RM: disasters and reactions

[campbell]

I've decided to create a single fiasco-related thread, keeping track of individual stories of risk management failures and proposed fixes to prevent those particular troubles from occurring again [I guess shutting the barn doors will prevent the cows from getting out].

Anyway, to kick it off, I'll put up this from the WSJ:
http://online.wsj.com/article/SB124052874488350333.html

How Business Schools Have Failed Business
Why not more education on the responsibility of boards?

As we try to understand why our economy is so troubled, fingers are increasingly being pointed at the academic institutions that educated those who got us into this mess. What have business schools failed to teach our business leaders and policy makers? There are three profound failures of sound business practices at the root of the economic crisis, and none of them have been adequately addressed by our business schools.

....
American icon General Electric was stripped of its coveted AAA-rating because of problems emanating from its financial services unit. Yet its board has only one director with experience in a financial institution. If it is the board's job to oversee a corporation, it seems logical that there would be a segment in the core curriculum of every business school devoted to board structure, composition and processes. But most programs don't cover the topic.
....
Nationally, finance departments at business schools offer hundreds of courses in asset securitization and portfolio diversification. They have taught a generation of financial leaders that risk can be diversified away. But in their B-school days, few investment bankers examined the notion of "agency costs." That concept explains that as the gulf between the provider and the user of capital widens, the risks involved with selecting and monitoring the participants in the portfolio increase. It should come as no surprise that financial institutions amassed securities that consist of a diversified portfolio of deadbeats.
....
Most B-schools paper over the topic by requiring first-year students to take a compulsory ethics class, which is necessary, but not sufficient. Would Bernie Madoff have acted differently if he had aced his ethics final?

Could we have avoided most of the economic problems we now face if we had a generation of business leaders who were trained in designing compensation systems that promote long-term value? And who were educated in the proper make-up and responsibilities of boards? And who were enlightened as to how shareholders can use their proxies to affect accountability? I think we could have.

America's business schools need to rethink what we are teaching -- and not teaching -- the next generation of leaders.

I read that article. The best quote in it is:

Recently, when I delivered a guest lecture at another school, a distraught-looking student pulled me aside after class. She explained that my talk was very disturbing to her. After investing two years and $100,000, she was only weeks away from receiving her MBA. But prior to our class, she had never heard a discussion about board responsibilities or the rights of shareholders. She said she felt cheated.

[campbell]

Which reminds me, check out this:
http://soa.org/library/newsletters/s...2008-iss32.pdf

Starting on page 1 is my article "Quit Paying for Business Education!"

If you're not going to learn about responsibilities of the board to shareholders, at least don't pay for not learning it [or something]. Anyway, it's off-topic, but lots of good resources in that article. I have a followup coming out this July, I hope.

[WellThen]

Originally Posted by campbell

If you're not going to learn about responsibilities of the board to shareholders, at least don't pay for not learning it [or something].

No one is paying to learn something, they're only paying to receive the three letter acronym. I also hope that people don't need a six figure education spanning multiple years to realize that if you are going to compensate me for simply making a deal, then I'm going to do whatever it takes to make the "deal", regardless of what the outcome is. Especially if the outcome is 5 or 10 years away, and can't be traced back to my actions.

[campbell]

Originally Posted by WellThen

No one is paying to learn something, they're only paying to receive the three letter acronym. I also hope that people don't need a six figure education spanning multiple years to realize that if you are going to compensate me for simply making a deal, then I'm going to do whatever it takes to make the "deal", regardless of what the outcome is. Especially if the outcome is 5 or 10 years away, and can't be traced back to my actions.

Yes, just as those "ethics" classes crack me up. Can I trust someone who needs to be taught ethics?

Lesson 1: Don't be Evil

Lesson 2: Don't use lesson 1 as your company motto, because it will bite you on the butt.

There are a lot of good letters to the editor in the WSJ today relating to these issues:
http://online.wsj.com/public/page/letters.html (can't find a permalink)

The Moral Hazards of Managing Other People's Money

John C. Bogle in "A Crisis of Ethic Proportions" (op-ed, April 21) proposes that we try harder to be more moral, and in that misses the point of Adam Smith. Mr. Bogle cites Adam Smith's statement, "[M]anagers of other people's money [rarely] watch over it with the same anxious vigilance with which . . . [they] watch over their own" which is an indictment of human nature. Smith's position is that man's essential nature is a given, not something which can be altered. It is from this base that the invisible hand is derived. Setting up structures which rely on what man ought to be, compared to what he is, is like building a house on sand.

Adam Freund
Oak Park, Mich.
....

