Risk Management: Connecting Consequences with Decisions

I came across two articles recently whose themes on risk management intersected nicely.

The first article called “Avoiding Another Great Recession” is by a professor at London Business School named Julian Birkinshaw. He correctly attributes the market crash of 2007 to a huge failure in decision-making at some of the largest US banks, and that this particular problem has not yet been addressed. The risk of it repeating therefore remains high. His solution is to personalize the risk evaluation process in large companies. In his words, personalization “involves pushing the responsibility for evaluating and making a judgment around risk to those individuals who are making decisions – and requiring them to live with the consequences of those decisions.” He cites Goldman Sachs and JP Morgan Chase as examples of banks who have this personalization culture in place, and how they fared much better through the crash than other banks.

The second article in the Financial Post had the catchy title, “Why Swiss Banks Don’t Go Broke.” Richard W. Rahn explains how Swiss banks, particularly privately-owned Swiss banks, rode through the financial crisis so much better than banks in other countries. “Banks that are organized as general partnerships have had fewer problems because the partners have a very strong vested interest not to take on risks they do not fully understand because it is they who take the hit if something goes wrong.” Rahn goes on to propose an impractical solution called “mutual fund banking” but the rest of his article stands on its merits.

Bottom line: If you personally stand to lose everything from a careless investment decision, you tend to make fewer careless investment decisions!

As simple as this concept appears, it apparently has not been considered by governments when it comes to fixing the banking system. Governments prefer to believe that increasing and formalizing bureaucracy around these risk management processes will somehow reduce risk. The track records prove otherwise. Managing risk by increasing bureaucracy rarely seems to work. The Basel Accords are a good example.

Global central bankers set up the first Basel accord in 1988 to measure credit risks and to ensure banks retained sufficient reserves to cover those risks. Apparently this higher reserve requirement prompted JP Morgan to use credit default swaps to practically get around that requirement, and later those types of swaps played a significant role in the Lehman Brothers collapse in 2008. Warren Buffet predicted this danger in 2003, calling these swaps and other derivatives like them “financial weapons of mass destruction.”

Basel II was released in 2004 in an attempt to not only tackle credit risk, but other types of risk such as operational market, pension, and liquidity risk. It also failed to prevent the meltdown of 2007.

So, the solution to these regulatory failures? Basel III, currently in development. Just close your eyes, click your heels together three times, and it will be sure to succeed where its predecessors failed!

The failure of the Basel Accords is not in its content or a lack of expertise that went into it, but in its fundamental assumptions. Like Rahn points out, forcing banks to increase their reserves does not reduce the risk of their investments. To be safe, reserves must exceed the level of investment risk, which varies between banks and over time. There is no arbitrary reserve percentage that is safe enough. Safety comes in avoiding poor investments.

As a self-employed business owner, managing risk involves one person so it's not complicated. However, we're not immune from bad financial decisions either. I recently heard about a self-employed contractor who traveled a lot, but did not stay in the expensive hotels that his fellow self-employed contractors did. His comment: "They're spending money like it's not their own company."

And that's what it all boils down to: People have to make decisions like it's their own company, and then they have to experience both the rewards and consequences of those decisions like it's their own company.