! [Day] ppt_fi governance changes_prmia_april 18 2011

The Professional Risk Managers’ International Association Dodd‐Frank Series, Event 3 of 4 Financial Institution Governance Changes: The Linking of Corporate Governance to Risk Management, the Role of Compensation, g p g , p , Shareholder Rights, and Investor Protections PROFESSIONAL RISK MANAGERS’ INTERNATIONAL ASSOCIATION www.prmia.org presentation by: thomas.day@prmia.org, Vice‐Chairman of the Board, PRMIA details and supporting information at: support@prmia.org

The Professional Risk Managers’ International Association (PRMIA)Disclosure• The views and opinions within this presentation are those of the presenter and do not necessarily reflect the views and opinions of PRMIA• All i f All information in this presentation come from sources we ti i thi t ti f believe to be reliable• All images and other content is attributed, freely available through public websites, or otherwise licensed under the Creative Commons Attribution‐Share Alike 3.0 Unported C ti C Att ib ti Sh Alik 3 0 U t d license. Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Agenda for Today• The Role of Corporate Governance• Lessons Learned: Linking Corporate Governance to Risk Management• Current changes in the Governance Landscape• Conclusion and Q&A Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance• Contribution to the crisis: – Ineffective board and senior management oversight g g • Recent RAND report points out Enron had an award winning 62 page Code of Conduct (CF277_Directors as Guardians) • See also the Weinberg Center’s report: Bridging Board Gaps – Poor education and training of board members • Lehman (FCIC, pg. 355): an actress, a theatrical producer, and an admiral. p “…not one person who understood financial derivatives.” – Short‐term gains, private profits; Long‐term risks, social cost/payment (i.e., tax‐payer bailouts) • How much did the crisis ‘really’ cost? Consider home equity wealth loss, How much did the crisis really cost? Consider home equity wealth loss $1.3T in new currency, fiscal initiatives, job and productivity loss, etc. Estimates range from $3 trillion to $17 trillion (St. Olaf, Eugene Ludwig) • Focus on three numbers: $17 trillion, $700 billion, and 8.7 million. Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance• Observations from experience: – Co‐Opted Boards • CEOs are often involved – explicitly or implicitly – in the selection of board members. As co‐option increases, board oversight declines, risk increases, CEO pay increases, and CEO turnover diminishes) – See: Cole, Daniels, Naveen. October 27, 2010 – “U “Unexplained” changes in compensation result in greater l i d” h i ti lt i t default risk and is indicative of weaker corporate governance (Moody’s, July 2005) – Board members don’t truly understand leverage moral Board members don t truly understand leverage, moral hazard, economic value‐added v. GAAP measures • Profound need for enhancements on risk‐based measures – Level of engagement focus and effectiveness needs Level of engagement, focus, and effectiveness needs improvement – Self‐reference credit measures, risk reporting and analysis Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance The third bullet‐point conclusion (of nine) from the FCIC’s Final Report: “We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this y y y p y crisis.” [Emphasis Added]• …even so, few of the DFA changes to corporate …even so, few of the DFA changes to corporate governance practices are unique or new. – Question: Would the DFA have included enhanced corporate governance expectations and standards had t t ti d t d d h d Congress waited for the FCIC conclusions? • (Perhaps a bit like conducting surgery prior to diagnosing the patient) ti t) – Note that the major element of focus in the media ‐ so far ‐ has been around DIF “risk” fees and “compensation” Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance • Based on the assessment of compensation arrangements, DI fee could be increased fee could be increased • Interesting to note feedback: – FRB Minneapolis: √ – Buy‐side (e.g., Calpers): √ y ( g p ) – ABA: X (strongly opposed) – FSR: X – Many others; good to review • “Wages of Failure” “Wages of Failure” – Harvard, Feb 2010 • FCIC – BSC: “D” in governance; board and BSC: D in governance; board and compensation practices; Corporate Library – LEH: “D” (2004)

