Enron

Enron's company logo. It prompted employees to refer to the firm as the "Crooked E."

Enron's experience with financial risk management is instructive. The firm maintained a risk management function staffed with capable employees. Lines of reporting were reasonably independent in theory, but less so in practice. The group's mark-to-market valuations were subject to adjustment by management. The group had few career risk managers. Enron maintained a fluid workforce. Employees were constantly on the lookout for their next internal transfer. Those who rotated through risk management were no different. A trader or structurer whose deal a risk manager scrutinized one day might be in a position to offer that risk manager a new position the next. Astute risk managers were careful to not burn bridges. Even worse, risk mangers were subject to Enron's "rank and yank" system of performance review. Under that system, anyone could contribute feedback on anyone, and the consequences of a bad review were draconian. Risk managers who blocked deals could expect to suffer in "rank and yank."

Of the above four criteria for independence, Enron was weak on the first but utterly failed to satisfy the second two. Despite the sophistication of individual employees, financial risk management at Enron was hollow.

Proceeding now to the fourth criteria for independence, we want to distinguish between risk taking and risk management. Within firms, there are strategic and tactical risk takers. The CEO and other senior managers are strategic risk takers. They formulate a strategy for the firm that entails taking certain risks. They communicate the strategy to tactical risk takers--including traders, structurers, and asset managers--whose job it is to implement that strategy. This is how businesses have operated for hundreds of years, so where do risk managers fit in? While not typically acknowledged, there are two competing models.

According to one model, strategic and tactical risk takers need help taking risk. Under this theory, super risk takers--risk managers--are required to intervene. They identify risks that should be avoided and, in doing so, risks that should be taken. In this manner, risk managers help the less qualified strategic and tactical risk takers do their jobs.

There is much wrong with this model. First, it is redundant. If strategic or tactical risk takers are not capable of doing their jobs, the answer is not to hire a super risk taker to do it for them. Rather, it is to replace them with strategic and tactical risk takers who are up to the task. Second, it undermines accountability. If a trade turns sour, is the trader at fault, or is the risk manager who failed to block the deal? Third, it leads to conflict. While strategic risk takers will never feel threatened that a super risk taker might usurp their prerogatives, tactical risk takers often do. At some firms, the result has been a cold war between the front and middle offices. Finally, risk managers are positioned to be used as scapegoats.