The ERM Current™

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.

The debate over financial regulatory reform continues on Capitol Hill with a great deal of attention on compensation practices.  It has become blatantly obvious that incentive plans have not been designed to promote the best interests of shareholders or the long-term viability of institutions.  Here is what Federal Reserve Chairman Ben Bernanke had to say as reported in yesterday’s New York Times.

Last week, Ben S. Bernanke, the Fed chairman, also called on regulators to supervise executive pay at banks more closely to avoid “compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers.” Much of the plan would require the approval of Congress, where divisions are forming over how best to overhaul financial industry oversight.

The core of effective risk management hinges on the alignment of a company’s strategic objectives, risk appetite and compensation plans.  Once these become out of alignment, the company will certainly suffer over the long-term.

Chairman Ben Bernanke of the Federal Reserve Board spoke yesterday to the Council on Foreign Relations about his strategic view of regulatory reform.  His comments were focused on managing risk at the macro level, but still ring true for companies on a micro level as well.  He stated the following,

“We must have a strategy that regulates the financial system as a whole, in a holistic way, not just at its individual components.  In particular, strong and effective regulation and supervision of banking institutions, although necessary for reducing systemic risk, are not sufficient by themselves to achieve this aim. “

His view sounds very similar to the aims of enterprise risk management underway at many corporations today. Much like risk and compliance processes must be streamlined in companies, the Federal government must streamline its hodge-podge approach to regulating our financial system.