The ERM Current™

The regulatory reform starting gun was sounded by President Obama yesterday and it was described more as a marathon than a sprint to the finish.  However, the President was clear on the objectives of the reform as noted in the Wall Street Journal.

Mr. Obama said “financial institutions that pose serious risks — systemic risks — to our markets should be subject to serious oversight by the government.” He said U.S. taxpayers “should be assured” that the Federal Reserve, which is acting as a lender of last resort in many cases, “understands the institutions it insures and actively monitors them to keep their risk-taking in check.”

The president said the overhauled regulatory structure “must be strong enough to withstand both systemwide stress and the failure of one or more large institutions.”Mr. Obama also called for greater transparency, more-uniform supervision of financial products, and “strict accountability” for market players who engage in risky behavior. “Executives who violate the public trust must be held responsible,” the president said.

Representative Barney Frank commented on the nature of the process required to reform the regulatory structure.

Rep. Frank said he expects the effort will be done in stages, with action first on a bill that will empower a regulator, likely the Federal Reserve, to regulate risk across the financial system.  ”It’s either the Fed or you start from scratch,” Mr. Frank said.

Early preparation is critical to achieve a competitive advantage of addressing the regulatory changes in a cost-effective and efficient manner.  Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more.

Back in September, one of the first posts to this blog focused on the systemic risk failure that led to the current financial crisis.  The systemic risk discussed was related to the use of derivative instruments such as credit default swaps (“CDS”) to mitigate credit risk associated with corporate debt.  The rapid increase in use of these CDS instruments combined with the lack of regulatory oversight led to a dramatic increase in systemic risk that has not been well managed.  A recent article by Institutional Risk Analytics provides a great example.

The basic tension over CDS starts with the fact that these instruments actually increase overall systemic risk. 

Consider a real world example: When the auto parts make for General Motors, Delphi, filed bankruptcy in October 2005, there were between $20 and $30 billion in CDS outstanding and deliverable against the $2 billion in debt outstanding and another $2 billion in bank loans that were also deliverable against the CDS.  Whereas the maximum cash loss to investors in the Delphi default might have been limited to the $4 billion of extant debt without CDS, the existence of CDS actually multiplied the potential opportunities for gain and loss on the Delphi default nearly 10 fold. 

While proponents of the CDS market will and do argue that the “net” exposure from the Delphi default was quite small, the fact remains that the “innovation” of CDS actually created a multiplicity of new risks around the existing cash default of Delphi, risks whose sole benefits seem to be a) providing speculative opportunities for a certain class of market participants – I won’t call them investors, because often they are not — and b) generating commission for CDS dealer banks.

A great deal of work must begin immediately to address this situation that is at the core of our economic meltdown.  While potential solutions have been discussed, no real steps have yet been taken by the public or private sector.  However, as we all know too well, risk waits for no one.

As the plans for regulatory reform in the financial sector evolve, one thing is certain – it will be a work in progress for some time to come.  The companies that are well prepared and nimble in addressing the regulatory demands will certainly have a competitive advantage over others.  Here is what an article in Bank Systems & Technology magazine had to offer in light of the upcoming changes.

Predicting precisely how a new administration and Congress will address the financial crisis is difficult over the long term, but the early returns are instructive. Banks that participate in TARP will be subject to a range of new reporting requirements that go above and beyond the existing regulatory requirements—combining the needs of the SEC, the Federal Reserve, and the Office of the Comptroller of the Currency. But with new regulations and uncertainty come added burdens, and building a competitive advantage will require having insight into the infrastructure (systems and data) required to get ahead of regulatory pressures and minimize the millions of dollars required for compliance through careful planning and investment—rather than issuing knee-jerk responses to each new change in regulations.

U.S. banks can borrow from the lessons of others. European banks have been managing a more active regulatory environment for some time, and have successfully used SWAT-team-like functions to meet this challenge. For instance, Barclays PLC created a nimble central organization to actively manage new regulations and to act as the single point of contact between all business units and critical group functions. However, it first needed the technology infrastructure in place to meet these goals.

