Looking for Risk in All the Wrong Places! Part 1 of 2

I was trying to avoid writing about the financial crisis since it is hard to say anything substantive briefly and in order to stay away from politics. However, since my book’s subtitle refers to averting crises, I cannot. So, here is the first of two posts. This one expresses three ideas: (1) We need a mindset change from a bilateral to a multilateral (or networked) perspective in business. (2) Unless work practices change, such crises will recur. (3) The (regulatory) culture must change, for it affects perceptions of risk.

20+ years ago, I was a junior banker at an American owned international bank. Today, I understand finance from a strategist’s perceptive, but am not an expert. So, my wife and business partner, Sanghamitra Dutt, has co-authored these posts. Before we co-founded Ishan Advisors, she was a Managing Director at a “money center commercial bank.” In the 1990s, the US Office of the Controller of the Currency recommended that other major banks adopt the information and analysis packages she had designed for use by her bank’s top managers and Board.

Let’s understand that financial innovation did not cause this crisis. Financial innovation has been with us ever since Europeans reshaped the world centuries ago by creating the first stock market. Nor is the complexity of innovations the problem. As an MBA, I had considered doing a Ph.D. in Finance and had learned risk analysis at levels beyond those taught to my peers. So, when my bank entered the new commodities lending business, I got tasked to understand the credit issues – and these to teach others, including my bosses. That fact did not depress our stock price or sink the markets! Blaming innovation for the crisis is akin to blaming Edison for destroying the livelihoods of candlestick manufacturers.

Now consider a simplified description of how financial institutions assess risk. Let’s say Bank A asks an analyst to evaluate whether AIG is a good credit risk. She would study its financials (including confidential information) and pass a judgment. However, unless Lehman Brothers was also A’s client, no one would analyze its financial statements in depth. If both were clients, any direct interactions between them would be looked at, but no one would necessarily evaluate how a failure of a partner of a Lehman client could affect AIG. To address such broad issues, an analyst would be asked, “Given our capital structure, should we be comfortable with our exposure to all financial institutions in this particular sector?” He would perform “what if analyses” (or “stress tests”) and posit an opinion. A group of senior executives would debate these analyses and reach consensus on policy, keeping in mind the revenues A was earning (no risk, no reward). A’s board might provide oversight over this decision (by mandating “portfolio limits”) but would not delve into details. It could not; look at a few annual reports to see for yourself how many Board members of financial institutions actually have deep financial expertise.

If you asked any executive involved, “Can you precisely describe a situation that could cause every financial institution in the market to implode over a matter of a week?” they would probably answer “No.” The idea would seem irrational, given this type of analysis and decision making. Scientists have established that humans are notoriously bad at estimating, understanding and acting on probabilistic information.

The root cause of the crisis, then, is the limited ability of financial institutions to estimate risk that arises from sources beyond their immediate trading partners. In the past, they operated as relatively isolated organizations linked loosely to each other by specific transactions. Today, they form a global network that is constantly managing flows of monies; here, any institution’s failings can affect every other institution it touches.

Yet, they lack the management mechanisms essential for this changed world. Their standard risk approval mechanisms, anchored on an “one lender, one borrower” and “one lender, one sector of borrowers” mindset, are outdated. Their standard tools of risk analysis focus on individual institutions or sectors and cannot reveal risks buried in the network. The data they have available to do any analysis is weak: these are usually, but not always, available in the US and less so in Europe; they are usually unavailable or unreliable for institutions from the rest of the world. So, without being the demons they are being made out to be, financial managers have for long been on the edge of today’s crisis.

The loosening of regulatory requirements, particularly under the present administration, exacerbated this weakness by encouraging a culture tolerant of imprudent risk. We can recall saying “There goes the neighborhood” when investment banks abandoned the partnership model and became common stock companies. When their partners’ personal wealth was at risk, they were more cautious. Even when risks were apparent, important people looked away. Consider The New York Times report (“A Professor and a Banker Bury Old Dogma on Markets” September 21) that Secretary Paulson praised Chairman Bernanke for identifying the possibility of today’s crisis a year ago. He meant to praise Chairman Bernanke’s brilliance; we were outraged. Messers Paulson and Bernanke, what did you do over the last year to head off the crisis before it occurred? If you did nothing, why not? If you did act behind the scenes, what caused you to fail? Congress should ask these two gentlemen these questions before giving them a blank check.

Keep in mind that the paucity of financial information about ‘Rest of the World’ institutions suggests the possibility of a widening crisis. Think of this not as the falling of “another” shoe, but in terms of a well shod millipede! Foreign banks with exposure to Lehman could be grossly weakened by its bankruptcy. Their weakness could precipitously weaken other US banks that are (thus far) healthy. Some European banks have already lobbied for their share of the $700 billion and in principle, Secretary Paulson has already acquiesced to their request.

Moreover, what about the “non-bank banks” in the US economy? GE and GM get more than 50% of their profits from their financial arms. GE might be financially sound, but will the meltdown be the straw that breaks GM’s back? Trickle down network effects can reach pension funds, state and local governments and the like.

Networks at their best, are wonderful. Networks that are not managed appropriately are deadly. Nokia and Ericsson tried to teach us these lessons. Too bad we haven’t learned them yet.

Category: Business Environment | Tags: , One comment »

One Response to “Looking for Risk in All the Wrong Places! Part 1 of 2”

  1. Barlow Keener

    I think that connections between the policy makers and the money are causing most of the trouble with having the funding happen and with the auto bailout. Paulson joined Goldman Sachs in 1974 and went to Treasury from the position as CEO of Goldman. I realize Goldman is a good firm. Warren Buffet put his money there. But it seems obvious where the loyalties lie when Paulson lets Lehman Brothers go into Chap 11 – basically bringing an end to the company but saving Goldman. He knocked out the biggest competitor to Goldman in one decision as a neutral “policy maker.” I am sure Lehman had wished their CEO was Sec of Treasury. We might have seen Goldman in Chap 11 if that had been the case. Huge conflict of interest on the face of the matter. Where will Paulson go to work after Treasury? Goldman Sachs. Why does Paulson not want to bailout the auto industry? GM and Ford are not part of the network he needs to protect.


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