A Catch-22: Fraud and Financial Risk Management (from the Wall Street Law Blog Greatest Hits Collection)

CAN YOU PROVE THE CAUSE OF OUTCOMES THAT DON'T HAPPEN...

- OR - 

WHAT IS AN OUNCE OF PREVENTION WORTH ANYWAY?  

Who among us isn't a sucker for a company that can make us money and has a firm-wide commitment to superior, disciplined risk management?  Profitable and safe, what could be better?  

But how can you - as an outsider - really confirm that a company does practice sound risk management?  Or even that a company gives risk management a second thought?  

Hmmmm...

  

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Claims of quality risk management are hard to disprove most of the time because good risk management is about prevention (i.e., keeping bad things from happening).  By nature, preventative actions are fertile territory for fraudsters.  Why? Because, in the absence of a negative outcome, claims of success or quality based on preventative measures are often very hard to disprove.

If you did not get the flu this past winter, was it because you got a flu shot or because you weren't exposed to the influenza virus?  If you are in a car accident and escape injury, is it because your Jeep has anti-lock brakes, air bags, and the latest whiplash resistant seatbelts or would you have walked away from the crash without all the state-of-the-art safety features?  Who the hell knows?
Before the "Great Recession," financial services companies could - and did - win investor trust by falsely touting their supposed high quality risk management systems.  But, as the failure to contract flu does not prove the effectiveness of a flu shot, the absence of evident risk management failures (like catastrophic losses) is not proof of high quality risk management.

On the other hand, if you DO get the flu, you have pretty clear evidence that your flu shot was a waste of time and money.  And if a financial institution DOES suffer catastrophic losses, that is certainly a hint that a firm's purported "best in class" risk management systems may not have been so good after all...

Comments

[Colin Thompson]

After looking at the behaviour of companies like Bear Stearns etc., The only way of telling there might be a problem is to compare the performance of the stock relative to an index of similar companies. The percentage movement of a stock in trouble is greater than the index of companies it is being compared to.

My hypothesis:It looks like insiders know when there are problems and act on that information before the market. So Bear and Lehmann's creditors might be making trades to protect themselves.