New Proposed Guidance on Stress Testing for Banks

Yesterday, the Office for the Comptroller of the Currency (”OCC”), the Federal Reserve and the Federal Deposit Insurance Corporation (”FDIC”) issued proposed guidance for banking institutions to create a robust stress testing framework to adequately assess potential risks. The largest financial institutions have been subject to direct stress testing during the financial crisis in association with the administration of the Troubled Asset Relief Program (”TARP”). This new guidance formally outlines requirements for a broader population of institutions, specifically those with $10 billion or more in assets. According to the guidance, all banks of this size should structure their framework in the following manner.

“….. a banking organization’s stress testing framework should include, but are not limited to, augmenting risk identification and measurement; estimating business line revenues and losses and informing business line strategies; identifying vulnerabilities and assessing their potential impact; assessing capital adequacy and enhancing capital planning; assessing liquidity adequacy and informing contingency funding plans; contributing to strategic planning; enabling senior management to better integrate strategy, risk management, and capital and liquidity planning decisions; and assisting with recovery planning.”

While this guidance does not explicitly meet the requirements of section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act for non-bank companies, the OCC, Federal Reserve and FDIC plan to issue rules consistent with this guidance for those companies. So, this serves as a preview of what is to come. Public commentary on this proposed guidance is requested by June 29, 2011.

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.

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.

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Federal Reserve Plans to Manage Risk by Regulating Pay

The Wall Street Journal reported today that the Federal Reserve is planning to begin regulating pay practices at financial institutions that it oversees currently.  The intent of the Federal Reserve is to limit short-term compensation that rewards excessive risk taking.  Here is what the Journal says about the plan.

Details of the Fed’s plan aren’t final, but the central bank will propose to review pay packages for tens of thousands of bankers to guard against the encouragement of excessive risk, and to allow banks to “claw back” compensation in certain cases. In essence, the Fed is moving to greatly broaden the kind of scrutiny that Obama administration pay czar Kenneth Feinberg has applied to seven firms receiving large amounts of federal aid.

The Fed’s move is the latest, and potentially most sweeping, of several efforts to curb risk-taking in the wake of the financial crisis. Congress approved provisions in both the bank-bailout bill last year and the economic-stimulus package in February to restrict some pay. Treasury Secretary Timothy Geithner also addressed the issue in the administration’s proposed regulatory overhaul in June.

All of these efforts have had to confront a difficult truth: The relationship between risk-taking and compensation is neither simple nor well understood. Moreover, bankers and many others say it is important to encourage some risk-taking.

Since details of the plan have not yet been released, it is too soon to offer opinions on the effectiveness or impact of such oversight.  However, the Federal Reserve must be careful to avoid micromanaging pay and usurping the authority that is placed in the hands of the Board of Directors at these institutions.

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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.  

[Timothy Geithner ]

Devil is in the Details

This week the U.S. Senate Committee on Homeland Security and Governmental Affairs conducted a hearing on how systemic risk needs to be governed by our financial regulatory agencies.  All agreed for the need of a single regulator, but there was not unanimous agreement on who should serve in the role.  Most point to the Federal Reserve given their role as the lender of last resort.  However, a few fear the increased level of political influence on the Federal Reserve given that they are the central bank for the United States.   Here is the view of Robert Pozen, Chairman of MFS Investment Management and Senior Lecturer at Harvard University.

1. The United States needs one federal agency to play the role of systemic risk regulator because of the increasing frequency of global financial crises and higher correlations among different investment markets.

2. Congress should give this role to the Federal Reserve Board because it has the job of bailing out financial institutions whose failure would threaten the whole financial system.

3. The Federal Reserve Board should focus on five areas that are likely potential sources of systemic risk – inflated prices of real estate, institutions with high levels of leverage, new products falling into regulatory gaps, rapid growth in an asset class or intermediary and mismatches of assets and liabilities.

4. The Federal Reserve Board should monitor closely the activities of all types of financial institutions with very large or otherwise very risky assets since they are the ones most likely to impact the whole financial system.

5. If the Federal Reserve believes that actions need to be taken to reduce systemic risks, it should work closely with the regulatory agency with primary jurisdiction over the relevant institution, product or market.

Senator Joe Lieberman, chairman of the committee holding the hearing, said lawmakers have a large task in redesigning financial regulation, which is now broken. “We cannot expect the creation of a systemic risk regulator to be a universal remedy for all that ails our financial services industry today,” Lieberman said. “As always, the devil is in the details.” 

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No Time for Complacency

In a speech last week to the Banque Centrale du Luxembourg, Vice Chairman of the Federal Reserve Donald Kohn provided a thorough analysis of events leading to the current financial crisis.  A major portion of his remarks focused on the inadequate investment in risk management by many financial institutions.  In his view, the long period of relative stability in financial markets bred a high level of complacency and inattention to the growing risks.  As he stated,

“Complacency contributed to the unwillingness of many financial market participants to enhance their risk-management systems sufficiently to take full account of the new (perhaps unknown) risks they were taking on.”

Risk management should be a primary focus of all companies, financial and non-financial, at all times.  It is precisely the moment when profits are at their peak and economic times are good that companies should be most vigilent.  Now, we are in catch-up mode and must make greater investment in risk management to ensure complacency does not become part of the risk equation again.

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