Keynote address

Fordham Journal of Corporate & Financial Law, 2003 by Bies, Susan Schmidt

PROFESSOR RECHTSCHAFFEN: We are very honored this year once more to welcome a Member of the Board of Governors of the Federal Reserve System.

The most important thing I want to emphasize about Governor Bies is that she has been on both sides of the fence. She has served as an officer of a major corporation and now as a regulator, as a Member of the Board of Governors of the Federal Reserve System.

We are very honored to have Governor Bies with us today. With that, I would like to introduce a Member of the Board of Governors of the Federal Reserve System, Governor Susan Schmidt Bies.

GOVERNOR BIES:1 I want to thank Dean Treanor and Alan Rechtschaffen for the invitation to participate in this timely symposium on corporate governance issues. When I joined the Federal Reserve Board of Governors last December, I knew I would be doing more than helping to set short-term interest rates. While the general public and market focus on the decisions of the Federal Open Market Committee, Board members spend much of their time on various operating committees, focusing on payment and settlement systems, and the safety and soundness of financial institutions and markets. But the rush of current events has meant that I have spent less of my time dusting off my economics Ph.D. and more time using my experience as a corporate chief financial officer, auditor, risk manager, and accountant, to consider the policy issues of recent corporate control failures.

Today I want to focus on the role that risk management can play in strengthening corporate governance from the point of view of boards of directors, management, and internal control functions.

I. MANAGING RISKS

The last decades of the twentieth century were, without a doubt, a period of dramatic change in financial engineering, financial innovation, and risk-management practices. Enterprisewide risk management has been evolving as financial theory has advanced, new technology has made modeling of risks more feasible, and innovation has helped to find better ways to mitigate risk. Some types of risk are further along in the evolutionary process.

While there are many ways to categorize risk, I will use three broad categories for illustration-market, credit, and operating. Operating risk is the least developed, as conceptual frameworks, metrics, and databases are still in preliminary stages. I will come back to the issues surrounding operating risk in a few moments.

Market risk arguably has evolved the furthest because of the transparency of markets, frequency of transactions, and financial engineering that can parse the various forms of risk exposure so that appropriate financial instruments can be developed to hedge the specific components of risk. The treasury functions of corporations routinely use models to assess and manage price, interest rate, liquidity, and foreign exchange risk. As a result, managers can better anticipate changes in revenue and expense due to these factors and develop responses to their specific circumstances.

One tool for managing risk is securitization. Many of the assets on a firm's balance sheet, such as receivables and customer leases, can now be securitized-that is, grouped into pools and sold to outside investors. Securitization helps a firm manage the risk of a concentrated exposure by transferring some of that exposure outside the firm. By pooling a diverse set of assets and issuing marketable securities, firms obtain liquidity and reduce funding costs. Of course, moving assets off the balance sheet and into special-purpose entities, with the attendant creation of servicing rights and high-risk residual interests retained by firms, generates its own risks.

Derivatives are another important tool for managing risk exposures. In the ordinary course of business, firms are exposed to credit risk and the risk of price fluctuations in currency, commodity, energy, and interest rate markets. For example, when an airline sells tickets months before a flight, it becomes exposed to fluctuations in the price of jet fuel. A higher price of jet fuel translates directly into lower profits and, perhaps, a greater risk of bankruptcy. Firms can now use derivatives-options, futures, forwards, and so on-to mitigate their exposure to some of these risks. The risk can be transferred to a counterparty that is more willing to bear it. In my example, the airline could buy a forward contract or a call option on jet fuel to hedge its risk and thereby increase its financial stability.

Another major category of risk is credit risk, which also has become much more quantified. Models analyze a corporate customer's or borrower's probability of default, the loss in the case of default, and the borrower's likely exposure at the time of default, taking into consideration future draw-downs. The greater use of credit models in retail transactions provides a stronger framework to assess risk and ensure that pricing reflects credit quality. For consumer credit, however, models are less proven, since data collection and loss estimates generally evolved after the 1990-91 recession and so have not been proven under stress conditions or for subprime borrowers. Because many of these borrowers did not have significant access to credit in previous recessions, their ultimate default rate in the current cycle should help to validate the strength of the new statistical models.