Spheres of Influence: Risk Management after the Financial Crisis

By O'Neil, Vincent H. | Risk Management, April 2014 | Go to article overview

Spheres of Influence: Risk Management after the Financial Crisis


O'Neil, Vincent H., Risk Management


One of the biggest revelations of the 2008 financial crisis was that the scope of risk management is almost unlimited. The violations of sound risk practices that generated the crisis spanned numerous industries and sectors: Home loan originators actively relaxed mortgage lending standards, investment banks concealed the risky nature of the resulting mortgages while packaging them into bonds for sale, and the list goes on.

Oversight was also lacking as ratings agencies stamped seals of approval on those bonds without examining them closely, and entities seemingly unconnected to the mortgage industry sold esoteric financial products that essentially insured those dangerous bonds. Government regulators failed to control the hazardous activities, and some public officials even promoted ultimately disastrous practices.

Unexpected consequences abounded as a result of the meltdown, endangering markets and businesses that initially appeared unconnected to the mortgage industry. The crisis demonstrated that the business world had become so complex and interconnected that risk management needed to widen its scope accordingly. It became evident that, because threats can come from unexpected sources, risk awareness needs to be spherical.

In the past, risk management could be viewed as a single sphere containing the most direct hazards facing a business, but this approach must now expand. Every factor and entity impacting a business should be examined individually, in terms of its own sphere containing its own influencers. These secondary spheres will frequently extend beyond the limits of the original sphere surrounding a business and usually will overlap yet more spheres. Those overlaps represent an organization's potential second- and third-order threats, whose connection to the company might not be readily apparent. While it may be impossible to sever the interconnections linking you to these outside influences, identifying them allows you to prepare for their possible effects.

Before going any further, consider two important lessons from the THIS financial crisis. First, the information is out there, but getting it requires effort. While there was plenty of warning that lending standards had declined prior to the meltdown, only a few entities recognized the danger this posed. Detailed information on the deteriorating quality of home loans was available, and the story might have been quite different if the entities rating and buying mortgage bonds had scrutinized their underlying assets.

Second, remember the importance of questioning what you are being told. Many people who doubted the overall health of the mortgage industry later accepted explanations they should have challenged. Assertions that the business had fundamentally changed and somehow become virtually risk-free turned out to be simply wrong.

Remember that unscrupulous or incompetent players frequently suffer little harm from their actions--in fact, some of them actually benefit from misfortune. You cannot rely on someone else to provide warning of approaching danger.

With these lessons in mind, the following three-step process will help you gauge your company's risk exposure.

Look in the Mirror

The first step is thinking of your business as a sphere that contains all the different factors and entities of direct influence. Then, analyze each of those influences in terms of risk. This should be familiar ground, as it is similar to basic risk analysis and disaster recovery planning. List the factors and entities that directly affect you, then examine each of them for potential problems. Identify areas of concern and take action to mitigate or control them.

This list will be extensive, as it includes everything you do and more. Starting with your own operations, examine the threats in such basic categories as communications, transaction processing and product delivery. That is the first sphere, and its analysis never ends. …

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