— Sep 3, 2014

Article by Professor George Feiger

Executive Dean, Aston Business School


Before joining Aston Business School in June 2013 Professor Feiger was the Chief Executive of a $3.4 billion wealth management company in the United States. Private sector roles have included Head of Strategic Planning at the Bank of America’s world banking division, Senior Partner at McKinsey and Co, Global Head of Investment Banking for SBC Warburg, and Global Head of Onshore Private Banking at UBS.

His academic credentials include appointments as Associate Professor of Finance at Stanford University’s Graduate School of Business and Lecturer in Economics at Harvard. He has served on the Advisory Board of the Berkeley Centre for Law, Business and Economics. As a student, he gained an undergraduate degree from Monash in Australia, a PhD from Harvard and a Fulbright Fellowship.

The wishes in this title are, of course, for a truly effective risk management system for financial institutions. And the beggars, unfortunately, are us.

There are many kinds of risks that a financial institution (indeed, any institution) needs to manage. I will focus on what nearly brought the world economy to its knees in the recent (perhaps still ongoing) financial crisis: bad financial transactions made and bad financial positions taken that add up to what are called systemic risks.

A lot of actions have been taken since 2008 with the intent of mitigating systemic risk, largely mandated by regulators, but the message that I want to convey today is that it likely to be ineffective. This is for two reasons:

  • First, we don’t know enough to be able to manage financial system risks; and
  • The fundamental incentives in our economic system make this problem worse.

We Don’t Know Enough

Financial/economic decisions about the future go wrong because the future cannot be predicted perfectly.

We are continually surprised by what markets produce because markets are linked in ways that are poorly understood and constantly evolve.

Here is one chain of events that unfolded to the surprise of most market participants.

  1. Lehman collapsed because its net worth was impaired due to underwriting and retention of grossly overvalued collateralized securities.
  1. A US money market fund (and significant holder of Lehman commercial paper) could not allow its investors to redeem at 100 cents on the dollar. This panicked holders of investments in all US money market funds and there was a wholesale run to US Treasury obligations as a safe haven.
  2. So US money market funds shrank in size. As it happens, however, US money market funds were the principal buyers of the commercial paper of large European banks. They turned into heavy sellers.
  3. …which created a liquidity crisis in the European banking system. The banks desperately tried to reduce their balance sheets and turned to the ECB for emergency liquidity. Their depositors also fled in fear. Hence the supply of credit to European economies rapidly plummeted.
  4. Rapidly shrinking credit availability forced these economies into recession and increased the volume of bad credit, further forcing retrenchment in bank balance sheets as their equity eroded.
  5. Governments stepped in to support banks, further adding to government debt at a time when government revenues were falling due to the recession. Deteriorating government credit drove interest rates on government debt sky high, meaning that some governments did not look like they could pay.

And so on……

We know these chains, looking backwards. We know also, however, that there are many other linkages being built throughout the world economy. These we will learn about with hindsight too, unfortunately.

Amplifying these linkages is what is known as endogenous anticipations; market participants place their bets based on what they think are the likelihoods of future outcomes. What they think, however, changes as the markets themselves move. As in the example above the US money market fund was a buyer of European debt at 100 one day yet a seller at 80 the next.

We may conclude that our limited ability to model systemic risk makes it exceedingly hard to devise effective risk mitigation strategies particularly as market participants do not behave with perfect rationality, whatever that means.

Bad Incentives

Interestingly, we add to the risk assessment problem by tolerating incentives that promote rather than discourage the taking of dangerous risks.

Some of the negative incentives are obvious and may even be able to be reduced.

  1. Constrained Operating Intelligence of Large Organizations

Because the future is uncertain, and because quantitative modelling can be at best a guide, informed judgment plays a critical part in risk management. It is extremely difficult to exercise informed judgment in large, particularly global organizations.

You may know the qualities of 3 partners; you can’t know the qualities of 3,000 or of 30,000. The larger an organization, the more it will operate by rigid rules that forbid discretion. Managers in such organizations are unable to understand or effectively respond to unanticipated events.

  1. Absence of Real Owners in Modern, Stock-Market Capitalism

Listed companies do not have owners in the old-fashioned sense. Most listed companies are owned by institutional shareholders like pension funds or by hedge funds or other opportunistic vehicles or even worse, by index funds and exchange-traded funds that do not even pretend to monitor or exercise control.

Such holders have no long-term interest in any one company. Both the shareholders and the management are short-term oriented. Making money quickly is more important than making money sustainably. Managers who do not follow the path of quarterly earnings are thrown overboard. This is the meaning of the infamous remark by Chuck Prince, then CEO of Citicorp, that “as long as the music is playing you have to keep dancing”. Had he, in 2006, stopped originating mortgages and creating securitized assets, he would have been lampooned in the press, his best performers would have defected and in all likelihood, the Board would have fired him.

  1. Penny-Wise, Pound Foolish

No society is willing to pay private sector salaries for its regulators. So, imagine that you are a clever person with a good market understanding and great analytic capabilities. You have the chance to earn £75,000 per year at the Bank of England or £1 million per year at an investment bank. Don’t rush to decide – give yourself at least 5 seconds. In consequence, on average the best talent is employed by the regulated rather than by the regulator.

  1. The Revolving Door

The constraints on regulatory effectiveness get worse. Consider those regulators who are really talented. Especially but not only in the US, we see that after a few years, the natural career step is to be hired into the industry you have been regulating, at a high level and at a good salary. If you anticipate that you will be working for a company before long, how hard will you be on it in the meantime?

We observe the revolving door in other industries such as the defense industry, where generals sell overpriced weapons to their former colleagues.

Taking these two limiting factors into account it is perhaps too strong to echo William Goldman’s line about the film industry “Nobody knows anything. Not one person in the entire motion picture field knows for a certainty what’s going to work. Every time out it’s a guess and, if you’re lucky, an educated one.”

However, Jeremy Grantham’s response, when asked what we had learned about the financial crisis, is resonant: “In the short term a lot, in the medium term a little, in the long term, nothing at all. That would be historical precedent.”

This is an edited version of a lecture given by Professor George Feiger in 2014 to the Lunar Society. The Full lecture can be found below.