The ERM Current™

The criminal investigation into the accounting practices at AIG is progressing and the focus is none other than Joseph Cassano, former head of the Financial Products group that brought AIG to its knees.  Here is what the Wall Street Journal reported yesterday.

Federal prosecutors are also focusing on a December 2007 investor presentation in which Mr. Cassano said write-downs tied to the swaps had reached an estimated $1.6 billion. Authorities are looking at whether Mr. Cassano should have disclosed to investors that the figure would have been higher by several billion dollars if not for the aid of a value adjustment known as “negative basis,” according to people familiar with the matter. Several months later, when AIG disclosed that its auditor, PriceWaterhouseCoopers, found a “material weakness” in its accounting of the swaps, it said it would abandon the adjustment, according to company filings.

Had it not been for the identification of a material weakness by the auditors, who knows how long it may have taken to properly disclose the losses.  At this point, it looks like Mr. Cassano deserves to be bunkmates with Bernard Madoff.

Companies working to integrate and improve their Information Technology (“IT”) applications are also inadvertently increasing the risk level across the entire enterprise.  Two professors from Carnegie Mellon University discuss this paradox in an article written this month for the Harvard Business Review.  Here is what they have to say about the problem.

Standard risk-management strategies are too outmoded to help companies contain catastrophic IT-linked risks. These strategies tend to assume that the risks are well understood and that the possibility of extreme events is tiny. As a result, organizations typically concentrate on ensuring that they have good policies and procedures for managing known risks and are using high-quality processes for creating and operating IT. But this old-fashioned focus can prevent firms from seeing new risks.

How do you identify events that, by definition, are hard to anticipate? Start by instilling from the top down an organizational culture that encourages employees to take ownership of risks and weigh their potential rewards and hazards. This means modeling risks and analyzing their business impact and, even more important, making the process integral both to corporate risk management systems and to every stage of IT system development. The culture must encourage employees to bring concerns about risk forward early, particularly when IT is being applied in new ways. 

Developing the proper organizational culture is critical not only for managing IT risks, but for all risks. Wheelhouse Advisors can help your company develop the frameworks and methodologies to create the optimal risk management culture.  Visit www.WheelhouseAdvisors.com to learn more.

Last week, the U.S. hosted a meeting of the G-7 finance ministers in Washington D.C. to discuss the current financial crisis.  In the meeting, Treasury Secretary Tim Geithner and the other ministers committed to addressing the recommendations from the recent G-20 Summit in London.  Here is what they had to say.

We also discussed regulatory reform in our countries and at the international level and will implement swiftly the commitments made in London.  We underscored the imperative of: strengthening our national efforts to address systemic risks; extending the perimeter of regulation to include all systemically important institutions, markets, and instruments; ensuring sound regulation, adequate capitalization of financial institutions, and strengthened risk management practices; enhancing transparency; reinforcing international collaboration; improving accounting standards on valuation and provisioning; and bolstering market integrity. 

These are certainly bold words and time will tell if they are met with bold actions.  For the sake of the world economy, let’s hope so.

In the volumes written about the cause of the current financial crisis, very little has been said about what the nation’s business schools did to prepare the leaders involved in creating the crisis.   Michael Jacobs, a professor at the University of North Carolina Kenan-Flagler Business School, had this to say in an op-ed column written in today’s Wall Street Journal.  

There are three profound failures of sound business practices at the root of the economic crisis, and none of them have been adequately addressed by our business schools.  Just about everyone agrees that misaligned incentive programs are at the core of what brought our financial system to its knees. Secondly, as Washington scrambles to restructure the financial regulatory system, those who still believe in the private sector are asking why corporate boards were AWOL as institution after institution crumbled. 

The third breakdown came in the investment community.  Nationally, finance departments at business schools offer hundreds of courses in asset securitization and portfolio diversification. They have taught a generation of financial leaders that risk can be diversified away. But in their B-school days, few investment bankers examined the notion of “agency costs.” That concept explains that as the gulf between the provider and the user of capital widens, the risks involved with selecting and monitoring the participants in the portfolio increase. It should come as no surprise that financial institutions amassed securities that consist of a diversified portfolio of deadbeats.  

By failing to teach the principles of corporate governance, our business schools have failed our students. And by not internalizing sound principles of governance and accountability, B-school graduates have matured into executives and investment bankers who have failed American workers and retirees who have witnessed their jobs and savings vanish.

Mr. Jacobs is spot-on and should know more than anyone since he is a professor at a leading business school. As we begin to emerge from the current crisis and re-build our foundations of business, our business schools must re-tool their programs to develop competent business leaders.   

For all that has been leveled at former Federal Reserve Chairman Alan Greenspan’s contribution to the current financial crisis, very little has been noted about the current Federal Reserve Chairman’s contribution.  Mr. Greenspan has been vilified for his comments in 2004 supporting the use of adjustable rate mortgages.  Here is what Mr. Bernanke had to say in a 2006 speech about the use of credit default swaps and asset backed securities. 

To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization. For example, trading in credit derivatives has grown rapidly over the last decade, reaching $18 trillion (in notional terms) in 2005. The notional value of trading in credit default swaps on many well-known corporate names now exceeds the value of trading in the primary debt securities of the same obligors.  Asset-backed securitization has also provided a vehicle for decreasing concentrations and credit risk in bank portfolios by permitting the sale of loans in the capital markets, particularly loans on homes and commercial real estate.

Given the implosion of the credit default swap and mortgage backed securities markets, Mr. Bernanke’s comments seem to be equal if not more impactful than Mr. Greenspan’s comments in 2004.   As we now know, the use of these vehicles actually increased risk on a systemic basis rather than lowering it.

