4 Vital Lessons For Alternative Finance From What Went Wrong With FS Risk

By Mike Baliman on 16th June 2015

It’s A Wrap – Part 1/2  

I have written eight articles in my series on Risk in Alternative Finance (“AltFin”).

In part 2 I will summarise the key points from the last five more specifically AltFin Risk articles.

In this article I will cover the key points I made in my first three articles[1] about what AltFin can learn from the story of FS risk management.

This is vital context particularly as in AltFin few have much FS experience - itself a (the?) major concern. 

One heartening development is that AltFin is gradually realising that it is actually Finance. 

We must start with some understanding of Risk and Finance.

What is the story of FS Risk in recent decades? 

You know it’s failure. As a taxpayer you have had to bail the banks out. 

FS Risk clearly lost its way.

Bigtime.

Over my 30+year FS career we have ironically gone from a less risky world of “no risk managers” into a climate of “sempiternal FS crisis and billion dollar fines”.

How did that happen?

For those of you that didn’t live and work in FS Risk through decades of all sorts of cock-ups and disasters, here are my key four Must Not Forget lessons/themes for AltFin folk.

1) The Past Is A Guide To The Future

Hubris is a word with a pedigree of well over 2,000 years so I think we can assume it points to something persistent and deep in the human psyche.

FS/City “short-termism” is not just about the future but also about the past. It’s good at forgetting.

The boom in AltFin is in large part just the latest and greatest example of the classic “New Bank” vs “Bad/Old Bank” split which always follows a banking crisis. 

This split has always been accompanied by the traditional act of hubristic sanitised differentiation - “we are not like them”.

But in a few years the shiny-shoed new boys always end up in the sixth form as prefects or caught smoking behind the bike sheds.

I was glad back in January to find that some key industry insiders did acknowledge that they too were human beings playing an age old game of lending and borrowing and subject to the same laws of nature as all their predecessors.

Less astute players seemed (and seem) to feel the laws of gravity don’t apply to them.

This is particularly the case in the age-old pattern of chasing volume in FS. 

There is plenty of denial right now around the fact that you cannot increase quantity (especially exponentially) without impacting quality

Not just producing beer, cheese, wine but more pertinently loan books. 

Much of Fintech as a whole and AltFin comes from tech roots.  There is a lot of strength in that.

However there are vital differences. 

If you are exponentially scaling your latest chat app to take the world by storm your servers crash today if there is a problem

Facebook is, in essence, “a webpage”.  In its exponential growth it was always immediately apparent if that crashed.

By complete contrast consider exponentially scaling 5yr loans…

Every pattern like that I have ever seen involves folks taking nice rewards upfront and a different set of folks coming in to sweep up the mess.

2. Complexity

The root cause of the disastrous story of modern FS is complexity.

Over the past 30 yrs the industry has been transformed in two ways.

Firstly following on from “de-regulation”, ever larger, ever more complex organisations.

Now far too big to manage.

Secondly ever more complex transactions due to the advent of cheap computers.

The response to this increase in complexity has been two-fold.

Firstly the advent of in-house “risk management” departments. 

Secondly (and more recently) an explosion in out-house “regulation”.

Internally banking risk departments have thousands of people in them, believe too much in “risk models” and much that passes for “risk” is actually compliance box-ticking. 

Externally regulation itself has morphed from controlling structure, through controlling competition to controlling minutiae. 

AltFin is very much in the vanguard of a return to sanity (although that can easily be derailed).

It’s worth noting (and of relevance to AltFin which is about new structures) that the only proven “best answer” to managing FS Risk lies in industry structure.

I say “proven” as the siloed structure of building societies, commercial banks, merchant banks, stockbrokers, stockjobbers et al worked very well for a long time. 

Simple speciated businesses, easy to understand, easy to manage, focused.  Personal responsibility and business management which knew that the world can always change tomorrow.

Or see the case of Iceland, the only country in the world to decide to bankrupt the banks and not the people.  “Narrow-banking” is the way there.

Nothing else makes sense actually. If we have “state money” which is in reality just bits in certain organisations' computers then we have to keep them going.

But the quid (ha!) pro quo should be that those organisations can only indulge in a very narrow range of transactions and must be simple enough to be easily understandable.

The best AltFin has certainly started from those principles – in a way it has more in common with a pre-Big Bang world than with the modern world of vast “do everything” banks.

