New Breeding Ground for Risk Topics

Board members of public companies are accustomed to passing along any risk related issues to the Audit Committee and/or Risk Committee. However, many of these directors are discovering risk related issues are not necessarily the specific purview of those groups. One committee in particular is becoming a breeding ground for risk topics - the Compensation Committee. With incentive programs entering the spotlight through greater disclosure about their impact on risk taking and heightened investor scrutiny, a new set of board directors need to be concerned with risk management. Here is what a leading expert had to say recently about the change.

Finally, an important means for compensation committees to address the risks that they now face is to ensure that they and the compensation-setting process are fully integrated into the overall risk-oversight activities of the board and the company. The financial crisis and its legislative and regulatory aftermath have focused considerable attention on the relationship between incentives in compensation programs and the risks that arise for companies, and as a result the compensation committee has become a crucial component of the risk-oversight process. The compensation committee’s attention to risks—through a periodic evaluation of the compensation program and how pay elements could create risks—has now become a regular part of the analytical framework.

How is your Compensation Committee addressing risk? Having the ability to articulate the linkage between incentive programs and a company's risk appetite is critical to proactively addressing investor concerns.  If you or someone else in your company is interested in learning more about bridging this gap, contact us at NavigateSuccessfully@WheelhouseAdvisors.com.

Incentive Pay & Risk Back in the Spotlight

Yesterday, the Federal Deposit Insurance Corporation (FDIC) approved a proposal to limit excessive risk taking that is tied to incentive programs at large financial institution. The proposed rules are a result of the Dodd-Frank Act of 2010. Here is a summary of the new rules from the FDIC's website.

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved a joint proposed rulemaking to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 956 prohibits incentive-based compensation arrangements that encourage inappropriate risk taking by covered financial institutions and are deemed to be excessive, or that may lead to material losses.

Consistent with Dodd-Frank, the proposed rule does not apply to banks with total consolidated assets of less than $1 billion, and contains heightened standards for institutions with $50 billion or more in total consolidated assets. For these larger institutions, the rule requires that at least 50 percent of incentive-based payments be deferred for a minimum of three years for designated executives. Moreover, boards of directors of these larger institutions must identify employees who individually have the ability to expose the institution to substantial risk, and must determine that the incentive compensation for these employees appropriately balances risk and rewards according to enumerated standards.

Chairman Bair said "This proposed rule will help address a key safety and soundness issue which contributed to the recent financial crisis – that poorly designed compensation structures can misalign incentives and induce excessive risk-taking within financial organizations. Importantly, we believe the rule will accomplish its objectives in a way that appropriately reflects the size and complexity of individual institutions. Importantly, this inter-agency proposal will apply across all types of US financial institutions, limiting the opportunity for regulatory arbitrage. Similarly, it will better align US compensation standards with those which have been adopted internationally under the framework approved by the Financial Stability Board in 2009."

Public comment will be accepted for 45 days prior to final approval. In addition, the rules are a joint effort of the Federal Financial Institutions Examination Council (FFIEC), the Securities & Exchange Commission (SEC) and the Federal Housing Finance Agency (FHFA) who each must also approve the rules. These rules are a step in the right direction for those more interested in long-term results, but they will certainly be the subject of intense debate.

Federal Reserve Issues Final Guidance on Risks & Incentive Pay

Yesterday, the U.S. Federal Reserve along with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision issued their final guidance on incentive compensation for financial institutions. This final guidance is based on proposed guidance issued in October 2009 and a series of incentive compensation reviews by the Federal Reserve and the other supervisory agencies. The agencies will conduct a second round of reviews later this year to evaluate the financial institutions compliance with the new guidance. Here is what the Federal Reserve had to say about their next steps.

"Many large banking organizations have already implemented some changes in their incentive compensation policies, but more work clearly needs to be done," Federal Reserve Governor Daniel K. Tarullo said. "The Federal Reserve expects firms to make material progress this year on the matters identified as we work toward the ultimate goal of ensuring that incentive compensation programs are risk appropriate and are supported by strong corporate governance."

