Risk and Reward: Two Sides of the Same Coin
New rules to live by...
Once upon a time we were told that tax evasion was bad (and illegal) but tax avoidance was good. For who wanted to pay more tax than they legally had to? Things today are not so black and white. Regulators, tax authorities, the media and perhaps most importantly, the general public take a different view. Not only should individuals and corporations operate their tax affairs within the law, but they should also do what is morally right. Well betide those who don't, as many high profile celebrities and Silicon Valley behemoths can attest. All now have to operate in a more complex environment of grey, where the application of appropriate judgment is increasingly important. One can not live by the application of simple rules alone.
Taking risk bad, eliminating risk good?
There may be an interesting parallel with taking risk, decision-making, regulation and the banking system. The primary role of a bank, one could argue, is risk intermediation. Pre-crisis, loading up with risk (and leverage) was a "good thing" that generated out-sized returns for banks, shareholders and of course for the bankers themselves. Banks have now spend the last 6 years de-risking and de-leveraging their businesses and balance sheets at the insistence of ever increasingly onerous regulators. Regulation now shapes pretty much every aspect of activity in a bank. While at the extreme as a sector, bankers are certainty not alone in facing growing scrutiny. Big pharma, energy companies, oil and gas, healthcare, construction, the list goes on, are all in the same boat. So when executives and managers in such industries are faced with a complex decision, what do they do? Typically, they'll reach for the "rule book". What does my company handbook / regulator / process guide / corporate guideline tell me what to do. If there is an answer to be found in such sources, chance are it will advise (or indeed direct) the decision-maker to take the safest, most conservative and least risky path. This may be prudent in certain circumstances, particularly if you are trying to create a safe working environment post (or ideally pre) a major accident. But what if you are trying to find growth or generate a return? Does blindly following the rule book still make sense?
Maybe not...HSBC pushes back
Douglas Flint, HSBC Chairman, came under considerable flack early this month when he suggested that bankers had become too risk-adverse at the penalty of stifling growth not only within the banking system, but the broader economy at large. Flint was quoted by Businessweek as saying. “We’re in a business that takes risk and manages risk, and we have to avoid getting to a state where people believe there is a zero risk tolerance.” Why the fuss? Possibly because of the echoes with the now infamous claim from Bob Diamond to the Treasury Select Committee back in January 2011, that bankers should stop apologising for the crisis. We now know this remark precipitated his downfall at Barclays. Any comment from a banker that isn't full of contrition and that even hints at wishing to make a profit is subject to potential derision.
But what if Flint has a point? Risk and reward do go hand-in-hand. If you completely eliminate the former, it stands to reason that you eliminate the latter. Losing all sense of that relationship - a major contributor to the financial crisis in our view - is atrophying at best and catastrophic at worst.
Finding a balance
So how should banks (and other highly regulated entities) think about risk? How do you build risk- intelligence and judgment into your decision-making? Part of the answer is of course cultural, part also is about process and a significant element comes down to individual skills, experience, and the ability to overcome decision-making biases.
1. Creating the right risk-taking culture
Not a trivial task by any means, requiring an in-depth understanding of the external environment, the risks and opportunities, combined with an honest assessment of an organisation's capabilities and "risk appetite". Successful organisations are able to build a shared strategic understanding of risk, tied explicitly to the ambitions of the enterprise.
2. Implementing an appropriate set decision-making processes
Too bureaucratic, too slow, lack of accountability, too many layers of sign-off. These are the objections we hear from virtually all the organisations we work with. Creating an appropriate decision-making framework and process that upholds the checks and balances required by regulation (and good management) but allows the speed of reaction to take advantage of market opportunity is a notoriously tricky balance to strike. Working through each type of decision, making sure there are clear and appropriate lines of authority, decision rights and accountability is crucial. Ensuring shared incentives exist across silos to avoid conflicting priorities, particularly between departments that have traditionally seen themselves as risk-takers and others that see their roles as risk-elimination. Success will come from building a sense of shared ownership; risk management is everyone's job, not just the Risk department.
3. Making implicit biases explicit
We all are subject to implicit cognitive biases in our decision making. Whether this is useful heuristics (rules of thumb) we use to get by in our day-to-day lives or deep psychological flaws that hamper our ability to make a balanced, informed decision. Wikipedia kindly lists over a hundred different cognitive biases - see how many you recognise! Making those biases explicit, recognising that we are not rational economic animals, is the first and very important step in improving our decision making capabilities.
So banks just need to take more risk?
The short answer is yes. The much longer (and much more interesting) answer will be built on which risks they choose to take, how well they manage them and how they navigate the still evolving regulatory environment, differing by market jurisdiction, evolving in both substance and nuance, and almost exclusively focused on encouraging banks to do exactly the opposite.