Mr. Young mentions several dangers that warrant consideration by the board: credit risk, liquidity risk, accounting risk, market risk, legal and compliance risk, and operational risk.  He considers these important elements of risk management because they all influence the cash flows of the firm and they all have the potential of deposing the business enterprise.

Young then considers the office of Chief Risk Officer, as a number of firms have instituted.  The idea is to sensitize business units to the concept of risk—as if they didn’t understand this—and provide a more objective and corporate-wide analysis.  Unfortunately, Mr. Young does not bother to examine the role played by Richard B. Buy, Chief Risk Officer at Enron.  As we all know, Mr. Buy neither sensitized Enron’s business units to the concept of risk nor provided a more objective and corporate-wide analysis.

Next Young considers the structure of the board so as to “optimize its oversight of risk.”  He considers whether some committee should be assigned this task, such as the audit committee, or whether a separate risk management committee should be created.  He claims, “the problem involves putting in place a workable system of oversight that builds in sufficient accountability, expertise and manageability while still covering the full spectrum of risks warranting board attention.”  Unfortunately, this proverbial band-aid doesn’t work because the problem is really not a technical hitch.

Young’s examination has two shortcomings.  First, risk management is not the fundamental problem.  The basic issue is that the typical board is weak, if not impotent, and in bed with management, instead of acting as independent agents of shareholders.  Second, the solution does not depend on structure, but instead on the generation of incentives and disincentives that motivate board members to perform socially desirable tasks and to avoid dysfunctional behaviors.  The idea is to align the interests of directors with the interests of shareholders and not with the interests of managers.

Overarching this discussion is the observation that the critical business issue for society is the continued enervation of shareholders by the management class.  If board members strive to solve the risk management problem as described by Michael Young, they most likely will accede to the wishes and desires of the CEO and his or her staff.  In other words, risk management will become risk management for the managers and not risk management for the shareholders.

The solution rests with the creation of incentives and disincentives so that the directors are more in line with the shareholders, even if at the expense of management.  Congress could and should help by enacting legislation that would allow investors to sue directors when the directors abrogate their duties to the shareholders.  (Recall that the Supreme Court greatly restricted the liability of directors in Central Bank of Denver v. First Interstate Bank of Denver but invited Congress to change the law.)

In addition, the SEC should empower shareholders to vote for the directors and, if the SEC remains on the sidelines, then the Congress should do this.  The only way to obtain truly independent directors is to give shareholders the right to vote for the directors.  And not with a manager-stacked deck of choices.

The proposal to create the position of Chief Risk Officer or to re-structure the board of directors to manage risk is merely a subterfuge.  As the directors of investment banks are culpable for recent events in that industry, they and their advisors are attempting to deflect criticism by claiming that the problem is technical and requires technical solutions.  This is not the case.  The problem is that we have perverse incentives for directors to close their eyes and permit managers to do what they will.  Improve the incentives and one improves the behaviors of board directors.  Improve only the structure of the board, and the directors will continue to sleep through the corporate misdeeds.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) published by BNA in 2007.