The ERM Current™

The Risk and Insurance Management Society released a white paper this week that examines the role of Enterprise Risk Management in the current financial crisis.  The paper highlights a number of lessons learned that can be applied to companies in all industries, not just financial institutions.   Here is a summary of those lessons learned:

Ultimately, when we look for a cause of the current financial crisis, it is critical to remember that organizations failed to do a number of things:

a) truly adopt an enterprise risk management culture

b) embrace and demonstrate appropriate enterprise risk management behaviors, or attributes

c) develop and reward internal risk management competencies, and

d) use enterprise risk management to inform management decision-making in both taking and avoiding risks.

Enterprise risk management, when designed and implemented comprehensively and systemically, can change future outcomes. When it is practiced fully, enterprise risk management does not just help protect businesses from setbacks, it enables better overall business performance. With that in mind, and with so much economic uncertainty on the horizon, now is the perfect opportunity for organizations to use the many strengths of a solid enterprise risk management program to their advantage.

Wheelhouse Advisors is uniquely equipped to help companies implement a solid enterprise risk management program in a cost-effective way.  Visit www.WheelhouseAdvisors.com to learn more.

President Obama’s nominee to head the U.S. Securities and Exchange Commission (“SEC”), Mary Schapiro, recently responded to inquiries about her view on compliance with Section 404 of the Sarbanes-Oxley Act (“SOX 404″).  This section of the Act has been widely criticized as overly burdensome and costly.  However, in light of the escalating number of financial reporting frauds related to the recent financial crisis, this view is changing.  Here are Ms. Schapiro’s thoughts on SOX 404.

Regarding, SOX 404, accurate, robust, and easy-to-understand financial reporting — and the internal controls that guarantee it — are critically important to investors and to the efficient functioning of our markets. Right now, we have a system where some issuers are complying with 404 and others are still exempt from it. It’s time that we bring uniformity to the system so that investors know what to expect from companies, while being sensitive to the needs of small businesses. I look forward to working with the small business community in making sure they have the tools they need to comply with 404.

This is certainly an 180 degree about-face for the SEC, who under the leadership of Chairman Christopher Cox worked to delay full compliance for many years.  For those companies hoping for another delay, it will not be coming.  If your company needs assistance with SOX 404 compliance, email Wheelhouse Advisors at NavigateSuccessfully@WheelhouseAdvisors.com to learn more about cost-effective compliance solutions.

A recent article in Business Finance Magazine highlights the rising tide of interest in Enterprise Risk Management. More companies are realizing that risk takes many forms and the agility to address risk events effectively is a key source of competitive advantage.  

Given the focus on risk at many firms, it’s not surprising that the concept of “enterprise risk management” is capturing greater interest. In the past, most financial executives could zero-in on their companies’ exposure to financial risks and not be as concerned with operational risk, says Carol A. Fox, chair of the ERM Development Committee at the Risk and Insurance Management Society (RIMS). Now, they have to be aware of potential surprises on the operational side, as well. “Risk management can’t be siloed and be effective,” she says.

Visit www.WheelhouseAdvisors.com to learn more about how we can help your company implement and streamline an Enterprise Risk Management program.

The Government Accountability Office recently released its proposed framework for modernizing the U.S. financial regulatory system.  The report provides a great overview of the evolution of our current, byzantine regulatory agency structure and offers some broad objectives for establishing a new structure.  Here is a summary of their proposed objectives.

1. Clearly defined regulatory goals - Goals should be clearly articulated and relevant, so that regulators can effectively carry out their missions and be held accountable. Key issues include considering the benefits of re-examining the goals of financial regulation to gain needed consensus and making explicit a set of updated comprehensive and cohesive goals that reflect today’s environment.

2. Appropriately comprehensive - Financial regulations should cover all activities that pose risks or are otherwise important to meeting regulatory goals and should ensure that appropriate determinations are made about how extensive such regulations should be, considering that some activities may require less regulation than others. Key issues include identifying risk-based criteria, such as a product’s or institution’s potential to create systemic problems, for determining the appropriate level of oversight for financial activities and institutions, including closing gaps that contributed to the current crisis.

3. Systemwide focus - Mechanisms should be included for identifying, monitoring, and managing risks to the financial system regardless of the source of the risk. Given that no regulator is currently tasked with this, key issues include determining how to effectively monitor market developments to identify potential risks; the degree, if any, to which regulatory intervention might be required; and who should hold such responsibilities.

4. Flexible and adaptable - A regulatory system that is flexible and forward looking allows regulators to readily adapt to market innovations and changes. Key issues include identifying and acting on emerging risks in a timely way without hindering innovation.

5. Efficient and effective - Effective and efficient oversight should be developed, including eliminating overlapping federal regulatory missions where appropriate, and minimizing regulatory burden without sacrificing effective oversight. Any changes to the system should be continually focused on improving the effectiveness of the financial regulatory system. Key issues include determining opportunities for consolidation given the large number of overlapping participants now, identifying the appropriate role of states and self-regulation, and ensuring a smooth transition to any new system.