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance Incentive‐Based Compensation Arrangements • Applies to firms with total assets of more than $1 billion – M i St t W ll St t i Main Street v. Wall Street issue? April ? A il 6, 2011 SBC on DFA/Impact – May 31, 2011 deadline to respond • Proposed Rule is consistent with p prior guidance issued in June 2010, G‐20, FSB, and BCBS guidance: – Balance risk and reward – Be compatible with effective controls bl h ff l and risk‐management – Strong ‘corporate governance’ and active and effective board oversight • 98% of all respondents to an IIF survey indicated that compensation practices were a contributor to the crisis (U.S. and abroad) crisis (U S and abroad)

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance• What is Corporate Governance and is this an important part of assessing enterprise risk? p p g p “The financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements…””…The risk management systems have failed in many cases due to corporate governance procedures y y p g p rather than the inadequacy of computer models…””…information about exposures in a number of cases did not reach the board and even senior levels of management, while risk management was often activity rather than enterprise‐based. These are board responsibilities. enterprise based These are board responsibilities ” ‐ OECD, “The Corporate Governance Lessons from the Financial Crisis”, 2009• There is a lot of “talk” about Corporate Governance, There is a lot of talk about Corporate Governance, but: 1) What is it?, 2) How did weakness contribute to the crisis?, and 3) How do we know when it is effective or defective? ff ti d f ti ? Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance• Definitions abound – Important documents and groups to reference Important documents and groups to reference All papers available at http://www.box.net/shared/le68kzeu7k 1. OECD – relationship between the board, management, shareholders and other stakeholders; creates structure for shareholders and other stakeholders; creates structure for defining , attaining and monitoring objectives. (2004 paper) 2. “Standards for decision‐making within a company, duties of the board, the internal structure of the firm, and the relationship board the internal structure of the firm and the relationship between the corp., shareholders, and other stakeholders.” • More in alignment with BCBS and emerging supervisory expectations 3. BCBS: Corporate objectives, operate on a day/day basis, 3 BCBS: Corporate objectives operate on a day/day basis accountability to equity and others (supervisors, governments and depositors), align corporate activities to operate in a safe & sound manner, protect the interests of depositors. ,p p Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance• Corporate governance, main duties are to: – Ensure effective management – Define proper risk appetite for the organization • Operational and under stress – Ensure there is a philosophy and culture of risk Ensure there is a philosophy and culture of risk governance and compliance – Be willing to say “no” to executives, to ask the ‘next’ questions, to be skeptical, and to act in accordance questions to be skeptical and to act in accordance with sound ethics and a certain “corporate morality” – Align incentives to focus on long‐term value creation, not short‐term accrual earnings t h tt l i • The 1985 article from Fisher Black entitled “Noise” is a good reference document Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)The Role of Corporate Governance• It is important to note that: • Proxy access y • CEO and Chairman disclosures (nothing really new here) Corporate Governance • Broker proxy voting rules • Establishment of a board‐level risk committee (DFA is all banks over $10 billion) Incentive Incentive • Various additional requirements additional requirements Compensation • Say‐on‐pay and golden‐chutes • Disclosures • UK: Financial Reporting Council • Includes hedging • Compensation Committees • Compliance, Ethics, and Values Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Lessons Learned: Linking Governance and Risk• Is there a disconnect between shareholder wealth‐ maximization and systemic risk appetite at a national level? Societal level? “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, youve got to get up and dance. Were still dancing.” – Chuck Prince, FT, July 2007• While the corporate form of organization can create alignment between ‘owners’ and ‘managers’, we have moved away from an ‘ownership’ society. Our markets are dominated by ‘Noise’ trading not ‘information’ trading. The ready access to vast data and models promotes this culture. y p Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA) Lessons Learned: Linking Governance and Risk We take this commercial break to set the record straight: The crisis wasn’t the result of a lack of regulation, but unenforced regulation.Without the direct influence of We continue to possess a patchwork of congressional action(s), the breadth, regulatory agencies, even if we have depth, duration, and scope of the p , , p vested one agency with more power financial crisis could never have than any other – the Fed. While the happened. This crisis is a direct number of supporting characters is vast, consequence of legislative ineptitude the fault rests squarely with our and an almost complete absence of p legislators – which means it rests with timely and responsible action by our the American people. What happens legislature. when the sovereign becomes the greatest sources of systemic risk?

