Gradually over time, however, financial institutions began to get paid progressively less for doing simple tasks — commercial banking, insurance, investment banking, brokerage, etc. In the spirit of natural selection, many financial firms failed to properly respond to these profound changes in the competitive landscape. By maintaining static behavior, these firms descended into “red oceans” of bloody commoditization and intense competition, subsequently leveraging up and taking on more risk to maintain the same level of profitability.
On the other end of the spectrum were more positive responses to pressures. Successful companies adopted much more dynamic ways of decision making and risk management.
In general, dynamic behavior advocated by Financial Darwinism involves visionary transformations of organizations that develop new avenues of delivering returns while properly and actively managing risk.
What role did the Great Moderation play in the transformation between these two regimes?
The Great Moderation denotes the time period between the mid 1980s and today where the volatility of GDP, inflation, and interest rates declined. During this time, the pressures on financial institutions intensified.
Thus, in the context of Financial Darwinism, the Great Moderation is not simply a description of the macroeconomic environment. It is an evolutionary catalyst that diminished the viability of static, routine-based financial businesses.
In terms of its potency, the Great Moderation was as profound of an evolutionary catalyst as the Great Depression and the Great Inflation of the 1970s, leading to the massive extinction of unprepared financial species. Interestingly, up until the 2007-2008 financial crisis, the Great Moderation was a long evolutionary change characterized by tranquility and record profits. All of this has obscured how stressed the economics of traditional financial service businesses has become.
What are the main challenges faced by financial institutions in the dynamic new regime? What gives rise to competitive advantages at the individual firm level?
First and foremost, the greatest challenge facing financial institutions is to develop the executive level strategic vision reflective of this radically new world. What is the value proposition for a firm in this new environment? Is it to leverage economies of scale in low-margin, commoditized businesses (think of companies like JP Morgan Chase and Bank of America)? Or is to create shareholder value through sophisticated risk-taking and risk management, which is the path of Goldman Sachs and Wells Fargo appeared to be on in the years preceding this crisis.
In terms of differentiating success and failure, I truly believe that it is the strategic vision of executives that has been and will continue to be one of the most critical factors. Helping executives crystallize a strategic vision that properly integrates business and risk activities in a formal and practical way is what Financial Darwinism does.
In addition to strategic vision, what is a must in this day and age is what the Nobel Prize winner Edmund Phelps who wrote the Foreword to Financial Darwinism calls “systemic knowledge” of financial executives. Systemic knowledge – that includes business acumen and intuition as well as the broad perspective on the macroeconomic, business and market environment – enables financial executives to identify desirable investments, projects, and risks that their firms should take on.
Executives of financial firms that suffered losses and ruin often lacked both the strategic vision and necessary systemic knowledge.
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