Criminal Failure to Disclose

The criminal investigation into the accounting practices at AIG is progressing and the focus is none other than Joseph Cassano, former head of the Financial Products group that brought AIG to its knees.  Here is what the Wall Street Journal reported yesterday.

Federal prosecutors are also focusing on a December 2007 investor presentation in which Mr. Cassano said write-downs tied to the swaps had reached an estimated $1.6 billion. Authorities are looking at whether Mr. Cassano should have disclosed to investors that the figure would have been higher by several billion dollars if not for the aid of a value adjustment known as "negative basis," according to people familiar with the matter. Several months later, when AIG disclosed that its auditor, PriceWaterhouseCoopers, found a "material weakness" in its accounting of the swaps, it said it would abandon the adjustment, according to company filings.

Had it not been for the identification of a material weakness by the auditors, who knows how long it may have taken to properly disclose the losses.  At this point, it looks like Mr. Cassano deserves to be bunkmates with Bernard Madoff.

The IT Risk Paradox

Companies working to integrate and improve their Information Technology ("IT") applications are also inadvertently increasing the risk level across the entire enterprise.  Two professors from Carnegie Mellon University discuss this paradox in an article written this month for the Harvard Business Review.  Here is what they have to say about the problem.

Standard risk-management strategies are too outmoded to help companies contain catastrophic IT-linked risks. These strategies tend to assume that the risks are well understood and that the possibility of extreme events is tiny. As a result, organizations typically concentrate on ensuring that they have good policies and procedures for managing known risks and are using high-quality processes for creating and operating IT. But this old-fashioned focus can prevent firms from seeing new risks.

How do you identify events that, by definition, are hard to anticipate? Start by instilling from the top down an organizational culture that encourages employees to take ownership of risks and weigh their potential rewards and hazards. This means modeling risks and analyzing their business impact and, even more important, making the process integral both to corporate risk management systems and to every stage of IT system development. The culture must encourage employees to bring concerns about risk forward early, particularly when IT is being applied in new ways. 

Developing the proper organizational culture is critical not only for managing IT risks, but for all risks. Wheelhouse Advisors can help your company develop the frameworks and methodologies to create the optimal risk management culture.  Visit www.WheelhouseAdvisors.com to learn more.

Bold Words Require Bold Actions

Last week, the U.S. hosted a meeting of the G-7 finance ministers in Washington D.C. to discuss the current financial crisis.  In the meeting, Treasury Secretary Tim Geithner and the other ministers committed to addressing the recommendations from the recent G-20 Summit in London.  Here is what they had to say.

We also discussed regulatory reform in our countries and at the international level and will implement swiftly the commitments made in London.  We underscored the imperative of: strengthening our national efforts to address systemic risks; extending the perimeter of regulation to include all systemically important institutions, markets, and instruments; ensuring sound regulation, adequate capitalization of financial institutions, and strengthened risk management practices; enhancing transparency; reinforcing international collaboration; improving accounting standards on valuation and provisioning; and bolstering market integrity. 

These are certainly bold words and time will tell if they are met with bold actions.  For the sake of the world economy, let's hope so.

Educated Fools

In the volumes written about the cause of the current financial crisis, very little has been said about what the nation's business schools did to prepare the leaders involved in creating the crisis.   Michael Jacobs, a professor at the University of North Carolina Kenan-Flagler Business School, had this to say in an op-ed column written in today's Wall Street Journal.  

There are three profound failures of sound business practices at the root of the economic crisis, and none of them have been adequately addressed by our business schools.  Just about everyone agrees that misaligned incentive programs are at the core of what brought our financial system to its knees. Secondly, as Washington scrambles to restructure the financial regulatory system, those who still believe in the private sector are asking why corporate boards were AWOL as institution after institution crumbled. 

The third breakdown came in the investment community.  Nationally, finance departments at business schools offer hundreds of courses in asset securitization and portfolio diversification. They have taught a generation of financial leaders that risk can be diversified away. But in their B-school days, few investment bankers examined the notion of "agency costs." That concept explains that as the gulf between the provider and the user of capital widens, the risks involved with selecting and monitoring the participants in the portfolio increase. It should come as no surprise that financial institutions amassed securities that consist of a diversified portfolio of deadbeats.  