The Professional Risk Managers’ International Association (PRMIA)Lessons Learned: Linking Governance and Risk• Bank supervisors, equity analysts, creditors, and investors have little training in the assessment of good v. bad corporate assessment of good v bad corporate governance• Compensation disparities between the ‘average’ worker s pay the highest‐paid is an average worker’s pay the highest paid is an interesting benchmark.• Management guru Peter Drucker, in 1984, urged this ratio to be no more than 20x. Today it is over 350x‐to‐400x. than 20x Today it is over 350x to 400x• If executives/rain‐makers earn millions by selling options, book the premium via compensation, make equity holders happy via dividends and price appreciation, perhaps interests can (and do) get out of alignment. price appreciation perhaps interests can (and do) get out of alignment• Remuneration reports need to stop comparing CEO pay across one‐industry v. another. The real comparison is within the organization itself – lowest to highest paid (or similar) highest paid (or similar) Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Lessons Learned: Linking Governance and Risk• Independent and prudential risk management should ensure that an organization has appropriate and effective corporate governance programs governance programs – Shocking as this sounds, regulatory examinations of corporate governance do not occur today. While the “words” corporate governance are often used, they are rarely defined. governance are often used they are rarely defined – It was only July 2010 when Section 2068 ‐ “Guidance on Sound Incentive Compensation Policies” ‐ was included in the Federal p p g Reserve’s BHC Manual. Incen ve comp ≠ corporate governance. More work needs to be done.• What the above expectation requires is that internal audit and risk management assess and “rate” the quality of a firm’s g q y corporate governance practices. Reports should be periodically provided to the board’s risk committee, at least y annually. Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Lessons Learned: Linking Governance and Riskhttp://www.prmia.org/events/view_events.php? http://www.prmia.org/events/view_events.php?eventID=4418 eventID=4387 Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Lessons Learned: Linking Governance and Risk Risk Governance: PRMIA‐DC and the Management: Weinberg Center on PRMIA‐DC and FDIC Corporate Corporate Governance University on ERMhttp://www.prmia.org/events/view_events.php? http://www.prmia.org/events/view_events.php?eventID=4418 eventID=4387 Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA) Lessons Learned: Some Conclusions• Misguided public policy in the form of directed credit and capital to the housing industry spurred on by an aggressive curve slope for an “extended period” extended period 1. USG writing mispriced credit derivatives on housing should come to an end. Dealing with housing policy should be the national priority, not simply the mortgage interest deduction as discussed in the 1‐Dec‐2010 National Commission on Fiscal Responsibility and Reform Report R ibili dR f R 2. USG writing of other guarantees should stop, or be accounted for via GAAP o Sidebar: Should USG finances be GAAP‐based? According to shadow stats, debt using GAAP is ~$70.7 trillion in 2009, or approximately ~5x GDP (read “Skunked” by Bill Gross)• Poor incentive structures within firms and a “sell‐side”, “HFT”, “make a quick buck” (i.e., “Noise”) mentality to equity ownership. This institutional arrangement fosters rationally unsavory capital allocation decisions in the pursuit of GAAP EPS. • It raises profound questions about the corporate structure itself, and especially corporate governance, board responsibility, and the Duty of Care v. the Business Judgment Rule (see Rogers v. Hill (1933)) ‐ Judgment Rule (see Rogers v Hill (1933)) ‐ Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Current Changes in the Governance Landscape• United States – Dodd Frank Act Title IX Investor Protections Dodd‐Frank Act, Title IX, Investor Protections – G‐20, FSB, Basel, and Agency Rulemaking (14‐Apr‐ 11) – SEC Listing requirements (consistent cross‐border; related to compensation committees; 6 Apr 11) related to compensation committees; 6‐Apr‐11)• Europe – Fi Financial Reporting Council i lR ti C il – Walker