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From Innovation to Exploitation
An interesting aspect of the recent financial market chaos is how innovation plays into the facts. While arguably simply bad lending behavior was at the core of the problem, increasingly complex (i.e innovative) financial instruments such as credit default swaps played a key role as well.
What intrigues me is what some view as the cycle of innovation that produces these bad effects. I recently heard Mark Cuban say: first there's innovation, then come the imitators then come the idiots. While there are many examples of this cycle of creativity ending in disaster, few to date are of such magnitude as the current credit crisis. Oftentimes it's not bad behaviors as much as the way in which initial creativity and its success produces laziness.
One of the keys to this cycle is the constant drumbeat for better, faster, cheaper and more. Author Richard Swenson in a book titled "Hurtling Toward Oblivion" makes a compelling case for this phenomenon. First his observations: that we are subject to profusion or the phenomenon of always requiring more of everything, forcing progress. Progress, as it is achieved, whether with good or bad effect, is irreversible. Think of the economy and how it is inexorably tied to growth. Can companies meet shareholder expectations without constantly growing and expanding and making more profit? Thus, we are addicted to habitual progress, it is deeply ingrained in our thinking and expectations for most things. Exponentiality is another element that ultimately exacerbates the situation. Financially, we all understand this. We save money and we leverage the compounding effect of its growth. Similarly, weapons grow increasingly complex and lethal and now, with the nuclear weapons at the forefront of the public debate, the concept of exponentiality becomes clear. As we know all too well, there is no going back to prenuclear times now that the genie is loose. ENTER THE IDIOTS In Cuban's third element of his view of the innovation cycle, the need for more is the driver. Suffice it to say that in the imitation stage there is positive contribution to society. It is this "idiots" stage that leads to trouble. In short, this stage is where a third wave of parties enters the game. Having missed the window of opportunity to profit from imitation, they find themselves forced to cut corners, act badly, and generally exploit what they can from the original idea. So what does any of this have to do with risk? Well everything, I believe. To innovate is to embrace prudent risk for the sake of progress. To imitate is to desire to profit from the risk taken by the innovators, while taking less risk for what would then be a proven product or service. But to exploit the last stage of this cycle is to embrace a form of personal risk for personal gain that often skirts acceptability and often migrates into ruin. This is, I believe, how and why we got ourselves into this current credit crisis. The idiots emerged and took more risk than was prudent. Due to our very human nature, and the increasing complexity of the world, we are destined to learn little from our mistakes as history strongly suggests, and are doomed to repeat this cycle with increasingly more damaging results. CHRIS MANDEL is the enterprise risk manager for a leading financial institution and a former president of the Risk and Insurance Management Society. November 1, 2008 Copyright 2008© LRP Publications |
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