Rewarding Good Management, When Always Confronting Risk
September 8, 2009
Risk is the hottest topic in the compensation committee meetings in the boardroom in the current environment,'' says Irv Becker, national practice leader of Hay Group's U.S. Executive Compensation Practice. "Everyone's talking about risk," not just financial services firms.
Not too surprising, when pay packages on Wall Street were weighted 95 percent toward annual incentives. And caused a near meltdown of credit and financial markets, when the seemingly simple risk that housing prices might decline and foreclosures surge was not anticipated.
But there is no easy way to create a benchmark that will be easy to implement and at same time provide a valid basis for rewarding chief risk officers, operations managers, fund managers, traders and their supervisors for managing and mitigating the risks of buying, selling and investing in increasingly complicated securities.
"It's a challenge. No one's figured it out yet. And everyone's working on it,'' said Becker.
Such a benchmark is critical, if there is to be meaningful compensation at year's end to good risk management, just as there are year-end rewards for trading profitability. Beat the number and you get a bonus. Miss it, you don't.
"'That's exactly what this is all about,'' says Allan D. Grody, president of Financial InterGroup, a New York consulting firm who is working on a framework to account for risk and along the way make it possible to give managers financial rewards which are based on quantified ways of managing risk well.
The measure that is recommended as a starting point by Grody, who is a retired professor of risk management systems at New York University, Robert M. Mark, the CEO of Black Diamond Risk and former chief risk officer of the Canadian Imperial Bank of Commerce, and Peter J. Hughes, managing director of financial modeling firm ARC Best Practices in the United Kingdom, is a return on capital that is adjusted for risk.
The chart ("Risk & Reward," p. 17) shows the overall calculation. Its pieces are risk-adjusted revenue and an amount of capital that is set aside to cover unexpected losses, known as "economic capital."
The risk-adjusted revenue is divided by the economic capital to produce the overall benchmark of risk management performance called Risk-Adjusted Return on Capital.
Two of the pieces of economic capital are fairly well-measured. They are market risk and credit risk. For these set-asides, securities firms, wealth managers and fund managers have extensive historical information that can guide them.
In fact, in their operating budgets already should be adjustments for, say, a 5 percent drop in overall market prices. In that case, a company managing $10 billion in assets should already have set aside $50 million, in reserve.
But a good risk manager should be allowing for an unexpected level of market risk. This would be resulting from an unforeseen event or sequence of events, such as 9/11 or the disappearance of two or more large investment banks from global markets.
In that light, a good risk manager might set aside enough capital to cover another 10% drop in market prices. That manager would have put aside another $100 million, or $150 million all told.