Wheelhouse Advisors is uniquely equipped to help companies build the infrastructure needed to address regulatory demands in a cost-effective and practical manner.  Visit www.WheelhouseAdvisors.com to learn more.  

According to a recent article in the Washington Post, the Securities and Exchange Commission (“SEC”) is gearing up for a review of corporate governance practices and the role of boards of directors in managing risk. The new SEC Chairman, Mary Schapiro, is looking to strengthen boards of directors in order to hold management more accountable.  Here is an excerpt from the article.

With few exceptions, boards have received little media attention as the country has sought explanations for financial firms’ taking on such perilous risks. These boards — which typically consist of a dozen or more well-known executives, politicians and other influential people — were ultimately responsible for the decisions of the Wall Street companies, housing firms and banks at the heart of the crisis. The boards signed off on the risks the companies took and the compensation packages awarded to top executives.

But many corporate watchdogs say the boards of top financial firms had characteristics that promoted risky business practices and harmed shareholders. ”Corporate governance is about managing risk. It’s about incentive compensation. It’s about corporate strategy and sustainability. And all of those things are what the boards failed to do,” said Nell Minow, a co-founder of the Corporate Library and an advocate of reforming corporate boards.

Boards of directors must ensure a strong enterprise risk management program is a core component of management’s responsibilities.  Without it, the directors will not have a leg to stand on when the questions are asked by the enforcers from the SEC.  

In the upcoming Harvard Business Review for March 2009, Rene M. Stulz highlights six ways companies mismanage risk.  Dr. Stulz suggests that these classic missteps can occur in good economic times as well as the rough economic times we are currently experiencing.  However, the current crisis has certainly magnified the impact of the following mistakes.

Relying on historical data. A risk manager who assessed real estate risk on the basis of statistics from the past three decades would have been sorely unprepared for the volatility of house prices in 2007.

Focusing on narrow measures. A daily Value-at-Risk (VaR) measure is commonly used for securities trading. But a daily measure assumes that assets can be sold quickly or hedged, so it doesn’t apply to portfolios with which the firm may be temporarily stuck.

Overlooking knowable risks. Risk managers often distinguish among market, credit, and operational risks, which they measure differently and in isolation rather than cross-organizationally. They may also fail to assess new risks embedded in the instruments they use for risk mitigation.

Overlooking concealed risks. Risk takers may deliberately hide their risks, as happened at the French bank Société Générale in 2007. Or they may underreport them when their trading positions are complex and short-lived.

Failing to communicate. Sometimes even the most scrupulous risk manager cannot clearly explain a state-of-the-art system to the CEO and the board. In such a case, their confidence in the system’s capabilities may be unwarranted.

Not managing in real time. It is difficult to hedge trading positions when their risk characteristics can change completely within a single day—as can happen, say, with barrier calls.

A truly effective enterprise risk management program should address all six of these potential shortcomings. Visit www.WheelhouseAdvisors.com to learn more about how we can help your company avoid these problems.

A recent article in Fortune magazine highlighted the views of two prominent management consultants on what boards should be doing in this time of crisis.  One of the consultants, Thomas J. Neff of Spencer Stuart, had this to say about Enterprise Risk Management.

The other subject that boards need to focus more on is enterprise risk management. It’s not just risk in the sense that banks need to focus on it, but what are the risks in our business model, what are the global risks that could affect our business? It’s a holistic approach to the subject, and stress testing what we’re doing.

Stress testing and scenario analysis results should be discussed at the board level to ensure a company is adequately prepared for the most strategic risks.  Visit www.WheelhouseAdvisors.com to learn more.

As most of us are seeing in today’s crisis through a multitude of corporate failures, the organizational culture can make or break a company.  In this week’s edition of Compliance Week, Richard Steinberg provides a wonderful circumspective article on the impact of culture.  Here’s a sample of his viewpoint.

Experience shows that culture has a strong and pervasive effect on a company, either positively or negatively. Top management usually has an accurate picture of organization’s culture, but reality is that a significant number of CEOs learn too late that they were badly mistaken. Among the most critical roles of a CEO and senior executive team is to have an in-depth and accurate understanding of the company’s culture, determine what changes are needed, and take quick and decisive action to mold the culture to what’s needed to enable the company’s successful future.

