Information Technology is a Core ERM Building Block

As the year nears an end, many folks are looking to 2011 in anticipation of the regulatory impact beset by the Dodd-Frank Act of 2010. One of the primary impacts discussed today in Bank Systems & Technology magazine is the specter of the new Office of Financial Reform. Financial services companies of all shapes and sizes will soon be subject to the requests for data from this new agency to support its mission of reporting emerging risks to the U.S. Congress. Here's an overview of what companies can expect.

The Dodd-Frank legislation establishes the Office of Financial Reform (OFR), a new department within the U.S. Department of the Treasury that is tasked with gathering and reporting to lawmakers information regarding potential risks and threats within the nation's financial industry. To accomplish this, the OFR's director can use his or her subpoena power to gather data from any financial institution.

Simply, says Michael Atkin, director of the Enterprise Data Management Council, a nonprofit trade association focused on managing and leveraging data, the regulation gives banks' corporate leadership a new opportunity to examine the growing problem of managing skyrocketing amounts of data and finally to budget appropriately to meet the challenge. "It kicked the practice of data management into high gear," Atkin says. "We're now set up for addressing the data dilemma that we have because we finally have a reason that is not subject to the whim of a business case. It is a regulatory requirement."

The OFR director, who has not yet been appointed, will make his or her report to Congress in 2012, adds Atkin. But that initial report, he notes, likely will be more on the state of the industry than a detailed analysis of its data, giving financial institutions a window of several years to prepare for potential requirements. "The implications from an infrastructure perspective are about getting the core building blocks of risk management in place," Atkin relates.

Now is the time, as Atkin says, to get your "core building blocks of risk management in place". Wheelhouse Advisors can help. Visit www.WheelhouseAdvisors.com to learn more.

Assessing Systemic Risk

New York University's Stern School of Business hosted a conference yesterday to discuss how systemic risk should be addressed under the Dodd-Frank Act.  One of the presenters at the conference, Stanford Finance Professor Darrell Duffie, proposed a new approach for identifying systemic risk.  Here's some detail on his proposal as reported by Bloomberg.

The world’s largest banks and investment firms should undergo quarterly stress tests to identify risks that could sink the financial system, according to a proposal by Stanford University finance professor Darrell Duffie. “I’m not talking about the ordinary, matter-of-course, risk management of institutions. We’re looking at what are the sources of risk and how are they flowing through the system. We want to connect the dots.”

Duffie calls his plan “10-by-10-by-10” because it’s based on 10 financial firms undergoing 10 stress tests that expose the banks’ 10 largest trading partners. For example, institutions would be tested on their ability to withstand the default of a single firm that they do business with, an idea replicating the 2008 Lehman bankruptcy.

“The objective is to alert regulators and the public to potential sources of financial instability before they reach dangerous levels,” Duffie wrote in a paper outlining the proposal. The tests, which would be adjusted over time to cover different scenarios, could flush out new systemically important firms as they arise, Duffie said. Central bankers could opt to conduct some of the stress tests using average financial numbers over a given timeframe “to mitigate period-end ‘window dressing,’” Duffie said. Regulators should also audit the way the banks measure the data they present, he said.

More specifics about the Duffie proposal are contained in his working paper, "Systemic Risk Exposures: A 10-by-10-by-10 Approach." By his own admission, Duffie notes that this proposal merely represents a first step for regulators to begin to analyze systemic risk. There are shortcomings to the proposal such as the current lack of data as well as the potential to exclude other entities that may pose risks to the system. However, the regulators must begin somewhere and this approach is a practical method for assessing systemic risk.

Is This Just the Tip of the Iceberg?

The Congressional Oversight Panel released its November report today and it focused on the continued foreclosure crisis. The panel is calling for additional investigation by regulators and is also requesting that the U.S. Treasury provide additional evidence of their claim that the crisis has been averted.  Below is an excerpt from their report as well as video commentary from the chairman of the panel, Senator Ted Kaufman.

At this point the ultimate implications remain unclear. It is possible, however, that “robo-signing” may have concealed much deeper problems in the mortgage market that could potentially threaten financial stability and undermine the government‟s efforts to mitigate the foreclosure crisis. Although it is not yet possible to determine whether such threats will materialize, the Panel urges Treasury and bank regulators to take immediate steps to understand and prepare for the potential risks.

In the best-case scenario, concerns about mortgage documentation irregularities may prove overblown. In this view, which has been embraced by the financial industry, a handful of employees failed to follow procedures in signing foreclosure-related affidavits, but the facts underlying the affidavits are demonstrably accurate. Foreclosures could proceed as soon as the invalid affidavits are replaced with properly executed paperwork.

