The risk of talking about risk

In a recent article in The New Yorker entitled "Rational Irrationality" John Cassidy seeks to explain how bubbles occur. In deconstructing the tech bubble and the housing bubble, the article basically argues that there is no such thing as the "irrational exuberance," so famously described by Alan Greenspan. According to Cassidy, it is precisely rational behavior that leads to bubbles and that fact pretty much guarantees the occurence of bubbles in the future. "In a market environment the individual pursuit of self-interest, however rational, can give way to collective disaster. The invisible hand becomes a fist," writes Cassidy.

Wall Street is particularly succeptible because of the pressure to generate earnings forces banks into riskier and riskier businesses. As Cassidy writes, "In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them."

As early as July 2007, Charles Prince, CEO of Citigroup acknowledged that a collapse in the credit markets could result in huge losses for Citi. He also understood the Catch-22 he was in. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance," he said.

The game of musical chairs appears to have started up again and is playing in real time. Morgan Stanley had a serious brush with insolvency last fall. The bank retrenched and posted losses while gutsier firms like Goldman Sachs scored huge profits from trading.

Now Morgan Stanley is playing catch up. Value-at-risk reached $123 million, the highest level since 2007 and its strong earnings of $2.1 billion are still more than $1 billion lower than Goldman's. VaR at Goldman hit $208 million last quarter. Morgan Stanley plans to hire 400 people to bolster its trading businesses and its VaR is bound to rise, whether they like it or not.

What is a bank CEO to do? Clearly there are massively complex business decisions to be made. But CEOs also need to begin speaking clearly and publicly about risk and it's not the big risk-takers that need to start that dialog. Rather, the imperative falls on those firms (banks, insurance companies, hedge funds, etc.) that do not want to get trapped in a game of financial musical chairs.

The conversation centers on articulating how an enterprise is prepared to balance reasonable growth with reasonable risk and the limits the firm is willing to accept to protect its strategy and growth plan. It takes vision and it takes courage and it will take perseverence because firms will see their earnings lag other, potentially riskier, firms.

Why can't a bank, for example, make a case for controlled growth? Don't firms like investment banks that tend to have volatility in their earnings have lower PE ratios than slower growing, but more predictable institutions?

CEOs with something to lose should be ready to begin the risky discussion about risk. If someone doesn't stop the game of musical chairs, we will know that the cynics are right and that on Wall Street the game really is heads I win, tails you lose.

Update: Warren Buffet in a new interview touches on Wall Street compensation. He says, "in addition to carrots, there need to be sticks...We need to create a downside to people who mess up large institutions...too many people have walked away from the troubles they've created for scoiety...and they've walked away rich." Creating this downside will bring risk management and communicating about risk to the forefront of the financial industry.

Update: Here is commentary advocating that investment banks need to return to being private partnerships in order to effectively manage risk.