Magazine article Risk Management

The Unseen Predator

Magazine article Risk Management

The Unseen Predator

Article excerpt

HOW A FINANCIAL CRISIS SO LARGE COULD COME OUT OF NOWHERE After watching the colossal failures, federal-backed buyouts and systemic reconfigurations of stalwart American financial firms that survived two World Wars, the Great Depression and 1987's Black Monday, it is time for all those in risk management professions to regroup and ask a fundamental question: "What kind of risk management did these organizations practice?"

Consider the plight of American International Group (AIG), the largest, most powerful insurance company in the United States-and one of few companies where the tag "global giant" truly applies to its trillion-dollar balance sheet. This is a company that specialized in underwriting risk, providing risk management services and training risk professionals, and even it could not avoid the same fate of the aggressive hedge funds and securities trading investment banks that either no longer exist, have been bought out or have been forced to reconfigure their operations.

Investor confidence has been shaken to the extreme. There is no doubt that increased regulations will be coming out of Washington soon after the Obama administration takes office and the new Congress convenes. Those new regulations will likely be broad in nature and apply to a whole host of industries, not just the financial sector. After all, there are thousands of publicly traded companies, private companies with public debt, companies that trade in the commodities markets, and organizations that have 401(k) programs in various stocks, bonds and other funds.

The confidence of investors, risk managers and money managers in the rating agencies has to be questioned. How can the basic elements of risk management take place and mitigation strategies be planned and effectively implemented when the value of all investment grade ratings has diminished? When an organization or securities with a AAA or AA rating fails or defaults while they still have a AAA or AA rating, or banks with investment-grade ratings refuse to lend to each other, the rating agencies either have to redefine their ratings or fix the entire process to accurately reflect the financial stability of an organization and the effectiveness of its risk management practices.

It is now obvious that all these firms that thought they were practicing risk management-and told everyone from ratings agencies and investors to common shareholders and the general public that they were practicing risk management-got it wrong. With U.S. taxpayers now on the hook for up to $1 trillion or more to counteract this colossal failure of risk management, it has become paramount for each and every organization to re-evaluate their programs and commit to an enterprisewide approach that will help ensure they are not among those who "get it wrong" the next time.

The Case for ERM

About 10 years ago, the notion of managing risks on an organization-wide basis started to circulate. Slowly, over the years, the concept of enterprise risk management (ERM) gained some traction. But ERM was still not widely practiced in corporate America and if it was, it was being practiced on a very limited scale. Then another improbable event with an enormous financial impact took place: the downfall of Enron.

After Enron, the various credit rating agencies determined that ERM made sense. They started to advise certain industry sectors that they would take an organization's ERM effort into account when conducting their annual reviews. In May 2008, Standard & Poor's announced that it would be expanding the list of industry sectors that it would like to see practice ERM. But do Standard & Poor's and the other rating agencies have the resources, expertise and commitment to conduct a thorough and objective assessment of the companies they review in the area of risk management? Moreover, are enough companies reviewed each year for the assessments to remain current?

Several of the risk management and related professional associations began educating their memberships about ERM a number of years ago. …

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