Yesterday, the U.S. Congressional Joint Economic Committee held a hearing on the systemic threats of large financial institutions involved in the current financial crisis.  Here is what Columbia University Professor and winner of the 2001 Nobel Prize,  Mr. Joseph Stiglitz had to say about the current steps being taken by the U.S. Government.

In short, our bail-outs run the risk of transferring large amounts of money, often in non-transparent ways, to those banks that did the worse job in risk management—hardly principles on which normal market economics is based. Among these are some of the too-big-to-fail banks. In effect, the government is tilting the playing field—towards the losers, worsening the tilt that is always there simply from the implicit guarantees associated with being too big to fail.

Regrettably, some of the discussion of regulatory reform has skirted the main issues. There is talk about the need for comprehensive oversight, bringing in the hedge funds. We should remember that the core problems were not with hedge funds; they were with regulations and regulatory enforcement of our big commercial and investment banks. This is what has to be fixed.

Again, transparency and accountability are his main themes and the keys to restoring confidence in the financial system.  The quicker these keys are fully embraced, the quicker we can move beyond the current crisis.

U.S. Treasury Secretary Timothy Geithner will particpate in a hearing today conducted by the TARP Congressional Oversight Panel.  The focus of the discussion will most likely be the contents of a report issued by the Panel about the Treasury’s TARP Strategy.  In the report, the Panel explores various governmental interventions over the past century and identifies their sources of success.  Here are the four critical success factors: 

• Transparency.  Swift action to ensure the integrity of bank accounting, particularly with respect to the ability of regulators and investors to ascertain the value of bank assets and hence assess bank solvency.
• Assertiveness.  Willingness to take aggressive action to address failing financial institutions by 1) taking early aggressive action to improve capital ratios of banks that can be rescued, and 2) shutting down those banks that are irreparably insolvent. 
• Accountability.  Willingness to hold management accountable by replacing—and, in cases of criminal conduct, prosecuting—failed managers. 
• Clarity.  Transparency in the government response with forthright measurement and reporting of all forms of assistance being provided and clearly explained criteria for the use of public sector funds.  

The report falls short of offering an ultimate view on the best strategy to take in the current crisis.  However, it does indicate that there is dissent among the Panel members on efficacy of the Treasury’s current strategy. This dissent will most likely lead to a very interesting hearing.

The results from a recent survey of financial institutions from across the globe indicate a urgent need to automate financial processes and integrate risk management efforts across the organization.  The survey was conducted by the Economist Intelligence Unit in the fourth quarter of 2008 during the height of the credit crisis.  Here is an excerpt from the report’s conclusion.

The ravages of the credit crisis have raised serious doubts about banks’ ability to effectively manage risk. Bankers now face arduous challenges as they attempt to restore the confidence of regulators, analysts, shareholders and customers. To the extent that senior managers have focused more heavily on governance, risk and compliance over the last five years, they may be tempted to despair about the possibility of anticipating potentially devastating risk exposures. However, a sober appraisal of banks’ efforts will reveal that cost considerations have limited the extent to which manual processes have been eliminated and, far more importantly, that sophisticated GRC isolated within lines of business or internal control functions is no substitute for an integrated, enterprise-wide approach to risk management.

Wheelhouse Advisors is uniquely equipped to help companies implement an integrated, enterprise-wide approach to risk management.  Visit www.WheelhouseAdvisors.com to learn more.

This week, an article was published by Wharton Business School about the need to re-think approaches to risk management.  The article presents the case that risk management approaches are not necessarily broken, but need to evolve to the next level.  That next level is adopting a true enterprise risk management focus.  Here is a summary of their view along with that of an executive at a major global corporation.

Experts at Wharton and elsewhere argue that too much blame is being placed on the risk management model and other tools of the trade, in banking and beyond. The models are not necessarily broken, but instead are only as good as the decisions that get made based on them, they say. As a result, the current crisis may represent an opportunity for companies to re-visit and re-think historical approaches to risk management. 

Philippe Hellich, vice president of risks, control and audit at Danone, is already moving to the new model. “We use very few mathematical models,” he says, although the organization is working on a small set of new ones for certain risks. “Instead, we rely much more on interviews and benchmarking with peers outside the group and between our subsidiaries around the world. Our approach is based on listening and challenging the operational management, common sense analysis, sound judgment and good governance at the top.”

Looking ahead, Hellich sees even more focus on risk from Danone’s leadership, a consequence of the increasing volatility in markets and the potential severity of impact. “Top managers are convinced of the necessity to use enterprise risk management. We now have an effective working session with part of the executive committee twice a year. And we continue to rely on yearly updates of the risk maps of all major business units worldwide.”

Wheelhouse Advisors can help your company reach the next level of risk management.  Visit www.WheelhouseAdvisors.com to learn more.

More speculation is being made about the stress test results and what the U.S. Government will eventually disclose to the public, if anything.  Here’s what was reported in the Wall Street Journal yesterday.

It isn’t clear precisely what information the government might disclose. It remains possible the data won’t be specific to individual banks. But some within the administration believe a certain amount of information needs to be released in order to provide assurance about the validity and rigor of the assessments. In addition, these people also are concerned that the tests won’t be able to fulfill their basic function of shoring up confidence unless investors are able to see data for themselves. Staff at the various regulatory agencies have been discussing the matter for several weeks and are expected to brief top regulators as soon as this week. One possible solution: Aggregating the data provided by the banks so the government could provide a broad snapshot of the banking industry’s health without disclosing firm-specific data.

Based on this report, it seems they are going in circles trying to determine what to do.  However, for an administration that is seeking to improve transparency and accountability, the answer should be clear.