Needed: Strategic Vision, Not More Regulation

If the Lehman collapse has taught us anything, it is that the financial industry has a more profound impact on the real economy than many had realized. It has the potential of helping fuel economic growth, raising people’s standard of living, self-realization, and inclusion in the process. Or, as we have witnessed over the past two years, it can wipe out trillions of dollars of wealth around the world, bringing capital markets and economies to a brink of a collapse. The conclusion that many people are drawing today is that we need better regulation — and more of it.

Rigorous, consistent, and internationally coordinated regulation will certainly help. But it will not address the fundamental behavioral dynamic at the core of the recent financial crisis. The fact is, executives in financial services are compensated based on ROE, P/E, and other such performance metrics — in absolute terms and relative to peers. Meanwhile, equity analysts and investors look for companies to deliver consistent and growing accounting earnings — irrespective of the prevailing economic and market environment. The net result? Vicious circles that lead to bad decisions and destroy value.

Suppose a publicly traded financial institution — having just witnessed the collapse of Lehman Brothers, Bear Stearns, and AIG — decides to pare down risk and grow less volatile businesses, like wealth management, advisory services, market making, or commercial banking. Meanwhile, its peers are back into the swing of things, loading their balance sheets up with risk in every way imaginable. How long can we expect the firm’s executives to stick to their vision before competitive pressures to deliver short-term earnings force them into excessive risk taking as well? How long before boards of directors run out of patience and replace these executives?

As this moment, financial institutions are having a heyday. After years of margin pressures preceding the latest financial crisis, the underlying economics of financial businesses has dramatically improved during the crisis, with yield curves becoming steeper, bid/ask spreads widening, underwriting fees and sales commissions increasing, and so on. But déjà vu is just around the corner. Soon enough, calming markets and competitive pressures of fully-commoditized financial businesses will compress margins and fees — if not to the 2006 level, then close to it. As a result, many financial institutions will go straight back into risk taking, the extent of which will often be misunderstood and mismanaged. The same vicious circle that created today’s financial crisis will be repeated.

If this grim prediction comes true, such future crisis — just like the most recent one — will not be a failure of risk management. It will also not be a failure of mathematical models, rogue rocket scientists, or normal distributions, as the Church of Black Swan would like you to believe. It will be a crisis caused by the continuing disconnect between strategic decisions and risk management. In other words, risk practitioners fully understand pros and cons of different risk management models – and what these models can and cannot do. The problems arise when senior financial decision-makers and institutional investors misunderstand or misuse those models as they try to keep up with competition or fight earnings pressures.

The regulatory reforms now being mooted can’t easily address these realities. There are a million different ways in which financial institutions can take on risk. Moreover, given the continuing lack of risk-based transparency and departure from mark-to-market accounting, financial markets, investors, and regulators will remain blind to the true riskiness of the balance sheets of financial firms until too late.

The burden on developing a strategic vision for the organization — one that explicitly incorporates risk management and makes use of the lessons learned from this crisis — remains squarely on the shoulders of boards of directors and executives. For them the key challenge is to foster corporate cultures that give risk management an equal seat at the table where strategic decisions are made. Financial institutions — and many non-financial companies — must explicitly acknowledge that risk plays a central role in their business models. Risk is already the key determinant of their ROEs, P/E ratios, earnings volatility, and more broadly, their value creation or destruction over time. The ways in which decisions are made on the most senior levels of financial institutions — and the ways that these organizations are structured and managed — must change to reflect that reality.

Crafting a sound strategic vision for financial service firms will be exceptionally difficult. It will take genuine leadership and resolve. It will need broad systemic knowledge as well as collective openness to new ideas. It will demand a longer-term horizon that fights the focus on short-term accounting earnings. Last but not least, it will require dynamism in the broadest sense of the word. All of this is hard work. But as difficult as these endeavors may be, they are far less painful than the alternative – a Darwinian failure to evolve followed by financial ruin.

If you were at the helm of a public financial institution, how would you resist the misguided short-term earnings expectations of investors and equity analysts — or reckless behaviors of your peers?

Leo M. Tilman is president of L.M. Tilman & Co., a global strategic advisory firm, and teaches finance at Columbia University. He is the author of Financial Darwinism: Create Value or Self-Destruct in a World of Risk (Wiley 2009) and other books.