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VI Other Case Studies

Constructive Dialogue and ERM: Lessons from the Financial Crisis

THOMAS H. STANTON

Fellow, Center for Advanced Governmental Studies at Johns Hopkins University

The financial crisis caused immense harm. Millions of people lost their homes to foreclosure and many more lost employment and, as the stock market dropped, their retirement and investment savings. The financial and economic carnage caused by the crisis has led to increased emphasis on enterprise risk management (ERM), in the sense of identifying and addressing risks that can prevent accomplishment of a company's mission or objectives.

ERM played little role in risk management of financial institutions before and during the financial crisis. In a 2005 report on the state of ERM, Anette Mikes found that "enterprise risk management remains a rather elusive and under-specified concept."[1] Many large, complex financial firms, such as Citigroup and American International Group (AIG), lacked even an enterprise-wide view of risks, which is a precondition but different from ERM. Parts of those firms continued to build their exposures to subprime mortgages and other risky financial products while other parts tried to shed those risks before the crisis broke.

To understand risk management at large, complex financial firms before the crisis, one must look for critical elements of ERM, but generally not for ERM itself. This chapter focuses on one critical element, constructive dialogue, which includes (1) processes for eliciting risk-related information that flows to the top of the organization where it can be addressed in decision making, and (2) full, candid, and respectful discussions of risk/reward trade-offs. The financial crisis demonstrated how constructive dialogue was essential to promote sound decision making at a time when the expanding housing and credit bubbles had lulled many financial firms into complacency.

As a staff member of the U.S. Financial Crisis Inquiry Commission (FCIC), I had the opportunity to interview CEOs, risk officers, traders, bankers, regulators, and policy makers to try to understand the difference between financial firms that successfully navigated the crisis and those that did not. FCIC interviews took place in 2010 while people, still in shock at the destruction caused by failures of financial firms and their regulators, were generally eager to tell their sides of the story. The FCIC also had access to thousands of internal documents that helped to inform our questions and establish patterns of prudent or imprudent decision making at various firms and regulators.[2]

When the FCIC published its final report,[3]I built on its work and wrote a book, Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012). The book examines a dozen large financial firms, four that navigated the crisis successfully and eight that failed in the sense that they went out of business, were acquired on disadvantageous terms, or required government aid to stay afloat. The book asks a simple question: What were key differences in governance and management (including risk management) that distinguished the two groups of firms?

  • [1] Anette Mikes, "Enterprise Risk Management in Action," London School of Economics and Political Science, Discussion Paper No. 35, August 2005.
  • [2] The FCIC placed numerous interview records and documents on the public record. They are available at the FCIC permanent website, at http:/ /fcic.law.stanford.edu/resource.
  • [3] Available for downloading at fcic.law.stanford.edu/report.
 
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