The ERM Current™

A recent survey of banking executives across the world provides confirmation of the very issues discussed on The ERM Current™ and should be a wake-up call to all corporate boards of directors – financial and non-financial alike.   The survey was conducted by KPMG and here is a sample of the results:

More than three-quarters (76 percent) of the almost 500 global banking executives surveyed report that risk management is still stigmatized as a support function at their bank. Only half (48 percent) said that risk management is understood to be the responsibility of everyone in the organization, and another 45 percent of respondents said their board lacks risk expertise.  When asked to rank the leading contributors to the credit crisis, the banking executives named incentives and remuneration (54 percent), followed closely by lack of risk governance (50 percent) and risk culture (48 percent).

For those who have been following The ERM Current™, these results should come as no surprise.  However, for those new readers, these are startling results indeed.  Much work remains to strengthen risk management practices and to ensure that they remain a vital part of corporate operations.

Is your company prepared for the coming wave of regulation?  How flexible and cost-effective is your company’s enterprise risk management program?  Answers to these questions may make or break companies as they struggle to emerge from the financial crisis.  A recent article in Treasury & Risk Magazine reinforces the risk management challenge.

With lip service paid to risk management but no real clout singled out as one of the culprits in the financial crisis, many companies in 2009 aim to make risk management a daily function of good governance. And since a new Congress and president both promise increased regulation, companies should expect to deal with risk management on Washington’s terms.  The chief risk officer’s (CRO) job will evolve from what was mainly a focus on regulatory compliance to include across-the-the board oversight of everything from Sarbanes-Oxley to credit risk to business continuity.

Wheelhouse Advisors is uniquely equipped to help companies build flexible, cost-effective and sustainable enterprise risk management programs.   Contact us at NavigateSuccessfully@WheelhouseAdvisors.com to learn how we can help you

Yesterday, in a letter to the U.S. Senate and House Leadership, Lawrence Summers provided a preview of what is to come in the new Obama Administration.  Mr. Summers has been appointed by President-elect Obama as the Director of the National Economic Council.  In the letter, Mr. Summers put forth the request for the release of the additional $350 billion of TARP funds.  More importantly, he presented President-elect Obama’s view on the current situation and planned restrictions on financial institutions that are recipients of the TARP funds. Mr. Summers commented on Mr. Obama’s views:

He (President-elect Obama) believes that the American people are right to be angry with the way this plan has been implemented.  President-elect Obama believes there has been too little transparency and accountability.

Beginning next week when President-elect Obama is inaugurated, financial institutions will be faced with new challenges and responsibilities to not only their shareholders, but also to the American taxpayers.  As they say in the old Western motion pictures, “There’s a new Sheriff in town.”  Is your company ready?

Last Friday, the Congressional Oversight Panel (“COP”) released its second report on the management of the Troubled Asset Relief Program (“TARP”) by the U.S. Treasury.  The COP was recently established by the United States Congress to review the current state of financial markets and the regulatory system.  The COP is empowered to hold hearings, review official data, and write reports on actions taken by the U.S. Treasury and financial institutions and their effect on the economy.

Through regular reports, COP must:

• Oversee Treasury’s actions
• Assess the impact of spending to stabilize the economy
• Evaluate market transparency,
• Ensure effective foreclosure mitigation efforts
• And guarantee that Treasury’s actions are in the best interest of the American people.

The report was scathing and highly critical of both the U.S. Treasury as well as U.S. financial institutions that are benefiting from TARP.  Below are two focus areas of the report and related comments.

Bank Accountability

The Panel still does not know what the banks are doing with taxpayer money. Treasury places substantial emphasis on the importance of restoring confidence in the marketplace. So long as investors and customers are uncertain about how taxpayer funds are being used, they question both the health and the sound management of all financial institutions. The recent refusal of certain private financial institutions to provide any accounting of how they are using taxpayer money undermines public confidence.  

Transparency & Asset Evaluation

The bubble that caused the economic crisis has its foundations in toxic mortgage assets. Until asset valuation is more transparent and until the market is confident that the banks have written down bad loans and accurately priced their assets, efforts to restore stability and confidence in the financial system may fail.

Based on this report, it seems that the two main causes of the financial crisis – lack of accountability and lack of transparency – continue to plague our financial system.  Until these two issues are fully confronted and addressed at all levels, the crisis will continue unabated.   

