By Joseph Neu
The release of the US Financial Crisis Inquiry Commission’s (FCIC) report has prompted yet another round of debate on what actually caused the financial crisis that nearly brought down the global system in the fall of 2008. There are multiple views within the Commission, and a number of people outside it believe that the root causes were not even addressed in the consensus or even the dissenting sections of the report.
In all likelihood, as an Op-Ed in the Wall Street Journal from three of the dissenting Commissioners argued, there were a variety of contributing factors. This is consistent with some of the takeaways from discussions in The NeuGroup’s Corporate ERM Group, which emphasize that big, take-down-the-firm, or take-down-the-system, risks are often best viewed as the cascading impact of multiple risks or exposures hitting either at once or in just the right sequence.
Thus, risk managers along with policy-makers hoping to avoid such a crisis from occurring again have to do a better job of emphasizing vulnerabilities to known risks that come at them in unexpected patterns, as well as the unforeseen risks. But they also need to be made to feel vulnerable.
NOT ACTING WHEN NEEDED
In line with this, regardless of the factors you believe to be influential, the first lesson of the crisis seems to be that risk-takers as well as regulators failed to act because the cost of action appeared dearer than the exposure to any flagged risk when viewed either in isolation or in the context of expected outcomes. To some extent, failure to appreciate exposures across a range of expected and unexpected outcomes led to inaction and allowed a crisis to happen.
This view is consistent with the first conclusion of the FCIC report: “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.”
But how do you know to act before a cascading effect leads to systemic crisis? Sometimes it’s just instinct, other times it’s being active always. One way to act is to build resiliencies or redundancies into systems so that they can withstand a multitude of scenarios. Total invulnerability is impossible, not to mention uneconomical, so the compromise is to maximize the risk resiliency created for every dollar allocated to risk management. Further protection can be bought if firms also shift resources to resiliency maximization when risks and risk sequences flagged as potential firm-busters appear on the radar screen.
According to the FCIC report, however, key institutions failed to perform this sort of risk mitigation or other prudent methods of risk management. This is perhaps the closest the report comes to identifying a root cause of the crisis.
Risk management failures belied the notion that self-preservation instincts, serving as a foundation for prudent risk governance, would protect the financial system better than any regulatory regime. Instead, the report contends, risk management became merely a way for institutions to justify that the risks they were taking were under control.
Helping this risk justification, as the report notes, were the compensation schemes at systemically important institutions which rewarded risk taking much more than they penalized excessive exposure creation.
WHERE’S THE SELF-PRESERVATION INSTINCT?
While the FCIC report touches on this fundamental reason for the crisis, it does not underscore the need to restore institutional self-preservation instincts that are vital to averting future crises.
Instead, it adheres to the consensus view that more regulation is needed to counter the loss of appropriate fight-or-flight responses on the part of key institutions. Furthermore, if you subscribe to the view that the moral hazard of too-big-to-fail institutions is essentially synonymous with the loss of self-preservation instincts, then you are basically left to conclude that the government response to the crisis has not done much to address its root cause. Indeed, things may have been made worse.
As a result, risk managers going forward will need to account for the presence of market participants who are not similarly inclined to guard against downside risk.