Mitigating “Margin Call” risks
The financial thriller, ‚ÄúMargin Call,‚ÄĚ which opened in movie theaters on Friday, tells the story of a firm in the mold of a Bear Stearns or Lehman Brothers at the height of the financial crisis. The firm in the film is akin to real-life firms that seemingly discover too late their reliance on a culture built on growth at any cost and tainted models at the expense of risk management.
Movies are great teachers, helping everyone better understand complex situations that can be confusing even to experts. ‚ÄúMargin Call‚ÄĚ does just this, by putting a spotlight on the crucial role that proactive and skeptical risk management (or lack thereof) plays, particularly in financial services. Although the Occupy Wall Street movement is still in its infancy, it demonstrates how ordinary people feel the impact of the financial industry‚Äôs actions ‚Äď and mistakes. Likewise, the movie demonstrates how great an impact one firm‚Äôs actions can have on the entire financial industry, underscoring the importance of risk management in such an interconnected system.
Based on our experience as actuaries, focusing on identifying and mitigating risks, we‚Äôve outlined what we believe are the most important lessons of both the film and financial crisis. Hopefully those who see this movie, and those who lived through the crisis, will heed them.
1. All models are wrong ‚Äď communicating the pros and cons of results is right
Models come in many shapes and sizes. Mental models can be simple, like rules of thumb, or they can be incredibly complex, like those used to calculate the expected payouts of structured securities. Models, however, rarely evolve to become simpler. In financial services, for example, some models will try to reflect second order interactions, like how often savers ask for their money when interest rates rise, or how many homeowners will default or prepay their mortgages given economic circumstances. As these models become more complex, they become harder for those who did not create them to monitor. The key is learning where the shortcomings are, and not being afraid to communicate the results to decision makers.
2.¬† It takes all kinds of people to make good decisions
The CEO is not always right. A common trait of many failed businesses is a culture that encourages, if not forces, employees to refrain from challenging executive leadership. Some refer to this as the ‚ÄúEmperor has no clothes‚ÄĚ syndrome. In corporate cultures with weak risk management, when the CEO has an idea, or blesses the proposal of his favorite subordinate, criticism is not welcome. Anything that slows the progress toward an established goal, even voicing concerns about a risk buildup, is frowned upon. Those with alternative views are often removed or silenced, sending a clear warning to others not to follow suit. This taints the risk culture, encouraging a freewheeling experience favoring fast growth areas. Business units try to outdo themselves to gain favor with the CEO. Exposures build up. This plays out painfully in the movie.
3.¬† Independent oversight isn‚Äôt always welcome at the dance
The absence of independent oversight of business operations can often go undetected during good economic times. When the ‚Äútide goes out,‚ÄĚ however, that lack of independence uncovers risks that were not previously transparent. Risks often grow when no one is looking and shrink only when the damage has been done. By then, as ‚ÄúMargin Call‚ÄĚ demonstrates, much of the impact is irrevocable. Former Citigroup CEO Chuck Prince illustrated this common tendency in his infamous quote about the financial crisis, ‚ÄúAs long as the music is playing, you‚Äôve got to get up and dance. We‚Äôre still dancing.‚ÄĚ No one wants to be the one to challenge the boss, but neither does anyone want to be like Demi Moore‚Äôs character, the face of blame for a firm on the brink.
4.¬† Chief Risk Officer is not the Chief Blame Officer
Chief Risk Officer has become a popular job title, especially since the financial crisis, when many companies sought to put a senior executive focused on risk management at the forefront of the fight for their firm‚Äôs survival. Some institutions are looking for a fall guy when markets deteriorate. Some firms simply want window dressing to convince regulators, rating agencies and analysts that they are minding the firm‚Äôs risks. These CROs are rarely included in strategic discussions about the firm‚Äôs future or invited to discuss potential risks inherent in the game plan.
Strong Chief Risk Officer positions are still scarce amongst today‚Äôs firms. Best practice C-suite risk officers are encouraged to play devil‚Äôs advocate and challenge executive decisions. This role becomes increasingly important as model complexity increases. It is crucial to have someone with the adequate skill set and expertise, such as the comprehensive risk training that actuaries receive, to be able to understand the key risks associated with strategic decisions and, if necessary, communicate concerns with them.
Understanding these important lessons can help companies understand how situations like the one in ‚ÄúMargin Call‚ÄĚ transpired, and can help mitigate similar future risks.
Photo: Dave Ingram