The "agency" problem in the public equity market which Mr. Bogle laments is a direct result of the growth of index funds, a product which his former firm (Vanguard) popularized. Index-fund managers not only do not care if there are governance issues within the firms in which they invest, they are required to hold every firm in the index. In this way, indexers aid and abet the very agency problem Mr. Bogle rails against.

Charlie Smith
Pittsburgh

John Bogle's contribution to the crisis literature sits oddly with his reputation. A father of indexing, he is happy to let the market make our investment allocation decisions. Yet he doesn't like the decisions of the people who make up the market -- the money managers who hold 75% of all public shares and "fostered the crisis with superficial security analysis." Ironically, people who index are in effect endorsing the valuations determined by the people who don't index -- those dreadful money managers.

To address "unchecked market forces" Mr. Bogle wants federal statutes to force money managers to put owners' interests first. We already have many statutes such as the Employee Retirement Income Security Act and other laws that require that. Are we to assume that under some new law, managers would never have bought mortgage originators, banks, or insurance companies? Could we really have averted the crisis with nothing more than sound stock selection?

While money managers and analysts made mistakes, so did the people who could really make a difference: bankers, regulators, government-sponsored enterprises, and politicians. Thousands of bankers are now suffering personally for decisions they might or might not have had a hand in, as are many money managers. The real agency problem is with those who suffer no repercussions for their poor oversight -- regulators and politicians.

Brian C. Ziv
Winnetka, Ill.


What Happens When the Referee Is Playing the Game?

George Akerlof and Robert Shiller give us a concise and clear history of the debate over the proper role of government in our society, and specifically in our economic lives ("Good Government and Animal Spirits," op-ed, April 24). An analogy they use is from sports: A brilliant player wants a referee, because only when the game has appropriate rules can he really show his talents.

Every talented player understands the importance of a strong referee. But in sports the referees are not participants in the game. Referees enforce rules that have been clearly outlined before the game begins and otherwise are notable for staying out of the way. A referee has done a good job if spectators never notice him.

Government intervention, particularly of the stripe we have witnessed since the global financial crisis began last fall, in no way fits that description. The government has put itself squarely in the middle of the playing field of American capitalism -- directly as a shareholder in Fannie Mae, Freddie Mac and AIG, as a lender to countless banks, auto companies and others, and in decision-making roles. Note Henry Paulson and Ben Bernanke's steam-rolling Ken Lewis into misleading his shareholders, forcing a deal for Bear Stearns and setting the initial price, and deciding not to backstop a deal for Lehman Brothers.

Additionally, this interventionist government "referee" has taken on the task of dramatically altering the rule book right at the most crucial moment of the game. At this moment no one -- company managements, investors, regulators, home owners, lenders -- has any idea what the rules are. I'd be fascinated to see how many people line up for a pick-up basketball game that Messrs. Akerlof and Shiller are refereeing.

Dan Goldring
New York

Messrs. Akerlof and Shiller make a case for more regulation of financial markets. However, their case is based on historic narrative without any concrete suggestions aside from exhorting the government to regulate more and better.

This is no accident as the specifics become hard to argue for, and the numerous ways government helped create this crisis become apparent and run contrary to the authors' suggestion.

Government is generally incompetent, political, corrupt, and a far less effective and fair referee than the market itself. That the market is not perfect will always drive tinkerers to try to "fix" it during bad times. Sadly, they will always stifle economic growth in favor of overregulation, litigation, grand-standing, pay-for-play and everything else government brings. Here they go again.

Clifford Asness
Greenwich, Conn.

[campbell]

I'd call this a reaction to current events:
http://knowledge.wharton.upenn.edu/a...articleid=2205

Re-thinking Risk Management: Why the Mindset Matters More Than the Model
Published: April 15, 2009 in Knowledge@Wharton

Forecasting used to be straightforward. Over the years, by the end of the first quarter, managers usually had a fairly reliable sense of how the business was shaping up and whether targets would be met, missed or exceeded. Confidence in quarterly and annual predictions was so high that coming in above or below by even the smallest amount was considered a surprise and set off moves in stock prices. This year, however, things have changed. Companies like Unilever, Union Pacific and Visteon are declining to make any predictions at all for their performance over the months ahead. In other words, all bets are off.

....
Constructing a New 'Risk Architecture'

Given recent events, "What I see now is a new risk architecture emerging for organizations," says Erwann Michel-Kerjan, managing director of Wharton's Risk Management and Decision Processes Center. "Whatever industry you consider, it is always the same pattern. Things are getting faster, and therefore we need to make decisions faster, but based on information that we often don't have. Of course, we would like to have time to get all the information, but the reality is that managers have to make decisions under uncertainty, if not outright ignorance."
....


