The ERM Current™

Yesterday, the U.S. Senate Banking Committee conducted a hearing to discuss ideas for financial regulatory reform.  Senator Christopher Dodd, chairman of the committee, argued the case for streamlining the governmental agencies that currently oversee the nation’s largest financial institutions.  In his remarks, he pressed the need for the creation of a new, single regulatory agency that will consolidate the handful of agencies that provide oversight today.  Here’s what he had to say.

“I have heard from many who have argued that I should not push for a single bank regulator.  The most common argument is not that it’s a bad idea – it’s that consolidation is too politically difficult.  That argument doesn’t work for me,” said Dodd. “We must eliminate the overlaps, redundancies, and additional red tape created by the current alphabet soup of regulators.”  Dodd went on to detail priorities in bank regulation.  “We need to preserve our dual banking system.  And I feel just as strongly on that point as I do the earlier point.  State banks have been a source of innovation and a source of strength, a source of tremendous strength, in their communities.   A single federal bank regulator can work with the 50 state bank regulators.” The chairman also recognized the important role played by community banks.  “Community banks did not cause this crisis and they should not have to bear the cost or burden of increased regulation necessitated by others.  Regulation should be based on risk – community banks do not present the same type of supervisory challenges their large counterparts do.”

Streamlining oversight in this way will not only strengthen the regulatory framework, it will also eliminate much of the excess governmental spending and bureaucracy that currently exists.

This week, Forbes magazine reported results from the 2009 Global Risk Management Study sponsored by Accenture. The detailed report demonstrates the need for significant improvement in enterprise risk management approaches at major corporations across the globe. Here’s a summary of the findings.

A snapshot of the results of the survey of 260 chief financial officers, chief risk officers and others responsible for corporate risk in 21 countries suggests just how much surgery may be needed to repair risk management. By huge margins, the respondents identified the following major problems:

• Ineffective integration of risk, return and capital issues in decision making: 85%
• Lack of alignment between a company’s strategy and its risk appetite: 85%
• Insufficient management understanding of risk exposure types, and lack of agreement on how to mitigate such risks: 82%
• Inadequate availability of timely risk, finance and business data: 80%
• Lack of company-wide processes that could provide a complete picture of the impact of risk exposure: 78%
• Ambiguous divisions of responsibility concerning risk between corporate and business units: 78%

Following the last big downturn, in 2002, businesses attempted to adjust their risk exposure by strengthening their internal controls and improving their financial transparency. Today’s world, however, requires much stronger fixes than just tweaking finance and accounting practices. In fact, businesses must fundamentally change their core risk processes.

If your company is searching for cost-effective solutions to challenges such as these, Wheelhouse Advisors can help. Visit www.WheelhouseAdvisors.com or email us at NavigateSuccessfully@WheelhouseAdvisors.com, to learn more.

Today, the U.S. House Financial Services Committee will welcome several experts to debate financial regulatory reform approaches.  Paul Volcker, former Federal Reserve Chairman and current Head of the President’s Economic Recovery Advisory Board, will testify first by offering his views on how reforms should be enacted.   Here is an excerpt from his prepared testimony.

Important parts of the Administration’s proposed reforms can be – and some are being – implemented and enforced under existing authority. The Treasury has set out principles for capital and liquidity standards. Other prudential approaches are under consideration. Most notably risk management practices, for banks and certain other regulated institutions have been placed under urgent review. At the supervisors’ initiative, useful and needed steps are being taken to encourage more prudent compensation practices.

These are needed steps toward a stronger reformed financial system. However, I want to emphasize two inter-related issues of fundamental importance that run across the more particular elements of reform. One is a matter of broad regulatory practice: how to deal with the insidious, potentially risk-enhancing, spread of “moral hazard”, the presumption that systemically important institutions may be protected in the face of imminent failure. The overlapping question is one of administrative responsibility: in particular the appropriate role of the central bank (the Federal Reserve) in regulation, supervision and oversight of the financial system.

Mr. Volcker has defined the problem very well.  The answer lies in the need to decelerate the consolidation of financial institutions and accelerate the consolidation of regulatory oversight.  Just the opposite has occurred over the past few decades and led us to the brink of financial collapse.

