For forward-thinking risk managers, the days of identifying and dealing with only a portion of the risks facing businesses today are over. We need to anticipate, prevent and mitigate risk throughout the entire enterprise. Traditional risk managers are generally comfortable dealing with property, liability, and heath and safety risks, often in isolation. Yet, while important, these risks are often just the tip of the iceberg and therefore you might consider the appointment of a Chief Risk Officer (CRO).
A company’s decision about whether to appoint a CRO (or an equivalent senior risk executive) is driven by many factors, such as its industry, business model, structure and culture, not to mention the nature and complexity of its risks and the extent of any fragmented silo activity. When it is deemed appropriate for a CRO to be in place, both executive management and the Board of Directors – not to mention the company’s shareholders – have a stake in that executive’s success. When it is decided to establish such an executive position, a fundamental question arises: How do we position this executive, as well as risk management and compliance management, to be successful within the organization?
Like all C-suite executives, the CRO has a difficult job. To be effective, he or she must have a prominent and meaningful voice in the C-level dialogue. At the crucial moment when someone must play a contrarian role to protect the interests of shareholders, how can a CRO go against a CEO, who holds all the cards relative to his or her career: progression, salary, bonus, etc.? And if the CEO doesn’t believe in the value of risk management, it’s game over.(1) Poor positioning of the CRO can lead to a risk management failure.
To be truly objective and effectively positioned within the organization, risk management and compliance functions should be insulated from and independent of business unit operations, lines of business and front-line, customer-facing processes of the business. Here is where some critical questions arise regarding expectations. Do the CEO and Board want someone to coordinate, educate, facilitate, evaluate and integrate risk management activities? While that may be a valuable role for someone to play, such activities do not necessarily constitute a “line of defense” if there is no veto and escalation authority. At the other extreme, do the CEO and Board want:
- An objective assessment of the risks resulting from a line of business, process, transaction, deal or business plan, broken down into the fundamental components of risk so that the risks can be measured and systematically evaluated and managed?
- Advice on actions to take if the risks inherent in a strategy, plan, process, transaction or deal are inconsistent with the desired risk appetite?
- A qualified, independent party to exercise veto and/or escalation authority when situations involving noncompliance with regulatory requirements and internal policies arise?
- Meaningful and actionable risk reporting to the overall Board, designated Board committees and senior management that is independently developed from the risk owners?(2)
- Ongoing assessments of the appropriate mix of centralized and decentralized approaches to establishing risk policy and standards, defining risk appetite and setting risk tolerances and limits?
- Periodic reviews of compensation plans to consider the impact of risk factors and the design of the compensation structure on risk-taking behavior?
Clearly, the expectations of the CEO and the Board of Directors set the tone in determining the expectations for risk management. If there are expectations on the part of the CEO and Board that the CRO and risk management function should constitute a robust line of defense, then proper positioning is vital to ensure success. Effective risk management and compliance requires an independent, authoritative voice to ensure that an enterprise-wide framework exists for managing risk, risk owners are doing their jobs in accordance with that framework, risks are measured appropriately, risk limits are respected and adhered to and risk reporting and escalation protocols are working as intended.
Proper positioning of risk management and compliance functions entails several important principles:
1. The more significant the risk area to the execution of the business model, the greater the need for the functional leader (the CRO) to be viewed as a peer to business line leaders in virtually all respects (e.g., compensation, authority and direct reporting to the CEO) and likewise down through the business hierarchy and across the organization. The only way that will happen is if the CRO has the scope of responsibilities, authority, compensation and direct reporting lines that demand respect. The total package of actively participating in the strategy-setting process, leading the formulation of the organization’s risk appetite statement, developing risk reporting mechanisms, chairing or participating in management risk committees and, when appropriate, escalating risk issues to the CEO and the Board all together must convey to the lines of business and the organization as a whole that the CRO is a player. That means the CRO should be a key executive who reports directly to the CEO or the Board. Depending on the industry, the same point may apply to sensitive aspects of a company’s operations, including environmental, health and safety; product quality; contracting; security and privacy and other areas. Either these executives have real authority and clout, or they are relegated to the role of a mere “champion.” The “C” in CRO needs to mean something.
2. The CRO (or functional leader) should have a reporting line to the Board or a committee of the Board and face no constraints of any kind in terms of access to the Board.
3. The CRO’s (or functional leader’s) position and how it interfaces with line-of-business management must be clearly defined.
4. The Board or a committee appointed by the Board should conduct periodic executive sessions with the CRO (or functional leader); these sessions should be mandatory and regularly scheduled.
5. A formalized escalation process should exist (i.e., written procedures and agreements requiring escalation of any significant issues raised by the risk management and/or compliance function that are being argued by line-of-business executives or other risk owners).
For the above principles to work effectively in practice, the Board and CEO must have mutual understanding of the value contributed by the CRO (or functional leader) with the intent of preserving his or her independent role within the organization.
(1) For example, the CEOs of some financial institutions were so fixated on executing their business model focused on driving volume and growth in the subprime market leading up to the financial crisis that they chose to ignore the warning signs posted by the risk management function.
(2) “Risk owners” are those managers responsible for the lines of business, operating units and business processes that create risks and, as a result, accept the ultimate responsibility to own and manage the risks their activities create.