The ERM Current™

The Wall Street Journal reported today that regulators are increasing the scrutiny over U.S. financial institutions as Congress debates the future of the regulatory system.  This certainly comes as no surprise given the state of the economy, but many of the banks are not comfortable with the new pressure.  Here is what the WSJ had to say.

Federal regulators have escalated the number of wounded banks they have essentially put on probation, with some of the targeted banks complaining that the action is too harsh. The Federal Reserve and the Office of the Comptroller of the Currency, two of the primary U.S. banking regulators, have issued more of the so-called memorandums of understanding so far this year than they did for all of 2008, according to data obtained from the agencies under Freedom of Information Act requests. The sharp increase comes as Congress considers changes proposed by the Obama administration that would overhaul the way the U.S. government oversees banks. Many bankers and analysts believe those changes would result in an even more assertive regulatory apparatus. Regulators have been criticized for going too easy on banks and securities firms.

Regulations and their associated risk will continue to rise into the foreseeable future.  How banks respond and proactively adjust to the risk will determine who thrives, who just survives, and who fails.

A recent op-ed article in the Wall Street Journal by professors from Columbia and Harvard Business Schools provides a view on the political impact on financial regulatory reform in the United States.  Here what they had to say about the missed opportunity in the current proposal by the Obama administration.

For political reasons the administration has decided not to upend the current system. Instead it proposes four federal entities—Financial Services Oversight Council, the Office of National Insurance, the Federal Consumer Coordinating Council, and the Consumer Financial Protection Agency—on top of the current alphabet soup of regulatory agencies. This is a shame. We need fewer, not more, regulators. The Committee on Capital Markets Regulation, a private, nonpartisan organization on which we serve, recommended in its May report that serious consideration should be given to the creation of a unified supervisor, such as a U.S. Financial Services Authority, modeled on the approach of the United Kingdom. Our financial system has had a complete meltdown and our outmoded regulatory structure is partially responsible. This is the time to redesign the system for the future, not for politics as usual.

Reduced complexity and more accountability will result from a streamlined regulatory system.  The professors should take their case to Capitol Hill.

A recent article in Treasury & Risk Magazine discusses the incorporation of ERM reviews in credit ratings by Standard & Poors.  These reviews have been a part of ratings reviews in the financial services industry, but now are being extended to non-financial companies.  Criteria for these reviews will be released soon as discussed in the excerpt below.

“Most companies these days recognize the value of risk management,” says Dale Hall, vice president and chief actuary at Bloomington, Ill., insurer Country Financial. But he says for a lot of them, it’s still mostly in the “should do” category.  Steve Dreyer, an S&P managing director who heads the ERM global integration project, says, “This is something we’re doing very deliberately and carefully.”

The plan is not for some kind of “big bang,” Dreyer says. Rather, S&P’s analysts, in the normal process of their reviews, are talking with corporate managers about risk management and developing criteria and a methodology, which will be published before ERM ratings are actually offered. “We’re getting the lay of the land,” he says. The target date for publishing the criteria to be used for risk management ratings is the third quarter of 2009.

Is your company prepared for these reviews?  If not, Wheelhouse Advisors can help.  To learn more, visit www.WheelhouseAdvisors.com.

Last week, a high-profile group of investor advocates published a report that provides practical recommendations on how to reform the U.S. financial regulatory system.  Known as the Investors’ Working Group (IWG), this independent, non‐partisan panel was formed to provide an investor perspective on ways to improve the regulation of U.S. financial markets.  The group is led by former SEC chairmen William Donaldson and Arthur Levitt and, among other things, recommends establishing a Systemic Risk Oversight Board rather than placing this responsibility in the hands of the Federal Reserve.  Here is a summary of their proposals.

