In the End-Zone
As the legislators work to put the final touches on the farthest reaching financial reform bill since the Great Depression, the fervent activities of the financial markets industry and its lobbyists evokes images of teams battling for a World Cup-like prize. Legislators and regulators drive the ball (read: football) down the field to score and the lobbyists valiantly defend the end-zone. The recent efforts by Paul Volcker, former Federal Reserve chairman, to defend the provision that he proposed limiting banks’ ability to engage in the higher risk, nontraditional private equity and hedge fund investment activities (appropriately named the Volcker Rule) illustrates this contest. There is skill and trickery involved. Depending on one’s allegiance, descriptions of the “end-zone” vary, but cries of paternalism, liberalism, moral hazard and “too big to fail” are clearly voiced by factions in the boisterous crowd. A common thread, however, runs through the arguments articulated and underlies many of the provisions in the legislation; the chief focus in each instance is the ability of systemically significant institutions to adopt and implement effective enterprise risk management policies.
An oversimplified definition might describe risk management as a quantitative calculation of potential profit weighed against possible loss (among other factors). This definition accurately describes the internal guidelines that a company may adopt to limit a business unit or an employee’s authorized investment decisions, such as the appropriate amount of risk to take in connection with an interest rate, currency, commodity, securities or similar trade or underwriting activity. Enterprise risk management, however, describes a more comprehensive view of the entire body of risks involved in an enterprise – the operational, investment and strategic risks. The difficulties with regulating enterprise risk management are many and well documented. (For a broad summary, see here.) Some rightly challenge the accuracy of quantitative risk models. Other theorists question the effectiveness of risk management to overcome cognitive biases such as market participants’ inclination to be overly optimistic despite evidence of severe losses or errors or the significant influence of their individual short-term interests. (See e.g., here, here and here.)
Eagerly awaited as a political response to the crisis, the financial reform bill will hopefully restore confidence that businesses will be better guided in their enterprise risk management decisions. Even if the strictest version of the Volcker Rule and similar provisions are adopted, enterprise risk management will likely remain a central concern for financial market participants and regulators. Rumors abound that financial institutions and certain of their investors are already investigating gaps in the proposed legislation that will allow them to continue to invest in exotic financial products.