Managing The Curse of Wealth

Just a few days ago, Citigroup revealed that it is experiencing an unusual new problem. It appears to be earning too much money … albeit only in its Phibro trading unit.

Nevertheless, Phibro’s profitability is causing such a headache that Citigroup is seriously considering selling the division. Apparently, at Citigroup, excessive earnings are as much of a risk nowadays as excessive losses.

Interestingly, enterprise risk managers have long been cognizant of the problems that may arise in response to a sudden and significant increase in wealth. Although Citigroup’s problems with its Phibro unit may pose an interesting dilemma, they certainly shouldn’t have taken the banking colossus by surprise.

Money and Politics

In a sense, the Phibro situation is a natural example of the risks that are faced whenever money and politics are mixed together. Early last year, energy companies made huge fortunes when the price of a barrel of crude oil spiked past $147; politicians were then blistered by the angry howlings of American drivers bemoaning the era of $4 per gallon gasoline.

But then, late last year, the economy itself melted down. Crude oil prices plummeted as low as $33, and gasoline prices dipped well below $2. Then Citigroup received a massive, and publicly unpopular, $45 billion government bail-out with TARP funds.

Energy companies suffered during this period as well, but they have subsequently rebounded to profitability as crude oil prices have soared above $70. Phibro, as an energy commodities trading firm, is now once again raking in huge profits; that has meant significant profits for its corporate parent Citigroup as well.

So where’s the problem? What’s the risk? Well, Phibro’s chief trader Andrew Hall is now demanding a $100 million bonus for his superior performance, but Congress is no mood to watch firms that received billions of dollars of TARP funds hand out such compensation awards. So Citigroup may decide to sell the entire division, and surrender the future profits that can be expected from it, instead of risking the wrath of the United States government.

A Familiar Problem

Is this an unusual problem? Of course not! In fact, one doesn’t even need to be the direct recipient of government bail-out funds to experience it. Any organization that transacts directly with government should be concerned by the prospect of excessive profits as well.

Lockheed, for instance, was excoriated during the Reagan Administration for charging the Navy $640 per toilet seat for furnishing the bathrooms on its P-3 Orion aircraft. And state treasurers are often criticized for overtaxing citizens when they run budget surpluses and deposit excess cash receipts in rainy day funds. Such problems are common when dealing directly with governmental officials who are responsible for approving government expenditures.

Nevertheless, many firms maintain no government business and yet are roundly criticized for earning excessive profits. Oil companies, for instance, are often threatened with windfall profit taxes when their earnings soar during times of high energy costs. Health insurers and pharmaceutical firms, likewise, are often criticized for earning profits when Americans are struggling to obtain coverage and purchase drugs. And colleges and universities are often urged to increase tuition grants and fellowships when their endowments climb into the billions of dollars.

So what can be done? How can firms anticipate and manage the risk of earning too much money? This are not complicated questions; in fact, they can be answered through the simple application of enterprise risk management.

Keeping it Simple with Risk Management

How would that be accomplished? Well, the first major task of enterprise risk management is the anticipation and description of potential crises. Adroit consumer polling, coupled by astute lobbying, can help us predict how public annoyance over profits may grow into maelstroms of rage.

The second major task of risk management is an assessment of the likelihood that each potential crisis may occur, and the extent of the harm that would be experienced if it actually happens. Lockheed, for instance, may have blundered here if they believed that their $640 toilet seat would never become a public issue, or – if it did – that they could minimize the damage to their reputation by quietly discounting the price.

Finally, the third and fourth major tasks of risk management are the respective definitions of risk response and internal control activities, with the former designed to reduce likelihoods of occurrence and the latter designed to reduce extents of harm. Citigroup, for example, may have goofed here by overestimating the government’s delight at the prospect of Phibro profits and underestimating their chagrin at Hall’s bonus demands.

So what should firms do to manage the risk of excessive wealth? First, they should anticipate situations where this may occur. Second, they should prioritize and then focus on the highest risks. And third, they should implement plans to prevent and/or manage these high priority crises.

Perhaps Citigroup’s decision to explore a sale of Phibro has actually been a step in its master risk management plan all along. If so, then it may prove to be a very costly step indeed.