ERM after the financial cri$i$: questions that often keep business executives up at night might be more easily addressed with a strong corporate commitment to enterprise risk management practices.

• Author: Barton, Thomas L.
• Position: RISK MANAGEMENT

In late 2009 and early 2010, Toyota Motor Corp. recalled more than nine million vehicles worldwide to correct separate acceleration and brake problems, both of which were potentially deadly. The company reportedly had been slow to investigate and acknowledge the problems, and seemingly needed a public scolding by the United States transportation secretary and an announced National Highway Traffic Safety Administration investigation to take decisive action.

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An opinion piece in The New York Times recently labeled the situation "the worst example of crisis management in the history of the auto industry," hammering down the company's stock price by 20 percent and causing billions of dollars in value destruction.

Enterprise risk management (ERM) researchers and consultants often ask business executives and directors, "What keeps you awake at night?" In other words, what are your biggest and most costly potential risks? It would be no surprise for an auto executive to respond, "A big and expensive product recall."

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Besides the exorbitant dollar cost, a massive product recall sends the signal that there were serious quality problems not corrected before the cars left the factory--a very public black-eye.

Under an effective ERM framework for an automaker, at the least, product recalls would be anticipated and managed so as to minimize damage to the company's reputation and ability to market its products in the future. At best, product recalls would be less necessary because quality and responsiveness to early problems would be more likely under ERM.

As examples such as this and the sober assessments of the financial crisis impact sink in, it becomes clear that ERM may be a solution to many of the problems nagging corporate America, as well as the rest of the world. ERM is not a magic elixir but robustly and wisely executed, it does offer a system to ensure that possible problems and opportunities are anticipated and managed effectively in a holistic framework.

Debilitating Financial System Failures

The financial crisis has been examined and dissected. And, though everyone has a pretty good idea of what happened, good explanations of why it happened are lacking. In truth, some of the brightest, most capable and most highly paid financial gurus in the world made some of the most egregious risk miscalculations in history. Despite some vigorous debates, this part of the puzzle remains pretty much a mystery: Why did they do it? The world is demanding that this not happen again, and so the search for safety mechanisms continues.

Much of the blame for the crisis has been attributed to derivatives; specifically, the apparent lack of understanding of how derivatives would behave under stress. The head of American International Group Inc.'s now-infamous London unit that handled credit default swaps said before the crash that he could not imagine a scenario in which his company would lose even a "dollar" on the swaps. Since the swaps were generating several hundred million dollars a year in fees with no apparent downside, he must have thought he had found the proverbial "whole new way of making money."

The risk of derivatives has been widely known and generally recognized since at least the mid 1990s. In a famous 1995 segment on television's "60 Minutes," a report on several...