Is your board ready for ERM? In the wake of the financial crisis, many are wondering about the role of boards of directors in enterprise risk management. Results of a major study provide a set of best practices to help boards in getting up to speed on their oversight responsibilities.

• Author: Barton, Thomas L.
• Position: Enterprise Risk Management

One of the most shocking realizations to emerge from the recent global financial crisis is the extent to which the governing bodies failed to understand the level of risk their organizations had undertaken. Perhaps the most egregious and highly-publicized example is insurance giant American International Group, whose $500-billion foray into credit default swaps not only brought AIG to its knees but came close to capsizing the world financial system.

The list of recent major risk debacles is already legend--Lehman Brothers Inc., Merrill-Lynch Inc. and Countrywide Mortgage Co. in financial services, the Fukushima Daiichi nuclear reactors in Japan, as well as other high-profile examples. Certainly, no board of directors wants to be viewed as asleep at the switch. So, a typical response might be, "we didn't know" or "no one told us."

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Even so, it is a legitimate question to ask with respect to all of these failures; "Where was the board?"

It can be argued that few, if any, of these board members had a clue about the risk levels company management had assumed. Though there has been considerable discussion about dysfunctional incentive systems excessively rewarding risk-taking on the upside--while failing to penalize risk-taking on the downside in the financial crisis--this seems to apply mainly to management.

Boards, on the other hand, appeared to be existing in a bubble of blissful ignorance, unaware of the "bet the farm" positions their CEOs had undertaken.

In this era, it has gotten much easier to play business roulette with highly exaggerated outcomes because of the existence of derivative financial instruments. By their very nature, derivative values can swing wildly up and down with an impact magnified well over the changes in the underlying asset or value. This inherent volatility is well known. For example, the value of an option on a traded stock is considerably more volatile than the price of the stock itself.

As the financial crisis continues to be dissected by corporate America and regulators, there has been something of an epiphany about risk management, that the governing bodies often were not engaged in appropriate oversight of their organization's risk exposure. A natural conclusion then is to find ways to improve the level of risk oversight by boards of directors.

Improving Board Oversight Of Risk Applying ERM

Congress, through the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the U.S. Securities and Exchange Commission have already acted separately on this front by fiat--requiring organizations to strengthen board risk reporting and mandating improvements in risk communication and disclosure, for example. But even with these regulations in place...