The ERM Current™

This week’s rescue of Citigroup serves as a prime example of how fragmented approaches to risk management can have disastrous consequences.  The New York Times presented a thorough review of the actions and inactions occurring within the ranks at Citigroup that ultimately led to far excessive risk-taking.  In short, the risk oversight was relegated to those in the business units who had the most to gain by taking excessive risks.  This, in turn, led to the creation of a culture that considered risk management as an after-thought and did not promote a full understanding of risks across the enterprise.  Lynn Turner, formerly the chief accountant at the Securities & Exchange Commission, offered his view of Citigroup in the article.

“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”

Financial and non-financial corporations alike should use the case of Citigroup as an example of how not to structure their risk management programs.  To be truly effective, enterprise risk management programs should be supported by a strong culture, strong controls and strong competencies in risk management disciplines. Visit www.WheelhouseAdvisors.com to learn more about building an effective enterprise risk management program.

Former SEC Commissioner Arthur Levitt recently testified before the Senate Banking Committee and offered his perspective on how to strengthen the regulatory oversight system in dire need of repair.  

“As we move forward in the process, we must make sure that there is an agency that is independent of the White House, dedicated to mandating transparency with robust law enforcement powers, with the wherewithal and knowledge to oversee and if necessary guide risk management, and built around one mission: protecting the interests of investors.  If we do, investors will know that they have someone in their corner, that the markets will be free and fair, and that they will invest with confidence.”

As Mr. Levitt suggests, the key to stabilizing the financial markets is by restoring trust and one of the critical elements to restoring trust is effective regulatory oversight and risk management.

An article in yesterday’s Washington Post provided some interesting details behind the collapse of Washington Mutual.  It appears that the Office of Thrift Supervision (“OTS”) failed in its job to provide effective oversight by allowing executives at the nation’s largest savings and loan institution to ignore the advice of its own risk managers.  Here is an excerpt from the article.

In 2005, a small group of senior risk managers drew up a plan that would have required loan officers to document that borrowers could afford the full monthly payment on option ARM loans. The plan was shared with OTS examiners, according to a former bank official who spoke on condition of anonymity because the bank’s practices are the focus of a federal investigation as well as several lawsuits. ”We laid it out to the regulators. They bought into it. They supported it,” the former official said.  But when a new executive team at the bank nixed the plan, the former official said, “the OTS never said anything.”

This is another example of the breakdown in regulatory oversight and management that fueled the current financial crisis.  It also shows that what is needed most is not necessarily more regulation, but more effective regulation.

Corporate executives are beginning to shift their priorities in response to the financial crisis and deteriorating economic conditions according to a recent survey by The Conference Board as reported in yesterday’s Wall Street Journal.  It is no surprise that risk management is now a top concern.  What is somewhat perplexing is that risk management was not a top concern when the same survey was conducted in July (see survey results below).  

Risk management should always be a top concern, but many do not consider it as a primary focus area until times of crisis.  While it is human nature to react in this manner, the full benefit of strong enterprise risk management programs is gained by averting such periods of crisis.  Risk management attention and investment at this time is certainly warranted.  However, let’s hope the investment and discipline is maintained so another crisis of this magnitude never comes to pass.   

It appears that the US Congress is beginning to ask themselves once again why they voted for a hastily arranged piece of legislation.  In testimony yesterday to the US House Financial Services Committee, Treasury Secretary Paulson had a rough time explaining why he used his $350 billion “allowance” in a way that differed from the original expectations.  Here is what Rep. Spencer Bachus of Alabama, the panel’s top Republican, had to say:

“Changing too quickly, without adequately explaining why you’ve changed or what you’re going to do next, risks sending mixed signals to a marketplace that is in dire need of certainty and a sense of direction.”

In addition, American Bankers Association Chairman and CEO Edward Yingling said during the hearing,

“…it (TARP) is also a source of great frustration and uncertainty to banks. Much of the frustration and uncertainty is because of the significant and numerous changes to the program and misperceptions that have resulted on the part of the press and the public.”

The continued changes to the application of the rescue packages are leaving both Congress and our financial markets asking themselves the same question – “Which way is up?”  It seems no one knows the answer.

