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 News | August 21, 2008 |
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Standard & Poor’s takes a risk on ERM
THE PLAN by Standard & Poor’s to add enterprise risk management analysis to its ratings for the non-financial sector has drawn a mixed response, but some say this aspect of ratings must be advanced in the present market turmoil – not least to repair the rating agencies’ bruised reputations.
The release of the plan last month by S&P, which will begin benchmarking for the new measures from the third quarter of this year, just preceded the announcement in Australia of a government inquiry into the role of financial product research houses and ratings agencies in the wake of collapses of property investment vehicles and the sub-prime meltdown and subsequent credit crunch.
One observer said S&P was taking “considerable risk” introducing such a scheme outside the financial sector, but said there was considerable support for the measures to be brought in sooner than the present plan, which won’t see these assessments influence ratings at least until next year.
“They may be seen to have diluted the quality of their ratings approach by introducing something that is new, perhaps not widely understood, and, perhaps, inconsistently applied,” said James Maxwell, principal risk consultant at insurance broker Marsh in London.
“But doing nothing was not an option. Various financial shocks – not least the ongoing credit crunch – have dented ratings agencies’ credibility, and S&P have sought to improve the overall quality of their ratings by taking a more forward-looking view than has been the case in the past,” he said.
“Overall the effectiveness of management in general, and of risk management specifically, is becoming much more important,” Maxwell said.
S&P acknowledges that ERM didn’t prevent large losses at many of the banks, but said the present crisis was a good opportunity to introduce ERM to the non-financial sector as it would allow them to “explore risk management in real time as many companies come under potential stress”.
Given the relatively cautious introduction of the new approach, Maxwell said he was struck by how “profound” the reaction has been from corporates, analysts and providers of advice.
“I think that there is a very high weight of expectation in terms of the additional impetus that this development will bring, and there will be pressure in consequence to roll out the new approach faster, not slower,” he said.
The other major ratings agencies, such as Moody’s and Fitch, have been more cautious about extending ERM into ratings outside the financial sector. Moody’s has been introducing assessments of risk management through its Enhanced Analysis Initiative. Fitch says at present it is sticking to the financial sector.
What ERM is not according to S&P
· A way to eliminate all risks
· A guarantee that the firm will avoid losses
· A collection of long-standing and disparate practices
· A rigid set of rules
· Replacing internal controls of fraud and malfeasance
· Exactly the same for all firms and sectors
· The same from year to year
· A passing fad
S&P itself notes there were “some doubts” expressed in submissions to its original plan, released in November. One was that financial companies had still suffered record losses, despite ERM analysis being included in their assessments. Quite apart from that was whether they had the ability to apply ERM assessment equitably across diverse industries.
Nevertheless, on the failure of ERM analysis to pick all the losers in the sub-prime meltdown, S&P said that the “fundamental structure of our analysis will remain intact”. It said the “assumptions underlying our ERM analysis will evolve” but said the credit crisis had only reinforced the need to focus on risk management as part of their ratings analysis.
“Clearly the downturn will provide new insights into these processes, which will guide our future analysis of institutions’ ERM capabilities,” the agency said in its announcement last month.
“Reputations [of credit agencies] were all a bit bruised in terms of the sub-prime issue, there’s no doubt about that,” said George Sutton, a partner at KPMG.
He notes that the recent report from the Senior Supervisors Group – Observations on Risk Management Practices During the Recent Market Turbulence – issued by regulators from the US, Germany, France, the UK and Switzerland, had concluded that many of those that had fared better following the sub-prime crisis took a gloomier view of the risks of the various securities they were investing in than the ratings agencies.
“The consistent thing was that: one, they had used enterprise-wide [risk management] frameworks, two they had used common definitions. And in terms of those definitions, and the actual pricing models they used across the organisation, invariably they had actually used more pessimistic scenarios than the rating agencies,” he said.
“So while the others had used those ratings as a basis for valuation and calculating default probabilities, it was the ones that said: ‘That just cannot be right in terms of what all [our own] assessments tell us’, they’re the ones that came through stronger,” said Sutton.
Nevertheless, he said that he was “reasonably confident” about the agencies’ ability to assess risk management frameworks for the non-financial sector and felt it would ultimately be a positive move.
For its part, S&P said a “fundamental re-thinking” of risk management functions is now being carried out by the boards of financial institutions, and that their conclusions would translate into new insights and updates to its own risk management analysis.
“The focus of these updates will be on the probabilities, magnitudes and types of losses that institutions may experience,” S&P said in their announcement.
The agency said its ERM analysis would take into account significant differences between sectors and the types and level of risks they faced, and would reflect differences by “weighting ERM’s importance by sector and by diving more deeply on certain risks”.
Assessments of risk culture and strategic risk management, however, would be applied “consistently” to provide the foundation for benchmarking “basic ERM capabilities and performance”, it said.
Sutton warned that S&P’s focus on strategic risk across organisations and risk culture meant that companies really had to be looking hard at their businesses because introducing cultural changes was always a lengthy process.
“They are the long-tail areas – particularly risk culture. If an organisation hasn’t got itself in shape, they would want to start now if they want to be ready for a review in six or 12 months’ time,” Sutton said.
Still, Maxwell said, S&P was wisely taking an evolutionary rather than revolutionary approach and would focus its initial efforts on industries where its analysts would not be completely out of depth.
These include what can loosely be termed “traders” – such as power generators, agriculture and commodities houses.
As the agency notes, it does not see ERM analysis radically altering its existing credit ratings. “Its value will be incremental in most cases, negligible in a few, and eye-opening in some others.”
See Standard & Poor’s website for details of their plans
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19 June 2008
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