The ERM Current™

A leading risk management expert and chief risk officer at a major U.S. financial institution offered his insight on risk management practices last week in the Columbus Business First Journal.  His views are candid and becoming more common as the dust begins to settle from the recent financial crisis.  Here is what he had to say.

Kevin Blakely, senior executive vice president of Huntington Bancshares Inc. in Columbus and its chief risk officer said years ago, things were relatively simple. “Most of our risk was centered in credit risk – lending to individuals and companies, and gauging our ability to get that money back,” he said. Until this past summer, Blakely had been president of the Philadelphia-based Risk Management Association. But as companies got bigger and financial products got more complex, financial institutions developed mathematical models to measure risk. They worked well, he said, but by the mid-1990s banks were depending on them too much. “We began to view them as the answer, rather than as one more input before you get to the answer,” Blakely said. “That was one of the rude lessons we learned over the last couple of years. As an industry, we weren’t as smart in the business of risk management as we thought we were.”

The false sense of security placed in risk management was certainly a rude lesson for many companies as they focused on quantitative models that told them what they wanted to believe.  A balanced view of both quantitative and qualitative factors is critical to an effective enterprise risk management program.

Yesterday, JP Morgan Chase CEO Jamie Dimon shared his views on the financial crisis with Charlie Rose at the Securities Industry and Financial Markets Association annual meeting in New York.  In the interview, Mr. Dimon reflected on risk management approaches taken by many financial institutions leading up to the crisis.  He stated, “You should never rely solely on VaR, Basel I or Basel II for risk management practices.  If you did, it was a mistake.”   He went on to explain that sound risk management practices require both quantitative analysis and management judgment to be effective.  He also noted that there are legitimate failures in the application of the Basel II Capital Accord that left many institutions with insufficient capital positions.   His full remarks can be viewed in the video web link below.

Jamie Dimon speaks with Charlie Rose at SIFMA Annual Meeting

U.S. House Financial Services Committee Chairman Barney Frank (D-MA) distributed a proposal for derivatives regulation this week and it was the subject of a hearing by the committee yesterday.  A major part of the discussion centered on a potential loophole that would allow many corporations, if not all, to avoid the new regulation altogether. Here is what Bloomberg.com reported about the hearing and draft legislation prepared by Chairman Frank.

A plan offered by the Obama administration would subject all swaps dealers and “major market participants” to new regulations for capital, business conduct, record-keeping and reporting. Frank’s version would exempt corporations from that definition if they use derivatives for “risk management” purposes.

While Frank’s proposal is a “step in the right direction,” its “ambiguous” definition of risk management may leave a large number of corporations unregulated, Henry T.C. Hu, director of the SEC’s new division of risk, strategy and financial innovation, told the committee.

“As just about all swaps could be defined as being used for risk management purposes, we’re concerned that unintentionally the category of ‘major swap participant’ could have been narrowed so significantly, or even to a null set,” CFTC Chairman Gary Gensler told reporters after the hearing.

“Major hedge funds” may be excluded from oversight, as may the mortgage-finance companies Fannie Mae and Freddie Mac “because of course the government-supported enterprises use swaps for risk management purposes,” Gensler said.

It looks like Chairman Frank may need to re-educate himself on the use of derivatives and go back to the drawing board on this proposal.

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. 

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.  

In the January 2009 issue of CFO magazine, an article examines the risk management challenges faced by many corporations in the wake of the financial crisis.  The article entitled “Rethinking Risk” rightly advises that new approaches are needed to successfully implement effective enterprise risk management programs.  Here is an excerpt from the article.

But some CFOs caution that formal enterprise risk management (ERM) programs won’t succeed if they don’t mesh well with a company’s culture. Impose a new framework from on high and you risk crushing something underneath.  Progress may depend largely on incremental improvements rather than technological leaps or massive consulting engagements. Existing risk-reporting processes must break down silos that impede risk oversight and prevent a broader awareness of risk throughout the organization. 

In most cases, a thoughtful, strategic approach to refining a risk management program is all that is needed. Wheelhouse Advisors provides cost-effective solutions to help corporations refine and streamline their risk management practices.  Visit www.WheelhouseAdvisors.com to learn more.

