The Art of Managing Risk...

Washington Post Business Columnist Steven Pearlstein recently had two excellent articles concerning business financial risk.

The first was an interview with Dr.Vince Kaminski, who has seen firsthand how sophisticated companies systematically underestimate and ignore the financial risks they take on until it's too late.

He was at Salomon Brothers when a rogue trader used false bids at Treasury auctions to corner the market in some government bonds, a scandal from which the venerable investment bank never really recovered.

At Enron he was one of the few who tried to warn top management of the financial house of cards created by Andy Fastow's off-book partnerships and the inadequate capital the energy company had to support its extensive trading operations.

Kaminski hardly fits the mold of the corporate gadfly. He is a careful man with a Ph.D. in economics, an MBA and a nearly completed degree in mathematics. His expertise is in the relatively new field of risk management, in which sophisticated quantitative techniques are used to measure and model a business's risks and what would happen under various unpleasant scenarios. It is this "science" of risk management that supposedly gives management the ability to foresee and prevent the kind of things that brought down Enron and that now befall Citi, Merrill, HSBC and the rest. And it is this "science" that regulators rely on to protect the health of the banking system.

So why doesn't it work?

He answers that question in a second article, an online chat with Dr. Kaminski and various members of the general public who joined the online chat.

One key comment...

"First, it requires a top management that won't let itself get pushed around by Wall Street and short-term investors. and that requires compensation packages that are less tied to medium and short-term movements in the stock price.

Second, you have to change the culture and incentives within the firm (monetary and career incentives). You can celebrate the guys who bring in the big money, but you also have to celebrate the people who save you from disaster.

I think the directors are somewhat to blame as well. They are supposed to be the wise outsiders. And when they see a particular line of business is suddenly delivering outsized profit margins for what looks to be modest risk and involves no great skill or originality, a light should go off. And they should engage someone from the outside to take a look at the business and decide if there are inbedded and unacknowledged risks in the line of business that need to be addressed.

Maybe I'm naive in thinking directors can do this. But they are the best candidates I can think of who might have enough distance that, when a company is raking in the money, doesn't think that the only reason is because of the brillance of management."

Interesting reading!!