Federal Reserve Focuses on Operational Risk

The Federal Reserve Bank ("FRB") has started to step-up its examination focus on operational risks in the nation's largest financial institutions as they seek to garner more supervisory authority through financial regulatory reform.  Not surprisingly, the FRB is looking at processes designed to support capital adequacy determinations, compliance with laws and regulations and compensation levels.  Operational Risk & Regulation Magazine provided the following report this week.

Although US regulators have not referred to the need to reform operational risk management regulation specifically, the Federal Reserve System has undertaken a series of horizontal reviews looking at op risk issues such as the Internal Capital Adequacy Assessment Process (Icaap), compliance risk and compensation. These are part of a broader programme of horizontal reviews looking at large, complex banking organisations (LCBOs).

As part of the same review, Fed supervisors are also reviewing compensation practices at regional, community and other banking organisations not classified as large and complex as part of the regular, risk-focused examination process. Ronald Stroz, assistant vice-president and head of the operational risk group at the Federal Reserve Bank of New York, commented during a panel discussion at OpRisk USA on March 24 this guidance will ensure incentives do not encourage excessive risk-taking, and that they are compatible with a sound risk management framework, supported by a strong corporate governance function with an active, effective board of directors that has risk management oversight.

Horizontal reviews of operational risk will continue in both frequency and intensity for the foreseeable future.  Are you prepared?  If not, visit www.WheelhouseAdvisors.com to learn how we can help.

Risk Management Moving to the Fore at Board Meetings

Risk management is increasingly moving to the fore in boardrooms across corporate America.  At least that is what some board members shared with finance professionals last week at a conference in Orlando, Florida.  According to a report in CFO magazine, risk management concerns among others are driving the desire for more exposure from the finance team.  Here is a summary of their report.

With board members more concerned about risk management and succession planning these days, CFOs should make sure they — and their staffs — have a strong presence in the boardroom, a group of retired CFOs-turned-board members told financial executives attending the CFO Rising conference in Orlando last Wednesday.  "The board wants to make sure they hear all opinions," said Ellen Richstone, former finance chief of several public companies, including Sonus Networks, and now on the board of Blue Shift Technologies. "They don't want to hear just the CEO." If the CFO and other members of the management team aren't available to the board, it sends up a red flag, she said.

Any red flags at your company's board meetings due to a lack of involvement by the finance team?  If so, there is no time like the present to remedy the situation.

Financial Reform Bill Emerges from Senate Committee

The financial regulatory overhaul bill finally emerged from the Senate Banking Committee yesterday after a 13-10 vote along party lines.  According to many experts surveying the political landscape in Washington D.C., the bill will likely be modified to gain broader support to ensure passage by the full Senate.  Here is what Bloomberg reported about the voting outcome and the bill today.

The final version “will be a much more business-friendly bill,” because Democrats will need to make concessions to win support from Alabama Senator Richard Shelby, the banking panel’s top Republican, said Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia. “They won’t get a bill done until Dodd and Shelby agree on the compromise, but Republicans do want to get a bill done this year,” said Miller. “So there’s incentive for both sides to come to agreement.”

The likelihood of major regulatory change this year continues to grow.  Are you prepared?  If not, Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more.

New SEC Ruling Promotes Better ERM Practices

U.S. public companies are now beginning to provide greater disclosure about their Enterprise Risk Management ("ERM") practices due to a new Securities and Exchange Commission ("SEC") ruling.  As these disclosures emerge, it is becoming apparent that companies are in varying stages of maturity.  In a recent webcast hosted by Marsh, executives from several companies described their experience with the new ruling.  Here is what one of the panelists had to say.

Denise Kuprionis, vice president, secretary and chief ethics and compliance officer for E.W. Scripps Co., a media company, said the new disclosure requirements are good, but they will not be easy for companies to implement.  At her company, she related, evaluating risk involves a wide range of management and requires the management committee that governs risk to both report on perils and give updates. Implementing ERM practices, she said, is not a hindrance to companies taking risk, but serves to encourage management to take a holistic  approach to thinking about risk. “Risk is good and companies have to take risk to be successful,” she noted.

As ERM becomes more widely understood, companies will begin to see how they can utilize it to their competitive advantage.  To learn more about ERM and how Wheelhouse Advisors can help, visit www.WheelhouseAdvisors.com.

FASB Looks to Expand Mark-to-Market Rules

The Wall Street Journal reported today that the Financial Accounting Standards Board ("FASB") is looking to expand requirements for mark-to-market accounting at banks.  If successful, the FASB will require banks to report the market values of loans rather than the historical cost.  This change could have a dramatic impact on the balance sheets and income statements for many financial institutions.  Here is some additional perspective from the WSJ.

Banks generally loathe mark-to-market rules, which rely on what they feel are too-often irrational market prices. The market value of some loans did fall excessively in the depths of the crisis. And many bankers, and bank regulators, believe the rules worsened the financial crisis.

But that argument ignores the fact that banks clearly didn't pay enough heed of market values in the run up to the crisis, and their own estimates of potential losses were woefully inadequate. This left bank balance sheets, and investors, unprepared for the credit crunch. If banks had focused on market values as well as internal models, many may have acted sooner to raise equity.

If these new rules are adopted, then the divide between the winners and losers among financial institutions will widen precipitously.  Investors and bankers alike will be keeping a close eye on this potential development.

Ignoring Risk Management at Lehman Brothers

The court appointed examiner for the Lehman Brothers bankruptcy case issued its final report yesterday.  The report provides some interesting insight into the final months of the firm's existence.  Most notable are the firm's efforts to shift massive exposures off of its balance sheet to prevent credit rating downgrades.  At the same time, the firm ignored its own risk management limits as it continued to pursue a high growth strategy. Here is what the examiner noted in the report.

In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital. In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis, Lehman was slow to recognize the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to “double down,” hoping to profit from a counter‐cyclical strategy. As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.

While many critics like to point the finger at the failure of risk management in the financial crisis of 2008, more evidence is pointing to the fact that it was the failure of management to acknowledge the risks that were made apparent by risk management practices.

Financial Restatements Continue to Decline

A recent report by Audit Analytics noted that the number of financial restatements among U.S. public companies has declined for the third year in a row.  630 companies filed 674 restatements last year representing a 27% decline from 2008.  Here is what CFO magazine had to say about the report.

The report attributes the decline in restatements to two factors: improved internal controls as a result of Sarbox, and a 2008 recommendation by the SEC's Advisory Committee on Improvements to Financial Reporting that the agency relax its requirements on what types of errors should trigger restatements.

"Frankly, I was pleasantly surprised," says Dennis Beresford, an accounting professor at the University of Georgia's J.M. Tull School of Business and a member of the CIFR. "It's always hard to know exactly what the reasons were, but I'd like to think it was a combination of better financial reporting, better auditing, and hopefully a little more reasonableness in terms of applying materiality [as to what needs to be restated]."

Interestingly, the majority of restatements continue to come from the smaller, non-accelerated filers that are not subject to an external audit of their financial controls (see chart below).  The decision to exempt these companies permanently from an external audit is still being debated by members of Congress and the Obama Administration.