Given the recent high profile cases of fraud and corruption in the United States and India (i.e. Bernard Madoff, Rod Blagojevich and Satyam Computer Services), a 2008 study by Transparency International is particularly enlightening (see illustration below).  In the study, the United States ranked 18th on a list of 180 countries.  Denmark, New Zealand and Sweden top the list as the least corrupt countries, with Somalia, Iraq, Myanmar and Haiti at the bottom of the list.  The authors of the study noted the following:

Whether in high or low-income countries, the challenge of reigning in corruption requires functioning societal and governmental institutions. Poorer countries are often plagued by corrupt judiciaries and ineffective parliamentary oversight. Wealthy countries, on the other hand, show evidence of insufficient regulation of the private sector, in terms of addressing overseas bribery by their countries, and weak oversight of financial institutions and transactions.

It remains to be seen what the 2009 study results will say about the United States and others.  Right now, it looks like a race to the bottom of the list.  Let’s hope for improvements in corporate governance, internal controls and risk management in 2009.

Corruption and fraud on a massive scale knows no boundaries as we discovered again in the disclosure by global outsourcer, Satyam Computer Services, Ltd.  The company’s chairman orchestrated the fraud by falsifying company accounts and inflating revenue and profit figures over several years.  In addition, the cash position of the company was most recently reported at more than $1 billion – an amount that was completely false.  The Wall Street Journal reported the following:

The news prompted concerns about corporate governance and accounting standards across Indian industry, especially since Satyam was audited by PricewaterhouseCoopers and had high-profile independent directors, including a Harvard Business School professor, on its board until recently. PricewaterhouseCoopers said it was examining Mr. Raju’s statement and declined to comment further. Immediate comparisons were drawn to the watershed in U.S. corporate accounting and governance standards that stemmed from the Enron crisis.

“Satyam is now India’s Enron. The independence of the board was already in question, now the auditors’ complicity in what seems to be a multi-year misstatement of financials will also be explored,” CLSA said in a note.  The chairman of the Securities and Exchange Board of India said Wednesday the unfolding fraud at Satyam is an event of “horrifying magnitude.”

Much must be done to stem the tide of corruption and fraud in the corporate boardrooms and executive suites. Our entire financial system depends on investor confidence that is quickly eroding.  Strong internal control over financial reporting is essential and can be a source of competitive advantage in an environment such as this.  Visit www.WheelhouseAdvisors.com to learn how we can help you.

In the January 2009 issue of CFO magazine, an article examines the risk management challenges faced by many corporations in the wake of the financial crisis.  The article entitled “Rethinking Risk” rightly advises that new approaches are needed to successfully implement effective enterprise risk management programs.  Here is an excerpt from the article.

But some CFOs caution that formal enterprise risk management (ERM) programs won’t succeed if they don’t mesh well with a company’s culture. Impose a new framework from on high and you risk crushing something underneath.  Progress may depend largely on incremental improvements rather than technological leaps or massive consulting engagements. Existing risk-reporting processes must break down silos that impede risk oversight and prevent a broader awareness of risk throughout the organization. 

In most cases, a thoughtful, strategic approach to refining a risk management program is all that is needed. Wheelhouse Advisors provides cost-effective solutions to help corporations refine and streamline their risk management practices.  Visit www.WheelhouseAdvisors.com to learn more.

Yesterday, the U.S. House Committee on Financial Services conducted a preliminary hearing into the investigation of regulatory failure associated with the $50 billion Madoff Hedge Fund fraud.  Among those testifying was Leon M. Metzger, a Yale University professor and expert on hedge fund management.  His commentary included the following:

I wish to stress two things: first, the need for top-notch internal controls and second, that operational risk is the great unspoken danger.   A 2003 study of 100 hedge fund failures over a 20 year period concluded that 50 percent of hedge funds had failed due to operational risk…  When I was interviewed in August 2004 about teaching a hedge funds course at the Yale School of Management, I said that I wanted to emphasize good operational controls, which investors tend to overlook, and are essential to the success of an investment.  I was offered the job, and the importance of those controls is what I stress whenever and wherever I teach.  

Many risk experts fail to recognize the importance of strong internal controls, but they are (to use a football analogy) the “blocking and tackling” of risk management.  Without a solid internal control framework, any hedge fund, financial institution or corporation is likely to suffer a similar demise.  Wheelhouse Advisors can provide a no-cost diagnostic review of your internal control structure.  Visit www.WheelhouseAdvisors.com to learn more.

An article in this week’s edition of The New York Times Magazine entitled “Risk Mismanagement” provided a view into the use of statistical models in the world’s largest financial institutions to understand risk.  Value at Risk (“VaR”) models are the focus of the article and are criticized for not predicting rare, catastrophic events (known as Black Swans) such as the financial crisis that we have experienced.  

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives.  It made black swans all the easier to ignore.  All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. 

While the VaR models are not perfect, they should not shoulder the blame for the mismanagement of risk.  The mismangement of risk was driven by short-term decision making and pure greed.