Like MG, Baring Securities suffered from a clash of cultures that led to an
insufficient knowledge base in a critical area of its operations - a problem
compounded by Barings' failure to recognize and close that gap. Like Kidder
Peabody, Barings' management was only too willing to assume infallibility on the
part of a star performer, Nick Leeson. Ostensibly, Lesson was engaged in
riskless arbitrage on the Japanese Nikkei equity index between different
exchanges.(2) However, unknown to senior management, he parlayed this into
highly risky volatility-based trades, the success of which was conditional on
the stability of the Nikkei. Unfortunately, for Barings and for Leeson, in
January 1994, the Nikkei fell suddenly, resulting in a $ 1.4 billion loss for
Barings and the bankruptcy of one of the UK's oldest banks. No one questioned
Leeson's trades until it was too late. Management hubris about the quality of
its knowledge can only be limited by frequent testing and evaluation of the
organization's supposed competence, in this case how the firm makes its money.
Ineptitude at Barings, MG, and Kidder Peabody in managing knowledge is an
outrageous failing. What, after all, is their competitive advantage if not
superior insight? We often see manufacturing firms discounting the role of
knowledge in their strategies and operations, and we attribute their myopia to
their technological cultures, which encourage a focus on physical assets such as
raw materials, capital equipment, and inventory. But it is dismaying to see this
in financial services, given that, in a real sense, risk management is knowledge
management.
What is Knowledge Management?
Before exploring how better knowledge management can drive better risk
management, it is important to define some key terms. In particular, care must
be taken to differentiate knowledge from its close cousin, information, and its
more distant relative, data. Borrowing from the Western Rationalist and
Empiricist traditions, knowledge is argued to be a set of justified beliefs.
Information is the meaning that human beings assign to incoming data; Gregory
Bateson described it as "those differences that make a difference."(3)
Information affects knowledge by adding something to it or restructuring it.(4)
Unlike data, both knowledge and information require an understanding of the
socially defined context, where the knowledge and information came from, its
embedded assumptions, and thus its importance and its limitations.(5)
It follows that the management of knowledge goes far beyond the storage and
manipulation of data, or even of information. It is the attempt to recognize
what is essentially a human asset buried in the minds of individuals, and
leverage it into an organizational asset that can be accessed and used by a
broader set of individuals on whose decisions the firm depends. According to
Sachiko Nonaka, a leading theorist in this area, knowledge management requires a
commitment to "create new (task-related) knowledge, disseminate it throughout
the organization and embody it in products, services and systems."(6)
There are at least seven things that can be done with knowledge at the
organizational level: knowledge can be generated from internal operations or R&D
groups; it can be accessed as it is needed from sources inside or outside the
firm; knowledge can be transferred formally before it is utilized, through
training, or informally, through on-the-job socialization; knowledge can be
represented in the form of reports, graphs, and presentations, enabling easier
access; after its validity is tested, knowledge can be embedded in processes,
systems, and controls; and finally, these different knowledge processes can be
facilitated, by the steady development of a culture, based on incentives and
management leadership, that values, shares, and uses knowledge.
The Case for Knowledge Management
In industries as diverse as automotive manufacturing, chemical processing,
electric utilities, and architectural engineering, firms are pursuing
initiatives with the stated goal of generating, facilitating the transfer of,
and improving the access to organizational knowledge:
* Hughes Space & Communications, the world's largest manufacturer of
communications satellites, is busily constructing an internal "knowledge
highway" to help its people avoid "reinventing the wheel" on highly complex,
multi-year projects.
* BP, the huge energy concern, is reorganizing its global business around
the knowledge, technologies, and processes associated with 88 major corporate
assets. The new organization brings the right source of expertise rapidly to
bear on problems and decisions around the world.
* Bechtel, the architectural engineering firm, has defined and implemented
structured knowledge processes to ensure that its project teams bring to their
design decision making all the benefit of discoveries made by other project
teams past and present.
* Northeast Utilities, faced with post-deregulation upheaval in its
industry, is re-engineering its fundamental work processes with a view to how
they must be infused with new learning and be supported by cross-functional
knowledge sharing.
Why the sudden emphasis on knowledge management? After all, haven't firms'
greatest competitive assets always been the judgment and experience of their
people? There are two basic answers: first, because organizational knowledge
management is more necessary now than ever before; and second, because it is
also more feasible.
Increasingly, senior executives are recognizing that knowledge and learning
represent the preeminent source of sustainable advantage in a fast-moving,
highly competitive world. They know it is no longer enough to leave critical
knowledge sitting passively in the minds of individual employees. Workforce
mobility, falling educational standards, and the rapid rate of business change
mean that individuals can no longer be relied upon to provide consistent,
comprehensive insight. Instead, the knowledge trapped within the employee base
must be leveraged to the organizational level, where it can be accessed,
synthesized, augmented, and deployed for the benefit of all. Organizations and
individuals must learn rapidly and uniformly across different functions and
levels of the organization. Yesterday's informal or tacit knowledge management
techniques - the desktop, the hallway conversation, the memo, the trade show -
are no longer sufficient in a period of radical change.
The Rise of Financial Risk Management
If knowledge management is of growing importance to every kind of business,
its impact is perhaps most obvious in the financial services industry. This is
because effective management of knowledge is key to managing risk. And the
driving issue in both financial services and corporate treasuries today is risk
management. Dennis Weatherstone, the former Chairman of J.P. Morgan, put it even
more starkly when he said: "These days, the business of banking is risk
management." Risk Management is ranked by CFOs as one of their most important
concerns.(7) Why this emphasis? Accelerating technological change, more volatile
markets, globalization, and deregulation have all led to increased uncertainty
regarding underlying risk exposures facing all firms, both financial and
non-financial.(8) In addition, leading practitioners' utilization of advances in
financial theory, and a wider choice of hedging vehicles such as derivatives,
have upped the competitive ante for all other players. Both trends translate to
greater complexity, which if not managed appropriately, invariably leads to
greater risk. Fundamentally, risk management is about managing the complexity
inherent in the tradeoff between return and risk, through organizational
knowledge, for the benefit of the firm's stakeholders.
