Studies of recent failures of risk management suggest three underlying
causes: dysfunctional culture, unmanaged organizational knowledge, and
ineffective controls. The first and the last of these causes have been
extensively discussed in the media. This article explores the importance of the
second - knowledge management - as a more structured approach to: transferring
knowledge to the business decision makers before it is needed, enabling the
access of information as it is needed, and generating and testing new knowledge
about the firm's changing risk management requirements.

   A Series of Risk Management Failures 

   In the aftermath of recent risk management failures - such as at Baring
Securities, Kidder Peabody, and Metallgesellschaft Refining & Marketing - many
commentators are searching for common themes. It is becoming clear that such
failures are not isolated incidents. Even a casual observer of the financial
press could name other well-known organizations that have recently suffered risk
management embarrassments: companies such as Proctor & Gamble, Gibson Greetings,
Air Products and Chemicals, financial firms such as Paine Webber and Showa Bank,
and public institutions such as Orange County and the State of Wisconsin.(1)
What's really behind this spectacular series of losses? Some critics blame the
nature of the investment instruments themselves, demanding legislation to limit
the use of derivatives. Many, resisting more government-imposed external
controls, point to a need for improved internal controls for corporate and
financial services' trading activities. Others believe the failures result from
a misalignment of incentives within firms, encouraging individuals to assume
risks with a personal upside but a corporate downside.

   While acknowledging improved controls and incentives as elements of the
solution, we believe the critics have missed the larger, strategic element that
binds them: the way in which the knowledge of the organization is managed. In
this article, we propose a framework for knowledge management that integrates
the firm's culture, the skills of its employees, and their day-by-day actions
into an effective risk management competence. Such a framework is long overdue -
for both corporate treasuries and financial service firms. The problems at
Barings, Kidder Peabody, and Metallgesellschaft illustrate only too vividly that
while these firms were playing high-stakes games with their money, they were
also mismanaging an even more valuable asset: their organizational knowledge.
Many of the themes and lessons offered by their experience are equally
applicable to other treasuries and financial service firms.

   Consider the series of events at Metallgesellschaft Refining & Marketing
(MGRM). There, traders in the corporate treasury pursued an innovative risk
management approach that led to their taking large positions in derivatives
(mostly oil futures contracts). As the exposure reached an uncomfortably high
level, the subsidiary's supervisory board stepped in to cut the losses (at the
same time removing all possibility of eventual recovery). Metallgesellschaft
(MG), the parent company, had excellent knowledge resources at work, but
apparently no effective means of transferring that knowledge across different
parts of the organization.

   Bad knowledge management was also the underlying problem at Kidder Peabody,
where Joe Jett, a government securities trader, created $ 350 million in phantom
profits from his manipulation of the firm's trading and accounting systems.
Given Jett's reputation as a "rising star," no manager wanted to trust his or
her own skepticism concerning Jett's trading. Kidder Peabody had a
knowledge-hoarding culture at the trading level, and it depleted organizational
knowledge at the management level. Compounding those problems, it had only
limited and (as it turned out) easily sidestepped controls to check the almost
inevitably dysfunctional consequences.

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   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. ...

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