Financial Regulatory Forum

Mitigating “Margin Call” risks

By Max Rudolph
October 26, 2011

By Dave Ingram and Max Rudolph
The opinions expressed are their own.

The financial thriller, “Margin Call,” 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. “Margin Call” 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’s actions – and mistakes. Likewise, the movie demonstrates how great an impact one firm’s 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’ve 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 – 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 “Emperor has no clothes” 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’t always welcome at the dance

The absence of independent oversight of business operations can often go undetected during good economic times. When the “tide goes out,” 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 “Margin Call” demonstrates, much of the impact is irrevocable. Former Citigroup CEO Chuck Prince illustrated this common tendency in his infamous quote about the financial crisis, “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” No one wants to be the one to challenge the boss, but neither does anyone want to be like Demi Moore’s 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’s 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’s risks. These CROs are rarely included in strategic discussions about the firm’s future or invited to discuss potential risks inherent in the game plan.

Strong Chief Risk Officer positions are still scarce amongst today’s firms. Best practice C-suite risk officers are encouraged to play devil’s 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 “Margin Call” transpired, and can help mitigate similar future risks.

Photo: Dave Ingram

Comments
2 comments so far | RSS Comments RSS

Good points and well-focused. But don’t overdo the implied criticism of “growth.” One of the best indicators of impending failure or trauma at any institution is sluggish or negative growth. It is only “reckless growth” that is cause for alarm, but identifying “reckless” in the heat of the fray is the real trick, just as distinguishing legitimate whistle-blowing from ignorant disgruntlement is only easy ex post.

Posted by jimbridgeman | Report as abusive
 

“All models are wrong – some are useful” Any attempt to improve on the poetry of George Box (or W.E. Deming?) is fraught with risk and tends to discredit the risk manager.

One additional suggestion: It may be risky to lure readers with a movie-review expectation if you intend to abruptly turn preachy. This is considered bad form in some circles.

Posted by Harrisburger | Report as abusive
 

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