Wall Street Law Blog

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...

What is Capitalism?

Capitalism. We Know it When We See It.  But Can We Define It?

Wall Street Law Blog Takes A Shot (without the help of investopedia, wikinvest, wikipedia, or any other kind of wiki...)

Scrolling through emails today, I came across an interesting discussion from a linked-in group that I follow.  The topic: What is Capitalism?

As I have often said, no economists write for Wall Street Law Blog.  Still, since we blog about finance and the economy on a regular basis, I decided to try defining capitalism without a net  (no research of any kind, and no review of any comments from the aforementioned linked-in discussion).  

Here is what I came up with -

Capitalism (n): A market-based economic system in which profit motive drives allocation of capital.

In other words - In a capitalist system (a) business activity is funded by investors and creditors, and (b) these investors and creditors assume the risk of loss in exchange for the possibility/expectation of financial gain.

In a pure capitalist economy, all capital allocation is driven by free markets, and all investment capital and debt capital is at risk. There would be no regulation.  Investment and extension of credit (loans and bond issues)  would instead be subject to the doctrine of caveat emptor (buyer beware).

Disclaimer...

I should probably add that I don't believe pure capitalism could work in the real world any better than pure communism (which does away with profit motive altogether).

By Brett Sherman
The Sherman Law Firm