal agencies.  It will be chaired by Attorney General Eric Holder.  Here is more on the task force from a Securities & Exchange Commission press release.

The task force, which replaces the Corporate Fraud Task Force established in 2002, will build upon efforts already underway to combat mortgage, securities and corporate fraud by increasing coordination and fully utilizing the resources and expertise of the government’s law enforcement and regulatory apparatus. The attorney general will convene the first meeting of the Task Force in the next 30 days.

“This task force’s mission is not just to hold accountable those who helped bring about the last financial meltdown, but to prevent another meltdown from happening,” Attorney General Eric Holder said. “We will be relentless in our investigation of corporate and financial wrongdoing, and will not hesitate to bring charges, where appropriate, for criminal misconduct on the part of businesses and business executives.”

While noble in its intent, this new task force faces several challenges.  First, its membership is quite large and politically unwieldy.  Second, it is made up of agencies that were charged with enforcing laws and regulations that were intended to prevent fraudulent activity from occurring in the first place.  Third, its creation falls on the heels of an unsuccessful prosecution of hedge fund managers that brought Bear Stearns to its knees.  Only time will tell if the task force can successfully achieve its mission.

Financial Risk Management in the 21st Century

Last week, an article in InformationWeek magazine profiled the current issues with the financial industry’s risk management practices and offered some solutions.  The article compared the approaches to risk management in the financial industry to the design and production of computer chips.  Both are highly complex exercises.  However, risk management to date lacks the standardization and control found in chip manufacturing.  Here is what the article suggests as a solution.

The industry’s kludge-filled, error-prone, and unsafe financial engineering needs to be replaced with a more secure financial infrastructure that’s been tested and debugged to the level of a major chip release. Regulatory oversight won’t be simple, but it doesn’t have to be. It just has to work, every single day and for every single transaction. That’s the type of change with the potential to jump-start a global economy.

Through stronger controls over data collection, improved networking among industry participants, and greater use of standards across a wider range of financial instruments, the future of the financial services industry can be assured in a way that enables a bright future for the rest of the economy. It’s high time for the industry’s circuits to get an upgrade.

The article provides a unique perspective on a major problem.  The solution is fairly obvious, but the task is massive and will require a significant investment to successfully implement.  However, our global economy and the financial services industry as a whole will suffer additional crisis situations in the 21st century without this sort of change.

Global Solutions for a Global Problem

Last week, the Wall Street Journal in the United Kingdom published an article featuring the views of Britain’s Financial Services Authority Chairman Adair Turner.  Given the continued debate and relative inaction from the U.S. Congress, the thoughts from Lord Turner are particularly refreshing.  Here’s what he had to say:

One, finance got too big. “We must be more willing to ask…whether the financial system is delivering its vital economic functions as efficiently as possible, or whether parts of it can, and before the crisis did, swell beyond their economically efficient size,” he said in a recent speech.

Two, there was too much debt in the system. “There is a huge bias in the tax system towards debt,” he said, largely because companies can deduct interest payments before computing taxable profits. “If we can’t change that, then the regulatory approach needs to lean against that.”

Three, regulators failed to curb excesses, but politicians hardly encouraged aggressive regulation. The cry for “better regulation” meant less regulation, both in the U.K. and U.S. The diagnosis of Britain’s economic woes was that regulation was stifling entrepreneurship, he said.

Four, erecting a wall between ordinary deposit-taking and lending, on one hand, and trading on the other is impractical and unwise. Economies benefit when banks turn loans into securities or hedge their positions — to a point. But by forcing banks to hold capital in the trading operations to provide thicker cushions to absorb losses — he calls it “a bias towards conservatism” in trading beyond what is necessary for ordinary banking — speculative trading will migrate away from banks toward hedge funds and the like, a change Lord Turner welcomes.

Five, for all the angst about the slow pace of post-crisis repair of the financial system, global regulators are making surprising progress toward consensus on a new regulatory regime. “We are attempting in 18 months to do changes far more radical than we did in Basel II that took between 12 and 15 years and dealt with some of the areas which proved to be less important,” Lord Turner said, referring to the pact regulators reached in the Basel Committee on Banking Supervision that didn’t avoid the crisis. Pushed by the newly empowered Financial Stability Board, the process, he said, “has worked better than I would have expected,” he said.

Since the crisis was global in both cause and impact, it is encouraging that some are working towards global solutions to the problem.  As the regulatory reform effort unfolds, the U.S. must ensure that our reforms are aligned with our global partners.

