Mismanaged Risk or Ignored Risk?

Richard Thaler opines in last Sunday's NY Times that the mismanagement of risk by Wall Street investment banks and the mismanagement of risk by oil and other extractive industries derive from similar problems:

AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isn’t fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.

I remember thinking as I read it that it seemed a remarkably naive and kind assessment of "top management" who are presumably paid big bucks to understand and manage risk, to understand and manage complex technology and to manage tricky relationships between companies. And it ignores that regulators' powers were often either eviscerated or nonexistent particularly since the 1980's in finance and more recently in environmental matters, particularly those related to energy.

James Kwak at Baseline Scenario weighs in with what I think is a better description of what the real common problems are.

The problem isn’t that people have cognitive biases in assessing unlikely events. When you’re dealing with a big company like Citigroup or BP, you have many people applying lots of clever thinking to these problems. The problem is that there is a systematic bias within these companies against certain assessments and in favor of others. That is, the guy who shouts, “Danger! Danger!” will be ignored (or fired), and the guy who says, “Everything’s fine, the model says disaster can only happen once every hundred million years” will get the promotion — because the people in charge make more money listening to the latter guy. This is why banks don’t accidentally hold too much capital. It’s why oil companies don’t accidentally take too many safety precautions. The mistakes only go one way. You have executives assessing complex situations they don’t even begin to grasp and making the decisions that maximize their corporate and personal profits. (Is BP’s CEO going to give back years of bonuses now?)

Perhaps most importantly, it appears that, as with tobacco companies and smoking risks in the past, these corporations have fairly accurate information on risks associated with what they are doing:

In a recent Fresh Air interview, Abrahm Lustgarten discussed three internal BP memos, written in 2001, 2004, and 2007, each of which warned that the company’s culture of inattention to safety — “a consistent emphasis of profits over production over safety and maintenance and environmental compliance,” in Lustgarten’s words — was creating a high degree of risk. The problem wasn’t cognitive fallacies; it was that BP employees were almost certainly falsifying internal inspection reports because of pressure to let production go forward.

This isn’t inability to quantify the likelihood of unlikely events; this is willfully looking the other way.

Kwak goes on to describe current unregulated (EPA under Bush-Cheney) risks associated with chemicals, including benzene (a highly carcinogenic aromatic hydrocarbon), used to extract natural gas by companies like Halliburton. He then picks up on what I think is crucial to informed public discourse. Bad corporate behavior has hidden behind ideas associated with "free market economics" for many years. The Thaler article suggests that uncritically applied ideas from behavioral economics can and will also be used to provide a free pass to corporate mismanagement and malfeasance. Here's Kwak again:

This is what happens when you have a weak regulatory agency crippled by pressure from above (and political appointees who are opposed to regulation) and a private sector that simply does whatever it pleases in pursuit of profits. It’s not individual irrationality; it’s power, pure and simple. Free market economics has already whitewashed enough egregious corporate behavior. Let’s not repeat that mistake with behavioral economics.

No. Let's not repeat that mistake. And let's remember that corporate power, pure and simple, is not a characteristic of a competitive market nor is it likely to serve the public interest no matter how "free" the market.

Comments

[Morgan]

BP may be another matter, but what is the evidence that the investment banks mismanaged risk?

Objectively, they went from record profitability for an extended period of time to solid profitability despite the recession, without making deep cuts to staffing or other major cost-cutting changes.

From my perspective it looks like the big investment banks managed their risks quite well. They had a very rich insurance policy that covered even massive losses.