The Real Culprit in the Financial Crisis

Ken Makovsky

Remember the financial crisis of 2007-08?

While I am not being facetious, it really wasn’t that long ago. Major institutions went under or were saddled with big TARP debt — government support, without which these institutions would not have survived.

The cause was mostly related to over-investment in subprime mortgages, a high-risk enterprise, which investors were aware of. But if the risk in these instruments was so significant and the investment community consciously knew that, what happened to risk management?

In a nutshell, there was a lot of risk at the time but very little management of it and probably still less communication among those involved. How can we imagine such a gap in some of the most famous houses on Wall Street? And when you get into the trenches, was the cause really downright sloppiness?

I’d say yes, based on a recently released article about the crisis, “Wall Street’s Management of Risk: Why It Failed,” by John Biggs, former chairman of TIAA-CREF and past member of multiple blue chip and non-profit boards.

The paper is a chapter in Global Asset Management, edited by Michael Pinedo and Ingo Walter and published in 2013 by Palgrave Macmillan. The book was commissioned by SimCorp StrategyLab.

Biggs contends that lots of money had been allocated for risk management systems…but even more was spent on verbiage to shareholders boosting risk management capabilities. Neither did the trick. Biggs points out, in a CEO letter to shareholders, “excessive boasts about discipline, comprehensiveness and senior management’s hands-on devotion to risk control.” Based on this, the question he raises is, “What should be the real focus of management, regulators, creditors, auditors, consultants and shareholders, in the future, to avoid similar enormous errors?”

His article analyzes two contrasting styles of risk management, both of which failed, as illustrated by the bankruptcy of MF Global and the huge losses at JPMorgan Chase.

Nevertheless, he implies that one is more viable than the other.

The two approaches are the “Wall Street Style” and the “Accountability Model.” The former is a centralized approach used by most of the organizations that suffered severe losses; it is focused on the CEO or centralized with a Chief of Risk Management. The latter is the “Accountability Model,” which relies much more heavily on risk responsibility distributed into the basic businesses of the companies.

“Wall Street Style” is criticized as representing “excessive centralization…of the function at too high a level to be effective.” It was found mostly in the institutions deemed “Too Big to Fail.” With such centralization, there was no serious communications system that permeated downward, thus diminishing awareness and reinforcement. At MF Global, Biggs emphasizes, the “Wall Street Model” degenerated into control by one individual whose avowed purpose was to increase revenue quickly by increasing risk.

Biggs cites a PricewaterhouseCoopers study which argues that embedding risk managers within individual business lines leads to greater understanding and awareness of risk and its link to performance. Although this study of 400 financial services executives found 61% supporting the “Accountability Model,” only 1 in 8 thought their own organization’s business units and risk management were well-integrated.”

Even if the “Accountability Model” is employed, it needs to be accompanied by a well-organized communications system that demands ongoing interaction between line operation heads of risk and the CFO and CRO. In effect, they need to serve as checks on each other from both a process and content standpoint. Periodic group meetings need to be held, with agendas that cover possible business risks and solutions. Talking to each other is a potential cure.

Further, the standards for managing risk in asset management operations must be set by people who technically understand the business, not audit committees or CEOs, as an article Biggs cites contends. The CFO in an “Accountability Style” company may insist on common financial planning and reporting,

“Surely, since the events of ’08-’09, it’s time for thoughtful regulators and audit committees, as well as management, to examine the governance and culture of risk management in their companies,” Biggs concludes.