The ERM Current™

Last week, the Financial Accounting Standards Board (“FASB”) adopted changes to off balance sheet accounting standards that previously permitted many financial institutions to obfuscate their true financial condition.  The changes will require companies to consolidate special purpose entities onto their balance sheet for reporting purposes.  Here is what BusinessWeek reported on the impact of the accounting changes.

In general, companies transfer assets from balance sheets to special purpose entities to insulate themselves from risk or to finance a large project. Under the change by the FASB, many qualifying special purpose entities will have to be moved back to a company’s main balance sheet.

Outside investors often take stakes in those entities, for example, making an investment in a bank’s holdings of mortgage loans in exchange for payments from borrowers. Under the new standard, companies must bring back onto their balance sheets any entity in which they hold an interest that gives them “control over the most significant activities,” according to FASB. Companies must perform analyses to determine that.

The change could result in about $900 billion in assets being brought onto the balance sheets of the 19 largest U.S. banks, according to federal regulators. The information was provided by Citigroup Inc., JPMorgan Chase & Co. and 17 other institutions during the government’s recent “stress tests,” which were designed to determine which banks would need more capital if the economy worsened.

The changes take effect at the beginning of 2010 and certainly will require a great deal of work on the part of financial institutions to ensure they have the necessary capital to shoulder the added burden.  In addition, it will require strong quantitative and qualitative analysis to determine the need to bring assets back on the balance sheet.  As a result, this change could prove to be the straw that breaks the back of some banks.

The much anticipated regulatory reform proposal from the new Obama administration is nearing completion according to a report today in the Wall Street Journal.  The aim of the proposal is to streamline the byzantine regulatory framework within which U.S. financial institutions have been operating for many decades.  Here is what the WSJ had to say.

Top Obama administration officials are close to recommending that Congress create a single regulator to oversee the entire banking sector, people familiar with the matter said, a departure from the hodgepodge of federal agencies that failed to contain the financial crisis as it ballooned out of control last year.

The new agency is expected to be a major plank in a proposal that Treasury Secretary Timothy Geithner and White House officials send Capitol Hill in a few weeks with the goal of overhauling supervision of financial markets.

The new bank regulatory agency could prove controversial because it would consolidate the Office of the Comptroller of the Currency and the Office of Thrift Supervision and strip supervisory powers from the Federal Reserve and the Federal Deposit Insurance Corp.

The Fed and the FDIC would gain other powers, though, as White House officials want the Fed to be able to oversee systemic risks in the economy. They also want the FDIC to have new powers to take large financial companies that aren’t banks into receivership.

While the outcome of the proposal is far from certain, one thing is certain – major regulatory change is on the horizon. Is your company prepared to manage this change?  Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more. 

This past weekend reports surfaced about new rules on limiting executive pay at financial institutions that received taxpayer assistance. The rules are expected to be promulgated by the U.S. Treasury as reported by Reuters below.  

Treasury Secretary Timothy Geithner is expected to issue rules as early as next week on how bailed-out banks must limit their executives’ pay. He is also working on ways to reform the compensation practices of the entire banking industry to discourage a focus on short-term gains and undue risk-taking.

Lucian Bebchuk, a professor at Harvard Law School, and colleague Holger Spamann argue that a banker’s pay should be tied to all of the bank’s assets, not just to equity, which they say accounts for only about 5 percent of overall assets.

“Banking regulators should monitor executive pay in banks, and prevent arrangements that incentivize top bankers to focus only on the bank’s equity, which … can gain through strategies that are detrimental to the other 95 percent,” they write in a forthcoming paper.

Bebchuk and Spamann suggest top bankers should be paid on a “broader set of claims, including deposits and junior debt,” which would prod them “to place much greater weight on possible losses in their choice of strategy.”

These new rules on executive pay most likely will serve as extra incentive for financial institutions to return taxpayers’ money as opposed to lasting changes in pay practices. True changes must emanate from within the financial institutions’ corporate governance structure beginning with pressure from the boards of directors.  