A strong culture, like a company’s reputation, can take years to build and a very short time to destroy. Corporate leaders must work daily to ensure a strong organizational culture is maintained for a company to withstand rough economic times.

Capital investment will be limited this year due to the continuing financial crisis.  However, there is one area that will see increases as a result of the crisis – risk management.  To get ahead of the risk curve, financial services companies as well as non-financial companies will need to invest more in technology and people. Here is what one analyst had to say recently.

Dana Wiklund, a research director in the risk management practice at Financial Insights, a unit of International Data Group Inc., said banks are willing to spend in a few key areas, including this kind of risk analysis.  ”Risk is an area of investment this year,” he said. “This is an area where, if banks haven’t done their homework up till now, this is going to be a priority for them.”  Shareholders, boards and examiners are asking tough questions about how executives are analyzing risk and how they are implementing the necessary fixes, he added. “They have to make the investment.”

Is your company prepared to make the necessary investments in order to get ahead of the risk curve?  If so, then contact Wheelhouse Advisors to learn how you can implement the necessary enhancements in the most efficient and cost-effective way.  

Financial institutions across the U.S. are bracing themselves for stress testing by the U.S. Treasury.  The results of these stress tests will determine which institutions are healthy enough to survive and which ones are terminally ill.   Last Friday, the Wall Street Journal highlighted the results of one research firm’s recent stress test report.  

“Bank and thrift failures are a function of capital, liquidity and regulatory risks. Some of the largest “failures” of last year were the result of a combination of these factors,” the stress-test report by Sanford Bernstein said.  Liquidity refers to money banks need to fund their day-to-day operations. Longer term, capital is needed to make investments and, most importantly right now, to provide a cushion for delinquent loans.  Liquidity risk is largely mitigated at this point — banks are liquid enough to be able to make the loans their borrowers want. But capital and regulatory risk are “alive & kicking,” the report said. While regulators put in place programs to prevent bank failures through capital infusions, those programs could essentially wipe out common equity at some banks, leading to “common equity failures,” Sanford Bernstein wrote.

The next 4 – 5 months will be very interesting and could result in a completely different landscape for financial institutions.  Expect a great deal of change and upheaval as these capital and regulatory risks begin to crystallize.

This week, Britain’s primary financial regulator – the Financial Services Authority (“FSA”) – issued its Financial Risk Outlook for 2009.  The FSA provided several key messages related to effective risk management.  

1. Senior Management should ensure appropriate risk management is undertaken and that there is a clear understanding of the underlying risks to their business model, particularly risks associated with complex hedging strategies. Firms need to satisfy themselves that key risks are appropriately managed and continually re-assessed as financial market and economic conditions evolve.
2. Stress testing and scenario analysis should form an integral part of firms’ risk management, business strategy and capital planning decisions. It is of particular importance in this unpredictable environment, when the financial sector is vulnerable to further shocks, that firms also consider the implications of deteriorating economic conditions and the long-term viability of and weaknesses present in their business models. In addition, the financial sector and economy will also remain vulnerable to potential shocks, such as a large-scale terrorist attack. Firms should continue to consider such risks in their business planning to ensure effective plans are in place for dealing with these shocks.  
3. Strategies need to be underpinned by strong risk management systems and controls for all areas of risk: credit, market and operational risk; conduct of business risks; compliance with relevant rules, codes and standards; and managing risks of fraud and financial crime.
4. Remuneration policies should be in line with sound risk management. Firms should ensure that staff are not given incentives to pursue higher-risk strategies than are consistent with the firm’s overall risk appetite, undermining the impact of systems designed to control risk to the detriment of shareholders and other stakeholders, including depositors, creditors and ultimately taxpayers.

These are solid principles not only for companies in the UK, but for companies across the globe.  Visit www.WheelhouseAdvisors.com to learn more about how we can help your company Navigate Successfully™.