Impact of Risk Management Failures on the Financial Crisis

An extensive report released by the Financial Crisis Inquiry Commission presents findings and conclusions related to the causes of the 2008-2010 financial and economic crisis in the United States. Failures of corporate governance and risk management at many systemically important financial institutions are among key causes of the crisis, as concluded by the Commission.

In this detailed report, published by the Financial Crisis Inquiry Commission, the Commission highlighted several aspects related to governance and risk management.  The report highlights how many large financial institutions took on significant amounts of risk with limited capital and a large dependence on short-term funding. These institutions increasingly focused on risky activities that would result in large payoffs, such as acquiring and supporting subprime lenders in creating and selling trillions of dollars in mortgage-related securities. Additionally, mathematical models were over-relied upon to predict risk, and the need for qualitative judgment and review was diminished. Poorly executed acquisition and integration strategies created challenges for effective management as well. Also, compensation plans for corporate management and mortgage brokers rewarded short-term results, rather than focusing on long-term outcomes. These short-term focus compensation plans encouraged bets with large payoffs and created ignorance in respect to risk exposure.

A hunger for larger market share, profits, and bonuses lead important financial institutions to ignore risk exposure involved in high-risk activities. This ignorance, coupled with lack of judgment and irresponsibility, created a breakdown in corporate governance and risk management practices, one of the factors to blame in the 2008-2010 financial and economic crisis in the United States.

Original Article Source: “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States”, The Federal Crisis Inquiry Commission, January 2011

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