Management by Paul Engle

Industrial Engineer's monthly column about engineering management (September 2010)

Unrelated events?

What do the subprime financial crisis, the Gulf oil leak and the Madoff scandal have in common? All three concern rare occurrences with catastrophic consequences.

The real estate boom and subprime mortgage crisis were based on widely held assumptions that proved incorrect, including the notion that real estate values only increase over time. Historically, the trend is up, but the rate of increase is much lower than the rates between 2000 and 2007. This led to a near collapse of the global financial system. Compounding the crisis was an assumption that the risk associated with debt that allowed unqualified borrowers to buy property could be spread among debt holders. The notion that free markets are efficient, self-correcting and always will produce the optimum solution without oversight and regulation also turned out to be misguided. When the markets did begin to correct, the entire financial system was brought to its knees.

The results of the Gulf oil leak, like the subprime crisis, likely will be felt for years. Before the explosion of the Global Explorer, the assumption was that drilling practices, technology and equipment mitigated the risk. Instead, decisions, actions and the failure of key pieces of equipment produced the largest environmental disaster in U.S. history. The probability of this combination occurring was small, but the consequences were enormous. While the oil industry has a proud safety record and has drilled thousands of undersea wells without incident, blowouts, although rare, do occur.

Bernie Madoff operated a multibillion-dollar investment fund for many years with hundreds of satisfied clients. Despite numerous audits, reports of fraud, and SEC investigations, the fund operated without the basic controls required of most businesses. Again, the market was viewed as self-policing despite the numerous cases of financial fraud that plague investors. Regulators point to their record of oversight and the small number of frauds that go undetected, cold comfort to the thousands who lost their life savings.

These seemingly unrelated events occurred because those involved did not adequately recognize the risk. Regulators appeared to remain on the sidelines and did not identify risky behavior and force an appropriate response until after the catastrophe.

These events show that managers, in their day-to-day business dealings, must perform an enterprisewide risk assessment at least annually to identify events that could affect the business negatively and take adequate steps to prevent, avoid or mitigate the consequences of negative events, however remote they may seem. Perform this risk assessment in conjunction with the strategic business planning process that most companies employ.

The insurance industry understands this process well and employs actuaries whose role is to calculate the probability of events and the cost of the event to the organization. Many organizations also employ enterprise risk management programs to identify and mitigate risk. While nothing guarantees that all risks will be identified and the consequences mitigated, it does provide a framework of recognizing risks and planning for prevention, avoidance or mitigation.

Even unlikely events can involve massive intervention after the fact that costs governments, investors and innocent victims billions. Lives were lost, property destroyed and people’s hopes dashed. Timely recognition of the risks involved and effective oversight may have prevented one or more of these tragedies.

Paul Engle is a senior manager with Grant Thornton’s Management Advisory Services. Engle, who holds an M.B.A. in finance, has more than 25 years of experience in management, operations, product development, sales and marketing, strategic planning and business process improvement consulting.