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...

The two most important words in financial risk management? (encore)

WHAT -and- IF

By Brett Sherman, The Sherman Law Firm                  

Worst Case Scenario Analysis - Management of low frequency / high magnitude risks. 

Companies must have methods for controlling risks inherent in activities with -

(a) a high probability of success, but

(b) can produce catastrophic losses with just one failure.

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The ultimate risk management responsibility for publicly owned corporations is to assure that a company cannot be crippled if a business strategy / model goes horribly wrong.  

 

It is impossible to manage against the risk of high loss magnitude events unless corporate risk managers and senior management agree to start all risk analysis with two words - 

"WHAT" and "IF"

 

FOR EXAMPLE-

What if our hedging strategy fails?

-or- 

What if home prices fall?  (the common sense question that could have prevented the failure of Lehman Brothers, and Bear Stearns - and maybe even the financial crisis)

* * *

So, why weren't these basic questions asked by nearly enough companies during the housing bubble?  

That's right - Because an overloaded money train was pulling into Wall Street and Orange County, California (the epicenter of nonprime lending) on a regular basis, and asking "what if" questions would have yielded (pun intended) answers that lenders and bankers did not want to hear.  This is risk management by denial (also called willful blindness or, more colorfully, burying one's common sense in the sand).

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