Contributor: Dr. Vince Kaminski, Rice University; In 1774 Prince Grigory Aleksandrovich Potemkin-Tavricheski received nomination as a governor of the southern provinces of Russia, annexed recently after a successful war with Turkey. Prince Potemkin distinguished himself as a commander of Russian forces in this war, fought between 1768 and 1774, and as a confidant, lover, and possibly consort of Empress Catherine the Great. His primary responsibility was development and repopulation of the new province ravaged by the war (today we call his mission public-private partnership or a stimulus package). Many historians believe that some of the funds were diverted to personal uses of the good Governor and in 1787, when the Empress visited Crimea to check on the progress, he was in serious trouble (love affair or not). In order to fool her, Prince Potemkin is reputed to have built nicely painted facades (known today as the Potemkin villages) with happy peasants in front. The Empress came back from her trip fully satisfied.
Whether the story is true or not, it is a good allegory describing subterfuges and tricks used by people in positions of public trust to cover up their failures and develop a false sense of security in those who depend on them. I cannot help thinking about the good Prince whenever I read about another risk management fiasco, and watch another risk manager squirming in public, unable to answer why he or she failed to see the most obvious threats to the firms they had a fiduciary duty to protect. One can write a book explaining why presumably smart people make catastrophically bad decisions. In a short post, we can focus on one fundamental problem haunting the art and practice of risk management: in many companies risk managers are not truly empowered, serving as decorations put in place for outside consumption. The moment they to assert themselves, they are unceremoniously escorted to the door. As William Black[1] put it:
“[S]enior officers will use their ability to hire, fire, promote, and compensate to create perverse incentives that suborn its employees and internal and external controls (the appraisers, auditors, and credit rating agencies) and turn them into fraud allies. The perverse incentives create a “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace. This produces what white-collar criminologists refer to as “echo” epidemics of fraud.”
Another favorite analogy I use to describe the predicament of risk managers is that of food tasters in old royal courts. It’s a job with a limited upside and one cannot effectively counter a slow acting poison. What’s even worse, the cooks don’t like you because you always complain that the food tastes funny. When they catch you in a narrow and dark passage, they will make their feelings obvious.
Risk managers cannot be fully effective, unless they become independent of the C-suite and report directly to the Board, and serve with long-term employment contracts. They also have to be ready to walk any time. By the way, if you are looking for the stocks being good candidates for shorting, set up a news filter to identify companies firing their risk managers.
[1]William Black is the author of the book “The Best Way to Rob a Bank is to Own One,” University of Texas Press, 2005. The book is based on the author’s experience accumulated during the Savings and Loans crisis in the US.
Note from Rusty: The list of risk management failures keeps getting longer, with some of the best known cases including Jérôme Kerviel (January 2008, Société Générale), Kweku Adoboli (September 2011, UBS), and recent MF Global case. A long history precedes these failures. In this Markets Post, Dr. Vince Kaminski looks back into this history in his reflections on the fundamental flaws of risk management as it is practiced today in “Risk Management and its Discontents: The Curious Case of Prince Potemkin”.