However the siren call of increased organisation and transactional complexity is always out there.

Complexity is like a drug – you think you can handle it but plenty before you have come a cropper. From a risk perspective complexity is a far greater challenge than folks realised at the time in countless FS examples.

3. You Can’t Measure Risk Dudes

The first wave of banking risk management were “poachers turned gamekeepers” – folks who “had a feel”, who instinctively knew who to trust, who knew that arithmetic was arithmetic.

The second wave was the IT brigade – complex models and lots of computers.  At this point all (not so common) “common-sense” went out of the window.

They should have watched Days of Thunder:

“Control is an illusion, you infantile egomaniac. Nobody knows what's gonna happen next: not on a freeway, not in an airplane, not inside our own bodies and certainly not on a racetrack with 40 other infantile egomaniacs.”

“In-house” FS risk management screwed up right royally in an inability to distinguish arithmetic (“Risk Models”) from real knowledge of the future (“It’s Uncertain”). 

That simple sentence sums up most of what precipitated the 2008 crash.

Well that and “infinite greed” which (cough, cough) looms large in all tech sectors today.

The concept you can measure risk is still a pervasive, pernicious and must-know-about error.

If you type “risk measurement” into Google you get over fifteen million links. 

But you can’t measure risk (uncertainty) – you can only model it.

Now don’t get me wrong – risk modelling is a vital thing to do.

Absolutely.

But it’s just a model.

4. FS Regulation - Gordon Bennet

In the Thatcherite-Reagensque-Monetarist world of the ‘80s, the theme was “de-regulation”.

Which led to the increase in organisational complexity referred to earlier. 

And ironically (along with these computer thingies) to the most micro-regulated economic activity ever in the whole of human history. 

And I am not exaggerating in the slightest. 

If you think I am then, by definition, you have never worked on a big regulatory project in a bank.

De-regulation to over-regulation in one generation.

Not oft covered, so let’s slice the salami.

4a) FS Regulation - Adam Smith to Joseph Stalin

Originally country-specific FS regulation was regulation of structure [eg Glass-Steagall]. 

This was complemented by human (ie non rule-based) oversight of banks by the Bank of England.

Next the first global FS regulation (in the ‘80s) was aimed at economic regulation [eg Basle 1 aimed at “creating a level playing field for banks globally”].

Now we are in a dystopia of regulation of minutiae [Dodd-Frank, MIFID, individuals - the Orwellian-sounding “approved-persons” etc etc].

This dystopia amounts to “the nanny state knows best and will micro-manage and police every aspect of your business from outside”. 

It’s an outgrowth of the stalinist/civil service mentality of centralised “command and control”. 

As a result FS Risk has had a Dantean descent into a hell of vast bureaucratic rule books and risk management descended into box-ticking legalistic compliance.

Seasoned risk veterans whisper to me that current regulation is like a fundamentalist religion.  No-one dare take a stand and even express a view lest they compromise their prospects.

As Emperor Palpatine said “the bureaucrats have taken over”.

All of this excessive regulation would be less problematic if it didn’t crowd-out managerial attention on managing the sheer uncertainties of business. 

Tomorrow’s problems are never foreseen as we are always looking over our shoulder at rules designed around yesterday’s problems.

Furthermore the kind of people who are able to spot tomorrow’s problems, who look forwards are antithetical to a culture based on looking backwards and have been crowded-out.

4a) Good Regulation

Good regulation is good :-D [Strike a light, where’s me gin bottle? Ed.]

My favourite source of insight into “good risk management” is Air Crash Investigates.

Airplanes get safer and safer as a result of (a) successful in-house “risk management” and (b) successful “out-house” regulation which is constrained by the need for the airplane to fly.

You can’t make wings out of steel girders “just to be on the safe side”.

By contrast there appears to be absolutely no restraint whatsoever on FS regulation. 

So it’s no surprise that the FS airplane flies less and less well as a consequence.

However writing about how the issue is actually the necessity to regulate structure and competition sells far less newspapers than railing about organisations and more rarely pillorying an individual.

So we get lots of stories of ginormous fines on this bank or that bank as if the fundamental flaw lies with this bank or that bank rather than in the rules of the FS game.

4b) FS Regulation’s Intellectually Bankrupt Philosophy

Philosophically current global FS regulation screws up by assuming that vast complexity actually helps. 

