What Agencies Can Learn From Wall Street When it Comes to Risk Management

Winston Chang is a director at The Ambit Group.

Striking the perfect balance of risk is a difficult task for any executive. In particular, federal agencies face competing priorities with compliance, audits, process and oversight needs while managing a shrinking budget.

Today’s government leaders searching for tangible examples to follow on risk management should look to the private sector. 

Specifically, the financial industry lives and breathes risk, essentially boiling down to a duel between risk and reward. For centuries, the financial sector studied and tested concepts and methodologies to identify, manage and shift risk. Using these lessons learned from finance could help the government forge a better path to managing risk.

Risks Hidden in Assumptions

Before you can really manage risk, you first have to identify hidden risks. Finance ran into this issue with Collateralized Debt Obligations or CDOs, a type of financial product traded by banks that essentially consists of repackaged mortgages, bonds and loans. 

However, CDOs were typically analyzed at the fund-level, based on third-party ratings, causing the individual risk in the underlying assets (i.e. subprime mortgage loans that often made up part of the CDOs) to be overlooked. When risk in an underlying assets (mortgages) crept up, it didn’t raise enough alarm and the markets paid the price.

The 2008 crash was an important lesson in the dangerous nature of underlying assumptions.

These assumptions exist in budget planning, metrics for programs or any number of day-to-day operations. Unexamined habitual processes and a lack of transparency compound assumption risks that are overlooked and never assessed.

These root risks are hidden below multiple layers of cover, infecting every industry. Driving down into the base assumptions is necessary to bring light to these risk factors.

With the penalty the world paid for this mistake in finance, it would be wise to learn and not repeat the same failure.

Portfolio Management

Many of the best-known financial gurus, like Warren Buffet, made their name managing portfolios. With slightly less fanfare, government executives manage portfolios such as IT, acquisition, supply chain, fleet, project-management offices and even disposal.

What lessons about risk management translate from finance to government regarding portfolios?

The balance of the portfolio should match the vision. If the fund manager looks ahead and sees sunshine in technology and rough waters in energy, then the fund manager will adjust the portfolio’s balance to be heavy in tech stocks and light in energy.

Similarly, a government portfolio should complement the vision and mission of the office. If a project management office is managing the project and investment decisions, the balance of the portfolio should reflect the agency’s strategic priorities. An agency executive should be able to show up on the first day, look at a project portfolio dashboard and understand her predecessor’s vision based on the allocations.

A fund is managed with an indeterminate framework. In government, it can be difficult to acknowledge that any project or investment might fail. While the best project managers work to mitigate risks on a technical, cost and schedule level, thresholds to terminate a project are rarely defined.

On a portfolio level, anticipating a certain amount of failure allows for greater risk taking, which can reward the organization with better overall performance.

A determinate framework is based on mapping out the start-to-finish performance of each asset. An indeterminate framework uses statistics to predict the outcome of the group as a whole, as opposed to each individual asset. Typical inner workings of a fund have managers and analysts assessing for return against upside risk, downside risk and opportunity cost.

This asset-level analysis is similar to a project manager optimizing the plan and team for success. Government executives can frame these individual decisions within the overarching strategy of the entire portfolio, and then view the portfolio in terms of probabilities.

Venture capital funds investment with a strategy where only 20 percent of the portfolio will return a profit. VC funds expect 80 percent of the portfolio to fail outright and the remaining 20 percent to make 30 times the return for an overall six times the profit on the entire portfolio. Managers are willing to lose on a vast majority of individual picks because they view risk across the portfolio indeterminately and envision the success of the whole.

The government isn’t a venture capital firm and shouldn’t invest the same way.

However, adapting a willingness to embrace some failure will free leadership to take calculated risks for major payouts. Used wisely, a strategic indeterminate view will reduce risk across a portfolio or enterprise.

Shift Risk

One of the most-traded contracts in finance is the swap. The swap does exactly as it sounds; it swaps one type of payment for another, usually for an underline cost. The financial sector applies this same principle of shifting risk with many other techniques like hedging, options and futures. The financial industry learned to shift specific risks out to strategically manage overall risk.

The complexity behind hedges, swaps, derivatives and options may seem to not apply in the government, but the principle of shifting risk does.

Many IT shops outsource infrastructure needs to the cloud to transfer their risks in operations, scaling, security and costs to a service provider. This shift does not remove all risk factors and comes with its own unique set.

Despite the additional risk types, government can outsource a number of significant risks to experts equipped to handle them, while the government maintains responsibility for those risks it can better manage. Taking a different perspective on how a business can function will open possibilities to shift risk away in government.

The financial world has the benefit of years of practical and academic studies on risk. Best practices analyze root assumptions to gain necessary transparency and oversight for decision-making. The industry manages indeterminately across a portfolio and finds creative ways to shift risk, easing overall risk in support of strategy.

By taking advantage of their findings and experiences, government leadership can translate these principles into actionable risk management strategies and tactics. As the government looks to offer more while consuming less, it should take advantage of the many risk management lessons and techniques refined in the crucible of the financial world.