The Two Most Important Words in Financial Risk Management?

WHAT -and- IF

By Brett Sherman, The Sherman Law Firm                  

Worst Case Scenario Analysis - Management of low frequency / high magnitude risks. 

Companies must have methods for controlling risks inherent in activities with -

(a) a high probability of success, but
(b) can produce catastrophic losses with just one failure.

***

The ultimate risk management responsibility for publicly owned corporations is to assure that a company cannot be crippled if a business strategy / model goes horribly wrong.  

It is impossible to manage against the risk of high loss magnitude events unless corporate risk managers and senior management agree to start all risk analysis with two words - 

"WHAT" and "IF"

 

FOR EXAMPLE-

What if our hedging strategy fails?

-or- 

What if home prices fall?  (the common sense question that could have prevented the failure of Lehman Brothers, and Bear Stearns - and maybe even the financial crisis)

* * *

So, why weren't these basic questions asked by nearly enough companies during the housing bubble?  

That's right - Because an overloaded money train was pulling into Wall Street and Orange County, California (the epicenter of nonprime lending) on a regular basis, and asking "what if" questions would have yielded (pun intended) answers that lenders and bankers did not want to hear.  This is risk management by denial(also called willful blindness or, more colorfully, burying one's common sense in the sand).

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