…different and potentially much more difficult issues arise in the identification and measurement of risks where past experience is an uncertain or potentially misleading guide. When risk materialises, it may do so as a risk previously thought to be understood and managed that turns out to be very different indeed, and may do so quickly, well within normal audit cycles. The valuation of an asset or liability in a stressed market environment and the identification of other potential risks that may not previously have been encountered pose major questions for real-time assessment that are unlikely to have been factored into construction of the pre-existing business model.
Excerpt from the Walker Review
To survive such situations, it seems that the ability to quickly assess new situations, especially ones that look like old tried and true but that are seriously more dangerous, and to change what the organization is doing in response to these risks is key.
But to do that, significant amounts of senior resources must be dedicated to determining whether such risks are NOW in the environment each and every day. The findings of this review must be taken very seriously and the organization must consider the possibility of changing course – not just a minor correction – a major change of business activity.
In addition to the discernment to identify such situations, the organization must cultivate the capacity to make such changes quickly and effectively.
An organization that can do those things have true adaptability and have a much better chance of survival.
However, for a business to be very profitable, it needs to be very focused, very efficient. Everyone in the organization needs to be pointed in the same direction. Doubt will undermine.
Within capitalism, the conflict is resolved by allowing individual businesses to maximize profits and relying on an assumption that there will be enough diversity of businesses that enough businesses will have chosen the right business model for the new environment. Some of the most successful businesses from the old environment will fail to adapt, but some of the laggards will now thrive.
And therefore, the system survives.
But, that is not always so. In some circumstances, too many firms choose the exact same strategy. If the environment stays unchanging for too long, individual firms lose any adaptability that they might have had, they all become specialists in that one “most profitable thing”. A major change in the environment and too many businesses fail too fast.
How does that happen?
Regulators play a large role. The central bankers work very hard to keep the environment on a steady course, moderating the bumps that encourage diversity.
Prudential and risk management regulation also play a large role, forcing everyone to pay attention to the exact same risks and encouraging similar risk treatments through capital regime incentives.
So for the system to remain healthy, it needs adaptability and adaptability comes from diversity. And diversity will not exist unless the environment is more variable. There needs to be diversity in terms of both business strategy and interms of risk management approaches.
So improving the prudential regulation will have the effect of driving everyone to have the same risk management – it will have the perverse effect of diminishing the likelihood of survival of the system.