The worst-case scenario is considerably grimmer. In this view, which has been articulated by academics and homeowner advocates, the “robo-signing” of affidavits served to cover up the fact that loan servicers cannot demonstrate the facts required to conduct a lawful foreclosure. In essence, banks may be unable to prove that they own the mortgage loans they claim to own.

Only time will tell whether the foreclosure issues are merely the tip of the iceberg.  However, if the issues are real, then the financial institutions and other involved parties will be best served to proactively address the problem now rather than hoping it goes away on its own.

The Need for ERM is Crystal Clear

Unlike the waters of the Gulf of Mexico, the need for companies to have robust enterprise risk management ("ERM") programs became crystal clear during an interview of former BP CEO Tony Hayward aired this week by the BBC. Here's some of the highlights from the interview.

Former BP PLC chief Tony Hayward has acknowledged that the company was unprepared for the disastrous Gulf of Mexico oil spill and the media frenzy it spawned, and said the firm came close to financial disaster as its credit sources evaporated.

In an interview with the BBC to be broadcast Tuesday, Hayward said company's contingency plans were inadequate and "we were making it up day to day."

Hayward said BP had found itself unable to borrow from international investors during the spill crisis, threatening its finances. He said that before a meeting with President Barack Obama at the White House in June, "the capital markets were effectively closed to BP." "We were not able to borrow in the capital markets, either short or medium term debt at all, " he said. "It was a classic financial crisis issue."

Hayward's successor, Bob Dudley, told the program that "these were frightening days" for BP. "With a company the size of BP, its reputation, what it does — you almost can't quite believe how close you are" to financial disaster, he said.

This interview demonstrates the catastrophic impacts of a risk event not only to the environment at large, but also to every corner of the company responsible for the event occurring. BP obviously did not have a comprehensive ERM program at the ready that resulted in improvisation and ultimately a full-blown crisis. Only a company of BP's size and resources could weather this type of event. So, how effective is your ERM program?

Navigating Risk: From Crisis to Innovation

A big challenge for many companies today emerging from the financial crisis is retaining their ability to innovate new products and services. The typical view is that the larger the company, the harder it is to innovate. Why is that? It seems counterintuitive given the vast resources of larger companies compared to their smaller competitors. This issue was recently highlighted in an article on CNN.com. Here are the views of a few who have examined the issue in greater detail.

Can companies grow and continue to be creative and innovative? Or will smaller operations always have a monopoly in the new-ideas department? "I don't think there's any reason why you can't be as big as Goliath and as nimble as David," said Jim Andrew, a senior partner at the Boston Consulting Group, which publishes a yearly list of the world's top innovative companies in conjunction with Bloomberg Businessweek. This year, Apple, Google, Microsoft and IBM led the list. Facebook and Twitter were nowhere to be found.

"Big companies have a tremendous number of advantages that should allow them to actually be, I would argue, more innovative than a given smaller company," Andrew said.  The tech giants tend to have a wide range of products or services to offer -- meaning they can take bets on new ideas without risking their entire business, Andrew said. Start-ups, in contrast, tend to base their future on a single product or concept. They bet big, but most of them "end up dying," said Karim Lakhani, an assistant professor at Harvard Business School. "They go out there, they try different things and then there's a large, large failure rate," he said.

Both Lakhani and Andrew said it's easy for big companies to get too comfortable and forgo the risks that are necessary for innovation to occur. "As companies get bigger that latitude [for employees to be creative] often unfortunately gets taken over by more rigid management structures and more rigid philosophies," Lakhani said.

For those interested in exploring this dilemma further, mark your calendars for an upcoming workshop that will help you navigate the risks associated with innovation.  On January 11 & 12, Wheelhouse Advisors will conduct an executive workshop entitled Navigating Risk: From Crisis to Innovation. The workshop will be held at the highly renowned Old Edwards Inn & Spa in beautiful Highlands, NC.  For more information, email Navigate@WheelhouseAdvisors.com or call 404-805-9203.

SEC Seeks to Shed Light on Foreclosure Crisis

The U.S. Securities & Exchange Commission ("SEC") has entered the foreclosure fray by requiring publicly traded financial services companies to disclose their estimated risk of foreclosure related losses. Here's what Bloomberg Business Week reported on the recent SEC actions.

Lenders must disclose circumstances that they “reasonably expect” to have an “unfavorable impact” on financial results, the SEC said in a letter posted on the agency’s website today. The letter was sent because of “concerns about potential risks and costs associated with mortgage and foreclosure-related activities,” the SEC said. Federal regulators and attorneys general from all 50 states are investigating whether loan-servicing companies used improper procedures during foreclosure proceedings, including so-called robo-signers who didn’t check documentation. Investors such as Pacific Investment Management Co. have demanded that banks buy back faulty loans that were bundled into bonds.

These forced disclosures will shed more light on the potential dollar impact of an operational risk that was neither fully anticipated nor proactively managed.