In this month’s issue of the Journal of Accountancy, Enterprise Risk Management (“ERM”) is profiled as a management discipline that has much room for improvement in many companies today.  The authors of the article note that few companies have adopted a true ERM approach and a large number of companies have yet to see the value of implementing an ERM program.  However, with the complexity and interconnection of risks increasing, many senior executives and board members are realizing the need for a solid ERM program in their company.  Here is what the authors have to say.

Much of the shift in thinking about risk oversight has centered on ever-growing calls for boards and senior executives to embrace the business paradigm widely known as enterprise risk management (ERM). ERM is championed as an effective approach to identifying, assessing and monitoring risks across organizations and establishing communication protocols to efficiently share this risk information quickly across the entity. The ERM approach emphasizes a top-down, holistic view of the inventory of key risk exposures potentially affecting an enterprise’s ability to achieve its objectives. Proponents argue that a comprehensive ERM process helps to ensure that significant risks are given adequate consideration by senior management and boards of directors in the strategic planning process. Boards and senior executives use this inventory of risks with the goal of preserving and enhancing stakeholder value.

Is your company contemplating an ERM implementation?  If so, Wheelhouse Advisors can help. To learn more, visit www.WheelhouseAdvisors.com.

The debate about the Federal Reserve’s plan to regulate pay practices at financial institutions is heating up.  Reports in the Wall Street Journal indicate that views on the matter are highly polarized.  In addition, experts are suggesting that the new regulations could mean that boards of directors will need to work harder to understand their company’s risk profile and compensation systems.  Here is an excerpt from the WSJ.

The Federal Reserve’s new push to regulate pay at U.S. banks will make things more difficult for boards and their compensation committees, already under fire for controversial pay practices. The planned Fed move could increase time demands, recruitment challenges and legal exposure for boards, predict directors and pay consultants. “You’re going to have to make sure the whole board is involved in risk issues,” says Robert E. Denham, a Los Angeles attorney and former chief executive of Salomon Inc. Mr. Denham is co-chairman of an executive-pay task force created by the Conference Board, a New York business group.

Companies and board members will need to rely more than ever on their enterprise risk management (“ERM”) programs to provide timely information to support compensation related decisions.  In addition, greater regulatory scrutiny will demand the implementation of strong ERM programs.  Wheelhouse Advisors can help your company design and implement a cost-effective ERM program.  Visit www.WheelhouseAdvisors.com to learn more.

The Wall Street Journal reported today that the Federal Reserve is planning to begin regulating pay practices at financial institutions that it oversees currently.  The intent of the Federal Reserve is to limit short-term compensation that rewards excessive risk taking.  Here is what the Journal says about the plan.

Details of the Fed’s plan aren’t final, but the central bank will propose to review pay packages for tens of thousands of bankers to guard against the encouragement of excessive risk, and to allow banks to “claw back” compensation in certain cases. In essence, the Fed is moving to greatly broaden the kind of scrutiny that Obama administration pay czar Kenneth Feinberg has applied to seven firms receiving large amounts of federal aid.

The Fed’s move is the latest, and potentially most sweeping, of several efforts to curb risk-taking in the wake of the financial crisis. Congress approved provisions in both the bank-bailout bill last year and the economic-stimulus package in February to restrict some pay. Treasury Secretary Timothy Geithner also addressed the issue in the administration’s proposed regulatory overhaul in June.

All of these efforts have had to confront a difficult truth: The relationship between risk-taking and compensation is neither simple nor well understood. Moreover, bankers and many others say it is important to encourage some risk-taking.

Since details of the plan have not yet been released, it is too soon to offer opinions on the effectiveness or impact of such oversight.  However, the Federal Reserve must be careful to avoid micromanaging pay and usurping the authority that is placed in the hands of the Board of Directors at these institutions.

In an acknowledgement of the need for improvement in their risk management practices, the U.S. Securities & Exchange Commission (“SEC”) has created a new division for risk and strategy.  The SEC is following a similar path that many corporations are taking by creating an enterprise risk management program that will integrate silos of risk practices across the agency.  Here is what was reported by the Associated Press yesterday.

The Securities and Exchange Commission has merged several offices and functions to create a division of risk, strategy and financial innovation.  The new division will be headed by Henry T.C. Hu, a professor of banking and finance law at the University of Texas, the agency announced Wednesday. The division combines the SEC’s Office of Economic Analysis, Office of Risk Assessment and other functions. It will assume those areas as well as strategic and long-term analysis, identification of new trends in financial markets, and risk to the financial system.