By failing to teach the principles of corporate governance, our business schools have failed our students. And by not internalizing sound principles of governance and accountability, B-school graduates have matured into executives and investment bankers who have failed American workers and retirees who have witnessed their jobs and savings vanish.

Mr. Jacobs is spot-on and should know more than anyone since he is a professor at a leading business school. As we begin to emerge from the current crisis and re-build our foundations of business, our business schools must re-tool their programs to develop competent business leaders.   

Haunting Words from the Federal Reserve

For all that has been leveled at former Federal Reserve Chairman Alan Greenspan's contribution to the current financial crisis, very little has been noted about the current Federal Reserve Chairman's contribution.  Mr. Greenspan has been vilified for his comments in 2004 supporting the use of adjustable rate mortgages.  Here is what Mr. Bernanke had to say in a 2006 speech about the use of credit default swaps and asset backed securities. 

To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization. For example, trading in credit derivatives has grown rapidly over the last decade, reaching $18 trillion (in notional terms) in 2005. The notional value of trading in credit default swaps on many well-known corporate names now exceeds the value of trading in the primary debt securities of the same obligors.  Asset-backed securitization has also provided a vehicle for decreasing concentrations and credit risk in bank portfolios by permitting the sale of loans in the capital markets, particularly loans on homes and commercial real estate.

Given the implosion of the credit default swap and mortgage backed securities markets, Mr. Bernanke's comments seem to be equal if not more impactful than Mr. Greenspan's comments in 2004.   As we now know, the use of these vehicles actually increased risk on a systemic basis rather than lowering it.

Keys to Restoring Confidence

Yesterday, the U.S. Congressional Joint Economic Committee held a hearing on the systemic threats of large financial institutions involved in the current financial crisis.  Here is what Columbia University Professor and winner of the 2001 Nobel Prize,  Mr. Joseph Stiglitz had to say about the current steps being taken by the U.S. Government.

In short, our bail-outs run the risk of transferring large amounts of money, often in non-transparent ways, to those banks that did the worse job in risk management—hardly principles on which normal market economics is based. Among these are some of the too-big-to-fail banks. In effect, the government is tilting the playing field—towards the losers, worsening the tilt that is always there simply from the implicit guarantees associated with being too big to fail.

Regrettably, some of the discussion of regulatory reform has skirted the main issues. There is talk about the need for comprehensive oversight, bringing in the hedge funds. We should remember that the core problems were not with hedge funds; they were with regulations and regulatory enforcement of our big commercial and investment banks. This is what has to be fixed.

Again, transparency and accountability are his main themes and the keys to restoring confidence in the financial system.  The quicker these keys are fully embraced, the quicker we can move beyond the current crisis.

TARP Critical Success Factors

U.S. Treasury Secretary Timothy Geithner will particpate in a hearing today conducted by the TARP Congressional Oversight Panel.  The focus of the discussion will most likely be the contents of a report issued by the Panel about the Treasury's TARP Strategy.  In the report, the Panel explores various governmental interventions over the past century and identifies their sources of success.  Here are the four critical success factors: 

• Transparency.  Swift action to ensure the integrity of bank accounting, particularly with respect to the ability of regulators and investors to ascertain the value of bank assets and hence assess bank solvency.


• Assertiveness.  Willingness to take aggressive action to address failing financial institutions by 1) taking early aggressive action to improve capital ratios of banks that can be rescued, and 2) shutting down those banks that are irreparably insolvent. 


• Accountability.  Willingness to hold management accountable by replacing—and, in cases of criminal conduct, prosecuting—failed managers. 


• Clarity.  Transparency in the government response with forthright measurement and reporting of all forms of assistance being provided and clearly explained criteria for the use of public sector funds.  

The report falls short of offering an ultimate view on the best strategy to take in the current crisis.  However, it does indicate that there is dissent among the Panel members on efficacy of the Treasury's current strategy. This dissent will most likely lead to a very interesting hearing.

Banks Seeking to Improve

The results from a recent survey of financial institutions from across the globe indicate a urgent need to automate financial processes and integrate risk management efforts across the organization.  The survey was conducted by the Economist Intelligence Unit in the fourth quarter of 2008 during the height of the credit crisis.  Here is an excerpt from the report's conclusion.

