The Cost of Risk Management

PNC Chairman and Chief Executive Officer James E. Rohr is quoted in the Balitomore Sun as saying that Dodd Frank would raise costs and that those costs would ultimately be passed along to the customers.

Now Riskviews is not trying to suggest that Dodd Frank is necessarily good risk management.

But risk management, like regulation, usually has a definite cost and indefinite benefits.

The opponents of Dodd Frank, like the opponents of risk management will always point to those sure costs and a reason not to do regulations or risk management.

But with Dodd Frank, looking backwards, it is quite easy to imagine that more regulation of banks could have a pennies to millions cost – benefit relationship.  The cost of over light regulation of the banks was in the trillions in terms of the losses in the banks plus the bailout costs to the government PLUS the costs to the economy.  Everyone who has lost a job or lost profits or lost bonuses or who will ultimately pay for the government deficit that resulted from the decreased economic activity have or will pay the cost of underregulated banks.

The same sort of argument can be made for risk management.  The cost of good risk management is usually an increase to costs or a decrease to revenues in good times.  This is offset by a reduction to losses that might have been incurred in bad times.  This is a view that is REQUIRED by our accounting systems.  A hedge position MUST be reported as something with lower revenues than an unhedged position.  Lack of Risk Management is REQUIRED to be reported as superior to good risk management except when a loss occurs.

Unless and until someone agrees to a basis for reporting risk adjusted financials, this will be the case.

Someone who builds a factory on cheap land by the river that floods occasionally but who does not insure their factory MUST report higher profits than the firm next door that buys expensive flood insurance, except in the year that the flood occurs.

A firm that operates in a highly regulated industry may look less profitable than a firm that is able to operate without regulation AND that is able to shed most of their extreme losses to the government or to third parties.

Someone always bears those risk costs.  But it is a shame when someone like Rohr tries to make that look as if the cost of regulation are the only possible costs.

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3 Comments on “The Cost of Risk Management”

  1. riskczar Says:

    The cost of the prevention is usually less than the cost of the cure. These fools will grudgingly pay for the cures (read: bailouts) because their small brains cannot see the value of paying for the preventions.


  2. Yes, Rohr makes a faux-naif argument.

    Of course, the safer party (one who hedges/insures/changes operations…) looks worse because the current accounting model does not report the actuarial benefit of those explicit costs.

    But we must not presume regulation is a net benefit. In fact, each cycle of market woes arise exactly from the unintended consequences of the prior regulatory efforts.

    The most important role for government is simply to ensure the premises of free markets: many small independent agents; free flow of information; no distortions, subsidies, tariffs; no monopolies; and as we have learned to our dismay, no “too big to fail.” Then let greed balance fear, and many small and regular corrections occur.

    Firms like Citi and Merrill are ungovernable. Highly paid, top tier managers, with access to all real-time inside information, cannot manage them Citi alone has been bailed out four times in the last 90 years. It is ludicrous to think outside bureaucrats—with partial and late information, under-talented staff, and political rather than economic motivations—can begin to regulate them.

    Yet once again Messrs. Dodd and Frank in their arrogance, presume to first identify “systematically important firms,” and then attempt to micromanage them. That will be the next crisis, without any doubt.

    We do not learn from our errors, we simply make new and more subtle mistakes.

    • riskviews Says:

      The regulatory regime that was created in the wake of the Great Depression coexisted with a very long period without a major global meltdown.

      On the other hand, the regime of light regulation that has existed over the past 20 years has coincided with some of the worst financial market experience in the past century.

      All coincidence I am sure.

      The May 14th Economist states “Perhaps the biggest casualty of the crisis has been the idea that financial markets are inherently self-correcting and best left to their own devices.”

      But in fact, we have never tried to let the financial markets self correct.

      Perhaps we would have been better off if instead of the government bailing out the existing banks, they used $800 B as start up funds for new banks. Small new banks. I wonder what we would have now as a financial system if they had done that?

      Those new banks with funds would not have lent any money to the old banks with lots and lots of sub prime mortgage exposure and shares of AIG in leiu of collateral. Maybe only JP Morgan and Goldman survive, with Goldman seriously downsized because of the failure to get paid by AIG.

      In the end, those new banks would have simply hired their pick of the people fleeing the old banks. Just like happens in the insurance industry after a major round of losses.

      I agree that the best role for government is to stop the monopoly forming behaviors.

      But in the end, we give our legislators credit for passing laws, not for sitting on their hands. So pass laws they will. In good times they will pass laws to spend the money that is in abundance. In hard times, they will look for someone to bail out and for someone to blame and punish.

      Rather than prohibit the larger and larger firms, I would simply impose a graduated income tax for corporations. With a AMT based upon reported GAAP profits. Create an economic incentive for firms to split once they grow too large. What would have happened if Microsoft had an economic incentive to split up. Thats easy, they have several separable businesses. They could have spun them off to keep profits below the point where taxes ramp up.


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