Do you know any one whom you consider to be a lackadaisical person? Someone who can’t seem to hold a secure job, even in the best of economic times?
If that person decides to march down to his local community bank tomorrow to apply for a small business start-up loan, he will likely be rejected. “No collateral,” the banker might declare, “no credit history, and no experience in a business setting.” Unless a far more responsible family member agrees to co-sign the loan document and guarantee repayment, our friend would not have a chance.
And yet, as recently as two years ago, he would have been able to finance his start-up venture anyway by using a stack of zero-percent “teaser rate” credit card loans. And his credit card companies would have sliced and diced his debt balances into thousands of investment vehicles, which would then have been graded “AAA” by the major ratings agencies. Conservative investors would have purchased his loan balances for their pension and retirement accounts. Frankly, the president of the community bank himself – the very same person who would have rejected the lackadaisical person’s loan application outright – might have purchased bits and pieces of the credit card loans and placed them in his retirement portfolio to secure his family’s future.
It defies common sense for the president of a community bank to reject a person’s loan application because he knows him well, and yet to purchase his loan balances afterwards because a ratings agency (that doesn’t know the borrower at all) bestows a AAA rating on them. And yet this is how we, as a society of supposedly rational investors, have been structuring our financial investment strategies.
Irrational, aren’t we? Perhaps we act this way because we aren’t creatures of logical analysis at all; perhaps, instead, we are actually behaviorally disinclined to trust in our own common sense.
Your Lying Eyes
The legendary stand-up comic Richard Pryor once drew howls of laughter by telling a story about a man who cheated on his wife in his own bedroom. When caught by his wife “in the act,” how did he react? By denying the obvious … or, as Pryor would exclaim, “Who you gonna believe? Me, or your lying eyes?”
To the frustration of marriage counselors everywhere, too many women choose to ignore their own senses and believe the denials of their cheating spouses. And yet this is not uncommon behavior; a willful disregard of common sense permeates other areas of society as well. For instance, if you ask any physician what people can most easily do to prevent the transmission of serious illnesses, most will respond that the most effective weapon against common disease is the simple washing of one’s hands. Yet, even in public bathrooms, large numbers of users resolutely refuse to do so.
The credit crunch has often been described as a financial virus. By extending the metaphor, we can conclude that financial risk managers were assigned the task of isolating this virus and preventing it from poisoning the global economy. Why did they fail to do so? Considering all of the resources, levels of experience, and educational credentials that existed (and that still exists) on Wall Street, why weren’t they able to maintain the health of their patient?
In Search of the Magic Elixir
To understand our positions regarding these questions, it is important to remember that it is simply human nature to make the assumption that a catastrophe (as well as the solution that might have prevented it) must have been terribly complex if it was not in fact prevented. Ask ten people who have contracted the flu why they fell ill, and they are bound to respond with a comment like “I heard that the new Asian flu strain is particularly resistant to the human body’s natural defenses this year.” You’ll hardly ever hear them admit “I guess I should have washed my hands after touching the flush lever in the train station’s restroom.”
Similar attitudes permeate our federal government’s crisis control activities regarding the global banking quagmire. Although a few voices have complained that it defies common sense to continue entrusting hundreds of billions of dollars to the very financial professionals who have driven our economy off a cliff, others continue to assert that our magic elixir is an extremely complex three-sided Treasury / Federal Reserve / FDIC Purchase Facility that will provide funding to purchase real estate-related legacy assets. These experts believe that such costly and complicated plans will do more to help the average unemployed American than simple, traditional solutions such as the expansion of unemployment insurance, vocational training services, public health care programs, and other components of our social safety net.
At a series of online graduate and post-graduate level seminars co-sponsored by Suffolk University and the Maryland Association of CPAs, expert after expert from the financial services industry emphasized common sense solutions to what ails our economy. And yet, in an anonymous feedback survey, one attendee complained that “The guest speakers provide little in terms of unique perspectives or unique situations related to risk management. The content is predominantly ”common sense” approaches to risk management – e.g. the guest speaker talking about diversifying investments is not a useful or productive exercise for a capstone course.”
Hmm. Common sense, according to the attendee, is not a useful or productive exercise for a capstone seminar in risk management. But how can any useful or productive discussion of risk management be otherwise conducted when all of the guest speakers assert that our failure to apply common sense is the common denominator that explains the failings of our global economic system?
COSO: A Similar Criticism
In all fairness to this anonymous attendee, he is certainly not the only educated professional who criticizes certain risk managers who espouse the application of simple common sense. The Enterprise Risk Management model that has been developed by a COSO, a consortium of every national professional accounting trade association in the United States, has been similarly criticized for being long on common sense generalities and short on complex specifics.
Nevertheless, professionals who are struggling to adapt to the volatile global business environment do need to select and apply a risk management model that can address the financial challenges that are plaguing our global economy. What model should they use?
We at Enterprise Man may not have all the answers; who among us does? Nevertheless, we do believe wholeheartedly in the “common sense” COSO model. We also cast our lot with such legendary investment professionals as David Swensen of Yale and John Bogle of Vanguard, who are renowned for advocating the simple solution of investment diversification to address the twin problems of industry and firm risk. In other words, we cast our vote with the risk management professionals who avoid overly complex decision models and opt instead to build their programs on sturdy foundations of common sense.