1. Designating a systemic risk regulator, with appropriate scope and powers. One option would be for the Systemic Risk Oversight Board to evolve into a full‐fledged regulator.
2. Adopting new regulations for financial services that will prevent the sector from becoming dominated by a few giant and unwieldy institutions. New rules are needed to address and balance concerns about concentration and competitiveness.
3. Strengthening capital adequacy standards for all financial institutions. Too many financial institutions have weak capital underpinnings and excessive leverage.
4. Imposing careful constraints on proprietary trading at depository institutions and their holding companies. Proprietary trading creates potentially hazardous exposures and conflicts of interest, especially at institutions that operate with explicit or implicit government guarantees. Ultimately, banks should focus on their primary purposes, taking deposits and making loans.
5. Consolidating federal bank regulators and market regulators. Regulation of banks and other depository institutions may be streamlined through the appropriate consolidation of prudential regulators. Similarly, efficiencies may be obtained through the merger of the SEC and the Commodity Futures Trading Commission (CFTC).
6. Studying a federal role in the oversight of insurance companies. The current state‐based regulation makes for patchwork supervision that has proven inadequate to the task.

This report offers a middle path on many issues under debate today and may prove to be the best way forward for all involved.

Over the past few years, companies have become enamored with key performance indicators (“KPIs”) as a method for improving their operations and bottom-lines.  However, when viewed in the short-term, KPIs are only one side of the coin.  To have a full view, companies must understand their key risk indicators (“KRIs”) as well.  Here is a recent viewpoint from Ventana Research.

Key Risk Indicators (KRIs) are emerging as an important element of performance management. This reflects the times, since corporations tend to pay closer attention to understanding and mitigating risk during a crisis or a tough business environment. In a challenging business environment, KRIs are becoming increasingly important because they are an important complement to Key Performance Indicators (KPIs). KPIs are related to the most important business objectives. They indicate the degree to which individuals, business units or companies are achieving them. KRIs are specific events or root causes that prevent achievement of performance goals.

Does your company have a full view through KPIs and KRIs?  If not, Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com.

As the current recession continues into its seventh quarter, many companies are living on the edge when it comes to risk management and compliance.  To conserve cash in the short term, a company will often forego investments in risk management and compliance because it does not bear an immediate return to the bottom line.  While this may be true, the ultimate value of solid risk management and compliance  is in its ability to avoid catastrophic losses or major impacts to a company’s reputation.

Southwest Airlines is a case in point this week as its weak compliance practices have been brought to light through a faulty fuselage that imperiled a flight and its passengers.  On a flight from Nashville to Baltimore, the airplane suddenly developed a hole in its fuselage that caused the cabin to lose pressure and forced an immediate emergency landing.  Here is what was reported in the New York Times about the incident and subsequent investigation.

The National Transportation Safety Board has sent an investigator to the airport in Charleston, W.Va., where the 15-year-old plane landed, to inspect it and determine what caused the failure in the fuselage at cruising altitude. Representatives from Boeing and the Federal Aviation Administration are helping in the investigation. The event could have been catastrophic, and an F.A.A. spokesman, Les Dorr, said Southwest was being prudent to examine its airliners immediately. More sophisticated analysis will have to wait for details to emerge from the investigation, he said. “In the absence of any identified problem in the top of the airplane, that’s all you can do,” Mr. Dorr said.

In March, the agency ordered Southwest to pay a $7.5 million fine for a series of safety violations in which its jets were flying with undiagnosed fatigue cracks. The investigation against the airline, based in Texas, also uncovered efforts by managers at the F.A.A. to cover up reports of maintenance problems at Southwest.

As companies continue to sacrifice safety and reputation to protect the bottom line, more reports such as these will surface.  However, a proactive, cost-effective risk management and compliance program can help companies avoid “holes” in their approach and maintain a significant competitive advantage over the long-term.

An article in Wall Street Technology this week emphasizes the need for financial institutions to prepare for the coming wave of new rules and regulations.  Here is a sample of their view.

The Obama administration’s new proposals to regulate the financial industry, which respond to calls for greater transparency and oversight, will completely overhaul the way Wall Street firms operate. But even while specific regulations still are being mapped out, it is vital for financial institutions to prepare now to comply with any new rules that may be coming down the road.

Brian Cummings, director of information risk management, Tata Consultancy Services, North America, agrees that it is more essential than ever for firms to consolidate their risk and compliance efforts, rather than to just bolt on new tools. “You can’t have IT doing its own thing and accounting doing its own thing too,” he insists. “You need to take an enterprise view of risk management and consolidate your efforts.” Then firms can use the appropriate tools to analyze their risk exposure, Cummings continues. “That’s powerful, as trying to do it on an ad hoc basis makes it very difficult to get a grand view of where you are,” he says.

