Monday, June 8, 2009

Risk Management at Harvard Business School

This morning we find ourselves back at Harvard Business School listening to some of the finest minds in the country talk about "major failures in companies’ risk management practices" that led to the current financial crisis.

David Champion, of Harvard Business Review opened the discussion by posing the question: was the current f

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inancial crisis "unknowable?"
Robert S. Kaplan, the Baker Foundation Professor at the Harvard Business School and chairman, Professional Practice, at Palladium Group, Inc. answers first. Prof. Kaplan sees it as a "classic credit crunch. " Together with David P Norton, Kaplan created the Balanced Scorecard." He sees the current crisis as essentially a "human problem." Financial engineering and executive pressure for growth and on share price, were two factors and nothing new. What is new, sees Simons, is "rationalization...that greed is good...and self-interest is a defining principal...and some people can be smarter than anyone else and can capture value better than anyone else." He felt the measurements they used gave them a "false sense of control," enjoying the numbers but failing ot appreciate the complex assumptions behind the numbers.

Robert L. Simons, the Charles M. Williams Professor of Business Administration at Harvard Business School and an expert in performance measurement and control,
talks about "responsibility and rationalization."

Mikes says, "blaming modeling is not good enough, because models don't make decisions, people do." She sees risk managers tied to the view that all risks are quantifiable. The "ultimate fragility of risk models," is one of the lessons of the current situation, because they are so heavily based on assumptions is where they fail. Different risk areas lend themselves to quantifiable models, other do not, points out Mikes.

Peter Tufano, the Coleman Professor of Financial Management at the Harvard Business School, serves as the school's Senior Associate Dean for Planning and University Affairs, and sits on the executive committee of the Global Association for Risk Professionals (GARP) (, says, he would "hate to see entrepreneurs stop being entrepreneurial."

Acording to the program, Michael W. Hofman is "Vice President and Chief Risk Officer at Koch Industries, Inc., a privately-owned Wichita, Kansas, based group involved in re

CAMBRIDGE, MA - JUNE 7: Microsoft co-founder a...Image by Getty Images via Daylife

fining and chemicals; process and pollution control equipment and technologies; minerals and fertilizers; polymers and fibers; commodity and financial trading and services; and forest and consumer products. He is a member of the executive committee of the Global Association for Risk Professionals (" He sees risk managers excessively caught up in the technique of financial modeling, and losing focus on why they are doing the modeling.

Hofman sees advantages in a privately-owned company that "you are playing with real money, the owner's real money. Not shareholders money, not stock option money, not play money, real money." Mikes ponts out some companies like Citigroup who "tried to get out of te dance earlyand got really hammered...they were unable to successfully educate shareholders aboutthe kind of risk with which they wer comfortable."

Simons points out that in the 1970s the questoins was, "how do we get corporate managers take on greater risk?...That led in the 1980s and 90s to a set of performance incentives that led managers to take on more risks." Tufano sees regulatory rethinking in the Obama administration regarding capital structures on companies' balance sheets.

Kaplan returns to the Balanced Scorecard which, he explains, contains measures of the varying types of risk. He explains a 'heat map approach" which highlights high risks and reasonable likelihood of adverse consequences. "This doesn't count black swan events, very low likelihood, catastropic consequences," though, cautions Kaplan.

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Hofman comments on all these tools that "there are times when these tools are very helpful in informing your decisionmaking. And there are other times when they just aren't. We start with the premise that the future is unknown and unknowable." The best premise for a risk manager is to assume that "whatever predictions you make for the future, you will likely be wrong." That leads risk managers to spend time considering, "what will happen if I am wrong?" in their predictions, which, Hofman feels, is productive thinking. A self-confessed reformed accountant, he feels the problem with derivatives is that the leverage is invisible.

Tufano feels greater professionalism and independence among risk managers is an answer, to which end he has devoted time and energy to GARP.

Mikes comments, "Risk manages were seen only as compliance officers or buyers of insurance. The road to professionalism and independence has been problematic for this reason."

Simons has a concern that the professionalism of different disciplines like IT and HR has led to the view among CIOs that they can then be freed up from significant personal involvement. "Risk," he says, "is not like that." Kaplan feels a problem with risk officers is their lack of line experience, sine they are staff. He feels risk officers need line experience.

Mikes points out that functions that have evolved over the last 100 years have been reframed depending on changing priorities, and she sees te rise of the "risk executive" as a possibility going forward.

Hofman responds to Kaplan's suggestion that risk managers should come from the line, however, he sees drawbacks. A line manager is too anchored by his experience of what goes on in the business, and he may need to think bigger than than. For example, what will be the effect of the global economy today? More important is a willingness to admit when the risk officer does not understand. "I don't get that, can you explain that to me?" articulates Kaplan.

Simons closes by saying we need the courage and confidence to say, "hold on, I don't understand."

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