Book Review: The Risk in Risk Management

Case 1: ‘Institutional’ Risk Management

The first case focuses upon ‘innocent fraud’ within the Canadian banking industry. Only six banks control 90% of Canada’s banking assets, which are characterized by intense isomorphic pressures. Vit teases out the isomorphic pressures that led to institutional conformity, including industry lobbying against legislation to promote competition, recruitment of staff from a small number of elite MBA schools, and a drive for innovation in the industry that led to herding behaviour around certain technological products. According to this account, the event of mismanagement in Canadian banks emerged from a background of macro changes within the social structure which Vit characterizes in terms of ‘institutional risk management’.

Case 2: ‘Contrarian’ Risk Management

The next case study Vit confronts is the Parmalat scandal which hit Italy in the early 2000s when the food retailing giant took the rather unusual step of moving into derivatives trading, a move previously attempted by the energy giant ENRON. Parmalat was able to borrow vast sums of money from Citigroup, which it categorized on its books as an investment. Vit asks how it was that investment banks that purport to be experts in the area of finance could themselves routinely ignore the ‘underlying economic rationality of a situation over time’ (p. 35). He provides numerous possible explanations for this institutional blindness including the opacity of the financial models and products employed, the meaninglessness of the jargon bandied about in the trades – one corker being the notion of ‘risk arbitrage’, i.e. risk-less risk – and also the manic cultures within which these deals were made. In short, the people involved may have been remarkably clever as individuals, but as a group they exhibited a mix of ignorance, wilful stupidity and apparent madness. This leads Vit to propose what he terms ‘contrarian risk management’ in order to resist conformist pressures that permeate corporate cultures and to support contrary opinions.

Cases 3 and 4: ‘Evolutionary’ Risk Management

The third case of fraud that Vit examines occurred in the National Australian Bank. The main conceptual tool employed to understand this particular case is ‘decoupling’, where the technical rationality of financial risk management was undermined by other social forces. Vit discusses how rogue traders within the bank were able to persuade their managers to ignore information provided by their quantitative risk models to enable them to engage in riskier and potentially more profitable trades. At the same time, the board of directors ignored internal advice from its own risk committee on the known dangers of such trades (a fact which appears all too common in this industry, as witnessed by other instances where the advice of corporate risk officers was ignored and overridden by senior management, such as at HBOS and at ENRON). The risk management processes took on a purely ceremonial role, assuring clients that it was business as usual instead of engaging in an adequate level of operational oversight. Vit picks out two glaring instances that demonstrate the ‘decoupling’ of risk management from its ostensible function, the first involving the over-simplification of the mechanism used in the bank for escalating concerns about its operations, and the second involving the ignoring of the external auditors where KPMG had discovered ‘800 limit breaches and lack of reporting related to the currency options desk’ (p. 54). Vit argues that the ‘ideo-logics’ of NAB overrode the fundamental economic risks involved in the bank’s deals and led its senior management to ignore signals of malpractice in their narrow focus on the pursuit of profit.

Vit provides another case of evolutionary risk management with the example of the failure of a Canadian public-private partnership, Gaspesia. This failed for a number of reasons, including a lack of private sector commitment, the introduction of unfamiliar technology, and a substantial change to the project design half way into the project. This case differs significantly from the others presented in its focus on public sector rather than private sector mismanagement. Again, Vit finds a ‘decoupling’ of risk management from operations and an abdication of responsibility and oversight by senior management.

Case 5: ‘Contrarian’ Risk Management

The last cases that Vit undertakes to examine are the Union Bank of Switzerland and Societe Generale meltdowns, which he uses as proxy cases for the financial crisis as a whole. UBS alone lost $53 billion during the 2008 crisis, largely as a result of its involvement in trading CDO derivatives and losses accrued by its internal hedge fund, DRCM. Vit finds a number of now familiar factors contributed to the evolution of the crisis, including the complexity and opacity of the financial models and products, the ceremonial role of audit and risk management, a lack of oversight by senior management, the lack of independence of external auditors, perverse incentives for traders to take excessive risks, and the manic culture of trader in-groups.

