Thursday, May 15, 2008

When tackling risk it’s good to talk

(FT - Gillian Tett) Imagine for a moment that you are a banker, who stumbles across a juicy new instrument called the “lemming” product that your sales team could sell to retail clients for a fat profit.

This product, however, looks risky even though it has been rubber-stamped by your compliance department, since investors will suffer big losses if stock markets fall more than 30 per cent.

Would you go ahead, and approve the sale of lemmings – even if investors did not understand the risk? Or would you dig in your heels and insist that the lemming structure was reviewed, or carried a high-profile health warning?

On Thursday, exactly this question was posed to the sombre-suited participants of a conference organised by London’s venerable Securities and Investments Institute. And in some senses the results were cheering: over 70 per cent of the audience voted to block the lemming deal in an anonymous poll, taken after the participants had discussed the issue with neighbours.

But then the organisers presented a chart which highlighted a more sobering point: when the SII has done these tests before, it has typically found that the proportion of bankers who block risky trades falls dramatically when participants do not discuss the issue with their neighbour first – even if they vote anonymously.

When it comes to taking the moral high ground – at least in relation to the sale of lemmings – the critical issue is whether bankers are forced to talk to their neighbours, or not, or so the SII concludes.

So far, so unsurprising, you might say (although I cannot help wondering about the 30 per cent of the audience who still wanted to do the lemming deal in some shape or form).

But the poll findings carry much wider implications. These days, it is a truism to point out that one reason for the decade’s financial excesses is a flawed set of incentive and management structures inside banks. A veritable army of management consultants is already offering reams of complex advice on how to fix these flaws.

But as the SII debate shows, there is one simple step that might help improve matters inside the financial world: bankers should be forced to talk about their business with a wide pool of colleagues, including those outside their immediate silo, rather than just their bosses alone.

Some banks, of course, already claim to do just that. Institutions such as Goldman Sachs, for example, try to ensure that different business silos have ways of watching what each other does. They also invest heavily in creating a holistic risk management culture: Goldman Sachs’ risk systems, for example, are run by Gerry Corrigan, the former New York Federal Reserve president, who makes a virtue out of sticking his nose into as many dark corners as possible and trying to encourage firm-wide debate.

But, at many other banks, the corporate culture this decade has seemed akin to warring Afghan tribes: silos typically exist in fierce competition and only interact at the very top of the organisation. Thus, oversight tends to occur in a vertical sense, down the hierarchy, rather than across a wider group, and bankers would sooner die rather than talk about their doubtful deals with other groups.

So if I was a senior bank executive wondering how to force bankers to become reacquainted with their consciences, or at least demonstrate to shareholders that I cared about the issue, here are some suggestions for the “to do” list. First, banks should get their employees to take the SII “lemming” test, or versions of it, both with and without audience debate beforehand; second, they should organise a wider discussion of these results across the bank.

But, third, they should take a leaf out of the book of other organisations, such as the British army, and find ways to ensure that specialist silos can interact with each other at all levels of the bank, to ensure some mutual oversight, rather than just at the top. After all, it is not just sunlight which can be a good disinfectant; so too can common sense and talk – particularly given the real-life lemming-like deals that have proliferated in recent years.

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