Last week, Wheelhouse Advisors participated in a webinar hosted by OpenPages that examined some of the root causes of the current economic crisis associated with operational risk management, and how operational risk management can be leveraged for strategic advantage moving forward.  John Wheeler, Managing Principal at Wheelhouse Advisors, described how operational risk management is the one discipline that binds all the other risk disciplines together in a truly successful enterprise risk management (“ERM”) program.  Mr. Wheeler discussed the following strategies for risk professionals to improve their operational risk management program and, in turn, increase the overall effectiveness of the ERM program.

•Simplify & Streamline

1. Eliminating redundant activities
2. Adopting common methods / terminology
3. Coordinate efforts across functional silos

•Develop an Active & Consistent Dialogue

1. Frame conversations in relevant terms (e.g. discuss underwriting and documentation improvements as it relates to improvements in credit quality)
2. Meet on “their turf” to develop greater understanding and buy-in

•Measure & Monitor

1. Agree on a few key risk indicators
2. Monitor relentlessly

The webinar provided much more information about how to use operational risk management practices and supporting technologies to manage risk in a cost-effective manner that will translate into a major competitive advantage.  To learn more about how Wheelhouse Advisors can help your company, visit www.WheelhouseAdvisors.com.

This week, the U.S. Supreme Court agreed to hear a case regarding the constitutionality of the Public Company Accounting Oversight Board (“PCAOB”) formed as a result of the Sarbanes-Oxley Act of 2002 (“SOX”).  The crux of the case is the question of who should appoint the PCAOB directors.  As it stands today, the directors are appointed by the U.S. Securities & Exchange Commission (“SEC”).  The case argues that the board members should be appointed by the U.S. President or an appointee of the President.  However, the real aim of the case is to render the entire SOX act unconstitutional due to the lack of a severability clause in the legislation.  Here is some background on the case as reported by CFO magazine.

The question over the PCAOB’s constitutionality began three years ago, when the Free Enterprise Fund, a policy group interested in promoting small government, took on the case of a small accounting firm criticized by the board after one of its inspections. The group contends that because the regulator was not a legal body under the constitution, it had no standing to perform such inspections or make such criticisms.

According to the noted origins, it looks like a case of sour grapes on the part of an accounting firm that has gained a foothold with those looking to overturn SOX.  We are in a much different environment than we were three years ago when the case was filed.  As a result, the Supreme Court decision should be very interesting. Stay tuned.

In this year’s Global Risks report, the World Economic Forum provided many interesting insights about emerging risks across the globe.  In addition, the report provided research into how risks are managed in various organizations.  One particular study examined the common myopic view of risks and the resulting behavior.  Here is what the report concluded.

In many different experiments, research has found that people exhibit loss aversion by avoiding short-term expenditures, even though they could actually result in significant long-term gains. More specifically, people often miss an opportunity to mitigate risks by not acting with a long-term perspective and by not taking interdependencies into account.

Individuals and corporations have short time horizons when planning for the future so they may not fully weigh the long-term benefits of investing today in loss reduction measures that could benefit them in the future. The upfront costs of mitigation loom disproportionately large relative to the delayed expected benefits over time. Applied to businesses, short-term horizons can translate into a NIMTOF perspective (Not in My Term of Office).

Current performance metrics and compensation systems are driving this myopic approach to the detriment of companies’ long term viability and the economy at large.  Looks like it is time for some vision correction in risk management.

Now that the stress tests are over, it looks like the other shoe to drop may be certain changes in leadership at the nation’s largest financial institutions.  According to a report by CNN and Fortune Magazine, regulators are now interested in the ability of bank leaders to properly manage an institution’s risk profile.  Here is what was reported.