6. Consistent consumer and investor protection - Consumer and investor protection should be included as part of the regulatory mission to ensure that market participants receive consistent, useful information, as well as legal protections for similar financial products and services, including disclosures, sales practice standards, and suitability requirements. Key issues include determining what amount, if any, of consolidation of responsibility may be necessary to streamline consumer protection activities across the financial services industry.

7. Regulators provided with independence, prominence, authority, and accountability -Regulators should have independence from inappropriate influence, as well as prominence and authority to carry out and enforce statutory missions, and be clearly accountable for meeting regulatory goals. With regulators with varying levels of prominence and funding schemes now, key issues include how to appropriately structure and fund agencies to ensure that each one’s structure sufficiently achieves these characteristics.

8. Consistent financial oversight - Similar institutions, products, risks, and services should be subject to consistent regulation, oversight, and transparency, which should help minimize negative competitive outcomes while harmonizing oversight, both within the United States and internationally. Key issues include identifying activities that pose similar risks, and streamlining regulatory activities to achieve consistency.

9. Minimal taxpayer exposure - A regulatory system should foster financial markets that are resilient enough to absorb failures and thereby limit the need for federal intervention and limit taxpayers’ exposure to financial risk. Key issues include identifying safeguards to prevent systemic crises and minimizing moral hazard.

These objectives were based on the GAO’s analysis (see below) of the developments leading to the current financial crisis and regulatory shortcomings.  

As the report shows, it has taken more than a century to create the current regulatory structure.  The change required to achieve the GAO’s objectives is massive and will require strong leadership and determination to succeed.

The current Special Inspector General of the Troubled Asset Relief Program (“SIGTARP”) is working to begin a formal audit of the TARP as a result of the lack of transparency into how the initial funds have been utilized by financial institutions.  The head of SIGTARP, Neil Barofsky, detailed his concerns last Thursday in a letter to Charles Grassley, the ranking member of the U.S. Senate Finance Committee.  Here is an excerpt from that letter.

“the current lack of transparency with respect to what recipients are doing with the money could hamper the ability of SIGTARP – as well as the other oversight bodies and of Congress –  to assess the effectiveness of various TARP initiatives over time.  In the context of a program this large and this important to the Nation’s economic recovery, addressing the basic question, “Where did the money go?” is critical to credible and effective oversight of TARP.”

Here is Senator Grassley’s response to Mr. Barofsky’s letter.

“The mindset expressed by the Special Inspector General in this letter gives me hope that greater transparency can be achieved for the taxpayers with the massive effort to rescue America’s financial system. Lack of transparency, lack of accountability, and taking advantage of others were major factors in creating the financial crisis. The rescue effort won’t succeed if it’s got those same problems. I encourage the Special Inspector General to be as aggressive as possible in achieving full disclosure of how TARP dollars have been spent and will be spent so that program assessments can be made and future actions are as effective as possible.”

Let’s hope the SIGTARP finds an answer to their basic question quickly so that future funds are utilized in an efficient and effective way.

The lack of transparency into the TARP program is well known and a primary source of criticism.  The Wall Street Journal has presented new information into the side deals by our elected officials that are plaguing the rescue effort. In an article yesterday, they noted the following:

The goal of aiding only banks healthy enough to lend — laid out by the Treasury when the program began — clearly seems to have shifted, but in a way that’s hard to pin down and that the Treasury has declined to explain. Part of the problem is that some powerful politicians have used their leverage to try to direct federal millions toward banks in their home states.

One of those politicians is none other than Barney Frank, chairman of the U.S. House Financial Services Committee. According to the Wall Street Journal, Rep. Frank directed the issuance of $12 million in TARP funding to OneUnited, a small bank in Rep. Frank’s home state of Massachusetts.  Just prior to issuing this money, OneUnited had been given a “cease and desist” order by the FDIC due to poor lending practices and executive compensation abuses.  In addition, the bank was ordered to dispose of a 2008 Porsche sports-car that had been reserved for executive use.  Given the depreciation of high-end sports-cars, the Porsche must have qualifed as a “troubled asset”.  

Back door dealings and excessive pay practices led us into this current financial crisis.  Continuing these practices under the guise of a rescue effort will certainly doom it to failure.  Here is Rep. Frank discussing his planned bill to place restrictions on use of TARP funds.  Let’s hope he includes a Porsche restriction provision in the bill.

President Obama’s nominee for Secretary of Treasury, Timothy Geithner, finally testified at his Senate confirmation hearing yesterday after a week delay caused by the disclosure of his failure to pay income taxes several years ago. Evidently, this issue was discovered in early December and disclosed to the Senate panel responsible for examining Mr. Geithner’s nomination.  However, it was not disclosed to the public until last week.  Only then did the Senate Finance Committee decide to delay his confirmation hearing to investigate further.  

