CNBC Profiles Internal Audit & Risk Management Practices

Earlier this week, the Institute of Internal Auditors' Richard Chambers was interviewed by CNBC on the evolving nature of risk management practices in light of the recent financial crisis. Mr. Chambers emphasized the need for corporate boards to set the risk appetite and work with management as well as the internal auditors to monitor the level of risks. In addition, he noted that compensation programs still need to be improved such that risk metrics are included in pay determination.  To view the entire interview, click below.

Too Little, Too Late?

At long last, the Financial Crisis Inquiry Commission released its final report today on the causes of the great financial crisis of 2008. Unfortunately, the report probably raises more questions than answers due to the fact that the commission was split on the true cause of the crisis. The Democrat majority provided their view that the crisis was ultimately caused by greedy Wall Street bankers coupled with a lax regulatory system. On the other hand, the Republican minority of three panel members portrayed the following more complicated series of causes in their dissenting view.

1. Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.


2. Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.


3. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.


4. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.


5. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing  prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.


6. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.


7. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policymakers to be willing to allow them to fail suddenly.


8. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock.


9. Financial shock and panic. In quick succession in September 2008, the failures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.


10. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.

In total, the report and dissenting viewpoints provide a great analysis of the risk event. However, both fail to provide a forward-looking view on how such a crisis can be avoided in the future. In addition, the results of their analysis have emerged months after the U.S. Congress finalized the Dodd-Frank Financial Reform Act of 2010. Unfortunately, this is too often the case when it comes to risk management exercises. Most people will spend an inordinate amount of time debating past events rather than determining strategies to prevent emerging risk events.

Getting the Most Out of ERM

The Committee of Sponsoring Organizations of the Treadway Commission, or more commonly known as COSO, released a report this month on how companies can derive the most benefit from their Enterprise Risk Management (ERM) programs.  Authored by two professors and risk practitioners from DePaul University, the report provides approaches and action steps for companies to follow as they embark on their ERM journey.  Here is a summary list of key activities to bolster the ongoing implementation of an effective ERM program.

1. A program of continuing ERM education for directors and executives


2. ERM education and training for business-unit management


3. Policies and action plans to embed ERM processes into the organization’s functional units such as procurement, IT,or supply chain units


4. Continuing communications across the organization on risk and risk management processes and expectations


5. Development and communication of a risk management philosophy for the organization


6. Identification of targeted benefits to be achieved by the next step of ERM deployment


7. Development of board and corporate policies and practices for ERM


8. Further discussion and articulation of a risk appetite for the organization and /or significant business units, including quantification


9. Establishment of clear linkage between strategic planning and risk management


10. Integration of risk management processes into an organization’s annual planning and budgeting processes


11. Expansion of the risk assessment process to include assessments of both inherent and residual levels of risk


12. Exploration of  the need for a dedicated Chief Risk Officer or ERM functional unit

Wheelhouse Advisors is fully equipped to help companies with activities such as these.  For more information, please visit www.WheelhouseAdvisors.com.

Making the Leap from Risk Management to Risk Mindfulness

Viewpoints on the practice of risk management have changed dramatically over the past several years.  The financial crisis of 2008 as well as other high-profile catastrophes like the Gulf Oil Spill have forced companies and boards to re-examine how they are addressing potential risks to their businesses. A recent study by the Economist Intelligence Unit highlights this fact as evidenced in the following excerpt.

Risk management can be a thankless task. Just ask Paul Moore, the former head of regulatory risk at HBOS, who claimed that he was sacked because he told the bank's board that it was taking too much risk. In the wake of the financial crisis, stories that banks would sidestep risk managers in order to get deals done were legion. Risk managers with legitimate concerns about the business were ignored and regarded as a brake on growth.

Three years on, the perception of risk management has changed. In the financial services industry, there is a clear consensus that serious mistakes were made with either risk management or risk governance. In response, banks and other financial institutions are beefing up risk departments and creating new governance structures that add to the risk function's authority and independence. Boards are creating risk committees and ensuring that non-executives are providing effective oversight of the company's risk exposure. Chief risk officers are being granted powers of veto over decisions made by executive management and reporting directly into non-executive directors.

This renewed zeal for risk management extends far beyond the banking sector. Events such as the financial crisis, and more recently the oil spill in the Gulf of Mexico, have reminded senior executives that failures in risk management can prove to be extremely costly, not just to a company's financial performance, but to their own careers and, sometimes, the lives of employees. The incentive to ensure that there is a clear and consistent approach to managing risk across the enterprise has never been greater.

However, although risk management is currently enjoying an unprecedented level of authority and visibility, it remains a function in transition. Examples of companies that take a genuinely strategic approach to their risk management remain few and far between. Communication between risk functions and the broader business can sometimes be fragmented, while an enterprise-wide culture and awareness of risk can be difficult to achieve.

What is needed is a new approach towards addressing risks or what we call “Risk Mindfulness”.  "Risk Mindfulness" is a term coined by Wheelhouse Advisors as a result of discussions with many companies about their approaches to gain a better understanding of their risk profiles.  What we have discovered is that many people have a very narrow (and sometimes negative) view of the term “Risk Management”.  The term “Risk Management” usually conjures up thoughts of insurance or compliance activities that have a very limited, historical focus on minimizing known risks.

“Risk Mindfulness” is meant to be more forward-looking and integrative.  Rather than seeking only to minimize or eliminate risk altogether, “Risk Mindfulness” supports the notion that the only bad risks are those that are not well understood and not fully incorporated in a company’s strategic plan.  Also, “Risk Mindfulness” should be company-wide and not restricted to certain individuals.  As the company as a whole becomes more mindful of how objectives will be successfully achieved given the potential risk, better decisions will be made and greater value will be realized.  To learn more about how your company can benefit from this new way of thinking, email us at NavigateSuccessfully@WheelhouseAdvisors.com.

The ERM Current™ - 2010 in Review

The stats helper monkeys at WordPress.com mulled over how this blog did in 2010, and here's a high level summary of its overall blog health:

The Blog-Health-o-Meter™ reads Wow.

Crunchy numbers

About 3 million people visit the Taj Mahal every year. This blog was viewed about 51,000 times in 2010. If it were the Taj Mahal, it would take about 6 days for that many people to see it.

In 2010, there were 94 new posts, growing the total archive of this blog to 326 posts. The busiest day of the year was March 17th with 475 views. The most popular post that day was Winds of Corporate Governance Change Are Blowing.

Where did they come from?

The top referring sites in 2010 were en.wordpress.com, google.com, search.aol.com, linkedin.com, and wheelhouseadvisors.com.

Some visitors came searching, mostly for information technology, risk, and corporate.

Attractions in 2010

These are the posts and pages from 2010 that got the most views.

1

Ignoring Risk Management at Lehman BrothersMarch 2010

2

FASB Chairman Steps Down August 2010

3

Federal Reserve Focuses on Operational Risk March 2010

4

Now is a Great Time to Discuss Risks for 2011 September 2010

5

Reputation Risk Must Be Actively Managed January 2010

Wheelhouse Advisors Joins the Business Finance Expert Network

Business Finance Magazine recently invited John A. Wheeler, Managing Principal at Wheelhouse Advisors, to join its Expert Network as a regular columnist for their online publication called the Big Fat Finance Blog. John will be contributing articles and thought leadership on issues in Finance & Risk Management in his own blog called the Risk Vortex. Along with the other columnists, the blog is intended to arm finance professionals with innovative ideas and best practices that help finance organizations create value. For up to date information on the events and trends that may impact your Finance & Risk Management organizations, be sure to subscribe to the Risk Vortex by clicking here.