Growing Systemic Risk - Who Knew?

I'm writing today's post while visiting historic Boston, Massachusetts to review a evolving technology platform for managing Enterprise Risk & Control Programs.  Since I'm in Boston, I thought it would be appropriate to share some insight from an Economist at the Federal Reserve Bank of Boston, Ralph C. Kimball.  Mr. Kimball published his article, "Failures in Risk Management", in the New England Economic Review back in January 2000.  In his article, he describes in wonderful detail the forces of systemic risk that our economy is struggling with today - a full eight years after his writing.

As we are experiencing painfully today with the unraveling of financial institutions' hedging strategies and use of derivatives such as credit default swaps, Mr. Kimball notes,

"While an individual firm may mitigate its risks by purchasing insurance or hedging, these actions do not reduce systemic risk in the economy, but only transfer it elsewhere."

This transfer of risk has been accelerated throughout the US and global economies by the fervent use of securitization and leverage.  Individual firms such as Washington Mutual, AIG and Lehman Brothers were acting in their own best interest while spreading the systemic risk contagion.  As Mr. Kimball rightly concludes,

"....the greater the amount of risk mitigation undertaken through hedging or the purchase of insurance, the more likely that unforeseen losses will migrate quickly from one market to another, or from one country to another. That is, while hedging acts to reduce independent risk, it can enhance systemic risk."

What the economy is facing today is no surprise.  What is surprising is how long it took the Federal Reserve and others to address the mushrooming systemic risk infecting our economy.  Who knew?  Mr. Kimball knew.

What are your thoughts?  Share your comments below.

Corporate Fraud Risks Are On The Rise

In its recently released 2008 Global Fraud Report, The Economist Intelligence Unit and Kroll stated that corporations are reporting an overall 22% increase in fraud in 2008 as compared to a similar survey conducted in 2007.  The report noted that weakened internal controls and high staff turnover were the leading cause of the fraud increase.  The average company in the survey lost more than $8 million due to fraud at some point during the last three years.  Can your company afford these fraud risks and the potential impact on other areas such as public image, reputation and the resulting impact on shareholder return?  Share your thoughts below.  Also, to read more about this compelling report, click here.

Newly Released ERM Report from The Economist

As the economy continues to weaken and capital markets are shaken to their core, Enterprise Risk Management ("ERM") is surfacing as a "must-have" program for not only the largest financial services firms, but also for companies of all sizes.  Just this month, a new report published by The Economist Intelligence Unit underscores the need for solid ERM programs.

What Should Board Members Be Doing Now?

In times like these, the tension in most corporate board rooms is thick, but many board members may not be taking the necessary actions to ensure that they or their fellow members are not unduly exposed.   At the core of the issue is requiring management to establish a solid Enterprise Risk Management ("ERM") program that surfaces the appropriate issues and holds management accountable for addressing risks in a proactive manner.

The following was noted by Joann Lublin and Cari Tuna in Monday's Wall Street Journal.

"Now, more boards may take a bigger role in risk management. During a Sept. 9 roundtable held by the National Association of Corporate Directors, 24 chairmen of audit committees agreed "the whole board needed to be engaged" in monitoring risk, an association official says."

Other areas that board members need to address include the following.

• Pick directors with temperament, skills and experience to spot warning signs


• Engage in regular scenario planning


• Choose independent law firm as future crisis adviser


• Create an effective risk-management committee


• Appoint a nonexecutive chairman


• Develop and practice an emergency communications system


• Prepare for special committee to explore crisis's cause and remedies

Board members are realizing that in today's turburlent climate, a lack of action toward addressing a company's risks can be more deadly than originally thought.  Just ask the board members at Lehman, they can surely tell you.

What other areas should board members address to strengthen a company's corporate governance and enterprise risk management practices?  Please share your thoughts by commenting below.