The ravages of the credit crisis have raised serious doubts about banks’ ability to effectively manage risk. Bankers now face arduous challenges as they attempt to restore the confidence of regulators, analysts, shareholders and customers. To the extent that senior managers have focused more heavily on governance, risk and compliance over the last five years, they may be tempted to despair about the possibility of anticipating potentially devastating risk exposures. However, a sober appraisal of banks’ efforts will reveal that cost considerations have limited the extent to which manual processes have been eliminated and, far more importantly, that sophisticated GRC isolated within lines of business or internal control functions is no substitute for an integrated, enterprise-wide approach to risk management.

Wheelhouse Advisors is uniquely equipped to help companies implement an integrated, enterprise-wide approach to risk management.  Visit www.WheelhouseAdvisors.com to learn more.

Experts Agree: Enterprise Risk Management is Critical

This week, an article was published by Wharton Business School about the need to re-think approaches to risk management.  The article presents the case that risk management approaches are not necessarily broken, but need to evolve to the next level.  That next level is adopting a true enterprise risk management focus.  Here is a summary of their view along with that of an executive at a major global corporation.

Experts at Wharton and elsewhere argue that too much blame is being placed on the risk management model and other tools of the trade, in banking and beyond. The models are not necessarily broken, but instead are only as good as the decisions that get made based on them, they say. As a result, the current crisis may represent an opportunity for companies to re-visit and re-think historical approaches to risk management. 

Philippe Hellich, vice president of risks, control and audit at Danone, is already moving to the new model. "We use very few mathematical models," he says, although the organization is working on a small set of new ones for certain risks. "Instead, we rely much more on interviews and benchmarking with peers outside the group and between our subsidiaries around the world. Our approach is based on listening and challenging the operational management, common sense analysis, sound judgment and good governance at the top."

Looking ahead, Hellich sees even more focus on risk from Danone's leadership, a consequence of the increasing volatility in markets and the potential severity of impact. "Top managers are convinced of the necessity to use enterprise risk management. We now have an effective working session with part of the executive committee twice a year. And we continue to rely on yearly updates of the risk maps of all major business units worldwide."

Wheelhouse Advisors can help your company reach the next level of risk management.  Visit www.WheelhouseAdvisors.com to learn more.

To Disclose or Not to Disclose

More speculation is being made about the stress test results and what the U.S. Government will eventually disclose to the public, if anything.  Here's what was reported in the Wall Street Journal yesterday.

It isn't clear precisely what information the government might disclose. It remains possible the data won't be specific to individual banks. But some within the administration believe a certain amount of information needs to be released in order to provide assurance about the validity and rigor of the assessments. In addition, these people also are concerned that the tests won't be able to fulfill their basic function of shoring up confidence unless investors are able to see data for themselves. Staff at the various regulatory agencies have been discussing the matter for several weeks and are expected to brief top regulators as soon as this week. One possible solution: Aggregating the data provided by the banks so the government could provide a broad snapshot of the banking industry's health without disclosing firm-specific data.

Based on this report, it seems they are going in circles trying to determine what to do.  However, for an administration that is seeking to improve transparency and accountability, the answer should be clear.

TARP Leader Emerges

With financial institutions bending over backwards to repay monies received as part of the Troubled Asset Relief Program ("TARP"), the U.S. Government is close to filling the top job responsible for the program.  Here is what the Wall Street Journal reported yesterday.

President Barack Obama is expected to tap Fannie Mae Chief Executive Herb Allison to head the government's $700 billion financial-rescue program, people familiar with the matter say.  Mr. Allison would replace Neel Kashkari, a holdover from the Bush administration, who was asked by Treasury Secretary Timothy Geithner to stay on until a replacement was found.Mr. Geithner has been searching for months for someone to run TARP. Various candidates either have not made it through the vetting process or have pulled out of consideration. Last month, the leading candidate, hedge-fund manager Frank Brosens, withdrew for personal reasons.

It remains to be seen whether this candidate will survive the nomination process.  By the time he is confirmed, all the money may have been re-paid.  

Board of Directors Under Attack

In the wake of the financial crisis of 2008, boards of directors are coming under attack for their role in overseeing companies at the center of the firestorm.  Evidence can be found in yesterday's announcement by a prominent proxy advisory firm that it is recommending the removal of directors at Citigroup.  Here is a summary of their case against the directors as reported in the Wall Street Journal.

