Author: Bill Sharon

Over the past year we have heard intermittent calls for the restoration of confidence, usually by those who would relax all manner of regulation and oversight of commercial and financial ventures.  The past, it would seem, adds credibility to their argument.  Regulation in the financial markets and the internal financial operations of publicly held companies has done absolutely nothing to prevent the ongoing crisis we find ourselves in.

But this clamor for confidence tells us that despite all the calculations, projections and efforts by central banks to keep the flow of money moving it all comes down to how we feel.  If we felt confident, we are told, then we would behave differently.  The pathway to that better feeling varies from deficit spending to balanced budgets with the advocates of either position passionate about the correctness of their remedy.  But no matter what we do our feelings are only buoyed only for a few days and then sink once again.  We feel uncertain that we were right to feel better.

There are many analogies to this situation; Einstein’s definition of insanity comes to mind; doing the same thing over and over and expecting a different outcome.  Another would be the problem of transitioning from a moral society in which we apply a known set of rules to every situation to an ethical one where we begin to understand that solutions are intuitive and not measured solely by numbers on a balance sheet.

We are discovering that our set of rules is no longer relevant to the problem.  Laurie Hyland, in a set of papers that can be found at www.thenewmoneyreality.com provides us with a pathway to understand the new context we are all living in, regardless of whether we choose to acknowledge it.  The following example is borrowed from her work although its application is my own.

Take a bowl and let a marble slide down its side.  Eventually the marble comes to rest.  In classic physics we say that the marble has reached equilibrium.  In classic economic terms this is equivalent to the certainty that we allegedly crave.  We make rules about keeping the marble stable, not moving the bowl and so forth.

Now take the same bowl and fill it with fruit suspended in Jell-O.  If you take a fork and attempt to remove one of the pieces of fruit, everything moves.  In Quantum physics that’s called entanglement.  In what Hyland calls Quantum economics that’s Lehman brothers.  We have come up with the term “too big to fail” to express the fact that we recognize that the consequences of a collapse of even one of our major financial institutions are incalculable.  What we do know is that such a failure would have global consequences.  The idea that “we are all connected’ has transitioned from an esoteric mystical concept to an increasingly robust scientific theory to an economic reality.

It seems that the ongoing efforts at budgetary unity in the Eurozone reflect this new reality.  I would suggest that it is a continued attempt to apply a moralistic set of rules to an ethical challenge.  Economics is a discipline devoted to understanding how we relate to each other, what we think has value and how we interact with each other to enhance the human experience.  Tragic as it may appear to those who have elevated the left-brain to the highest form of human endeavor the rational mind is not up to the current task.  Kahneman and Tversky’s Prospect Theory has been telling us for some time that the rational mind does not determine how we behave; Taleb’s Black Swan tells us that the rational mind is really only useful in describing retrospectively what has caught us completely by surprise.  Our insistence on stability, he says simply creates greater instability.

Accepting that the environment has changed from classic to quantum raises an obvious question for those of us involved in the discipline of risk management; now what do we do?  I would suggest that there are several useful actions that could be taken.

We need to reexamine our definition of risk.  Prior to the last forty years risk was understood in the context of what an organization wanted to achieve.  The origin of the word, Peter Bernstein tells us in Against the Gods, comes from the Old Italian risicaré, which means, “to dare” (note that this is very different from “what negative events will occur if I do dare”).  For most of human history, managing risk has always been about understanding what needs to go right rather than what might go wrong.  Returning to this idea has some dramatic implications.

Warren Buffet put it very succinctly when he said, “Risk occurs when you don’t know what you are doing.”  Risk in the context of organizational goals moves us away from the sets of rules outlined in methodologies and into the uncertainty of the operating environment.  Here, we need to develop information about which risks must be embraced to execute the business strategy.  The first step in this process is to ensure that there is wide dissemination of that strategy throughout the organization.  While that sounds fundamental and obvious, there are many operational managers who identify with the businesses they support, but relatively few who really understand what they are actually trying to accomplish.

Once a strategy has been broadly disseminated, the legitimate authorities on whether a risk should that needs to be embraced are the operating managers themselves.  This is a departure from what we have convinced ourselves our role should be.  The new role is that of an information coordinator and facilitator who converges disparate perceptions of risk between operational groups and business functions.  In that role, we must learn and understand the multiple languages spoken throughout an organization rather than insisting that everyone learn a new one.  We need to bring the parties together and insist that everyone understand what they are getting into.

And this brings us back to how we feel.  Operational and business managers define risks based on their organizational responsibilities.  Their perception is limited to the issues in their area of expertise.  The role of the risk manager is to converge those perceptions so the entire organization understands the risks being accepted.  To have a more useful impact, we must change the definition of risk management.  Rather than position ourselves as the arbiters of what is and is not an acceptable risk we must understand that risk is experienced as a feeling rather than a rational thought.  Emotion drives commerce.  We start with an idea and we build a business driven by creative, non-linear passion; the spreadsheets come later.

It would also be helpful to make a clear distinction between compliance activities and risk management.  Obeying the law is not an exercise in the management of uncertainty.  While laws and regulations are implemented in an attempt to manage systemic risk, no individual entity or even group of entities can manage that risk.

A good analogy here is the process of getting a license to operate an automobile.  One has to pass a written test and then a road test.  Completing those tasks is an act of compliance; it gets you the right to be on the highway but has no impact on where you go and how you get there.  Risk managers are both those who develop the requirements and those charged with enforcing them.  I am not suggesting that compliance is a trivial exercise, far from it given the complexity of our economic environment.  It is a necessary activity, one that becomes eviscerated when we insist on confusing it with risk management in our organizations.

The role of risk management is tougher than our current job description.  It requires a high degree of emotional intelligence, a comfort with ambiguity and a drive to assist the organization in maintaining coherence.  The world is an uncertain place.  In considering a piece of fruit in Hyman’s Jell-O bowl we need to ask ourselves if it is more relevant to determine which direction you want to move in or attempt to determine where everything else is going to move.  Hedge funds spend millions in an attempt to do the latter but they only need a sense of where the market will shift in the next three to five seconds.  Insisting that we can do better is foolish

We live in a time similar to the days prior to Galileo when the sun was thought to revolve around the earth.  It is difficult for us to grasp today what people were thinking back then and how much their worldview was battered by the increasing awareness that they were living on a planet orbiting the sun.   I would suggest that we have been in a similar transition since Max Planck coined the term “quantum” over a hundred years ago. This new physics tell us that risk is more about understanding how you want to influence events rather than being influenced by them.  Given our penchant in this profession for cataloging real and potential calamities redefining risk has a clear benefit.  It results in a shorter list.

 

Bill Sharon is CEO of SORMS, Inc. and has been a risk management consultant for the past 15 years.  He has 25 years experience in the Financial Services and Marketing/Communications industries in a variety of “C” level positions and consultancies. The consistent thread throughout his career is a focus on streamlining operational environments in the service of the business strategy.

To subscribe or visit go to:  http://www.riskcenter.com