Welcome to The ERM Current™ Blog

Welcome to The ERM Current™ Blog.  This blog is an added feature to the monthly publication of The ERM Current™ dedicated to providing the latest updates and current trends in Enterprise Risk Management & Control.  We welcome your comments and participation in this forum. For more information, please visit www.WheelhouseAdvisors.com.

Show Me the Money and I'll Show You The Risks

As we all read the postmortem of the recent collapse of major financial institutions, the single thread throughout all the dead bodies are the litany of personal incentives tied to short-term rather than long-term results.  These incentives start at the very top as evidenced by the pay packages of the CEOs who drove their companies straight into a brick wall.  I was reading the Atlanta Business Chronicle yesterday and here is what they had to report on excessive CEO pay.

• Lehman Brothers Chairman and CEO Richard Fuld Jr. made $34 million in 2007. Lehman (OTC:LEHMQ) filed for Chapter 11 Bankruptcy protection earlier this month.


• Goldman Sachs (NYSE:GS), which Sunday gained Federal Reserve Bank approval to become a bank holding company, paid its Chairman and CEO Lloyd Blankfein $70 million last year. Co-Chief Operating Officers Gary Cohn and Jon Winkereid were paid $72.5 million and $71 million, respectively.


• Morgan Stanley Chairman John Mack earned $1.6 million. Chief Financial Officer Colin Kelleher got a $21 million paycheck in 2007. Morgan Stanley (NYSE:MS) also received approval to become a banking holding company, a shift that allows Morgan and Goldman to bring in bank deposit assets which offer more solid financial footing.


• Merrill Lynch CEO John Thain was paid $17 million in salary, bonuses and stock options in 2007. Merrill (NYSE:MER) is being acquired by Bank of America (NYSE:BAC). BofA CEO Kenneth Davis earned $25 million in 2007.


• JP Morgan Chase & Co. Chairman and CEO James Dimon earned $28 million in 2007. Chase (NYSE:JPM) acquired troubled investment house Bear Stearns earlier this year with the federal government promising to take on as much as $30 billion in Bear assets to help get the deal done.


• Fannie Mae CEO Daniel Mudd received $11.6 million in 2007. His counterpart at Freddie Mac, Richard Syron, brought in $18 million. The federal government announced earlier this month it was taking over the mortgage backers with Herbert Allison to serve as Fannie CEO and David Moffett the new CEO at Freddie.


• Wachovia Corp. Chairman and CEO G. Kennedy Thompson received $21 million in 2007. He was succeeded by Robert Steel as CEO in July. Steel is slated to get a $1 million salary with an opportunity for a $12 million bonus, according to CEO Watch. Wachovia (NYSE:WB) is one of the banks that could be sold in the midst of the financial crisis.


• Seattle-based Washington Mutual (NYSE:WAMU) will pay its new CEO Alan Fishman a salary and incentive package worth more than $20 million through 2009 for taking the helm of the battered bank, according to the Puget Sound Business Journal.

While this is no huge surprise, I'm sure if you dig further into the incentive structures of each of these companies, you will find much more excessive pay driving excessive risk taking.  Everyone seems to be saying that the regulators did not provide the appropriate level of oversight.  While that may be the case, one of the Fed Governors hit the nail on the head with his speech in February of this year.  Governor Randall F. Kroszner noted the following in his speech to the Global Association of Risk Professionals on February 25, 2008 in New York.

"In trading and certain other activities, there is a tendency for business-line heads or individual employees to focus on their short-term compensation and not think about the long-term risks that their activities create for the firm. But it is the responsibility of senior management to provide the proper incentives and controls to counter the potential for individuals within financial firms to discount risks to the broader institution, and of course to ensure that nefarious activity is promptly uncovered and stopped."

However, those very senior managers that should have been providing the proper incentives and controls were the very same senior managers who were receiving the excessive pay packages based on short-term results.  The risks will always be linked to pay packages and the behaviors they drive.   What are your thoughts?  Do you agree?  Please feel free to comment by clicking on the link below.

*For more on Governor Kroszner's speech, click here.