With the ‘08 meltdown fresh in mind, are we any better at assessing risk?

Have we fixed the problem? Is the risk of a financial system failure lower now than it was before the 2008 meltdown?

One of the things that distinguishes human beings from, say, fruit flies or even most animals is the awareness of risk. Most life forms seem to recognize danger and harm, but the perception of risk involves another level of abstraction.

In the chain of human development, our awareness of risk was eventually followed by our ability to calculate its probability. Isn’t evolution wonderful? Thousands of years of human development and what we get out of it is a math problem.

Actually, humans and their faithful computer companions have the math of probabilities pretty much nailed down these days. The problem is in figuring out what the important variables are and defining them in such a way that math’s power can be applied. Economics isn’t the only place where this problem comes up, but it certainly provides some ready examples.

The near-collapse of the financial system in 2008, for example, could not have happened if investors had not chosen to ignore the risk probabilities of lending large sums of money to people who could not pay it back, unless they found someone who would pay more for their house than they did. It was a Wall Street dream: the marriage of the “greater fool” theory into the illustrious Ponzi scheme family.

Without the mass psychology of risk-denial, the lo-doc, no-doc, and zero-down-payment mortgages would never have come to dominate the mortgage market. Some lenders and some investors might have been willing to make and underwrite these loans, but only at interest rates that accurately reflected the risk.

The other important risk factor, systemic risk, was different: It was not ignored; it was invisible. Both regulators and financial institutions were blissfully unaware of the systemic risk that the real estate bubble posed for our banking and financial system. When one large financial institution collapsed, as Lehman Brothers did, it could bring down others with it.

Perhaps on some psychological level the federal regulators and the markets themselves lacked awareness because they did not want to think about it. Maybe the symbolic sculpture of the bull that stands in front of the New York Stock Exchange is missing something. It should be fitted with three riders, bronze replicas of Mizaru, Mikazaru and Mazaru, the three monkeys who hear no evil, see no evil and speak no evil.

In the world of finance and economics, risk is an ever-present but elusive concept. In the private sector, business world, for example, there is a strong tendency to underestimate risk. This probably has its origins in the belief of most CEOs and entrepreneurs that they achieved success by ignoring the risks. It is the corporate version of Admiral Farragut’s “Damn the torpedoes. Full speed ahead.”

That attitude has carried over into today’s corporate boardrooms and decision-making processes in ways that muffle concerns over risk and keep risk assessment officers distanced from any real influence on strategic decisions.

Thomas J. Curry, the Comptroller of the Currency, made note of these tendencies in the large, complex banking corporations that present regulators and the U.S. economy with its most worrisome and most challenging risks. In a recent speech to the American Banking Association’s Risk Management Forum he said that in the past, operational issues such as risk management, “…were not viewed as core functions of the banking business.”

Just as banking has become more complex, risk management has become equally complicated. In the olden days before the crash pulled back the curtain and revealed the reality of our financial system, banks could keep themselves out of trouble by managing credit risk. Banks today, though, especially the large ones, also have to consider their exposure to systemic, third-party, cybersecurity and internal control risks — any of which has the power to destroy the institution.

The response of Congress to the risk problem has been to order up thousands of pages of new regulations. The Comptroller of the Currency’s approach to the problem focuses on the big banks’ awareness of risk and how they manage it. The Federal Reserve, one of the other organizations regulating banks, has thus far concentrated on banks’ capital adequacy as the primary defense against risk, although it is now raising liquidity standards as well. The adequacy of these balance sheet elements as risk defense, however, is more complex than it seems at first, and we are still on a long-distance learning curve regarding this issue.

Have we fixed the problem with our regulations and our balance sheet requirements? Is our financial system less fragile than before the 2008 near-collapse? Maybe; just a little. But the risks aren’t standing still, either.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.

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