Information Technology, Knowledge, and Risk Management
The dramatic spiral of financial innovation has been enabled by the
extraordinary growth of high-speed, low-cost information technologies. Today,
highly complex front and back office systems are the linchpin of any successful
financial services organization and many large corporate treasuries. This
complexity of operations (and hence of risk management) has been amplified by
the competitive need for rapid response to changes in the market. According to
Michael O'Gorman, European Operations and Systems Area Executive at Chase
Manhattan in London:
If you want to be a market leader, particularly in a business like
derivatives, you need to put enabling technology on people's desks. These new
products are so complex - and the time you have before everyone else works out
what you're doing and duplicates it is so short - that these machines are
absolutely necessary.(9)
While technology has amplified the potential of individual traders, it has
also intensified the pressures on them to act rapidly. This poses a critical
dilemma: if they take the time to study the investment opportunity thoroughly,
the window of opportunity may slam shut; if they act with haste, the full
implications, when they become clear, may be more than anticipated. Thus,
information is both part of the risk management problem and part of the
solution. According to Alan Sutherland, Senior Operating Officer at Salomon
Brothers in London:
Banks have become major information repositories. Their success depends on
that information, how fast they can access it . . . and on innovation - relating
previously independent items.(10)
But banks and treasuries are more than just databases. Risk management
information is highly contextual; a report claiming that a firm's credit rating
is "AA" must be interpreted in terms of the rating agency that produced it.
"IBM," "International Business Machines," and "Big Blue" all denote the same
entity, but woe betide any data entry clerk who enters the wrong one. According
to one recent report, risk management executives estimated they spent 20-30% of
their time "understanding context or explaining it to others."(11)
Information without knowledge of the context of the information is very
dangerous. An increased emphasis on information demands a commensurate emphasis
on knowledge. As the three cases outlined below make clear, risk management is
frequently not a problem of a lack of information, but rather a lack of
knowledge with which to interpret its meaning.
Could Better Knowledge Management Have Helped?
Metallgesellschaft Refining & Marketing (MGRM)
MGRM's experience is perhaps the clearest example of a knowledge management
failure. In 1992, MGRM, an American subsidiary of the German metals and services
group Metallgesellschaft (MG), began selling long-term fixed-price contracts to
supply fuel oil to its customers. To hedge itself against the risk of a price
rise in fuel oil, MGRM purchased short-term oil futures on the New York
Mercantile Exchange (NYMEX). But in late 1993, oil prices began to fall
dramatically, hurting the value of the futures positions (but, simultaneously
increasing the value of the underlying fixed price contracts). Margin calls from
NYMEX to cover the shortfall in the value of the futures forced MGRM to pay as
much as $ 50 million per month to the exchange. By the end of 1993, MGRM's
supervisory board (made up of executives from its parent company and Deutsche
Bank) had intervened and, against the wishes of the subsidiary's management,
liquidated the futures positions, incurring more than $ 1 billion in losses.
There remains disagreement about the validity of using short-term instruments
to hedge long-term risk. Some observers, including Nobel Prize-winning economist
Merton Miller, argue that the Board's decision to liquidate the derivatives
position contributed to the loss, making paper losses real.(12) Others, such as
MG's senior management, argue that Miller's analysis ignores the significant
costs of additional margin and the fact that the firm was rapidly becoming a
target for speculators taking advantage of the firm's large futures position.
While the familiar "smoking gun" shows up in the form of derivatives trading,
it is far from clear that the fuel-traders involved were ignorant of their risk,
or were acting in anything but what they perceived to be the strategic interests
of the firm. MGRM was innovative and sophisticated in its use of derivatives;
one of their traders had even written a textbook on the subject. The very fact
that argument continues in the academic community about the wisdom of MG's
risk management approach makes it difficult to accuse either party of a lack of
knowledge.
Whether the MG Supervisory Board did not understand the strategy, or simply
disagreed with it, the failure seems to have been a lack of knowledge transfer -
what the two management groups involved "knew" to be the best thing for the firm
did not proceed from a common base of knowledge defined before these trades took
place. That knowledge involved shared beliefs about the banks' ability to supply
liquidity, its expectations of the future, the parent company's willingness to
take on risk, the riskiness of the hedging strategy being employed, and the
acceptable/probable payback horizon. Without that exchange of risk management
knowledge describing the context of the trades, both parties were left to
discover their basic knowledge differences far too late. In addition, different
accounting standards in Germany and the U.S. seem to have exacerbated the
problem, as German standards did not offset the fall in value of the hedge by
the increase in value of the underlying contracts. A common understanding of
accounting standards are but one example of the consistent procedures for
knowledge-sharing between MGRM and its supervisory board that would have either
illuminated the strategy for the Supervisory Board and won its support, or
revealed to MGRM that it would ultimately not be supported if "the going got
rough."
Better controls, on the other hand, would have had only a limited impact at
MGRM. Controls affect actions - but not the underlying cultural assumptions and
task knowledge guiding those actions. The knowledge management solution, stated
most simply, is what one business commentator has called "management as
conversation."(13) It is the idea that the "truth" (consisting of beliefs with
greater validity) is more likely to emerge from a dialogue between contrary
beliefs than in isolation.