Nor am I being idiosyncratic here. See eg the Bank of England’s Chief Economist (and previously Head of Financial Stability) Andy Haldane’s paper “The Dog and the Frisbee”.  Exec summary - “you can’t manage complexity with complexity”.

Or economic historian Niall Ferguson who argued in his 2012 Reith Lecture that:

“Today, it seems to me, the balance of opinion favours complexity over simplicity; rules over discretion; codes of compliance over individual and corporate responsibility. I believe this approach is based on a flawed understanding of how financial markets work. It puts me in mind of the great Viennese satirist Karl Kraus’s famous quip about psychoanalysis, that it was “the disease of which it purported to be the cure” I believe excessively complex regulation is the disease of which it purports to be the cure.”

 

4c) FS Regulation – Show Me The Money

Every game has winners and of course vast complexity benefits armies of consultants, lawyers, and regulators.

There are massive conflicts of interest inherent in the system - something regulators would leap on and fine big time if it happened inside a bank. 

More regulations mean more jobs for regulators.

In the US the regulatory bodies keep the fines they levy.

Banks often argue and lobby for more complex regulation as a barrier to entry. 

Etc, etc, etc.

4d) FS Regulation Always Catches Up With “Alt.”

Regulatory creep is unstoppable – try and invent anything these days and it soon gets caught in the statist net (latest New York bitcoin regs qv).

Fintech and AltFin is just the latest wave at trying to invent from the ground up elements of FS.

In essence it is going back to the “good old days” of simple structure, and accountability and responsibility for outcome not bureaucratic process.

After all if your company failed no-one would bail it out and you all would lose (cf the insane world where shareholders pay the billion dollar fines caused by managerial laxity).

However sadly all the evidence is that AltFin is slowly getting sucked into a much more standard FS approach. 

It’s always the way. The last sub-sector of FS to make a break for the border was Hedge Funds. After all if you want to manage money in a particular way and I want to invest in it what role does the state have in telling you how to do it?

This was an argument that held sway for a long time but see for example the FT’s 2013 comments:

“Few financial institutions have been hit as hard by the onslaught of new global regulation since 2008 as hedge funds. An avalanche of acronyms is threatening to overwhelm the industry’s gentrified enclaves of Connecticut and Mayfair: from AIFMD to Mifid via Fatca and Ucits … an unprecedented set of rules and costs for the once freewheeling hedge fund world to get to grips with.”

FOUR LESSONS FOR ALT FIN FOLK

In the final article I will turn to summarising the main points re Risk within the AltFin sector.

However for the moment I will end with my main advice to AltFin-ers based on watching 30yrs of FS road-crashes around Risk.

Lesson 1 - Hubris

Especially with the VC dollars tsunami-ing in we might suggest that AltFin CEOs resurrect the triumphal Roman custom of employing a slave (or the politically-correct modern version “an intern”) to follow the victorious leader around and whisper “remember you are mortal”.

If nothing else it would make panel discussions more interesting seeing the slaves whispering away :-D

Lesson 2 - Complexity

Keep It Simple Stupid has served AltFin well for a decade.  It’s a fantastic Tech vibe as a whole.

Beware complexity or straying far from your knitting – it really is a gateway drug to danger.

Lesson 3 - Risk

You can’t measure it, you can’t control it.  At best, like a surfer you can do your best every day to keep your balance.

One simple step – and where AltFin is way off the curve compared to FS (and I hear compared to P2P-FX) is in not having a CRO who pulls together all (not just credit and compliance) of the sources of uncertainty into one locus on the organogram.

And what’s the job description for this CRO? “Ensuring the company grows without screwing up”

Lesson 4 – Regulation

As per FS as a whole, this can start by being helpful and end by being deleterious. It’s a ratchet that I have never seen loosened.

The sea change will come when it’s decided you are all macroeconomically important (the pretext for Hedge Fund world invasion (whereas in practice the command and control mentality of the state is the issue)).  Someone will say you are shadow banking (or some other pretext) and before you know it they are painting your house via your letter box.

 

[1] #1: “Those Who Don't Know History Are Condemned To Repeat It”

[www.altfi.com/news/672] #2: “Control Is An Illusion” [www.altfi.com/news/762] #3 “Deja-Vu All Over Again" [www.altfi.com/news/707]

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Bank of England