Can you describe the concept of Financial Darwinism and how it helps explain the current credit crisis?
The ongoing financial crisis is a culmination of profound evolutionary changes that came about during the Great Moderation. Financial Darwinism describes this transformation and then points out that financial firms en masse failed to properly respond to evolutionary pressures. The book also identifies the features of the financial landscape that exacerbated this crisis, making its scope and depth truly unprecedented. They included the lack of transparency and complexity of both financial instruments and financial institutions as well as the opaque dissemination of risks around the world due to the capital market globalization.
In addition to explaining how the stage for modern financial crises gets set up, Financial Darwinism also puts in perspective the deleveraging stage of the ongoing financial crisis. In the language of the book, everything that is going on today – government bailouts, the Fed actions with respect to monetary policy and liquidity injections, and attempts to stem foreclosures – are actions designed to break the vicious cycle of deleveraging that naturally follows the build-up in risk and leverage. Financial Darwinism helps understand how different public policy proposals fit into that paradigm.
Equipped with this evolutionary explanation, the book then proposes a practical decision-making framework that enables companies to become more dynamic with respect to how they take on risk and make business decisions.
Which institutions and CEOs have embraced the strategic imperatives required by the dynamic new regime and are likely to emerge with lasting competitive advantages?
In terms of positive examples discussed in the book, Wells Fargo and Goldman Sachs appeared to have deliberately and properly integrated risk-taking into business decisions over many years, allowing them to weather this crisis reasonably well, at least up until now.
On a different yet important note, this crisis has also revealed the limitations of some business models even for successfully managed companies, showing, for instance, that the business models of commercial banks were more stable than those of independent investment banks. The conversion of Goldman Sachs and Morgan Stanley into bank holding companies is a testament to that.
Were any of the recent financial institution failures the result of not embracing the concepts in your book?
Absolutely. I would argue that practically every one of the notable failures, in some form, was a failure to evolve and respond to pressures in ways that were viable and sustainable.
This crisis seems to claim a new victim every day. There were a number of firms that I described in the book as seemingly following the right path in the spirit of Financial Darwinism. However, what is becoming clear is that while Lehman Brothers, Wachovia, AIG, the GSEs were making the right decisions in some parts of their business, they neglected risks in other areas, ultimately paying the price
For example, as described in Financial Darwinism, Wachovia was extremely vocal about the firm’s objective to gather retail deposits and provide exceptional client service. According to its former CEO, retail deposits were the single most important focus of the institution and source of its profitability. While maximizing the earnings and outreach of Wachovia’s retail operations, however, risk management appears to have been overlooked. Some of Wachovia’s acquisitions exposed the firm to new significant risks, ultimately leading to problems.
How should financial institutions measure and manage risk in the dynamic new regime?
Sophisticated risk measurement tools and systems that can rigorously assess the risks of portfolios and balance sheets are widely available today. The challenge is to properly integrate them into strategic executive decision-making. Despite advancements in risk management, a significant disconnect between the language of strategic decisions and risk management still exists. This is one of the key limitations of static business models that must be addressed.
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