Report (26‐Nov‐09) Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Current Changes in the Governance Landscape• DFA Title IX: – Subtitle A—Increasing Investor Protection – Subtitle B—Increasing Regulatory Enforcement and Remedies Subtitle B Increasing Regulatory Enforcement and Remedies – Subtitle C—Improvements to the Regulation of Credit Rating Agencies – Subtitle D—Improvements to the Asset‐Backed Securitization Process – Subtitle E Accountability and Executive Compensation Subtitle E—Accountability and Executive Compensation – Subtitle F—Improvements to the Management of the Securities and Exchange – Commission – Subtitle G—Strengthening Corporate Governance – Subtitle H—Municipal Securities – Subtitle I—Public Company Accounting Oversight Board, Portfolio Margining, and Margining and – Other Matters – Subtitle J—Securities and Exchange Commission Match Funding Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Current Changes in the Governance Landscape• Walker Review Issues: – Board size composition and qualification Board size, composition, and qualification – Board functioning and performance evaluation – I tit ti Institutional shareholders: engagement l h h ld t – Governance of risk – Remunerationi• 39 separate recommendations – Worth a read Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Current Changes in the Governance Landscape• Institution of risk committees for all firms greater than $1 billion – Expectation is for demonstrable competency on the risk Expectation is for demonstrable competency on the risk committee – Risk and compensation committee will work closely together• Totally independent compensation committee Totally independent compensation committee – No inside executive directors permitted – Committee has right to contract with legal and compensation experts• Much greater emphasis on board “action”, independence, attention to detail, and broader “mandate” – Believe that overall expectations are going to increase Believe that overall expectations are going to increase significantly; may be harder to find excellent board members Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Current Changes in the Governance Landscape• Important final remarks: – Do not want to saddle banks with social missions, but do need to align incentives from top‐to‐ bottom. to align incentives from top‐to‐ bottom • Deferred cash compensation has attractive aspects to comp reform – Institutional dollars will need to become more involved – Best practices for compensation committees needed Best practices for compensation committees needed – Recognize some CEOs are worth their pay. The difficult problem is a reversion to the top • That is paying mediocre CEOs as if they were stars (i.e., “fake alpha”; p y g y ( , p ; need time horizon), thus claw‐backs are an important consideration – Needs to be a recognition that people respond to other things beyond money: 1) autonomy, 2) mastery, and 3) purpose • St Steve Jobs – P J b Purpose: “I want to put a ding in the universe.” “I tt t di i th i ” – Board reform, education, and performance assessement Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association (PRMIA)Current Changes in the Governance Landscape• Conclusion: – Review papers loaded on Box net Review papers loaded on Box.net – Pay attention to: • The Rock Center and Stanford • The Weinberg Center at the University of Delaware • Harvard’s Law Forum on Corporate Governance • Yale’s Millstein Center Y l ’ Mill i C – Keep close to think‐tanks and specialty magazines/periodicals, like: magazines/periodicals like: • http://www.rand.org/icj/centers/corporate_ethics/news.html • https://www.directorship.com/ • http://www.governanceprofessionals.org/society/Default.asp Customer Support Direct Dial: 1‐805‐617‐7002

The Professional Risk Managers’ International Association Dodd‐Frank Series, Event 3 of 4 Financial Institution Governance Changes: THANK YOU! dc@prmia.org PROFESSIONAL RISK MANAGERS’ INTERNATIONAL ASSOCIATION www.prmia.org presentation by: thomas.day@prmia.org, Vice‐Chairman of the Board, PRMIA details and supporting information at: support@prmia.org

! [Day] ppt_fi governance changes_prmia_april 18 2011

by PRMIA on May 05, 2011

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! [Day] ppt_fi governance changes_prmia_april 18 2011 — Presentation Transcript