Regulatory Reform “Doublethink”

What has happened to the promise of transparency and accountability?  According to a recent article in the New York Times, it has become a real-world example of “doublethink” – a term coined by George Orwell, the author of the famous novel 1984.  On the heels of one of the most serious financial crises of the past 100 years, the U.S. Congress is working against providing greater transparency and accountability.  Here is what the Times reported.

It took just five weeks after the WorldCom accounting scandal erupted in 2002 for Congress to pass, and President George W. Bush to sign, the Sarbanes-Oxley Act. That law required public companies to make sure their internal controls against fraud were not full of holes. It took three more years for Bernard Ebbers, the man who built WorldCom into a giant, to be sentenced to 25 years in prison for his role in the fraud.

Mr. Ebbers will be 85 years old before he is eligible for release from prison. He may be freed, however, before the law is ever enforced on the vast majority of American companies. A Congressional committee voted this week to repeal a crucial part of the law. Other parts are also under attack. Sarbanes-Oxley was passed, almost unanimously, by a Republican-controlled House and a Democratic-controlled Senate. Now a Democratic Congress is gutting it with the apparent approval of the Obama administration.

The House Financial Services Committee this week approved an amendment to the Investor Protection Act of 2009 — a name George Orwell would appreciate — to allow most companies to never comply with the law, and mandating a study to see whether it would be a good idea to exempt additional ones as well. Some veterans of past reform efforts were left sputtering with rage. “That the Democratic Party is the vehicle for overturning the most pro-investor legislation in the past 25 years is deeply disturbing,” said Arthur Levitt, a Democrat who was chairman of the Securities and Exchange Commission under President Bill Clinton. “Anyone who votes for this will bear the investors’ mark of Cain.”

Restoring investor confidence in the financial system is the most effective path towards long-term economic recovery. These actions may remove a short-term burden from some companies, but the long-term impact to investor confidence will be severe – just ask the former stockholders of WorldCom.

Leaders Fail to Recognize Risks

A new book detailing the events leading up to the recent global financial crisis hit the shelves this week and it is a compelling read.  Entitled “The Sellout”, the book provides an inside look within the largest financial institutions that contributed to the massive meltdown.  Author Charlie Gasparino provides a candid view of the leaders at these organizations as the Wall Street Journal reports below.

Mr. Gasparino chronicles how, across Wall Street in the years before the 2008 crisis, managers with a healthy fear of risk lost corporate power struggles to men more likely to ignore it. Stanley O’Neal, who climbed to the top at Merrill Lynch, would use the company helicopter to visit his favorite golf courses but never found time to learn about his firm’s multi-billion-dollar “warehouse” of collateralized debt obligations. Even after Mr. O’Neal was fired in late 2007, Merrill’s board somehow decided against hiring Lawrence Fink, a mortgage-market expert, and instead hired John Thain as CEO. During the interview process, Mr. Gasparino reports, Mr. Thain never even asked to see details on the assets that were generating billions of dollars in losses. A spokesman for Mr. Thain denies this account.

While many factors played a role in the crisis, it is apparent through Mr. Gasparino’s book that a large portion of the blame rests on the failure of  leadership to understand and appreciate the risks they were taking.  This is a primary reason that leaders must demand strong enterprise risk management practices at their companies.

Sarbanes-Oxley Deja Vu

Last week, the U.S. House of Representatives proposed amendments to the Investor Protection Act of 2009 that will in essence seek to roll back some of the reforms implemented as a result of the Sarbanes-Oxley Act of 2002.  Specifically, Representatives Carolyn Maloney and Scott Garrett are seeking to exempt public companies with a market capitalization of less than $75 million from the requirement to have their internal controls audited by an external firm.

Their approach is to request the SEC to perform a study on the costs of compliance for these firms and then, determine the need for the requirement. While this may be a reasonable request, it has already been made and the SEC completed a similar study this year.  As a result, the SEC confirmed the need for the external audit and announced it will be required of all companies next year.  The Huffington Post reported that several investor advocate groups as well as a former SEC chairman were outraged by the proposed amendment.  Read more at: http://www.huffingtonpost.com/2009/10/27/house-democrats-john-adle_n_334876.html

Rude Lesson in Risk Management

A leading risk management expert and chief risk officer at a major U.S. financial institution offered his insight on risk management practices last week in the Columbus Business First Journal.  His views are candid and becoming more common as the dust begins to settle from the recent financial crisis.  Here is what he had to say.

