The ERM Current™

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.

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.”