As more and more begins to emerge from the collapse of our financial markets, it is becoming clear that effective risk management was severely handicapped by those looking to increase their personal compensation.   The New York Times reported this past weekend some of the egregious mortgage lending practices at Washington Mutual (“WaMu”) that led to the largest bank failure in American history.   

WaMu gave mortgage brokers handsome commissions for selling the riskiest loans, which carried higher fees, bolstering profits and ultimately the compensation of the bank’s executives. WaMu pressured appraisers to provide inflated property values that made loans appear less risky, enabling Wall Street to bundle them more easily for sale to investors.  “I never had a clue about the amount of off-the-cliff activity that was going on at Washington Mutual, and I was in constant contact with the company,” said Vincent Au, president of Avalon Partners, an investment firm. “There were people at WaMu that orchestrated nothing more than a sham or charade. These people broke every fundamental rule of running a company.”

The major problem here is not that WaMu was poorly managed, but that the practices at WaMu became accepted by the mortgage industry as a whole.  Major reform is desperately needed to ensure that practices such as these are prevented from “becoming the norm” again.

Heading into 2009, many firms are beginning to realize the need to bolster their risk management practices and approaches.  The main challenge centers around the need for a solid risk management framework that can be employed throughout an organization.  In turn, the framework should shape the risk management culture with strong support from the CEO and Board of Directors.  In a recent article in Wall Street & Technology magazine, risk management is identified as the number one priority for financial firms in 2009.   Here is an excerpt:

Analysts agree that the biggest challenge firms face in managing risk is at the operating level. Risk managers will be given much more importance by a firm’s top managers than in the past, when the pursuit of alpha typically came at the expense of risk mitigation. 

This certainly comes as no surprise given the severity of the current crisis driven largely by the neglect of risk management.  Everyone is talking the talk.  2009 is the year to walk the risk management walk.

Some of you may recall previous posts regarding the SEC’s office of risk management that contained only one staffer for many years.  Well, according to the Wall Street Journal, the one person office was notified earlier this year about Bernard Madoff’s massive Ponzi scheme and did nothing to investigate.  The article details the many attempts of Harry Markopolos to alert the SEC to the fraud.  Mr. Markopolos final attempt was made to the head of risk management at the SEC, Jonathan Sokobin.   Here is the account of that attempt:

Early this year, Mr. Markopolos made one last major effort after receiving an email from Jonathan Sokobin, an official in the SEC’s Washington, D.C., office whose job was to search for big market risks. Mr. Sokobin had heard about Mr. Markopolos and asked him to give him a call, according to an email exchange between them.  

Mr. Markopolos also sent Mr. Sokobin an email — with the stark subject line “$30 billion Equity Derivative Hedge Fund Fraud in New York” — saying an unnamed Wall Street pro recently pulled money from Mr. Madoff’s firm after trying to confirm trades supposedly done in his account, but discovering that no such trades had been made.  It was his last try.  He never heard back about his allegations regarding Mr. Madoff.  ”I felt pretty low,” Mr. Markopolos recalls.  Mr. Sokobin, through an SEC spokesman, declined to comment.

To Mr. Sokobin’s credit, he did reach out to Mr. Markopolos to investigate.  However, given the size of his office, it is not surprising he could not act quicker to bring the fraud to an end.  Greater evidence is not needed to justify more investment in risk management.

The U.S. House Committee on Oversight and Government Reform conducted a hearing on Tuesday into the circumstances leading to the recent collapse of Fannie Mae and Freddie Mac.  Chairman Henry Waxman provided the committee with several documents detailing numerous warnings by internal risk managers that were purposefully ignored by executive management.  Below is an example provided by Chairman Waxman.

On October 28, 2006, Fannie’s chief risk officer sent an e-mail to company CEO Daniel Mudd warning about a “serious problem” at the company. He wrote: “There is a pattern emerging of inadequate regard for the control process.”  In another e-mail on July 16, 2007, the same risk officer wrote to Mr. Mudd again, this time complaining that the board of directors had been told falsely that the “we have the will and the money to change our culture and support taking more credit risk.” The risk officer wrote: “I have been saying that we are not even close to having proper control processes for credit, market, and operational risk. I get a 16 percent budget cut. Do I look so stupid?”  But these warnings were routinely disregarded.

Much has been said about the failures of risk management leading to the current crisis.  However, it is becoming increasingly clear, through examples such as these, that the failure to take action on warnings provided by risk management led to the current crisis.