Proxy-advisory firm Egan-Jones is recommending that Citigroup Inc. shareholders withhold votes for six incumbent directors at the annual meeting April 21, saying the current or former members of the board's audit and risk management committee failed to fulfill their risk-management responsibilities. Egan-Jones said the directors in question -- Michael Armstrong, Alain Belda, John Deutch, Andrew Liveris, Anne Mulcahy and Judith Rodin -- "failed to protect shareholders from excessive exposure to credit, market, liquidity and operational risk." The firm added that Citi's board failed to effectively manage risks, "helping cause the company's current instability and increasing volatility in the global financial markets." Egan-Jones cited as examples of that failure an increase in Citi's exposure to mortgage-related assets from $28 billion in 2005 to $234 billion in 2006, as well as an 85% increase in the number of subprime mortgages originated. Citi's 2008 losses "are a clear indication that the committee failed to properly assess and control risks," Egan-Jones said.

Directors at other companies should take heed of this action and ensure their corporate governance and enterprise risk management practices are solid.  Wheelhouse Advisors can help board audit and risk committees gauge the effectiveness of their current practices.  Visit www.WheelhouseAdvisors.com to learn more.

Race to the Top

As highlighted in an ERM Current™ blog entry last week, Goldman Sachs' CEO Lloyd Blankfein delivered a speech to the Council of Institutional Investors regarding his views on what contributed to the current financial crisis.  He offered a challenge to other financial institutions in his closing remarks below.

Though honest disagreements will occur, the best companies don't shy away or selfishly frustrate efforts to compel better industry practices. These companies recognize that they are the first to benefit from better standards, especially if their business requires extensive dealings with partners or counterparties. But, we have to recognize a higher responsibility: to speak up, to draw attention to potentially destabilizing trends and to act like an owner responsible for the integrity of the system.

During the past several years, we have witnessed a "race to the bottom" in terms of poor decision making, lax risk controls and weak regulation.  Let's hope Mr. Blankfein's viewpoint signals the beginning of a new "race to the top".

Mum's the Word

Reports surfaced today that the U.S. Treasury is delaying the release of the stress test results until after the financial institutions have issued their first quarter earnings reports.  Here is what one report from the Boston Globe had to say.

The U.S. Treasury Department is asking banks not to mention the regulatory "stress tests" as part of their first-quarter earnings results, according to a source familiar with government discussions. Officials are still discussing how to release the results of the stress tests, and the decision will likely be made by the Treasury. The source said officials are aiming to release them in some form at the end of April after the first-quarter bank earnings season is over, and are trying to be sensitive to financial market reaction.

This is a very interesting development that could mean the results are not favorable.  The nature of the results remain to be seen, but one thing is certain - the U.S. Government is exerting a great amount of control over these financial institutions.  

Tough Talk on Pay and Risk

Today, the Wall Street Journal reported that Goldman Sachs' CEO Lloyd Blankfein called on financial institutions and regulators to take a tougher approach to link compensation and risk taking.  Here's what he had to say in a speech yesterday to the Council of Institutional Investors.

When deciding on pay for traders, bankers and other employees, Wall Street firms should take into account not only the contribution the employee made to profit or loss, but also the risks taken and the overall contribution to the better functioning of markets. The evaluation "must be made on a multiyear basis to get a fuller picture of the effects of an individual's decision," Mr. Blankfein added. Regulations should get tougher in bull markets, he added, much like the Federal Reserve tries to keep the economy from overheating, he said.

This is a refreshing point of view from one of the top CEOs.  It remains to be seen if other top executives will view the situtation in a similar light.  

Making the Grade?

During what is spring break for many students across the U.S. this week, some corporate students will be wondering what grade they will receive on their recent tests.  Of course, these students are the nation's largest banking institutions and they are sweating the results of the "stress tests" that have been conducted over the past month.  While the Federal Reserve and Chairman Bernanke have been steadfast in their views that the tests are not "pass/fail" by nature, the results could prove to be highly impactful to the institutions.  Here is what the Wall Street Journal reported today.

Top federal bank regulators plan to meet early this week to discuss how to analyze the results of stress tests being conducted on the country's 19 largest banks, people familiar with the matter said. Regulators announced the tests two months ago as part of an effort to determine how much assistance big banks might need to continue lending if the economic downturn worsens. The government is wrestling with how to bolster the lenders without appearing to prop up banks that are beyond repair.  Meanwhile, Treasury Secretary Timothy Geithner said Sunday that the Obama administration would consider removing top management and boards at financial companies if the government were to offer "exceptional" assistance to keep the firms operating.