During the next stage, the banking agencies will be conducting additional cross-firm, horizontal reviews of incentive compensation practices at the large, complex banking organizations for employees in certain business lines, such as mortgage originators. The agencies will also be following up on specific areas that were found to be deficient at many firms, such as:

• Many firms need better ways to identify which employees, either individually or as a group, can expose banking organizations to material risk;


• While many firms are using or are considering various methods to make incentive compensation more risk sensitive, many are not fully capturing the risks involved and are not applying such methods to enough employees;


• Many firms are using deferral arrangements to adjust for risk, but they are taking a "one-size-fits-all" approach and are not tailoring these deferral arrangements according to the type or duration of risk; and


• Many firms do not have adequate mechanisms to evaluate whether established practices are successful in balancing risk.

In addition to the work with the large, complex banking organizations, the agencies are also working to incorporate oversight of incentive compensation arrangements into the regular examination process for smaller firms. These reviews are being tailored to take account of the size, complexity, and other characteristics of these banking organizations.

Having a solid understanding of your risk profile and the resulting impact of incentive programs is now critical for financial institutions as well as companies in other industries. Wheelhouse Advisors can help you develop stronger incentive programs with a thorough analysis of your risks.  To learn more, visit www.WheelhouseAdvisors.com.

The Real Problem Still Looms Large

This week, the New York Times reported that the Federal Reserve is completing a comprehensive review of incentive programs at the nation's largest financial institutions. The findings are surprising given the role of the incentive programs in igniting the financial meltdown of 2008.  Here's what the Federal Reserve has discovered.

The Federal Reserve, six months into a compensation review of the country’s 28 largest financial companies, has found that many of the bonus and incentive programs that economists say contributed to the worst financial crisis since the Great Depression remain in place, according to people briefed on the examinations.

Officials have found, for example, that risk managers at several of the biggest banks still report to executives who have influence over their year-end bonuses and whose own pay might be constricted by curbing risk. In many cases, risk managers do not have full access to the compensation committee of the banks’ boards.

The review also revealed that banks tend to set similar bonus formulas for broad sets of employees and often do not adjust payouts to account for risks taken by traders or mortgage lending officers. Bank executives and directors, meanwhile, are often in the dark on the pay arrangements of employees whose bets could have a potentially devastating impact on the company.

This disconnect between pay practices and risk taking is at the heart of the problem and must be resolved for financial institutions to thrive in the long-term. It starts with having a strong enterprise risk management infrastructure and framework as a foundation for addressing the major disconnects between the board, bank executives and line management. Then, financial institutions must begin to faithfully utilize risk-adjusted performance metrics to drive their pay practices. Until this happens, no amount of governmental regulatory reform will solve the real problem behind the financial crisis.

Out of Control

Yesterday, the U.S. Senate Subcommittee on Investigations conducted hearings to examine the largest bank failure in U.S. history and its role in the 2008 financial crisis.  The failure of Washington Mutual ("WaMu") was largely the result of years of increasing involvement in the mortgage-backed securities market.  Over a four year period, WaMu increased their securitizations of subprime mortgages from about $4.5 billion in 2003 to $29 billion in 2006.  Altogether, from 2000 to 2007, they securitized at least $77 billion in subprime loans.  At the same time, WaMu allowed its lending practices and controls to erode in the pursuit of greater loan production and short-term profits.  Here is a summary of the investigators' findings.

(1)   High Risk Lending Strategy. Washington Mutual (“WaMu”) executives embarked upon a high risk lending strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans.

(2)   Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (“Long Beach”), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors.

(3)   Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up.

(4)   Polluting the Financial System. WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss.

(5)   Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered.

(6)   Destructive Compensation. WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when its high risk lending strategy placed the bank in financial jeopardy.

These findings are not surprising in the aftermath of the financial disaster.  However, without significant oversight and change in the operations of financial institutions, a similar scenario will likely occur in the not too distant future.

