In the first article in this series - “Those Who Don’t Know History Are Destined To Repeat It" – I referenced the regular FS cycle of forgetting past crises. This is underpinned by a hubristic act of sanitised differentiation - “we are not like them”.
In the second article “Control Is An Illusion” I covered the paradox that, in an FS world pre-“risk management”, there were apparently less crises. I saw this as due to (a) individual responsibility for outcome not compliance, (b) simplicity of business models/transactions and (c) the siren call of “risk management”.
In the final two articles in the series I will come right up to the present in P2P and Equity Crowdfunding. But, before that, we need to dive deeper into this con-job that for me is best summarised by there being fifteen million webpages on “risk measurement” (you can model it but you can’t measure it).
This is the most dangerous FS delusion of the past 20+years – the failure to be clear about the fundamental difference between arithmetic and real knowledge of the future.
Air Crash Investigates
With the exception of Andy Haldane’s BofE paper “The Dog and the Frisbee” – exec summary “you can’t manage complexity with complexity” - I have read nothing of interest this millennium about FS “risk”.
My principal source of insight has been National Geographic’s “Air Crash Investigates”. One can’t begin to imagine the amount of effort that goes into designing planes and covering all risk scenarios.
Planes, for all their complexity, are mostly, flight crew aside, made up of mechanical components. These are modellable to a high degree unlike the human beings that comprise financial markets. However planes still crash.
One simple takeaway is the need to learn from every failure and make sure that type of failure never happens again.
If, say, the P2P industry – whether the trade bodies, or the FCA – did this then so far we would have individual reports and industry recommendations on the 6 closed down and 5 suspended firms [http://www.p2pmoney.co.uk/companies.htm] as well as the somewhat-survivable crash-landings (Wonga et al).
Not only that but all P2P’s investors/lenders/borrowers would be safer than they were before.
Contrast this with the current situation where, at best, a few of the lessons are learned by some – if at all :(
The second fascinating lesson – which is harder to transfer – is that regulation of airplanes is highly constrained by the need for the things to fly.
Contrast this with FS regulation. If FS regulators took over a case where, say, a wing had broken they would make it a hundred times thicker and then politicians would bemoan the fact that the thing doesn’t fly well :(
It’s Your Brain Brian
Your brain is deeply divided – literally and metaphorically.
Briefly all this popular stuff one hears about “language residing in the right hemisphere, maths on the left” is a load of nonsense – both hemispheres are always involved. Equally all this “99% of your brain is unused” is nonsense – stick someone in an MRI scanner and all bits of the brain will light up.
Iain McGilchrist is a rare Renaissance Man - psychiatrist, doctor, writer, literary scholar and Fellow of All Souls. When young he was torn between Plato’s view of the world (abstractions are the real thing) and Aristotle’s (the real thing is the real thing out of which we make abstractions). His magnum opus is “The Master and His Emissary: The Divided Brain and the Making of the Western World”. Very relevant.
The left hemisphere (great emissary (servant) but appalling master) makes precise models which decide eg for a bird whether what it is about to peck at is grain or a stone.
Necessary but not sufficient as this may well result in the bird being eaten while it is eating so at the same time the right hemisphere maintains an unquantifiable global awareness of “anything important”.
Culturally the left-hemispheric cognitive style is a bureaucrats wet-dream – you can and should control things, certainty, fixed awareness, lots of little entities that fall nicely into categories and can be systematically manipulated for the good of all - life (economies, societies) are like a complicated machine.
The right hemisphere’s cognitive style is about the ever-flowing, ever-changing, river of life, the unknowable uncertainty of it all – your life, your wife, your AltFin.
Recent FS history is rather like a right-hemisphere-impaired bird eating its lunch.
It – like risk regs, credit models, compliance et al – is fine for a while. Until it gets eaten (by a black swan?).
FS – Old and New – Needs Goldilocks
Goldilocks chose the porridge that was neither too hot nor not too cold.
When I started my first big gig running Fixed Interest fund management in ’88 the business was “too right-brained” – results were variable – more art than science. Solved that by adding structure.
In ’92 I started my second biggie – sitting, like George Smiley, in a room on my own with a whole stack of files – trying to work out what was going on across the whole of Kleinworts. Merchant Banking was “too right brained”. Plenty of art and feel but not always enough precision and prone to slip-ups. Needed more structure once again.
In the subsequent 23yrs FS Risk got carried away with left-brain structures, forgot its limitations and we all paid (literally). The benefits of “Art” were washed away by a tsunami of “Science” - IT, “rocket scientists”, modelling, legalistic regulation became the one true faith.
The left-brain always ignores or disses anything not in its models and the governor’s eyebrows were seen as an archetypally backwards way of running the City. However behind the eyebrows were experience, art, “feel” and “judgement” [all right-brained in nature, all unquantifiable therefore they don’t exist in this cult]. As I argued before the eyebrows outperformed.
In the late ’00s I did a variety of FS project turn-round gigs. Here the problem had also become excessive structure, too left-brained – everything sliced and diced but no-one having the global picture.
I recall saying to a senior regulator that FS projects, risk, businesses were these days all being managed by slicing and dicing everything into floor tiles. But there is a fundamental flaw in this approach.
In reality the kitchen floor is neither flat nor regular. So there are overlaps and underlaps. But no-one is ever responsible for those. Regulator didn’t get it at all – too trained to be left-brained.
Back to the Future
So what’s a simple takeaway for individual firms?
What’s an actionable consequence?
How do we apply my “control is an illusion” three lessons - individual responsibility, simplicity, and uncertainty?
Back to this article’s title of “deja-vu all over again”.
In ’92 the standard response to me saying we needed to formalise a Head of Risk role (which we did in the end) was “the traders (/bankers/credit/finance/audit) look after the risk”.
In ‘14/’15 the standard response when I ask folks about risk in AltFin is “the credit guy(/compliance/FCA/trade body rules…) look after the risk”.
Necessary but not sufficient dudes.
None of them manage “business uncertainty”.
None of the floor tiles is the kitchen floor.
Major/serious AltFin players need a CRO who pulls together all of the sources of uncertainty into one locus on the organogram.
Smaller ones will have to have the CEO (who is focused on the business’ future from a holistic perspective) “double-hat” both boxes (ultimately unsustainable as FS risk-qua-uncertainty is highly complex).
The job description is a right-brained one - “managing growth without screwing up”.
Unless one has a box on the organogram where someone is responsible for avoiding screw-ups, for ensuring that all the kitchen tiles fit as best as they can and the gaps are filled with glue, one hasn’t even touched the sides re “sanitised differentiation”.
Au contraire one is inheriting the most pernicious of the sins from the Ancien Régime.