The nation’s leading banks may have been deemed solvent, but it remains to be seen whether top management at those firms will soon go bust. Among the findings in its two-month long “stress test” program announced May 7, the government not only told 10 institutions to raise a total of $75 billion in additional capital, but also pushed banks to take a hard look at their leadership. Industry regulators specifically asked banks to review both top executives and board members over the next month “to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment.”

Performance to date indicates some institutions have developed “post stress test disorder” and changes may be needed. The only question is whether the changes will be made on their own volition or not.

A letter from AIG’s corporate counsel to Representative Gary Peters of the U.S. House Financial Services Committee was released to the public this week.  The letter responded to inquiries by Rep. Peters into the risk management practices at AIG leading up to and during the meltdown that nearly resulted in the collapse of AIG as well as the global financial system.  The following question related specifically to the structure of AIG’s enterprise risk management organization.  

Q: What was the role of the Enterprise Risk Management (“ERM”) Department and how did it relate to the overall risk management strategy in place at AIG during the time which the Financial Products unit was operating?  Did the Enterprise Risk Management Department have authority to review the activities of the Financial Products unit or give approval to credit default swaps entered into by members of the Financial Products (“FP”) unit?

A: Created in 2004, AIG Enterprise Risk Management (“ERM”) was responsible for assisting AIG’s business leaders, executive management, and board of directors in identifying, assessing, quantifying, managing and mitigating the risks incurred by AIG. The Chief Risk Officer and his team were responsible for enterprise-wide credit, market, and operational risk management and oversight of the corresponding functions at the business units.  Although FP risk managers, like risk managers in some other business units, had no direct reporting lines to ERM, as discussed above, the Credit Risk Committee did review and approve most of FP’s multi-sector CDS transactions with respect to credit risk and also engaged in periodic review of FP and its CDS portfolios.

The response from AIG shows a fatal flaw in their ERM program.  The risk managers in the Financial Products unit had no formal ties to the ERM organization or the Chief Risk Officer.  As a result, their compensation was directly linked to the performance of the unit.  This provided no incentive for them to raise red flags that may negatively impact their pay and ultimately cost them their jobs.  When the valuation of the credit default swaps were unreasonably high, the risk managers simply turned a blind eye.  This is precisely the situation that was described in the ERM Current™ blog post on December 19, 2008 entitled “Turning a Blind-eye Toward Risks.”

New rules are imminent for derivatives trading activities and are aimed at addressing the lack of transparency into counterparty risk that contributed to the current economic crisis.  The Obama administration is moving forward with a plan to require certain derivatives to be traded via a central clearinghouse and others to be traded on open exchanges.  Here is an excerpt from yesterday’s press release from the U.S. Treasury.

As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response. Today, to address these concerns, the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives.  Moving forward, the Administration will work with Congress to implement this framework and bring greater transparency and needed regulation to these markets. The Administration will also continue working with foreign authorities to promote the implementation of similar measures around the world to ensure our objectives are not undermined by weaker standards abroad.

This is a step in the right direction, but the details and timing of such changes remain to be seen. Also, it may require a great deal of coordination among several different regulatory bodies.  That may hamper what is on the surface a simple, straightforward plan.

Reports about new regulations on compensation practices at U.S. financial institutions emerged today in the Wall Street Journal.  Evidently, the Federal Reserve is working on new rules designed to reduce excessive risk taking such as incentives for mortgage loan production that fueled the current economic crisis.  Here is what was reported.  

Among ideas being discussed are Fed rules that would curb banks’ ability to pay employees in a way that would threaten the “safety and soundness” of the bank — such as paying loan officers for the volume of business they do, not the quality. The administration is also discussing issuing “best practices” to guide firms in structuring pay.

Government officials said their effort, which is just beginning, isn’t aimed at setting pay or establishing detailed rules. “This is not going to be about capping compensation or micro-management,” said an administration official. “It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation.”

Solid corporate governance practices and effective risk management programs should be enough to limit excessive risk taking through well designed compensation plans.  However, it seems the U.S. Government is not convinced that companies will navigate the proper course.