Wheel of Fortune? Not Your Family Board Game
posted by Kristin Johnson
Wheel of Fortune: Not Your Typical Board Game
In the wake of the recent financial crisis, many now ask whether we should blame the Board of Directors of investment banks, commercial banks and other financial services firms for failing to manage the economic risks associated with their market activities. (See here , here, and here. In teaching the Business Associations course, I find that we have the most interesting discussions when we cover the role of the Board of Directors and Management. The conflicts among the cast of corporate characters – the board, managers, employees, creditors and shareholders (to name a few)- intrigue students. In assessing risk management, we typically do not expect the Board to have a direct role in monitoring risk on a transaction-by-transaction basis or determining the day-to-day operating procedures that reduce risk. We do, however, expect the Board to have a role in establishing policies that address enterprise risk management. When we juxtapose the danger of risks of loss related to certain market activities (think AIG’s financial products group) with our traditional expectations of the Board’s role in firm oversight, we find ourselves asking if it may be prudent to require that the Board be more informed and active in monitoring enterprise risk management.
The diversity of risk management needs and cultural differences among financial services firms make it difficult to craft a one-size-fits all risk management model. A small brokerage firm may do business with few risk management failings for years by adopting a model that checks the safety and soundness of securities trading and settlement practices. For larger firms, risk management may be a more complex undertaking. Even among similar types of institutions, like banks, identifying a single plan for successful risk management may turn on the size of the bank, other businesses under common control of the same parent and the character of its shareholder. (See here.)
Risk governance programs helped some firms avert disaster and served as little more than window dressing at other institutions. Firms like JPMorgan and Goldman Sachs escaped the recent crisis almost unscathed by market disruptions. Both firms have executive officers who are well-known for detailed review of business proposals and reports and active participation in enterprise risk management. Commentators argue that well-informed management teams and integrated risk management and credit committees helped these firms stave off disaster. (See here.) In contrast, risk management professionals were second class citizens at firms like Citigroup and Lehman; urban tales abound of risk management professionals learning of important new ventures only hours before meetings during which a business unit intended to call for an up/down vote on the same proposals.
Some suggestions that may be useful for all firms include examining the size of the board, the frequency with which the board meets to discuss risk management issues. Boards may also be well served by ensuring that at least one director has strong risk management credentials. Compensation of risk management professionals should be left to the board or a committee comprised of a majority of independent members rather than a majority of business persons affected by the risk managers’ decisions. Thinking through the chain of command may help as well. If a risk management professional reports directly to the board or a senior business executive rather than the head of the business unit in which they monitor risk, there may be less anxiety about delivering unfavorable news.
Exploring the advantages and disadvantages of various board strategies engenders insightful discussion in classes about corporate governance. Students even tend to minimize their Facebook pages when we discuss these popular issues. As we move further and further away from the economic crisis and the issue diminishes in popularity, I expect some of this interest in corporate governance to wane. It would be truly unfortunate, however, if boards and management similarly maximize the more exciting fee generating conversations and relegate risk management to a minimized screen again without sorting out important failings in enterprise risk management.
February 25, 2010 at 2:29 pm
Posted in: Corporate Law, Securities, Teaching
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Responses (2)
Joe - February 25, 2010 at 6:54 pm
Well, doesn’t the board pay people to do all that work for them and keep making them money?
Ken - February 26, 2010 at 4:48 am
One of the [many] failures in the financial marketplace has been the systematic overrating of credit-worthiness by the ratings agencies. Risk managers at banks rely on the giant credit ratings companies to provide an assessment of credit-worthiness, which then relates to the cost of their borrowing. Riskier borrowers pay more interest, and lenders pay more for the credit insurance that covers their risk.
In the main, the lending arms of the big banks did pretty much what we should have expected in the way of risk management. The credit ratings companies (Moody’s, Standard and Poor, etc.) did a piss-poor job.
And then there was that other part of the marketplace–the insurers. They were the cowboys, for sure. Making a market in credit default swaps is little more than what the bookies do at Ladbrokes. A pretty important difference is that bookies adjust the odds so they take in approximately equal amounts on both sides, so they can’t lose. AIG, on the other hand, bet hundreds of billions on one side, relying on the odds to be so much in their favor that they were rolling in money for a while. Oops … when the underdog wins, the payoff is painful.
Just yesterday I red in the NY Times that there is a small London company named The Markit Group that has created indexes for CDS in national bonds. Some folks are now blaming The Markit Group for “the Greek problem.” The idea is that by having an index for the CDS, speculators are enabled to trade, including short selling, the index, which makes it harder for Greece to refinance its bonds, which may lead to collapse of the entire house of cards.
I understand the banks, and their perceived need for insurance. They are giant banks who lent money to a large, developed, country, not some third-world hole in the map. Now they are worried that the Greek bonds may default. A valid worry, and I can’t fault them for getting into the pickle they find themselves in. After all, Greece has been around quite a while.
So my question is this: Who the heck is issuing insurance on $85 billion of Greek paper? What’s their credibility to be able to cover their obligations if/when the Greek bonds default? Is it our old friends at AIG, at it again, or is it the next “too big to fail” high flier, issuing “insurance policies” that are nothing more than bookies betting on the point spread?
And somebody wants to blame the folks who publish the index? Wouldn’t that be like blaming sports betting on the AP because they report the scores of the games?
But returning to the original question — I think the Boards of banks have pretty much done what they can in re risk management, requiring that their banks implement risk management policies and procedures, and monitoring to make sure that the policies and procedures are followed. OTOH, I think the Boards of the insurers like AIG ought to be taken out behind the barn and whipped.
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