ERM Helps Avoid Risk Miscalculations

A recent article in the New York Times discusses the inherent failings in estimating risks in our society today.  As our environment becomes more complex, people are faced with ever-increasing amounts of risk that are difficult to quantify until it is too late.  Here is an excerpt from the article that explains the challenge very well.

But there also appears to have been another factor, one more universally human, at work. The people running BP did a dreadful job of estimating the true chances of events that seemed unlikely — and may even have been unlikely — but that would bring enormous costs. Perhaps the easiest way to see this is to consider what BP executives must be thinking today. Surely, given the expense of the clean-up and the hit to BP’s reputation, the executives wish they could go back and spend the extra money to make Deepwater Horizon safer. That they did not suggests that they figured the rig would be fine as it was. For all the criticism BP executives may deserve, they are far from the only people to struggle with such low-probability, high-cost events. Nearly everyone does. “These are precisely the kinds of events that are hard for us as humans to get our hands around and react to rationally,” Robert N. Stavins, an environmental economist at Harvard, says. We make two basic — and opposite — types of mistakes. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them. Similarly, Ben Bernanke and Alan Greenspan liked to argue, not so long ago, that the national real estate market was not in a bubble because it had never been in one before. Wall Street traders took the same view and built mathematical models that did not allow for the possibility that house prices would decline. And many home buyers signed up for unaffordable mortgages, believing they could refinance or sell the house once its price rose. That’s what house prices did, it seemed. On the other hand, when an unlikely event is all too easy to imagine, we often go in the opposite direction and overestimate the odds. After the 9/11 attacks, Americans canceled plane trips and took to the road. There were no terrorist attacks in this country in 2002, yet the additional driving apparently led to an increase in traffic fatalities.

The best way to avoid miscalculating risks is to develop a disciplined enterprise risk management program with a solid framework to help quantify the level of risk.  Wheelhouse Advisors can help.  To learn more, visit www.WheelhouseAdvisors.com.

Who Can Afford Not to Have an ERM Program?

Many people in the corporate world routinely argue that Enterprise Risk Management is simply a cost that few companies can afford to implement. However, time and again, it seems as though exactly the opposite is true. Companies can’t afford not having a robust ERM program. In reading today’s Wall Street Journal, one might find the following story on the off-shore oil drilling disaster to be eerily similar to the recent financial crisis. To make the case, financial terms have been included in parentheses to illustrate the point.

Without adequately planning for trouble, the oil business (financial services industry) has focused on developing experimental equipment (complex derivatives) and techniques (synthetic asset backed securities) to drill (operate) in ever deeper waters (more opaque markets), according to a Wall Street Journal examination of previous deepwater accidents (financial meltdowns). As drillers (bankers) pushed the boundaries, regulators didn’t always mandate preparation for disaster recovery or perform independent monitoring.

The Minerals Management Service (Federal Reserve, OCC, OTS, FDIC, etc.), the government agency that oversees offshore drilling (financial services), in recent years moved away from requiring specific safety measures (capital requirements) in offshore drilling (trading activities) and instead set broad performance goals (guidance for internal risk modeling) that it was up to the industry to meet. In joint MMS-Coast Guard (Federal Reserve, OCC, OTS, FDIC, etc.) hearings into the Deepwater Horizon accident (Bear Stearns, Lehman Brothers, AIG insolvency), Michael Saucier, an MMS official, testified that the agency “highly encouraged,” but didn’t require, companies to have back-up systems (specified risk limits) to trigger blowout preventers (increases in capital) in case of an emergency.

While there are many estimates of the cost to British Petroleum to deal with the Deepwater Horizon oil spill, the minimum consensus estimate right now is around $12-13 billion. Add to that estimate the recent market capitalization loss of nearly $50 billion and the case for having a robust ERM program seems fairly straightforward.

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