New Proposed Guidance on Stress Testing for Banks

Yesterday, the Office for the Comptroller of the Currency (”OCC”), the Federal Reserve and the Federal Deposit Insurance Corporation (”FDIC”) issued proposed guidance for banking institutions to create a robust stress testing framework to adequately assess potential risks. The largest financial institutions have been subject to direct stress testing during the financial crisis in association with the administration of the Troubled Asset Relief Program (”TARP”). This new guidance formally outlines requirements for a broader population of institutions, specifically those with $10 billion or more in assets. According to the guidance, all banks of this size should structure their framework in the following manner.

“….. a banking organization’s stress testing framework should include, but are not limited to, augmenting risk identification and measurement; estimating business line revenues and losses and informing business line strategies; identifying vulnerabilities and assessing their potential impact; assessing capital adequacy and enhancing capital planning; assessing liquidity adequacy and informing contingency funding plans; contributing to strategic planning; enabling senior management to better integrate strategy, risk management, and capital and liquidity planning decisions; and assisting with recovery planning.”

While this guidance does not explicitly meet the requirements of section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act for non-bank companies, the OCC, Federal Reserve and FDIC plan to issue rules consistent with this guidance for those companies. So, this serves as a preview of what is to come. Public commentary on this proposed guidance is requested by June 29, 2011.

SEC Proposes New Credit Rating Rules

This week, the U.S. Securities and Exchange Commission (”SEC”) issued proposed rules that will have a great impact on the integrity of credit ratings going forward. The quality of credit ratings were highly suspect in the aftermath of the financial crisis of 2008. Many of the greatest losses incurred by financial institutions, municipalities and pension funds resulted from investments in securities that were touted as “investment grade”. However, as we know now, those investments were anything but. Now, the SEC will require Nationally Recognized Statistical Rating Organizations (”NRSROs”) like Moody’s and Standard & Poors to adhere to stricter controls and disclose more information about how the ratings are derived. The SEC issued the following statement supporting the approval of these new rules.

“In passing the Dodd-Frank Act, Congress noted that credit ratings applied to structured financial products proved inaccurate and contributed significantly to the mismanagement of risks by financial institutions and investors,” said SEC Chairman Mary L. Schapiro. “Our proposed rules are intended to strengthen the integrity and improve the transparency of credit ratings.”

Under the SEC’s proposal, NRSROs would be required to:

1. Report on internal controls.
2. Protect against conflicts of interest.
3. Establish professional standards for credit analysts.
4. Publicly provide – along with the publication of the credit rating – disclosure about the credit rating and the methodology used to determine it.
5. Enhance their public disclosures about the performance of their credit ratings.

Let’s hope these rules help to restore integrity to the marketplace and help investors better understand the risks involved in a given investment.

Standard & Poor’s Emphasizes ERM Importance

Since September 2008 when this blog was launched, Standard & Poor’s has been evaluating enterprise risk management (“ERM”) practices at both financial and non-financial companies as part of their credit rating evaluation process. Recently, Standard & Poor’s issued a white paper discussing the importance of ERM and clarifying its review process of non-financial companies.  The white paper also contains a list of Frequently Asked Questions that provides a better understanding of the nature and scope of the reviews.  Here is their view of the importance of ERM today.

Managing enterprise-wide risks and capitalizing on opportunities are fundamental responsibilities of senior executives at all firms. Standard & Poor’s Ratings Services’ corporate credit ratings include evaluations of those managers’ strategies, effectiveness, and credibility. These evaluations help us develop forward-looking opinions on credit strength by supplementing our fundamental analysis of the company’s business and financial risk profile. Beginning in September 2008, we widened the scope of our analysis of some non-financial companies’ management to enhance our review of managers’ ability to identify, monitor, and manage key risks — those endemic to its industry and those that managers elect to take when running their businesses. Specifically, we started to look at how a firm’s culture (communications, structures, incentives, and risk appetite) affects the quality of its decisions and at the role risk considerations play when making strategic decisions. The public spotlight on risk management has intensified since we began this initiative.
  1. The U.S. Securities and Exchange Commission (SEC) now requires that proxy statements that public companies file include disclosure of risk-based compensation policies, the role of the board of directors in risk oversight, and the nature of communications between executives and the board on risk issues.
  2. The National Association of Corporate Directors’ Blue Ribbon Report on Risk Governance urges boards to assess risk in strategy, closely monitor risks in culture and incentives, and consider emerging risks to the firm’s business.
  3. The International Organization for Standardization’s ISO 31000 family of risk management standards define a common global approach to risk management.
Greater public scrutiny follows the extended global recession and accompanying wave of corporate defaults — grim reminders of the consequences of unpreparedness and weak risk management.
Given the increased importance and added scrutiny, ERM is a certainly critical success factor for all companies today. If you are interested in how your ERM program measures up, Wheelhouse Advisors can provide a quick, complimentary diagnostic review.  To learn more, email us at NavigateSuccessfully@WheelhouseAdvisors.com.

Getting a Handle on Credit Risk

Many financial institutions have found themselves flat-footed as the current credit cycle continues to play itself out. Since the recent economic downturn was so severe and relatively quick, these banks could not easily predict or sort through the mounting customer defaults.  Much of this had more to do with the banks risk management structure and supporting technology rather than the sheer volume of losses.  Tom Johnson of Zoot Enterprises discussed his view in a recent article in Payments Source Magazine.

Credit risk needs to be handled across the entire lifecycle so banks have a better view of the customer as a whole and all areas that can benefit from enhanced data and intelligence. In doing so, banks can minimize the risk of default and loss while improving service and retaining their best customers.

Historically, banks have been organized in silos by lines of business. This can exacerbate the banks’ ability to deal with their customers from a holistic point of view. Breaking down silos has not only been a problem politically, but system limitations and legacy technology reinforce boundaries between departments. Because a bank’s structure is a multi-dimensional matrix, this adds even more complexity.

Providing a holistic view through a well-designed Enterprise Risk Management (“ERM”) program can improve a company’s ability to manage risks and at the same time improve customer service.  Wheelhouse Advisors can help your company achieve better results through ERM.  Visit www.WheelhouseAdvisors.com to learn more.

Rude Lesson in Risk Management

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.

risk cube

The Credit Risk Paradox

In this month’s issue of Treasury & Risk Magazine, the dramatic increase in credit risk at financial and non-financial companies is examined.  As strategies to mitigate credit risk become more sophisticated, a paradox ensues.  Rather than lowering the amount of credit risk, the strategies can have the opposite effect because they provide a false sense of security.  Here is what the article concludes.

On a macroeconomic level, the dramatic rise in credit risk is partly a result of the very success of credit risk mitigation tools and strategies, argues Jerry Flum, CEO of CreditRiskMonitor in Valley Cottage, N.Y. “We’ve done a lot to promote stability and off-load risk, but the more risk companies transfer, the more they leverage up. When you hedge credit risk with derivatives, you feel confident in taking on more debt.”

The illusion of safety achieved by theoretically reducing risk has encouraged companies to take steps that increase the consequences of negative developments. “Because the foundation seems stable, you build a skyscraper,” Flum says. “It’s rewarding but catastrophic when it falls.” Whether and how the skyscraper will be rebuilt will be a big issue for treasuries of the future.

The big question is how many skyscrapers with weak foundations are looming out there?  Periodic credit stress tests can help provide a better view of the skyscraper and how their foundations can be strengthened.

paradox

Resorting to Plan C

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.

treasury