Wednesday, June 9, 2010
Barriers to Effective Risk Management, by Michelle M. Harner, University of Maryland School of Law, was recently posted on SSRN. Here is the abstract:
“As long as the music is playing, you’ve got to get up and dance. We’re still dancing.**
This now infamous quote by Charles Prince, Citigroup’s former Chief Executive Officer, captures the high-risk, high-reward mentality and overconfidence that permeates much of corporate America. These attributes in turn helped to facilitate a global recession and some of the largest economic losses ever experienced in the financial sector. They also represent certain cognitive biases and cultural norms in corporate boardrooms and management suites that make implementing a meaningful risk culture and thereby mitigating the impact of future economic downturns a challenging proposition.
The global recession highlighted significant failures in firms’ risk management practices. These failures implicated weaknesses not only in firms’ financial risk modeling but also the human/governance side of risk management. Unfortunately, fixing the former might be significantly easier than attending to the latter. Studies suggest that cognitive biases, including confirmation bias, overconfidence/optimism bias and framing, can impair a board’s and management’s ability to assess risk accurately. These problems are compounded by the typical incentive structure and the “winner-take-all” mentality adopted by many corporations in the United States.
This essay analyzes the potential benefits of improved risk management practices, commonly called enterprise risk management (ERM), and the potential barriers to implementing meaningful ERM at U.S. firms. ERM is an integrated risk management framework that seeks to improve knowledge of and communication about potential risks throughout the firm, starting with the board and senior management team. Indeed, the board and senior management team are vital to creating a risk culture. The essay considers the impact of boardroom dynamics and U.S. corporate culture on risk management practices. The essay further considers whether regulation or a different approach is needed to encourage U.S. corporations to invest the necessary human capital in meaningful ERM.