Kevin Blakely, senior executive vice president of Huntington Bancshares Inc. in Columbus and its chief risk officer said years ago, things were relatively simple. “Most of our risk was centered in credit risk – lending to individuals and companies, and gauging our ability to get that money back,” he said. Until this past summer, Blakely had been president of the Philadelphia-based Risk Management Association. But as companies got bigger and financial products got more complex, financial institutions developed mathematical models to measure risk. They worked well, he said, but by the mid-1990s banks were depending on them too much. “We began to view them as the answer, rather than as one more input before you get to the answer,” Blakely said. “That was one of the rude lessons we learned over the last couple of years. As an industry, we weren’t as smart in the business of risk management as we thought we were.”

The false sense of security placed in risk management was certainly a rude lesson for many companies as they focused on quantitative models that told them what they wanted to believe.  A balanced view of both quantitative and qualitative factors is critical to an effective enterprise risk management program.

JP Morgan Chase CEO Discusses Risk Management

Yesterday, JP Morgan Chase CEO Jamie Dimon shared his views on the financial crisis with Charlie Rose at the Securities Industry and Financial Markets Association annual meeting in New York.  In the interview, Mr. Dimon reflected on risk management approaches taken by many financial institutions leading up to the crisis.  He stated, “You should never rely solely on VaR, Basel I or Basel II for risk management practices.  If you did, it was a mistake.”   He went on to explain that sound risk management practices require both quantitative analysis and management judgment to be effective.  He also noted that there are legitimate failures in the application of the Basel II Capital Accord that left many institutions with insufficient capital positions.   His full remarks can be viewed in the video web link below.

Jamie Dimon speaks with Charlie Rose at SIFMA Annual Meeting

Regulators Stepping-up ERM Examinations

Yesterday, an article by FinCriAdvisor highlighted how regulators are stepping-up their reviews of enterprise risk management (“ERM”) programs at both large and small financial institutions.  As they have been calling for stronger enterprise risk management practices, regulators have also been working on new ERM guidance that banks will need to follow in the future.  Here is a portion of what was reported.

Regulators have begun to focus more heavily on the way banks handle risk assessment, urging in recent testimony and regulatory updates – as well as in examinations – that institutions move toward an “enterprise risk management” model.  ”There is an increasing interest with the regulators, no doubt, and a lot of risk management guidance in the works,” adds Bernard Mason, regulatory relations liaison with the Risk Management Association (RMA) in Washington, D.C. He cites new commercial real estate credit concentration rules that lean heavily on risk management, pending rules on liquidity risk management that would tie U.S. guidelines with those of COSO and Basel, and new September guidance on correspondent risk management.  ”Clearly, regulators are asking banks to identify risk appetite,” agrees Mark Zmiewski, head of research at the RMA in Philadelphia. “That reaches a higher level of importance today under governance issues.” This includes the role of the board in establishing the bank’s risk appetite (the amount of risk it is willing to accept to increase earnings), how well-versed senior management is in carrying out that plan, and how well risk is measured and monitored, he says.

Is your company prepared for the greater ERM scrutiny?  If not, Wheelhouse Advisors can provide cost-effective solutions.  Visit www.WheelhouseAdvisors.com to learn more.

Fair Warning to Improve Risk Management

This week, a report was published by the Senior Supervisors Group (“SSG”) regarding risk management lessons learned from the 2008 financial crisis.  For those who do not know, the SSG is a group of central regulatory agencies from seven nations including the United States.  The report highlights the following deficiencies in risk management practices at major corporations across the globe.

Some of the highlighted areas of greatest need, such as board and management oversight, articulation of risk appetite, and compensation practices, are potentially a result of the aforementioned imbalance between the stature and resources allocated to firms’ revenue-generating businesses and those afforded to the reporting and control functions. Other areas, such as risk aggregation and concentration identification, stress testing, and credit and counterparty risk management, can also be attributed to the weak condition of many firms’ IT infrastructure. While considered central to sound firm governance and risk management, the areas of continued improvement addressed here are not exhaustive.

In highlighting the areas where firms must make further progress, we seek to raise awareness of the continuing weaknesses in risk management practice across the industry and to evaluate critically firms’ efforts to address these weaknesses. Moreover, the observations in this report support the ongoing efforts of supervisory agencies to define policies that enhance financial institution resilience and promote global financial stability.

This report serves as fair warning for financial institutions to proactively strengthen their own risk management practices before the regulatory authorities are compelled to force necessary changes.  If your company is looking for cost-effective solutions, Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more.