A streamlined, efficient approach to enterprise risk management can yield great cost savings and provide firms with a true competitive advantage over rival institutions.  Wheelhouse Advisors can help craft a cost-effective plan for your company to implement an integrated enterprise risk management program.  Learn more at www.WheelhouseAdvisors.com.

An article published in the current issue of Bank Systems & Technology discussed the weak links in the risk management infrastructures of some of the larger financial institutions during last year’s economic meltdown.  It seems that many institutions had to rely on highly manual, time consuming processes to understand their full risk exposures. Here is their view.

Weaknesses in the infrastructure often limited banks to identifying and aggregating exposures across the bank. A fragmented risk architecture dispersed over a multitude of systems made the reconciliation of the relevant data a time-consuming exercise, which was at best semi-automated, but more often a manual process. This led to banks needing far too long to aggregate their exposures and other relevant accounting and risk figures on a firmwide level. In the bankruptcy case of Lehman Brothers, for example, it was reported that it took some banks more than three weeks to determine their overall exposure to Lehman.

An inflexible risk environment within the banks rendered them incapable of reacting to sudden changes driven by external and internal circumstances—for example, the ability to perform ad hoc stress tests to assess the impact of new stress scenarios designed to address a rapidly changing environment.

In short, the interlinkage among risk types was not captured. The recent crisis has exposed the strong dependency among credit risk, market liquidity and funding liquidity pressures. Banks need to move away from silo-based risk management to achieve a more integrated and connected way of managing risk.

An integrated approach is not only required, it is also the most cost-effective solution in times like these.  Wheelhouse Advisors provides services to help companies build an integrated risk management program.  Visit www.WheelhouseAdvisors.com to learn more.

A recent report by Governance Metrics International (“GMI”) demonstrates that most major public corporations have a great deal of work remaining to improve their enterprise risk management practices.  GMI rates corporate governance and risk management practice for 4,162 companies worldwide.  Here is a summary of the major findings from the report.

Standardized disclosure of company-wide risk management is lacking

• Only 33.1% of the 4,162 companies covered by GMI worldwide provide comprehensive disclosure on their enterprise risk management policies (ERM) in the annual report or other publicly available source
• Only 8.4% disclose they have implemented a nationally or internationally recognized risk management charter or standard such as COSO’s Integrated Framework for Enterprise Risk Management

Risk committees of the board are even less common and are sector-specific

• 27.6% of companies covered by GMI disclose having a combined audit and risk committees
• 5.9% of companies covered by GMI disclose a stand-alone board level risk committee or subcommittee
• These were most often found among Banks (35.1%), followed by Life Insurers (21.3%) and Non-life Insurers (17.6%)
• There were no stand-alone board level risk committees or subcommittees in 11 of the 41 sectors covered by GMI

According to GMI President and CEO Howard Sherman, “Events of the last year have made it clear there is a need for heightened risk oversight at the board level. As companies start to come to grips with the challenge, we thought now would be the right time to start to develop a baseline. Our expectation going forward is that companies seen to be taking serious steps to augment risk oversight, especially in the financial sector, will be rewarded by the market.”

Wheelhouse Advisors is prepared to help your company improve its corporate governance and risk management practices in a cost-effective manner.  Visit www.WheelhouseAdvisors.com to learn more.

This week, the Washington Post revealed that the U.S. Treasury has launched an internal effort to determine the size and nature of credit risk across the U.S. financial system.  The effort is portrayed as the development of a last-ditch plan to understand the full scope of credit risk and where it resides.  Here is how the Post described the effort.

Informally known as Plan C, the internal project is focused on vexing problems such as the distressed commercial real estate markets, the high rate of delinquencies among homeowners, and the struggles of community and regional banks, said government sources familiar with the effort.

Part of the mission is assessing which firms are the most vulnerable and trying to decipher what assets these companies hold and whether they pose a danger to the wider financial system. Plan C is a small-scale, relatively informal approach to a problem the administration hopes to address in the long term by empowering the Federal Reserve to oversee systemic risk.  The creation of Plan C is a sign that the government has moved into a new phase of its response, acting preemptively rather than reacting to emerging crises, officials said.

This revelation is somewhat disturbing and promising at the same time.  It is disturbing that the government is just now beginning to work on an effort such as this, but promising in that they are working to prevent future problems rather than just cleaning-up after the fact.