Improving Executive Compensation Oversight and Pay Processes

In light of the increased risks associated with executive compensation programs, The Conference Board recently established a task force to develop guidance for companies looking to improve their pay processes and oversight.  The guidance has been published and centers on five principles that companies should strive to achieve.  Here are the five principles.

Principle One—Paying for the right things and paying for performance

Compensation programs should be designed to drive a company’s business strategy and objectives and create shareholder value, consistent with an acceptable risk profile and through legal and ethical means. To that end, a significant portion of pay should be incentive compensation, with payouts demonstrably tied to performance and paid only when performance can be reasonably assessed.

Principle Two—The “right” total compensation

Total compensation should be attractive to executives, affordable for the company, proportional to the executive’s contribution, and fair to shareholders and employees, while providing payouts clearly aligned with actual performance.

Principle Three—Avoid controversial pay practices

Companies should avoid controversial pay practices, unless special justification is present.

Principle Four—Credible board oversight of executive compensation

Compensation committees should demonstrate credible oversight of executive compensation. To effectively fulfill this role, compensation committees should be independent, experienced, and knowledgeable about the company’s business.

Principle Five—Transparent communications and increased dialogue with shareholders

Compensation should be transparent, understandable, and effectively communicated to shareholders. When questions arise, boards and shareholders should have meaningful dialogue about executive compensation.

These guiding principles seem to provide what many may say is simply common sense advice.  However, given the environment that we find ourselves in today, common sense such as this may not be as common as one might think.

Risk and Pay Regulations Demand Strong ERM Programs

The debate about the Federal Reserve's plan to regulate pay practices at financial institutions is heating up.  Reports in the Wall Street Journal indicate that views on the matter are highly polarized.  In addition, experts are suggesting that the new regulations could mean that boards of directors will need to work harder to understand their company's risk profile and compensation systems.  Here is an excerpt from the WSJ.

The Federal Reserve's new push to regulate pay at U.S. banks will make things more difficult for boards and their compensation committees, already under fire for controversial pay practices. The planned Fed move could increase time demands, recruitment challenges and legal exposure for boards, predict directors and pay consultants. "You're going to have to make sure the whole board is involved in risk issues," says Robert E. Denham, a Los Angeles attorney and former chief executive of Salomon Inc. Mr. Denham is co-chairman of an executive-pay task force created by the Conference Board, a New York business group.

Companies and board members will need to rely more than ever on their enterprise risk management ("ERM") programs to provide timely information to support compensation related decisions.  In addition, greater regulatory scrutiny will demand the implementation of strong ERM programs.  Wheelhouse Advisors can help your company design and implement a cost-effective ERM program.  Visit www.WheelhouseAdvisors.com to learn more.

Risk and Reward Debate Heats Up

The debate over incentive compensation plans role in excessive risk taking at major corporations is heating up.  In today's Wall Street Journal, an article provides a good overview of both sides of the debate and what companies can expect from potential government regulation.

"There's not an easy cause and effect relationship" between pay and risk, says Don Delves, a Chicago compensation consultant. "We don't know how to do it yet."  Nonetheless, federal officials want companies to try. Treasury Secretary Timothy Geithner Wednesday recommended companies assess pay packages to discourage "imprudent risk-taking." Soon after, Securities and Exchange Commission Chairman Mary Schapiro said the agency is considering requiring companies to disclose "how compensation impacts risk-taking" in annual proxy statements.

Is your company prepared to assess risk associated with pay packages?  Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more.

TARP Compensation and Corporate Governance Standards Released

The U.S. Treasury released its proposed TARP standards for compensation and corporate governance yesterday. Among other requirements, the standards require members of the company's board compensation committee to sign the following certification.

“The compensation committee certifies that:

(1) It has reviewed with senior risk officers the senior executive officer (SEO) compensation plans and has made all reasonable efforts to ensure that these plans do not encourage SEOs to take unnecessary and excessive risks that threaten the value of [identify TARP recipient];

(2) It has reviewed with senior risk officers the employee compensation plans and has made all reasonable efforts to limit any unnecessary risks these plans pose to the [identify TARP recipient]; and

(3) It has reviewed the employee compensation plans to eliminate any features of these plans that would encourage the manipulation of reported earnings of [identify TARP recipient] to enhance the compensation of any employee.”

