Boards Are Reassessing Risk Management Practices

This month, Financial Executive Magazine highlights risk management survey results from a recent study by the National Association of Corporate Directors (NACD).  Not surprisingly, board members indicate they are not very satisfied with their respective company's risk management approach.  Here is what they said.

More than half of audit committee members polled in the NACD survey said they were only somewhat or not satisfied that their board has effective processes in place to oversee the company’s risk management activities. Risk management has been on the radar — if not a priority — for most companies and boards over the past several years. Yet many are asking whether “the ball is being moved forward,” and whether risk needs to be considered in a different way. Nearly 75 percent of the audit committee members surveyed said they are reassessing risk management and oversight processes as a result of the financial crisis. One of their biggest challenges, they said, is understanding the link between strategy and risk; and many are concerned that management may not have a holistic view of the company’s risk profile.

A true enterprise risk management program is required to address these challenges.  Wheelhouse Advisors can help.  To learn more, visit www.WheelhouseAdvisors.com.

Weathering the Storm

In a HedgeWeek special report this month, particular attention is given to the topic of managing hedge fund risk.  One article describes the failings of hedge funds over the past year to be attributable to poor operational risk management practices.  Here is an excerpt from the article referencing Moody's Investors Service's view.

According to Moody's, a significant portion of losses suffered by hedge funds last year probably reflects deficiencies in operational management and control.  "Losses that are disproportionately large in the context of the fund's stated investment strategy may indicate inherent flaws in the firm's approach to risk control that are not apparent until the market stresses become unexpectedly severe.  Alternatively, such losses may indicate an opportunistic departure from the investment strategy or portfolio guidelines described in the fund's offering memorandums or other representations made to investors.  In Moody's view, both scenarios indicate operational deficiencies.

Operational deficiencies can have tremendous impact at the worst possible time.  It is always better to know your weaknesses ahead of market catastrophes so you can remedy them to weather the inevitable storm. Wheelhouse Advisors can help your company or fund identify and correct the deficiencies in a cost-effective way. To learn more, visit us at www.WheelhouseAdvisors.com.

Looking to the North for Answers

Yesterday, the Wall Street Journal published a compelling op-ed article that compares and contrasts the banking systems in the U.S. and Canada.  The focus of the article is on financial institution management and the impact of regulatory structures on banking operations.  Here is a sample from the article.

When it comes to comparing the track record of the U.S. and Canadian banking systems, it is worth noting that Canada's regulations did not prohibit the sale or purchase of asset-backed securities. Early in this decade, Canada's Toronto-Dominion bank was among the world's top 10 holders of securitized assets. The decision to exit these products four to five years ago, Toronto-Dominion's CEO Ed Clarke told me, was simple: "They became too complex. If I cannot hold them for my mother-in-law, I cannot hold them for my clients." No regulator can compete with this standard.

Those who blame financial deregulation for the breakdown of U.S. markets should note that Canada shed its version of Glass-Steagall more than 20 years ago. Major banks thereafter rapidly bought and absorbed investment banks.

At that time, Canada established the Office of the Superintendent of Financial Institutions (OSFI) to provide common, consistent and more centralized regulation for federally regulated banks, insurance companies and pension funds. To this day OSFI is almost obsessively concerned with risk management, leaving social and economic objectives, such as access to affordable housing and diversity, to institutions better-suited to attain those goals.

Perhaps the U.S. should look to the North when seeking to improve its banking system in the coming years. That is certainly the direction we want to head.  

Regulatory Retirement Parties

The Wall Street Journal commented on the state of the U.S. Securities & Exchange Commission (SEC) today in an article by David Weidner.  The article also provided some interesting perspective on the effectiveness of regulatory bodies as they age.  Here is what Mr. Weidner had to say.

Just ask Harry Markopolos, the whistleblower who waged a decade-long, ultimately unsuccessful battle to persuade the SEC to prosecute Mr. Madoff. The commission was clearly reluctant to pester an established Wall Street force. However, the SEC also showed itself to be shockingly incompetent.

Consider Linda Chatman Thomsen's response to a recent congressional inquiry on the Madoff case. Ms. Thomsen, the SEC's enforcement director from 2005 to 2009, was asked why the SEC didn't respond to Mr. Markopolos' mountain of evidence against Mr. Madoff. "If we knew that it was provable fraud, it (investigating) would be easy," she said. This is what we can expect when a regulatory body has become too enmeshed with the industry it monitors, according to John Kenneth Galbraith, the late economist.

"Regulatory bodies, like the people who guide them have a marked life cycle," Galbraith wrote. "In their youth they are vigorous, aggressive, evangelistic and even intolerant. Later they mellow, and in old age – in a matter of 10 or 15 years – they become, with some exceptions either an arm of the industry they are regulating or senile."

