Corporate Governance Key to Sound Risk Management Says Fed's Kroszner

Sound risk management at financial institutions can be ensured only if directors and senior management establish overall governance that is credible, robust, and consistent throughout the firm, in the view of Federal Reserve Board Governor Randall S. Kroszner. In remarks to the Global Association of Risk Management Professionals, he said it is critical that senior management set the tone at the top that risk management is important, communicate such, and lead by example. Moreover, business lines should be held equally accountable, he declared, and there should be no special treatment for "star" employees, even if they are bringing in sizable revenues.

While some firms like to operate on a decentralized basis, he noted, at the end of the day risk management must be implemented and coordinated on an enterprise-wide basis. Corporate governance must see that a good risk management structure encompasses risks across the entire firm, gathering and processing information on an enterprise-wide basis in real time. Information on exposures and obligations must be rolled up and combined into one consolidated legal entity.

The financial institution's commitment to risk management must be eminently visible, emphasized the Fed official, both within and outside of the organization. For example, the firm should demonstrate that its risk managers have direct access to top management and play a key role in decision making. Risk managers must also be able to speak authoritatively about the risk profile and risk management strategy of the whole organization to market participants and counterparties.
Further, he said that risk management structures and their associated strategies should be embedded in the corporate culture and not be dependent on just a few people. They should be part of the fabric of the organization, he continued, and not just a few catchy phrases repeated from time to time. Even more, Gov. Kroszner wants understanding and living up to the firm's risk management standards to be a prerequisite for advancement to a senior management position.
Also, the corporate culture must produce independent risk managers with sufficient authority to engage in dispassionate thinking about the entire firm's risk profile, with no favoritism shown toward any business unit. Senior management should encourage risk managers to dig deep to uncover latent risks and point out cases in which certain business lines are assuming too much risk.
In other words, it is good to have a few people within the institution who, to paraphrase a former Federal Reserve chairman, know when to take away the punch bowl. Since removing the punch bowl can be very difficult in any organization, noted the Fed official, it is crucial for the risk manager to be known as an independent voice who is influential with top management.
Good corporate governance also means giving incentives for adhering to risk management practices. Problems can arise when incentives are not properly structured and appropriate risk discipline is not exercised. In his view, one good practice is to have reliable, interconnected enforcement mechanisms within the institution, mechanisms that can and will enforce limits.
Noting that some people focus on their short-term compensation and do not think about the long-term risks that their activities create for the firm, the Fed governor reminded senior managers that they have a duty to provide the proper incentives and controls to counter the potential for individuals within financial firms to discount risks to the broader institution.
While it is not the Fed’s job to decide how compensation should be structured, Gov. Kroszner said that directors and senior officers should understand the consequences of providing too many short-term and one-sided incentives. They should think about compensation on more of a risk-adjusted basis. He urged financial institutions to alter existing compensation schemes to include some types of deferred compensation, since the risks of investments or trades may not manifest themselves in the near term. He reasoned that the tenor of compensation should be matched with the tenor of the risk profile and thus expressly take into account the longer-run performance of the portfolio or division in which the employee operates.
More broadly, the senior official suggested the development of industry-wide principles of sound risk management that would touch upon incentive-compensation issues. Such principles could foster market discipline in firms if investors were to view the principles as best practices and were to more heavily discount the reported short-term earnings of firms that failed to adopt best practices. While acknowledging that reaching consensus on principles for compensation would be difficult, the governor believe it to be well worth the effort
Finally, he stressed the importance of proper disclosure of information by financial institutions so that depositors, counterparties, shareholders, and other market participants can judge the riskiness of the institution and act accordingly. Institutions that are able to provide a continual and accurate flow of information to market participants generally benefit from such transparency, he related. In this context, he noted that public disclosure is an important part of pillar 3 of the new Basel II Accord.