In addition, new techniques and technologies are now coming into the picture. For instance, so called "track-and-trace" technologies, integrating software and advanced scanning and identification technologies, are improving visibility across companies' supply chains, so they can precisely identify which components are coming from whom and where. Similarly, Michel-Kerjan is working on a project to identify the "DNA" of financial products, in an effort to provide more visibility into the components that go into a product and offer more effective tools for auditing. Consulting firms also are stepping up efforts to provide companies with a more holistic, multidimensional view of their risks. Even the definition of "business intelligence" is expanding from a focus on operating performance to increasingly include monitoring risks, both inside and outside the organization.

Philippe Hellich, vice president of risks, control and audit at Danone, is already moving to the new model. "We use very few mathematical models," he says, although the organization is working on a small set of new ones for certain risks. "Instead, we rely much more on interviews and benchmarking with peers outside the group and between our subsidiaries around the world. Our approach is based on listening and challenging the operational management, common sense analysis, sound judgment and good governance at the top."
....
Making Better Decisions

In the last pages of the 1996 bestseller on risk, Against the Gods, Peter Bernstein anticipated the challenge many companies are facing today. "Nothing is more soothing or more persuasive than the computer screen, with its imposing arrays of numbers, glowing colors and elegantly structured graphs," he wrote. "As we stare at the passing show, we become so absorbed we tend to forget that the computer only answers questions; it does not ask them.... Those who live only by the numbers may find that the computer has simply replaced the oracles to whom people resorted in ancient times for guidance in risk management and decision-making."
....
On the other hand, well-designed efforts to look ahead even three to five years can be stunningly prescient. Consider the annual Global Risks Report, published by the World Economic Forum in cooperation with Citigroup, Marsh & McLennan Companies, Swiss Re, the Wharton School's Risk Management and Decision Processes Center and Zurich Financial Services, which is based on a qualitative assessment of global risks, workshops and input from business leaders and experts around the world. In the 2007 report, a global collapse in asset prices was identified as the major risk with one of the highest probabilities of occurring and the biggest potential impact. Then again, in January 2008, the next report warned of a high likelihood that a "liquidity crunch will spark a U.S. recession in the next 12 months" and called for new thinking on systemic financial risk. As we know now, both predictions were right on target.

[JMO]

Interesting article.

As we know now, both predictions were right on target.

It would be interesting to review the other predictions, just to look at overall batting average.

[awriter]

I don't know whether this is the best thread to post this comment in, but here goes anyway. I may have missed it, but I haven't seen any written comments regarding the lack of effectiveness of SOX and the auditing firms in heading off the current financial crisis. In short, the law resulting from Enron, etc., didn't prevent AIG, etc.

At this point, my opinion is that at least for the financial services industry, having an audit of accounting issues only is too narrow. It seems like a team of experts (including accountants) with diverse training, such as would be used in a due diligence for an acquisition, is needed to evaluate the status of a financial services entity. It seems to me that in general the public accounting firms are overpaid for the value they add to the process. It isn't always that they lack insurance expertise (though that is sometimes the case) but the scope of the audit is far too narrow.

[campbell]

Originally Posted by awriter

I don't know whether this is the best thread to post this comment in, but here goes anyway. I may have missed it, but I haven't seen any written comments regarding the lack of effectiveness of SOX and the auditing firms in heading off the current financial crisis. In short, the law resulting from Enron, etc., didn't prevent AIG, etc.

At this point, my opinion is that at least for the financial services industry, having an audit of accounting issues only is too narrow. It seems like a team of experts (including accountants) with diverse training, such as would be used in a due diligence for an acquisition, is needed to evaluate the status of a financial services entity. It seems to me that in general the public accounting firms are overpaid for the value they add to the process. It isn't always that they lack insurance expertise (though that is sometimes the case) but the scope of the audit is far too narrow.

I think this is a good place for this. I've seen lots of calls for further regulations, but it doesn't seem to me that it's the regulations per se that lack, but the staffing/expertise and actual implementation by the regulators.

I'm not sure what's going on with the whole Madoff thing right now (been quiet on that front lately - too many things to look at all over the place), but that sounded like a case where outsiders warned of issues, but the regulators were entirely ineffective, for whatever cause. I'm not sure that new rules would have necessarily fixed the situation, given that it's not clear the extant rules were being [rigorously] applied.

[California]

Originally Posted by campbell

Yes, just as those "ethics" classes crack me up. Can I trust someone who needs to be taught ethics?

Perhaps it is semantics, but I believe individual concepts of right and wrong are relative. I am glad ethics is part of the code of conduct. One SoA exam I passed covered the code of conduct, so it I was required to know it. The fellowship admission test that began after my last exam covered the Equity Funding scandal. I actually saw the James Woods BBC movie on PBS before I took my first exam and first job. I later worked with people who, having worked at Equity Funding, knew those involved.