TARP recipients should brace themselves for more requirements such as these.  In addition, board members should begin educating themselves about their new responsibilities and potential liability.  Wheelhouse Advisors can help your institution navigate the new requirements successfully.  Visit www.WheelhouseAdvisors.com to learn more.

New Rules on Pay Practices

This past weekend reports surfaced about new rules on limiting executive pay at financial institutions that received taxpayer assistance. The rules are expected to be promulgated by the U.S. Treasury as reported by Reuters below.  

Treasury Secretary Timothy Geithner is expected to issue rules as early as next week on how bailed-out banks must limit their executives' pay. He is also working on ways to reform the compensation practices of the entire banking industry to discourage a focus on short-term gains and undue risk-taking.

Lucian Bebchuk, a professor at Harvard Law School, and colleague Holger Spamann argue that a banker's pay should be tied to all of the bank's assets, not just to equity, which they say accounts for only about 5 percent of overall assets.

"Banking regulators should monitor executive pay in banks, and prevent arrangements that incentivize top bankers to focus only on the bank's equity, which ... can gain through strategies that are detrimental to the other 95 percent," they write in a forthcoming paper.

Bebchuk and Spamann suggest top bankers should be paid on a "broader set of claims, including deposits and junior debt," which would prod them "to place much greater weight on possible losses in their choice of strategy."

These new rules on executive pay most likely will serve as extra incentive for financial institutions to return taxpayers' money as opposed to lasting changes in pay practices. True changes must emanate from within the financial institutions' corporate governance structure beginning with pressure from the boards of directors.  

Turning a Blind-eye Toward Risks - Revisited

A letter from AIG's corporate counsel to Representative Gary Peters of the U.S. House Financial Services Committee was released to the public this week.  The letter responded to inquiries by Rep. Peters into the risk management practices at AIG leading up to and during the meltdown that nearly resulted in the collapse of AIG as well as the global financial system.  The following question related specifically to the structure of AIG's enterprise risk management organization.  

Q: What was the role of the Enterprise Risk Management ("ERM") Department and how did it relate to the overall risk management strategy in place at AIG during the time which the Financial Products unit was operating?  Did the Enterprise Risk Management Department have authority to review the activities of the Financial Products unit or give approval to credit default swaps entered into by members of the Financial Products ("FP") unit?

A: Created in 2004, AIG Enterprise Risk Management ("ERM") was responsible for assisting AIG's business leaders, executive management, and board of directors in identifying, assessing, quantifying, managing and mitigating the risks incurred by AIG. The Chief Risk Officer and his team were responsible for enterprise-wide credit, market, and operational risk management and oversight of the corresponding functions at the business units.  Although FP risk managers, like risk managers in some other business units, had no direct reporting lines to ERM, as discussed above, the Credit Risk Committee did review and approve most of FP's multi-sector CDS transactions with respect to credit risk and also engaged in periodic review of FP and its CDS portfolios.

The response from AIG shows a fatal flaw in their ERM program.  The risk managers in the Financial Products unit had no formal ties to the ERM organization or the Chief Risk Officer.  As a result, their compensation was directly linked to the performance of the unit.  This provided no incentive for them to raise red flags that may negatively impact their pay and ultimately cost them their jobs.  When the valuation of the credit default swaps were unreasonably high, the risk managers simply turned a blind eye.  This is precisely the situation that was described in the ERM Current™ blog post on December 19, 2008 entitled "Turning a Blind-eye Toward Risks."

Navigating the Proper Course on Pay

Reports about new regulations on compensation practices at U.S. financial institutions emerged today in the Wall Street Journal.  Evidently, the Federal Reserve is working on new rules designed to reduce excessive risk taking such as incentives for mortgage loan production that fueled the current economic crisis.  Here is what was reported.

Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality. The administration is also discussing issuing "best practices" to guide firms in structuring pay.

