Corporate & Securities Law

ON WALL ST, RISK FREQUENCY COLLIDED WITH RISK MAGNITUDE

By Brett D. Sherman

Companies must have techniques for controlling risks inherent in activities that have

(a) a high probability of success, but

(b) can have devastating consequences from just one failure.

Confused?  Fear not - We are confident the following hypothetical will clear the matter up for any reasonably bright person who completed the 4th grade.

I'd like to take credit, but most of the hypo sprung from the brain of my nine year old son.

-Hypothetical

How old are you?  How often do you drive?  How often do you crash?  Do you wear a seat belt?

For the sake of our story, let's say you are 40, drive an average of 10 miles every day, and your most recent car accident happened when you were 17.  You weren't wearing a seatbelt that day, and you were thrown from the car. You were seriously injured. Blind luck saved your life.

You drive almost every day and you haven't been in an accident in 23 years. The chance of a crash is very small. From a frequency standpoint, the probability of a crash is a low risk activity for you.

Although the likelihood of an accident is small, you know (a) accidents happen every day, and (b) it is usually impossible to predict an accident until it is too late to avoid it.

Even if you are the world's safest driver, there are countless factors beyond your control that can cause a traffic accident.  Maybe your brakes fail. Maybe you get blindsided by a drunk or reckless driver.

You cannot prevent the possibility that you will be in another car crash one day. It may happen today, next week, in 15 years, or you may never have another accident. The point is you just don't know.

Because you don't know, you can't eliminate the risk of car accidents. But -and this is the key - you can do one very important thing that may reduce the consequences of an accident.

You can wear a seatbelt.  Wearing a seatbelt is your way of managing the low frequency/high magnitude risk of a bad car crash.

                                                         *  *  *  *  *  *

The take away:  

The importance of managing low frequency / high magnitude risk is not a new concept.  In fact, the ultimate responsibility of risk management in a public company is to assure that negative consequences of any policy, decision, or strategy gone wrong will not cripple the company or jeopardize a company's long-term survival.    

Bear Stearns often boasted of its strong culture of risk management.  It seems hard to reconcile Bear's claims of savvy risk management with the collapse of the former investment bank.  

On Wall Street, Bear Stearns, Lehman Brothers, Merrill Lynch, Citi, and others had at least one risk management failure in common.  None of these companies bothered to fasten its seatbelt. 

By Brett Sherman; The Sherman Law Firm

As always, Wall Street Law Blog welcomes your comments and/or criticism.

Full post as published by Wall Street Law Blog on December 19, 2009 (boomark / email).