READING 3: CORPORATE GOVERNANCE AND RISK MANAGEMENT

Best Practice

There are numerous best practices in corporate governance, including:

• Board is comprised of a majority of independent members with basic knowledge of the firm’s business and industry.
• Board watches out for the interests of all stakeholders, including shareholders and debtholders who may have somewhat differing interests.
• Board is aware of any agency risks and takes steps to reduce them (e.g., compensation committee).
• Board maintains its independence from management (e.g., CEO is not the chairman of the board).
• Board should consider the introduction of a chief risk officer.

There are numerous best practices in risk management, including:

• Board should focus on the firm’s economic performance over accounting performance.
• Board should promote a robust risk management process within the firm (e.g., upward mobility for risk management careers).
• Board should set up an ethics committee to uphold high ethical standards within the firm.
• Board should ensure that compensation is based on risk-adjusted performance.
• Board should approve all major transactions.
• Board should always apply professional skepticism to ask probing and relevant questions to management.
• Board should have a risk committee in place.

The role of the board of directors in governance would include the review and analysis of:

• The firm’s risk management policies.
• The firm’s periodic risk management reports.
• The firm’s appetite and its impact on business strategy.
• The firm’s internal controls.
• The firm’s financial statements and disclosures.
• The firm’s related parties and related party transactions.
• Any audit reports from internal or external audits.
• Corporate governance best practices for the industry.
• Risk management practices of competitors and the industry.

Risk Appetite

        A firm’s risk appetite reflects its tolerance (especially willingness) to accept risk. There is subsequent implementation of the risk appetite into defining the firm’s risk limits. Ultimately, there must be a logical relationship between the firm’s risk appetite and its business strategy.

Mechanisms for Transmitting Risk Governance

        Two mechanisms for transmitting risk governance throughout a firm are the audit committee of the board and the use of a risk advisory director. Additionally, the role of the risk management committee and the compensation committee further transmit risk governance.

Interdependence of Functional Units

        The various functional units within a firm are dependent on one another when it comes to risk management and reporting. Using an investment bank as an example, areas such as valuations, the profit and loss statement, and risk policy require input from more than one of the following units: (1) senior management, (2) risk management, (3) trading room management, (4) operations, and (5) finance.

Responsibilities of a firm’s Audit Committee

        The audit committee is responsible for the reasonable accuracy of the firm’s financial statements and its regulatory reporting requirements. It must ensure that the firm has taken all steps to avoid the risk that the financial statements are materially misstated as a result of undiscovered errors and/or fraud. In addition to the more visible verification duties, the audit committee monitors the underlying systems in place regarding financial reporting, regulatory compliance, internal controls, and risk management.