Need to Shift the Defense . . . and the ERM

Sports analogies are so easy.

ERM is like the defense in football.  You would no more think of fielding a football team without a defensive squad then you would think of running a financial firm without ERM.  On the football field, if a team went out without any defensive players, they would doubtless be scored upon over and over again.

A financial firm without an ERM program would experience losses that were higher than what they wanted.

The ERM program can learn something from the football defenders.  The defenders, even when they do show up,  cannot get by doing the exact same thing over and over again.  The offensive of the other team would quickly figure out that they were entirely predictable and take them apart.  The defenders need to shift and compensate for the changes in the environment and in the play of the other team.

Banks with compliance oriented static ERM programs found this out in the financial crisis.  Their ERM program consisted of the required calculation of VaR using the required methods.  If you look at what happened in the crisis, many banks did not show any increase in VaR almost right up until the markets froze.  That is because the clever people at the origination end of the banks knew exactly how the ERM folks were going to calculate the VaR and they waltzed their fancy new CDO products right around the static defense of the ERM crew at the bank.

They knew that the ERM squad would not look into the quality of the underlying credit that went into the CDOs as long as those CDOs had the AAA stamp of approval from the rating agencies.  The ERM models worked very well off of the ratings and the banks had drastically cut back on their staff of credit analysts anyway.

They also knew that the spot on the gain and loss curve where the VaR would be calculated was fixed in advance.  As long as their new creation passed the VaR test at that one point, nobody was going to look any further.

So what would the football coach do if their defense kept doing the same thing over and over while the other team ran around them all game?  Would the coach decide to play the next season without a defense?  Or would he retrain and restaff his defense with new players who would move around and adapt and shift to different strategies as the game went along.

And that is what ERM needs to do.  ERM needs to make sure that it does not get stuck in a rut.  Because any predictable rut will not work for long.  The marketplace and perhaps some within their own companies will  find a way around them and defeat their purpose.

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Explore posts in the same categories: Action, Enterprise Risk Management, ERM, Financial Crisis, Risk, risk assessment, Risk Learning, Risk Management, Value at Risk, VaR

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