In the U.S., we have not only the elderly SEC, but many other aging regulatory bodies that have lost their effectiveness over time.  It is time to host retirement parties for some of these agencies and streamline our regulatory structure for the 21st century.

Sound Advice About Corporate Governance

Companies looking to strengthen their corporate governance practices typically seek legal counsel to ensure the methods used will stand up against potential challenges from plaintiff attorneys and regulators.  Terry M. Schpok, a leading corporate governance attorney, was interviewed this week about the advice he is providing boards of directors during the current financial crisis.  Here is what he had to say about risk management.

A number of surveys have recently ranked risk management as one of the top concerns of a board. The cliché "desperate times breed desperate measures" has particular relevance today. Many boards are focusing on ensuring that management does not take desperate measures that may ultimately be challenged as improper, illegal, or exceptionally risky. The board should assure itself that the company is dedicated to enterprise risk management, meaning a top-down, holistic approach to risk management, including an assessment of operational, financial, strategic, compliance, and reputational risk. This approach eschews looking at each category independently in favor of assessing the company's overall risk.

Because the current financial crisis is generally attributed to poor risk management, boards should consider whether they have the ability to effectively monitor risk management. They should assure that the company has an education program that provides directors with a good understanding of the company's business and the major risks it faces. Depending on the nature of the risk and, particularly, new risks, a company may need to consider changing or adding board members with expertise in particular areas of concern. There also should be an oversight structure within the board to assure that regular periodic reports from those involved in the risk management function are provided to the board.

The entire board should remain engaged in the risk management process and be kept informed by any board committee that is reviewing details of the process on an ongoing basis. Finally, directors also need to be sure that they are getting information that they need to understand the company's risks as well as management's assessment of those risks. They need to be sure that management is properly assessing risks. They should review current risk management practices with the company. The board should also know what the company is doing to respond to and assess counterparty risk that may be posed to the company by lenders, insurers, suppliers, customers or other parties to business relationships the company.

This is sound advice from a leading expert in the field of corporate governance.  Wheelhouse Advisors is prepared to help companies implement the practices he suggests.  To learn more, visit www.WheelhouseAdvisors.com.

Spain Leads the Way

The Financial Times reported a few days ago that financial institutions in Spain have taken risk management to a new level as part of their overall corporate governance practices.  Board members are actively involved in decision making and frequently apprised of changes to the company's risk profile.  Here are a few examples.

Every Wednesday morning at 9.30am, five BBVA board members gather at the Spanish bank’s head office in Madrid. For the following three hours, they review new loans and discuss broader risks that might affect the bank’s operations. When necessary, they reconvene the next day. Other Spanish banks take a similar approach. Santander, BBVA’s main domestic rival, has a five-member risk committee, including three non-executive directors, which met 102 times last year. Managers believe that this intense board-level focus on risk is one reason why Spain’s large banks have so far weathered the credit crunch in better shape than many of their European rivals. Emilio Botín, Santander’s chairman, recalls a visit from a former chairman of the US Federal Reserve who expressed surprise at the amount of time the bank devotes to risk management. “It’s true, it consumes a lot of our directors’ time,” Mr Botín said in a speech last year. “But we find it essential. And it is never too much.”

While this may be hard to duplicate in the U.S., it is a testament to the importance and value of strong risk management practices.  In Spain, it seems they do know the rain stays mainly on the plain.

More Than Just Models

A recent article in Treasury & Risk Magazine highlights the shortfalls in enterprise risk management (ERM) programs leading up to the current financial crisis.  One of the main issues addressed in the article is the blind faith placed in the quantitative results of risk models such as Value-at-Risk (VaR).  Here is what David Fox, head of enterprise risk at global engineering and construction company KBR, Inc., had to say.

Banks had been held up as an example to risk managers in other industries because of their ability to precisely quantify their exposures. But the crisis has demonstrated that ERM is about much more than measuring risk, says KBR’s Fox: “The need for ERM in operating companies has been magnified by the banking crisis. However, risk quantification as practiced by the banks does not provide a meaningful ERM template. Apparently, few of them were able to convert the model-driven numbers into timely conversations about managing risk.”

Instead of producing numbers, Fox argues that the focus of ERM has to be on actually managing risk, and doing so by focusing on more elusive concepts like attitudes, behavior, governance and communication: “KBR is focused on how to marry risk awareness with expert and timely perspectives about emerging and strategic issues. I think this has to be done qualitatively.”

Mr. Fox makes a great point.  Effective ERM programs must include both qualitative and quantitative methods supported by strong communication channels.  Wheelhouse Advisors can help build programs such as these. Visit www.WheelhouseAdvisors.com to learn more.