Yesterday, Rick Steinberg wrote a great article in Compliance Week detailing the many failures of risk management leading to the recent financial market crisis.  For those of you who may not know,  Mr. Steinberg is a leading authority on the topic of risk management and a principal author of the COSO Internal Control Framework that has become the de facto standard for public corporations and their boards of directors.  As such, Mr. Steinberg has a unique perspective of the unfolding events in each of the firms that have contributed to the market collapse.  In particular, Mr. Steinberg points to boards and their responsibility for holding senior management accountable.  He states,

“….the board must understand what management is doing to identify, assess, and manage significant risks facing the company. It must be comfortable that management has a process in place, and that the process is working effectively. The board must be comfortable with management’s appetite for taking on risk, and that senior management is positioned to obtain accurate information about key risks and relays that information to the boardroom.”

While he also notes areas of weakness with other players such as the regulators and credit rating agencies, it is this critical component of risk management and corporate governance that cannot be ignored.  Without a strong enterprise risk management process and frequent communication between board members and management, companies will not be able to navigate the critical risks and new regulatory environment that is now on the horizon.

In a speech last week to the Banque Centrale du Luxembourg, Vice Chairman of the Federal Reserve Donald Kohn provided a thorough analysis of events leading to the current financial crisis.  A major portion of his remarks focused on the inadequate investment in risk management by many financial institutions.  In his view, the long period of relative stability in financial markets bred a high level of complacency and inattention to the growing risks.  As he stated,

“Complacency contributed to the unwillingness of many financial market participants to enhance their risk-management systems sufficiently to take full account of the new (perhaps unknown) risks they were taking on.”

Risk management should be a primary focus of all companies, financial and non-financial, at all times.  It is precisely the moment when profits are at their peak and economic times are good that companies should be most vigilent.  Now, we are in catch-up mode and must make greater investment in risk management to ensure complacency does not become part of the risk equation again.

The Group of Twenty (“G-20″) met in Washington, DC on Saturday to jointly develop action plans to address the growing economic crisis sweeping the globe.  A need for greater transparency and accountability in our financial markets served as the primary theme for the meeting.  The result of their discussion was a strong declaration regarding the root causes of the problems we are facing and recommended actions to remedy the situation.  One of their action plans focused squarely on risk management.  Below are the related risk management actions to be taken by the end of March 31, 2009.  

• Regulators should develop enhanced guidance to strengthen banks’ risk management practices, in line with international best practices, and should encourage financial firms to reexamine their internal controls and implement strengthened policies for sound risk management.
• Regulators should develop and implement procedures to ensure that financial firms implement policies to better manage liquidity risk, including by creating strong liquidity cushions.
• Supervisors should ensure that financial firms develop processes that provide for timely and comprehensive measurement of risk concentrations and large counterparty risk positions across products and geographies.
• Firms should reassess their risk management models to guard against stress and report to supervisors on their efforts.
• The Basel Committee should study the need for and help develop firms’ new stress testing models, as appropriate.
• Financial institutions should have clear internal incentives to promote stability, and action needs to be taken, through voluntary effort or regulatory action, to avoid compensation schemes which reward excessive short-term returns or risk taking.
• Banks should exercise effective risk management and due diligence over structured products and securitization.

A great deal of work will be required to properly address these recommendations.  However, the end result will be a much stronger global economy.  Wheelhouse Advisors can help your company quickly assess its risk & control programs and provide cost-effective solutions to the recommended actions.  Visit our website at www.WheelhouseAdvisors.com to learn more.

The sudden about-face in the direction of the US Treasury’s Troubled Asset Relief Program (“TARP”) has brought on new fears of increasing systemic risk in the financial markets.  TARP was originally intended to lower systemic risk by ridding the markets of the toxic securities that currently plague the balance sheets of numerous financial institutions.  By leaving those securities on the balance sheets, many believe that a crisis in confidence will re-emerge.  Bloomberg.com noted the following comments yesterday from a credit strategist at BNP Paribas,

“Substantial risk still remains within the U.S. financial system,” said Rajeev Shah, a London-based credit strategist at BNP Paribas.  ”Uncertainty about existing troubled assets could lead to increasing systemic risk.”

Where do we go from here?  Who knows?  However, one thing is certain.  Changing plans in mid-stream is certainly no way to reduce uncertainty in the financial markets.

Yesterday, the Wall Street Journal discussed the impact of moral hazard on the behavior of both corporations and individuals.  With the ever increasing amounts of money being doled out to those who invested in risky derivative securities and their underlying assets, the impact of moral hazard cannot be ignored.  Wikipedia defines moral hazard in the following way.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

There is great debate about whether the current efforts by the US Government will lead to a greater risk of increasing moral hazard.  Some may compare today’s situation to the behavior of the good ol’ boys in the old TV show, “The Dukes of Hazzard”.  They never crashed their car or went to jail even though they drove recklessly in every episode.  Sound familiar?