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You have to practice ERM to benefit from it
8/8/2008
 
What does the subprime crisis tell us about the effectiveness of enterprise risk management? Haven't investment banks spent millions on sophisticated risk management systems and talented chief risk officers? So what went wrong, and what lessons can we learn?

These are the questions raised in a recent column in Best’s Review by Wiilliam H. Panning, executive vice president at Willis Re Inc. He says the most fundamental lesson of the subprime crisis is that investment bank managers and CEOs ignored risks because they are compensated lavishly for growth, and even in failure.

“Wall Street chief executive officers are rewarded in proportion to the profits that their firms generate, regardless of the risks taken to generate those profits. Big profits generate big bonuses, regardless of risk. So there is little incentive for CEOs to take risk into account. Instances in which CEOs have been rewarded for avoiding losses are rare. And CEOs that incur massive losses may lose their job but nonetheless walk away with massive rewards that reflect the profits generated by prior risk-taking,” he writes. Mr. Panning cites the case of a fired CEO who received payments of more than $100 million despite presiding over a $20 billion-plus loss.

“The ultimate lesson of the subprime crisis, then, is simple. Measurement is not the answer. What really counts are the incentive systems that we create and within which senior executives make their crucial decisions,” he writes.

The author faults investment bank managers for closing their eyes to the risks posed by homeowners who obtained subprime mortgages but did not have to report or verify their income or assets or, indeed, even to verify they lived in the home they had purchased.

While enterprise risk management is a sophisticated approach to addressing a broad array of risks, ERM is no substitute for sound judgment or vigilance in the face of deteriorating circumstances. The author’s point is that the subprime mess reflects the failure of myopic investment bankers, not the failure of a useful model.