In the conclusions Vit attempts to outline a ‘holistic’ approach to risk management based upon a neo-institutional analysis of this phenomenon. The term ‘holistic’ derives from his categorization of four approaches to risk management that emerge from a framing of both economic and non-economic institutional logics of risk management. He summarizes this approach according to four generic categories: i) an institutional approach which assumes that ‘institutions work’, although this may entail the illusion of control rather than genuine oversight, ii) a contrarian approach to risk management which assumes that we can ‘game the other boxes’ – so let’s make hay whilst the sun shines and to hell with everyone else, iii) an evolutionary approach which highlights the way that contingency (chance events) and incumbency (habitus, routines) can override technical and quantitative approaches to risk (this takes a kind of Catholic approach to risk assuming that ‘accidents happen’), and iv) a quantitative-rational approach to risk management, which is the mainstream approach and assumes that ‘markets work’ – so no problem. ¹ My own impression as I read the closing pages of the book was that in practice risk management appears to be a deeply cynical exercise that has become quite detached from the textbook free market principles upon which it is purportedly based. One of the great strengths of Vit’s analysis is that it acknowledges the ‘gaming’ aspects of risk management, urging risk managers and auditors to be wary of the potentially disastrous systemic risks that such gaming entails.

The book succeeds in full in demonstrating how large-scale fraud can become normalized within a given organizational culture. It does this partly through the analytic skill with which it dissects its various case studies, but also through a stylistic manoeuver by refusing to adopt the easy position of the outraged onlooker, and without in anyway excusing the conduct that it is endeavouring to understanding. Vit’s analysis has much in common with other institutionalist approaches to risk management, particularly Mike Power’s (2009) analysis of the ceremonial and reputational aspects of neoliberal forms of risk governance, and Perrow’s (2011) analysis of regulatory capture and executive malfeasance in the unfolding of the crisis. Power’s work highlights crucial flaws in the structures of contemporary risk governance, including its largely ceremonial function and the seemingly deliberate confusion over diverse meanings of risk in the corporate governance literature which ambiguously frames risk both as a scientific precautionary term and as an entrepreneurial opportunity.

Vit’s critique of how ‘economic rationality’ is overridden by ‘social forces’ may be seen as somewhat limited if such a rationality is itself a contingent social and political force, grounded in the political misadventure of neoliberalism. Vit himself comes close to conceding this when he observes that the difference between an investment banker and a gambler is more a matter of terminology rather than practice (p. 36). The analysis of the book may be in danger of too great a reliance on neo-institutional theory and the idea of ‘decoupling’, where a social rationality supposedly becomes separated from a sound technical economic rationality. The presumption of this framing is that if bankers followed an underlying economic rationality then all would be well. There are a number of good reasons to doubt such a view as being adequate. Michel Foucault’s (2008) prescient commentary on the development of neoliberal economic theory highlighted its constructivist political dimensions, where markets were no longer understood as quasi-natural phenomena but must be actively fashioned by political intervention.

Recent research has highlighted the constructivist aspects of risk management, particularly the existence of ‘counter performative’ aspects of risk management where options pricing models have been used to construct new markets for risk which have actually amplified risk rather than mitigating it, as its theory proposes (MacKenzie, 2006). The economic historian Philip Mirowski (2013) has also disputed the idea of an ‘economic rationality’ that governs social relations, observing that the behaviour of economists over recent years has been more akin to the denial of empirical reality rather than being in any way scientific. Mirowski’s relentless shellacking of his own profession unearths a great deal of evidence to show that contemporary neoliberal economists are engaged in ‘agnotology’ and science denial in the pay of the finance industry (and the pursuit of publications in highly ranked orthodox journals). The complicity of the academic profession in the fraud has also been raised in Charles Ferguson’s film Inside Job, where major economic theorists are on camera denying that the firms from which they receive millions in consulting fees have any influence on their work. These socio-political accounts show that we have far too much faith in the notion of ‘economic rationality’ where such a creature is hard to find outside the fantasies of orthodox economists and credulous business school professors. Aside from these minor quibbles, this book provides a very insightful account of the normalization of ‘innocent fraud’ in our public and private institutions. This book deserves to be widely read and I have no doubt that its scrupulous lessons will better equip us and our students to avoid such financial misadventures in the future. ²