This is certainly a step in the right direction for an agency that is battling to regain its reputation for sound oversight and enforcement.  In addition, the goal of linking their risk assessment to long-term, strategic analysis will prove to be useful by proactively addressing problem areas before they become massive like the Madoff Ponzi debacle.

As we are emerging from the financial crisis, the debate on Capitol Hill is firmly focused on health-care rather than financial regulatory reform.  It seems as though Congress can only single thread major legislation and, as a result, financial regulatory reform has taken a back seat.  However, the American Banker reported this week that the president is still intent on passing meaningful regulatory reform this year.  Here is what they had to say.

With much of the political world focused on health-care reform, the president appeared to signal that a financial services overhaul is still a priority for him. He reiterated that he hopes Congress will act this year — an increasingly unrealistic timeline by most estimates — and warned that bankers and other lenders cannot return to business as usual now that the crisis appears to be passing.

“The growing stability resulting from these interventions means we are beginning to return to normalcy,” President Obama said in a speech at Federal Hall in the heart of New York’s financial district. “But what I want to emphasize is this: Normalcy cannot lead to complacency. … We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses.”

Unfortunately, a well conceived plan to reform our financial regulatory structure has not been put forth. Without a clear plan, action will come later rather than sooner. Let’s hope the bail-out band-aids hold long enough to see meaningful reform.

Today’s post marks a significant milestone for The ERM Current™.  This is the 200th post to the blog since it was launched a year ago.  As we all know, the past year has been a remarkable one for the global economy and the practice of risk management.  Given the milestone, it is certainly appropriate to look back to evaluate the role of Enterprise Risk Management (“ERM”) in the financial crisis that erupted at the same time this blog was launched.  In today’s issue of Business Insurance Magazine, the following assessment of ERM was made.

Some observers have questioned whether enterprise risk management was to blame for the financial crisis, as the industry where ERM is most widely practiced is financial services. Others say ERM was not the problem; the real culprit was companies’ failure to use ERM.

I agree with the latter view. Enterprise risk management makes both theoretical and practical sense, but what many people misunderstand is that there is no one-size-fits-all approach to managing risks, be they hazard risks or business risks.

Traditional risk management is concerned with hazard risk—that is, the effects of accidental loss. ERM encompasses hazard risk as well as business risk, which holds the possibility of loss, no loss or gain. ERM also is about maximizing organizational value, which requires viewing risk as both possibility of loss and opportunity.

One of the lessons from the financial crisis is that companies must take a strategic view of risk and manage it so that they can avoid disaster and position themselves to create opportunities, or at least take advantage of ones that arise.

This is a spot-on assessment that many companies and risk professionals should take to heart.  As we emerge from the crisis, some may become too focused on the hazard risks and miss out on exceptional business opportunities.  On the flip side, others may be emboldened by the fact that they survived the crisis and ignore potential risks.  A comprehensive ERM program is crucial to navigate through the myriad of risks successfully. Wheelhouse Advisors can help. Visit www.WheelhouseAdvisors.com to learn more.

This week, the Basel Committee on Bank Supervision released a statement regarding proposed changes to the Basel II Capital Accord that will significantly impact the capital requirements for financial institutions across the globe.  The intent of the proposal is to increase transparency into the capital reserves as well as reduce risk across a number of categories.  The following changes are slated to be assessed and implemented throughout 2010.

• Raise the quality, consistency and transparency of the Tier 1 capital base. The predominant form of Tier 1 capital must be common shares and retained earnings. Appropriate principles will be developed for non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital. Moreover, deductions and prudential filters will be harmonised internationally and generally applied at the level of common equity or its equivalent in the case of non-joint stock companies. Finally, all components of the capital base will be fully disclosed.
• Introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for differences in accounting.
• Introduce a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio.
• Introduce a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward-looking provisions based on expected losses.
• Issue recommendations to reduce the systemic risk associated with the resolution of cross-border banks.
• Assess the need for a capital surcharge to mitigate the risk of systemic banks.

These changes will have a sizeable impact on the way financial institutions manage and disclose risk in the coming years.  However, given the complexity and interconnectivity of our financial markets, it is certainly the prudent course to take.