Government officials said their effort, which is just beginning, isn't aimed at setting pay or establishing detailed rules. "This is not going to be about capping compensation or micro-management," said an administration official. "It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation."

Solid corporate governance practices and effective risk management programs should be enough to limit excessive risk taking through well designed compensation plans.  However, it seems the U.S. Government is not convinced that companies will navigate the proper course.

 

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.  

Implementing Compensation Reforms

This week, the Institute of International Finance released a study of the compensation practices at major financial institutions around the globe.  The results point to a need to increase the linkage between risk management and pay practices.  The study was based on a set of seven principles outlined by the Institute of International Finance last year that seek to improve the compensation structures at these institutions.  Here is a summary of their findings.

Respondents are working towards convergence with the Institute of International Finance principles: current alignment varies by principle, some critical gaps need to be addressed (see figure 1 below). Respondents have a high degree of alignment to a number of the IIF’s principles; however, there have been critical gaps in the area of risk-adjusted performance measurement and compensation phasing to coincide with the risk time horizon of profit. Only 11% of respondents stated that they were fully aligned to Principle 3: risk adjustment and time horizon alignment, although the vast majority of institutions (83%) already have plans to close the gap. Indeed, 60% of respondents expect to be fully aligned to all seven principles once their plans are implemented.

Changes required for successful implementation

1. Organisational will and strong leadership are needed to ensure internal acceptance of changes to compensation policy. The current point in the cycle unquestionably represents the most opportune time to implement change, although survey respondents still believe that retaining competitiveness versus peers will be a challenge. In order to implement change, senior management, including the CEO, CFO and CRO, need to be fully involved in the change process and closely engaged with Human Resources on compensation. Boards should demand transparency around performance metrics and employee incentives to accurately appraise compensation schemes. We encourage supervisors and regulators to support an industry push towards compensation structures and governance that avoid any undue build-up of risk at financial institutions.


2. More effective oversight of the compensation system; improved checks and balances. Discussions with industry participants indicated that improving the governance process through which compensation is debated and validated, and striking the correct balance between fact-based metrics and more discretionary aspects, will be critical to shaping new compensation practices.


3. At a time of significant industry and individual stress, significant mobilization is required. Dedicated resources, senior management time and influence, and strong links between management, finance, risk and human resources teams will be necessary to implement the changes required.

Now is the time to align risk management and compensation so that another crisis of this magnitude can be avoided.  Wheelhouse Advisors is prepared to help you with your implementation challenges.  Visit www.WheelhouseAdvisors.com to learn more.

Spotlight on Risk Management and Pay Practices

The debate over financial regulatory reform continues on Capitol Hill with a great deal of attention on compensation practices.  It has become blatantly obvious that incentive plans have not been designed to promote the best interests of shareholders or the long-term viability of institutions.  Here is what Federal Reserve Chairman Ben Bernanke had to say as reported in yesterday's New York Times.

Last week, Ben S. Bernanke, the Fed chairman, also called on regulators to supervise executive pay at banks more closely to avoid “compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers.” Much of the plan would require the approval of Congress, where divisions are forming over how best to overhaul financial industry oversight.

The core of effective risk management hinges on the alignment of a company's strategic objectives, risk appetite and compensation plans.  Once these become out of alignment, the company will certainly suffer over the long-term.

A Recipe for Failure

The lack of transparency into the TARP program is well known and a primary source of criticism.  The Wall Street Journal has presented new information into the side deals by our elected officials that are plaguing the rescue effort. In an article yesterday, they noted the following:

The goal of aiding only banks healthy enough to lend -- laid out by the Treasury when the program began -- clearly seems to have shifted, but in a way that's hard to pin down and that the Treasury has declined to explain. Part of the problem is that some powerful politicians have used their leverage to try to direct federal millions toward banks in their home states.