The next few weeks could be very interesting as the test results shape actions by the regulators.  At the same time, first quarter earnings will be released which could prove to be a "double whammy" for some firms.  

New Global Risk Oversight Board Announced

Yesterday, world leaders at the G20 Summit in London announced the creation of a new international organization that will have authority for overseeing systemic financial risk across the globe.  This new organization will be called the Financial Stability Board ("FSB") and will quickly evolve from the current Financial Stability Forum ("FSF") based in Basel, Switzerland.  The vision for the new organization is outlined below:

"....the FSB will promote and help coordinate the alignment of international standard setting activities to address any overlaps or gaps and clarify demarcations in light of changes in national regulatory structures relating to prudential and systemic risk, market integrity and consumer protection, infrastructure, and accounting and auditing."

In conjunction with the announcement, the FSF issued new principles for compensation at the world's major financial firms.  The principles included the following governance practices.

1. The firm’s board of directors must actively oversee the compensation system’s design and operation. The compensation system should not be primarily controlled by the chief executive officer and management team. Relevant board members and employees must have independence and expertise in risk management and compensation.

2. The firm’s board of directors must monitor and review the compensation system to ensure the system operates as intended. The compensation system should include controls. The practical operation of the system should be regularly reviewed for compliance with design policies and procedures. Compensation outcomes, risk measurements, and risk outcomes should be regularly reviewed for consistency with intentions.

3. Staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm. Effective independence and appropriate authority of such staff are necessary to preserve the integrity of financial and risk management’s influence on incentive compensation.

These principles will soon filter down into the nation's individual regulatory supervision structures.  Is your company positioned to adopt these changes?  If not, Wheelhouse Advisors can help you quickly assess and implement the necessary changes.  Visit www.WheelhouseAdvisors.com to learn more.  

Bracing for Basel Changes

Dr. Nout Wellink, Chairman of the Basel Committee on Banking Supervision, delivered a speech earlier this week on the work planned by his committee to address reforms in the global banking system.  Based in Basel, Switzerland, the Basel Committee is part of the Bank for International Settlements which fosters international monetary and financial cooperation and serves as a bank for central banks across the globe.  Here is what Dr. Wellink had to say about the Committee's long-term initiatives: 

When it comes to the long term, we need to establish a clear target for the future regulatory system which substantially reduces both the probability and severity of a crisis like the one we currently are working though. By providing clarity about the future regulatory framework, we will help re-establish near term confidence, reduce the risk of competitive distortions and limit the degrees of uncertainty for the public and private sector. Also, by emphasising that these reforms will be phased in over an appropriate horizon, we reduce the risk that our own actions contribute to procyclicality in the system.

Let me now say a few words about the steps the Basel Committee has and will be undertaking to produce a more robust supervisory and regulatory framework for the banking sector. Such a framework needs to have four key components:

1. Strong regulatory capital,

2. Robust standards for bank liquidity,

3. Enhanced risk management, governance and supervision, and

4. Better transparency

Needless to say, major changes are needed and will be promulgated by organizations such as the Basel Committee.  Is your company ready to adjust to the coming changes?  Wheelhouse Advisors can help you prepare.  Visit www.WheelhouseAdvisors.com to learn more.

London Calling

In advance of the G-20 Summit in London this week, UK Prime Minister Gordon Brown delivered a speech in St. Paul's Cathedral highlighting the need to reform the global financial regulatory system.  The Prime Minister used his speech to call for a reform of financial regulation that should include 'global rules founded in shared global values'. He said:

'We must reshape the global economic system so that it respects the values we celebrate in everyday life.'  He said the Summit needed to 'clean up the banking system' and set rules to:

1. make transparent the risks that banks take;


2. bring hedge funds and shadow banking inside the regulatory net;


3. ensure banks hold sufficient capital and ensure their liquidity;


4. require boards who understand their business and take responsibility for the decisions they take;


5. ensure pay and bonuses reward people for long term value and not short term risk taking.

The Summit will be watched closely by nations across the globe and some are skeptical that any major decisions will be reached this week.  For example, French President Nicolas Sarkozy is reported to be considering an early departure if key decisions regarding regulatory reform are not made.  The stage is set for an interesting week in London.