Whether or not paying his taxes was just an honest mistake on Mr. Geithner’s part is not the larger issue here. The larger issue is the lack of disclosure and transparency into the nomination process.  Mr. Geithner’s comments to the committee were ironic given the situation.  Here is an excerpt from his prepared testimony about the much maligned TARP program.

I know there are serious concerns about transparency and accountability, confusion about the goals of the program, and deep skepticism about whether we are using the taxpayers’ money wisely.  Many people believe the program has allowed too much upside for financial institutions, while doing too little for small business owners, families who are struggling to keep their jobs and make ends meet, and innocent homeowners.  

We have to fundamentally reform this program to ensure that there is enough credit available to support recovery.  We will do this with tough conditions to protect the taxpayer and the necessary transparency to allow the American people to see how and where their money is being spent and the results those investments are delivering.  And we are going to do that.  This is an important program and we need to make it work.

Mr. Geithner is right in his comments.  We need to make the TARP program work and the only way to do that is to provide full disclosure and transparency.  Without it, investor confidence will not return to our financial markets anytime soon.

Last week, a document was released by the Group of Thirty that provides some interesting ideas and insight into the future of our financial regulatory system.  For those unfamiliar with the Group of Thirty, it is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia that aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.  Notable members of the Group of Thirty include Paul Volcker, Tim Geithner, and Lawrence Summers – all future members of the Obama Administration.  

The document is entitled “Financial Reform: A Framework for Financial Stability” and provides recommendations for improving our financial system once we have moved beyond the immediate financial crisis we are in today.  Of particular interest to readers of this blog are the following set of recommendations focused on governance and risk management. 

Regulatory standards for governance and risk management should be raised, with particular emphasis on:

a. Strengthening boards of directors with greater engagement of independent members having financial industry and risk management expertise;

b. Coordinating board oversight of compensation and risk management policies, with the aim of balancing risk taking with prudence and the long-run interests of and returns to shareholders;

c. Ensuring systematic board-level reviews and exercises aimed at establishing the most important parameters for setting the firm’s risk tolerance and evaluating its risk profile relative to those parameters;

d. Ensuring the risk management and auditing functions are fully independent and adequately resourced areas of the firm. The risk management function should report directly to the chief executive officer rather than through the head of another functional area;

e. Conducting periodic reviews of a firm’s potential vulnerability to risk arising from credit concentrations, excessive maturity mismatches, excessive leverage, or undue reliance on asset market liquidity;

f. Ensuring that all large firms have the capacity to continuously monitor, within a matter of hours, their largest counterparty credit exposures on an enterprisewide basis and to make that information available, as appropriate, to its senior management, its board, and its prudential regulator and central bank;

g. Ensuring industrywide acceptance of and action on the many specific risk management practice improvements contained in the reports of the Counterparty Risk Management Policy Group (CRMPG) and the Institute of International Finance.

These are great recommendations that will certainly strengthen the governance and risk management of our financial institutions.   However, implementation of these recommendations will take a great deal of effort and time.  The sooner we can begin to address these recommendations, the better.

More and more companies are looking for ways to reduce expenses and a popular method recently has been outsourcing.  While many benefits come with an outsourced relationship, so does increased risk.  Proper due diligence and carefully crafted service level agreements are essential.  However, with the recent fraud at Satyam in India, those activities may not be enough.  A recent article in CFO magazine highlights the problem. Here is a excerpt from that article.

The enormously inflated cash balances at Satyam have popped a hole in the reputation of the outsourcing market, which has grown from business offering solely tech business, to back-office work such as finance and accounting. “This has really shaken up the outsourcing industry,” says Peter Allen, a partner and managing director for outsourcing advisory firm TPI. “The industry is built on relationships that imply some level of trust and confidence and integrity.”

How comfortable are you with your outsourcing partner?  Have you assessed the risks with the relationship lately?  If not, Wheelhouse Advisors can help.  Visit www. WheelhouseAdvisors.com to learn more.

Corporate boards of directors have their plates very full these days with mounting financial pressures and, as a result, it is becoming painfully obvious that having a solid understanding of risk management is critical.  A recent article in Corporate Board Member magazine highlights the role of the board as it relates to effective risk management.

In the view of most directors, risk is the responsibility of the full board and the crux of the job. That’s why it is essential that the board become comfortable with the way management perceives and deals with risk in the company’s operations. Management needs a company-wide process for uncovering risk, usually some kind of enterprise-risk-management system that aggregates all the known risks the company faces—from access to capital to talent retention to viruses in the software—and prioritizes them according to the magnitude of their potential effects on the company and the probability of their occurrence. Then it is the board’s role to define the 10 or 20 most important risks, making them regular agenda items and part of every discussion of strategy.

Wheelhouse Advisors can assist management or boards of directors in developing a cost-effective enterprise risk management framework that will facilitate a better understanding of how risks are being managed throughout the company.  Visit www.WheelhouseAdvisors.com to learn more.