I have been involved in business consulting, investment management, business valuation and corporate governance for most of the past 25 years, and I can say without hesitation that Doug Hubbard's book on The Failure of Risk Management is an outstanding and elucidating work. I have never been a risk manager per se, but I have frequently been deeply involved in risk assessment and risk management activities, so I do have firsthand experience in this topic.
This book is an eye opener from the outset. In Part One of his book ("An Introduction to the Crisis") Hubbard begins with fundamental, obvious questions about risk management that everyone (not just risk managers!) should be asking. For example: How do you know that your risk management program is effective? Would anyone in your organization know if your risk management program didn't work? (...and how would they know - and define - that it wasn't working?). These are very simple, obvious questions, yet I have never heard them asked by management teams or even members of boards where I have served as director. Alas, there is a huge "placebo effect" in so much of what passes for risk management nowadays - perhaps that is why it is so popular.
For example, consider the following: If risk management programs really do work, then it seems logical to assume that companies in a given industry with a (self proclaimed) "highly effective" risk management program would show greater shareholder returns, less earnings volatility, and better safety and regulatory compliance records than other companies in their peer group who lack such a program. Yet there appears to be no valid evidence that current risk management practices, taken as a whole, serve to improve overall corporate performance. The evidence just isn't there.
In Part Two ("Why It's Broken"), Hubbard provides a thorough and convincing overview of the many shortcomings of modern risk management practices. As a self proclaimed "Quant," he strongly endorse quantitative analytics as the most effective approach to both measuring risk as well as the implementation of risk management programs. His approach is compelling and convincing; after all, if we can't measure accurately, how can we rely on our system of "assessing" (i.e., measuring)? It sounds pretty obvious, doesn't it? Without metrics, what tools do we have, other than generalizations, hunches, intuition, and "gut feel"? Sure, certain qualitative techniques are helpful, but qualitative risk analytics is really effective (in my view) only for the most obvious risks, and therefore no better than having no risk management program at all. Indeed, Hubbard makes a compelling argument that ineffective risk management can be worse - possibly much worse - than having no risk management program at all.
Part Two also includes concepts that Hubbard brilliantly applies to risk management practices. This includes certain characteristics of human nature, such as a proven tendency to be overconfident in our estimates (of risk, but also of other estimates), that must be acknowledged and addressed in order for risk management programs to work effectively. He also provides a practical method of adjusting or "calibrating" for such overconfidence. Similarly, there is a fascinating discussion on risk correlations and how risk events seldom materialize in isolation from one another. Consider (my own example) certain risk correlations in mortgage banking. Banks that invested in mortgage backed securities no doubt undertook some sort of risk analysis of these investments. They also had risk management systems in place for their mortgage lending business. But how many lenders tied these two risk programs together, and properly concluded that a collapse of one market would also result in the collapse of the other? Thus, it's not just a case of accurately assessing and management individual risks, but also in considering the extent to which there might be a "domino" or "cascading" effect among different risk factors.
In reading Part Two (especially Chapters 6 and 9), it occurred to me that this book should be read by anyone and everyone involved in investing or lending money.
As one might expect, Part Three of Hubbard's book ("How to Fix It") embraces a scientific and quantitative approach to improving risk management. Once you get to this point in the book, you will find it very difficult to disagree. Another important concept introduced by Hubbard is that of language and communication with respect to risk. As a potentially murky and subjective topic (if not downright Byzantine at times) risk management systems require clear and concise language and terminology to be effective. Thus, if two different managers in the same factory concur that the likelihood of a risk event materializing is "very likely," we should not assume that they both agree on the use of the term "very likely." One may feel that this means the odds are one in three, while the other feels the odds are one in ten.
Hubbard is clearly on target when he proposes that risk managers apply scientific methods to risk management. His suggestions on how to do this are fairly simple and practical. Without such methodologies, risk managers are sailing through dense fog with an unreliable compass. You might even feel that you are making great headway, but if you can't measure where you are going, you will never know if you are really making any progress.
Finally, one of the greatest benefits to me in reading this book has less to do with the specifics of risk management and a lot more to do with the way people think. Consider, for example, why your sales team frequently falls short of their sales projections, or why so many portfolio managers buy stocks near their highs and sell near their lows. Or why risk management programs are so popular, and yet seldom work. Hubbard provides a brilliant and penetrating look into the human mind in the context of business decision making as a whole - not just with respect to risk. For me, this was an excellent "upside surprise" to this book. I finished reading this book several months ago, and I still think about it all the time. It has made a lasting and beneficial impression that I will never forget.