Thu, February 12, 2009
Sci-Tech > Science > Happy Birthday Charles Darwin

Survival of the (financially) fittest

2009-02-12 08:09:04 GMT2009-02-12 16:09:04 (Beijing Time)  Forbes

Evolutionary pressures and economic fate.

Having narrowly escaped total collapse, the global financial system remains on life support. The world's largest economies are in a deep recession. Bear Stearns, Lehman Brothers, Merrill Lynch and Wachovia have all ceased to exist. Fannie Mae and Freddie Mac have been nationalized. The need for government bailouts of previously high-flying firms seems endless. Worse yet, unprecedented monetary accommodation and fiscal stimulus programs are still struggling to break the vicious cycle that engulfs real economies and capital markets.

What does any of this have to do with Charles Darwin?

The sheer magnitude of these developments suggests that what we are confronting is not merely a burst of a recurring bubble. Rather, it is the culmination of profound evolutionary changes that went largely unnoticed until it was too late.

Over the past quarter century, huge pools of unregulated capital started to freely roam about the world in search for investment returns. Capital markets and financial institutions became embedded in the lives of consumers and real economies like never before. Advances in technology, securitization and derivatives allowed precise dimensions of risk to be isolated, sliced and diced, and disseminated around the world. Financial markets became more efficient and interconnected, while financial instruments and institutions became more intricate and opaque.

The increased complexity, uncertainty and risk surrounding modern capital markets and financial institutions--previously obscured by economic tranquility, lack of transparency and record profits--finally became undeniable.

Yet the discourse on the current financial turmoil has remained overly sensationalist and superficial. We read about faulty risk management, black swans, greed, regulatory complacency and how the Federal Reserve floods the U.S. economy with cash. While all of these factors have played a role, an important evolutionary angle is missing altogether.

In fact, by the time loose monetary policy and lack of supervision made leverage seemingly irresistible, margins and fees of financial institutions had been under severe pressure for decades due to globalization and a multitude of other potent forces.

The low return environment was translating into an equally challenging landscape for asset managers and hedge funds. Steady global economic expansion resulted in lower compensation for taking risk, while global imbalances kept investment dollars flowing into the U.S., adding fuel to the fire.

When faced with compressed earnings and returns--and out of perceived necessity--financial firms turned to leverage and risk-taking en masse. From this perspective, their subsequent astronomic losses or ruin can be viewed as Darwinian failures to adapt to the changed landscape.

Across the financial industry and around the world, these unfortunate firms had a lot in common. Their executives lacked an understanding of the new financial regime. These institutions clung to outdated business models, descending into the "bloody red oceans" of commoditized businesses. These firms myopically focused on growing book values and accounting earnings, with risk management remaining disconnected from strategic decisions.

Importantly, their inevitably disastrous endings came as a complete surprise to stakeholders, analysts, regulators--and in many cases to executives and boards of directors themselves--because accounting earnings, standard financial disclosures and credit ratings failed to illuminate the increase in risk.

In all fairness, however, these victims of evolution should be distinguished from firms where improper incentives and greed were in fact the main contributors to problems. Some financial institutions and investors did understand the increase in leverage and asset bubbles in the making but continued to play a proverbial game of musical chairs. When our competitors are printing money, they argued, persuading stakeholders to accept lower returns by taking less risk is a losing proposition.

Financial institutions should use current events as an opportunity to adapt and position themselves for sustainable value creation; recent actions by Goldman Sachs, Morgan Stanley, Wells Fargo and Blackstone serve as the first tentative examples of such evolution.

Change, of course, is not an easy feat. New strategic vision--that integrates business strategy, corporate finance, investments and risk management--will need to be developed. Business models and executive decisions will have to become less routine and more dynamic. Economic and accounting realities will have to be balanced. Risk management will have to become the framework for strategic decisions. Multi-year "change management" programs will have to be abandoned in favor of solutions that implement strategies quickly and with minimal operational risk.

On the system-wide level, the tasks are no less monumental. Loan origination fraud and abuses of the shadow financial system should be addressed. Protectionism and overregulation should be resisted, and proper attention should be devoted to the creation and enforcement of risk-based transparency--that is, clear and simple disclosures of how financial firms generate earnings and which risks they assume in the process. This would greatly empower both regulators and capital markets and serve as an early warning system for future systemic crises.

While accounts of the plights of once-venerable executives and institutions are entertaining, most of them underestimate the role of financial natural selection in recent dramatic events. Unless the debate on the evolutionary origins and drivers of this crisis adequately broadens, suboptimal policy and strategic decisions are likely to follow.

Equally unfortunately, market participants may fail to learn the most important Darwinian lesson of this crisis of all, courtesy of business consultant W. Edward Deming: "It is not necessary to change. Survival is not mandatory."

(Leo M. Tilman,

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