Do Firms Need A Chief Skeptical Officer?

What a roller coaster ride the past year has been! While we have occasionally had respites as the financial markets gained altitude, these have only made the next day's drop even deeper and scarier. Volatility in the system has increased.

Are we at the bottom now? Who knows?

But unless we think the world economy is completely falling apart and we are switching back to a barter system, we should seek lessons that could help prevent future problems. Learning from this difficult time will also provide a competitive advantage during the inevitable rebound.

While the current financial cycle has been particularly harsh, risk managers at financial firms have not proven effective. They either have not had the authority to address their concerns, or they have gotten caught up in the excitement of the “new paradigm.”

But while common sense has sometimes seemed in short supply, this accusation is not entirely fair.

As with any crisis, hindsight will be 20/20. And because the economy has many moving parts, actions by government and management often lead to unintended consequences.

Many of the reasons for the current crisis are not new. History truly does repeat itself. “It's different this time!” and “You don't understand the new economics” are mantras that have been repeatedly proven false.

Some people truly recognize when a scheme is created to rip people off. Others, however, buy into the excitement and sustain the momentum–and no one wants to impede the bus as it rolls downhill.

Many call this the subprime crisis, but risky mortgages were simply symptomatic of the underlying excesses building throughout the financial system.

Some Wall Street firms used low interest rates driven by government policies to take on high amounts of leverage. Many firms borrowed more than $30 for each $1 of their own capital, with neither investors nor bankers aware of the total extent.

While private-equity firms, investment banks and hedge funds were ringleaders, they were joined by many other willing participants.

Sometimes investments were entered into based entirely on a rating agency opinion of an asset–with no due diligence performed, despite the obvious conflict where the issuer paid for the opinion.

Where was the due diligence? Where was the discipline? Analysts were considered lacking if an investment opportunity made no sense to them. Putting some PowerPoint slides together and giving a presentation created a supposed expert–large egos ruled.

Investors, government, lenders and borrowers were all at fault. Where did the skeptics go? Where was someone asking the pointed questions? Why didn't chief risk officers identify and mitigate this situation? Why have they been so quiet?

Some did identify the growing problem. Those who tried to slow down the “good times” were neutered or ignored. Their options included quitting, being fired or being the fall guy.

Perhaps it's time for all firms to have a CSO–or “chief skeptical officer”–on staff. Or at the very least, the risk manager needs to assume that role to avoid financial debacles.

Risk and return are key components to creating an optimal position, but there needs to be a healthy balance while managing against goals and constraints.

Building models is useful as much for what is discovered from extreme scenarios as from the average results. When a modeler communicates complex results to a lay audience, everyone can better understand the risk/return relationship.

Risk management, especially when applied holistically to the enterprise, combines the best of quantitative and qualitative methods.

o Quantitative models provide an immense amount of information, but without the proper context, they can be misleading.

o Scenario planning, where specific concerns and assumptions are investigated, can provide knowledge to the strategic planning process and a story to accompany the recommendations.

o Qualitative methods, built from common sense and an effective risk culture, lead to superior results.

But these methods can't work unless the culture encourages challenges to assumptions, models and strategic thinking.

Better decisions can be made. As the saying goes, there is no free lunch.

Max J. Rudolph is owner of Rudolph Financial Consulting LLC in Omaha, Neb. He is a Fellow of the Society of Actuaries and a Chartered Enterprise Risk Analyst. His is one of a series of essays written for the SOA about the financial crisis. Mr. Rudolph can be reached at max.rudolph@rudolphfinancialconsulting.com.