In 1986, a relatively unknown economist wrote about the boom-and-bust financial cycles, contrasting them with the attendant cycles of risk. In the boom period, risks appear remote and companies are willing to increase leverage. Lending standards fall and risk management is marginalised, until boom gives way to bust. Governance and risk management are most necessary in the growth phase, rather than in the bust phase when caution would naturally dominate; however, the discourse on these topics takes place at the other ends of the cycle. The dreaded “Minsky moment” is the tipping point, when increased risk-taking on the part of lenders meets with a price slump, destroying asset value and engendering a sharp downward financial fall.
This was all studied and recorded decades ago, yet the crisis that began in 2007-08 could not be prevented. Will it happen again? Thomas Stanton argues that the very act of rescue by the government – of “privatising profit while socialising risk” – undermines the debt holders’ interest and ability to monitor risk, a vital source of market discipline. This could sow the seeds for a recurrence.
Collecting evidence from the debris of the financial crisis via interviews conducted in his capacity as staff on the Financial Crisis Inquiry Commission and his own research work at Johns Hopkins University, Mr Stanton brings together the complex story of the financial crisis. His account spans issues as diverse as mortgage and financial product pricing, approaches to governance of large and complex financial institutions, behavioural economics, organisational structure and public policy.
While risk-taking is natural in business, it has to be balanced with sound practices in risk management and governance. The likelihood of “Black Swan” events is accentuated in the case when companies become globalised or otherwise experience rapid growth. Mr Stanton makes a detailed comparison of companies that survived the crisis (with or without government support) versus those that went under (often despite government efforts).
Mr Stanton identifies specific organisational and behavioural issues that increased the risk to firms or reduced the effectiveness of regulatory bodies or both. “Normalisation of deviance” is a phenomenon of “reducing standards to unacceptable levels based on past success, without taking account of the risks involved in the new low standards”, a concept originally developed in the context of the Challenger space shuttle disaster. “In the pursuit of unprecedented profits, financial firms, mortgage originators, securitisers, rating agencies and investors deviated sharply from traditional standards of prudence. Increasing asset prices masked risks inherent in those lower standards,” he says. He emphasises the importance of distinguishing risk, which is quantifiable, from uncertainty, which requires judgement. “Successful firms used judgement to add more protection than quantitative modelling would have suggested by itself.”
Mr Stanton outlines the history of the financial crisis: the build-up of vulnerabilities, starting with the glut in global savings; the development of low-cost credit; and an active market for instruments that offered safety-plus-yield. As financial firms innovated with new products, companies lost sight of what was really backing a particular AAA-rated security. Individual transactions appeared “reasonable risks”, but in aggregate assumed very different risk profiles. “If one part of the daisy chain broke, the market was in danger of collapsing.”
And it happened: Mortgage defaults took place, funds failed, firms exposed to “toxic assets” collapsed, the market panicked, jobs disappeared, incomes fell — feeding the downward spiral.
However, the book is mainly about the learnings. The book offers well-illustrated examples of behaviours that worked and maxims that withstood the test. JPMorgan Chase was helped by a “fortress balance sheet”; and a “one client, one firm, one view” global approach. Goldman Sachs had a hands-on risk management approach with daily monitoring of the firm’s enterprise-wide risk profile on a mark-to-market basis and a focus on liquidity. For Wells Fargo, decisions to avoid risky instruments were hard choices, but ultimately protected its customers. Toronto-Dominion Bank CEO Edmund Clark, who holds a PhD in economics, opined, “I don’t think you should do something you don’t understand, hoping there’s somebody at the bottom of the organisation who does.” Generalising, the book cites a study that showed that banks with the highest returns in 2006 had the worst returns during the crisis.
Valuable insights are presented on board constitution, competencies, tension between revenue and compliance, lack of long-term data (in the statistical models), lack of experienced staff, and so on. The author describes the phenomenon of “cognitive capture” of supervisors by the business perspective. Another important observation is about regulators’ deference to the overriding belief in the self-correcting abilities of the market.
Each chapter is introduced with a powerful but pithy comment, usually sourced from the congressional hearings. By Chapter 7, one notices repetitiveness, but that reinforces points made earlier. The book lends itself even to the novice, but students, teachers and practitioners of risk, corporate governance and public policy would greatly benefit by studying it.
WHY SOME FIRMS THRIVE WHILE OTHERS FAIL: GOVERNANCE AND MANAGEMENT LESSONS FROM THE CRISIS
Thomas H Stanton
Oxford University Press, New York
278 pages; Rs 1,645 (hardback)
