BP and the Economic Crisis: Déjà vu?

Michelle Harner

The similarities between the BP oil spill in the Gulf of Mexico and the recent economic crisis are striking.  The unthinkable happened to trigger both disasters—a blowout preventer on a deepwater oil rig fails in the former and the housing market bubble bursts in the latter.  Formidable corporations are at the center of controversy regarding disclosure, compliance and resulting liability.  Bankruptcy is being discussed.  And the short sellers are circling (see here and here for BP).

I am not the first to suggest similarities between these two events (see here).  (I of course also recognize that there are differences, including the tragic loss of life associated with the oil spill.)  I want to take a moment, however, to reflect on the extensive risk management failures evident in both.

My colleague Robert Rhee posted an excellent discussion regarding how to teach the BP case, and he suggests, among other things, using BP as a case study to teach the importance of “legal risk in the context of a broader risk analysis, which increases the lawyer’s effectiveness and situational awareness.”  I completely agree with Robert.  I also think commentators and policymakers can use BP and the economic crisis to evaluate best practices in corporate governance and applicable law (in the U.S. and abroad) with respect to overall risk management practices.

The economic crisis highlighted significant weaknesses in existing risk management practices.  Firms typically invoke a silo approach to manage risk, with each department monitoring its own type of risk, but not coordinating or considering that risk in relation to the firm’s other risks or overall risk appetite.  This type of segregated approach to risk management frequently underestimates the firm’s risk exposure and fails to consider the Black Swan—i.e., an event that is considered rare and hard to predict, but has severe negative consequences.  Many financial firms never contemplated a hard downturn in the subprime mortgage market or the related impact of derivative trades.  BP never considered an explosion of one of its deepwater oil rigs (see here).  As a BP representative stated: “You have here an unprecedented event—never before have you seen a blowout at such depth and never before has a blowout preventer failed in this way. . . . The unthinkable has become thinkable, and the whole industry will be asking searching questions of itself.”

Were these triggers really Black Swans, or just examples of lax or suboptimal approaches to risk management?  Did the overconfidence or other cognitive biases of management contribute to the problem?  Can we encourage more thoughtful and integrated risk management practices—commonly referred to as enterprise risk management—through regulation, or is that better left to the markets?  I have addressed several of these issues in the context of the economic crisis (see here and here), and I think the BP oil spill emphasizes the urgency of the situation.  Notably, the BP oil spill has again increased the attention on risk management in the U.K.  I hope it has the same effect in the U.S.