One of those politicians is none other than Barney Frank, chairman of the U.S. House Financial Services Committee. According to the Wall Street Journal, Rep. Frank directed the issuance of $12 million in TARP funding to OneUnited, a small bank in Rep. Frank's home state of Massachusetts.  Just prior to issuing this money, OneUnited had been given a "cease and desist" order by the FDIC due to poor lending practices and executive compensation abuses.  In addition, the bank was ordered to dispose of a 2008 Porsche sports-car that had been reserved for executive use.  Given the depreciation of high-end sports-cars, the Porsche must have qualifed as a "troubled asset".  

Back door dealings and excessive pay practices led us into this current financial crisis.  Continuing these practices under the guise of a rescue effort will certainly doom it to failure.  Here is Rep. Frank discussing his planned bill to place restrictions on use of TARP funds.  Let's hope he includes a Porsche restriction provision in the bill.

Ignoring the Black Swan

An article in this week's edition of The New York Times Magazine entitled "Risk Mismanagement" provided a view into the use of statistical models in the world's largest financial institutions to understand risk.  Value at Risk ("VaR") models are the focus of the article and are criticized for not predicting rare, catastrophic events (known as Black Swans) such as the financial crisis that we have experienced.  

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives.  It made black swans all the easier to ignore.  All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. 

While the VaR models are not perfect, they should not shoulder the blame for the mismanagement of risk.  The mismangement of risk was driven by short-term decision making and pure greed.

Distorting Risks to Bolster Pay

As more and more begins to emerge from the collapse of our financial markets, it is becoming clear that effective risk management was severely handicapped by those looking to increase their personal compensation.   The New York Times reported this past weekend some of the egregious mortgage lending practices at Washington Mutual ("WaMu") that led to the largest bank failure in American history.   

WaMu gave mortgage brokers handsome commissions for selling the riskiest loans, which carried higher fees, bolstering profits and ultimately the compensation of the bank’s executives. WaMu pressured appraisers to provide inflated property values that made loans appear less risky, enabling Wall Street to bundle them more easily for sale to investors.  “I never had a clue about the amount of off-the-cliff activity that was going on at Washington Mutual, and I was in constant contact with the company,” said Vincent Au, president of Avalon Partners, an investment firm. “There were people at WaMu that orchestrated nothing more than a sham or charade. These people broke every fundamental rule of running a company.”

The major problem here is not that WaMu was poorly managed, but that the practices at WaMu became accepted by the mortgage industry as a whole.  Major reform is desperately needed to ensure that practices such as these are prevented from "becoming the norm" again.

Turning a Blind-eye Toward Risks

For those of you who have been following The ERM Current,  you may recall the post "Show Me the Money and I'll Show You the Risks".  In that post, the main advice centered on the need to examine incentive structures to determine where excessive risk-taking may be occurring.  As the current financial crisis continues to unfold, the excessive risk-taking driven by grandiose incentives is becoming more and more evident.  Yesterday, the New York Times featured an article on this very topic.   Below is an excerpt from the article,

“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.” Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.  “That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.

To be effective, risk management must have the authority and the independence to adjust incentive programs based on the risk appetite of the organization.  If risk managers are participating in the very incentive programs that they are charged with overseeing, then a blind-eye will always be turned toward excessive risk-taking.

ERM Case in Point

This week's rescue of Citigroup serves as a prime example of how fragmented approaches to risk management can have disastrous consequences.  The New York Times presented a thorough review of the actions and inactions occurring within the ranks at Citigroup that ultimately led to far excessive risk-taking.  In short, the risk oversight was relegated to those in the business units who had the most to gain by taking excessive risks.  This, in turn, led to the creation of a culture that considered risk management as an after-thought and did not promote a full understanding of risks across the enterprise.  Lynn Turner, formerly the chief accountant at the Securities & Exchange Commission, offered his view of Citigroup in the article.

“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”

Financial and non-financial corporations alike should use the case of Citigroup as an example of how not to structure their risk management programs.  To be truly effective, enterprise risk management programs should be supported by a strong culture, strong controls and strong competencies in risk management disciplines. Visit www.WheelhouseAdvisors.com to learn more about building an effective enterprise risk management program.