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Regulators Talk Risk-Based Compensation

In The Risk Paradox on January 18, 2010 by Jim McCormick Tagged: , , , , , , ,

 Think for a moment about this recent statement by the Chairperson of the U.S. Federal Deposit Insurance Corporation, Sheila Bair:

“A broad consensus of academic studies agrees that poorly designed compensation structures can misalign incentives and induce risk-taking.”

There are two observations this brings to mind.  The first is that this conclusion seems profoundly obvious.  As any accomplished manager will tell you on the subject of incentive compensation, you get what you incentivize – which is why incentive compensation plans need to be designed very thoughtfully and are often modified.  That is straight forward.  It seems odd that it took a number of academic studies to establish this fairly obvious conclusion.

The second observation is that risk-taking is presented in this statement as a negative outcome.  One more time with fervor; risk-taking is not the problem. Poor risk-taking is the problem.

In the midst of many well-intentioned efforts to reduce the chances of future turmoil in the U.S. financial system, we need to keep foremost in our mind that risk-taking is core of our economic system.  We need to be very cautious in trying to regulate the risk instinct.  It has served us all well much more often than it has worked against us.

Most of all, we need to always differentiate between intelligent risk-taking and excessive, ill-considered or poorly executed risk-taking.  We need to allow the former to thrive or we will all pay the price

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Risking Intelligently by Reducing Risk

In The Risk Paradox on January 4, 2010 by Jim McCormick Tagged: , , , ,

The whole concept of intelligent risk-taking is to make risk work to your benefit.  There are two sides to that equation.  One is to reduce risk when possible.  The other is to exploit risk when appropriate.  Due to our socialization, we tend to be more comfortable reducing risk. 

A news story just came out on Human Resource Executive Online that illustrates risking intelligently by reducing risks.  It focuses on companies re-hiring former employees as they increase their staffing.  The story reports that nine out of ten companies are open to rehiring former employees and that 18 percent of laid-off workers are rehired by their former employers.

This is an excellent strategy for reducing risk.  In my most recent book Business Lessons from the Edge (McGraw-Hill 2009), we emphasize the criticality of hiring decisions and the imperative that short cuts not be taken in the hiring process.  The brilliance of selectively rehiring former employees is that you know exactly what you’re getting.  They have functioned in the culture and clearly illustrated their talents and limitations.  A great deal of the risk that is inherent in the hiring process is eliminated.

One of the athlete/executives who contributed to Business Lessons from the Edge is employee engagement expert and HR Solutions CEO Kevin Sheridan.  Among other things, HR Solutions helps companies improve employee engagement.  What is one of the biggest problems they find in their client organizations?  Negative impacts on employee engagement due to poor hiring decisions.  Hence the value of selectively rehiring past employees – fewer hiring mistakes.

The referenced story on Human Resource Executive Online by Melvin Scales can be found at:  http://www.hreonline.com/HRE/story.jsp?storyId=312960252

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Intelligent Risk-Taking Illustrated – Warren Buffett’s Moves During the Financial Crisis

In The Risk Paradox on December 18, 2009 by Jim McCormick Tagged: , , , ,

What do Lehman Brothers, Morgan Stanley, Bear Sterns, AIG, Wachovia and Freddie Mac all have in common?  If you said they are all (or were) in the financial services industry, you would be right.  If you said they all struggled or went out of business during the recent U.S. financial crisis, you would also be correct.  But what you may not have known is that during the last few years, they all offered investor Warren Buffett opportunities to make significant equity or debt investments that he declined. 

What’s the insight here?  As a very successful investor who has been in the market for over sixty years, Berkshire Hathaway CEO Warren Buffett is clearly in a league of his own when it comes to picking winners and avoiding losers.  Is he always right?  Of course not.  Is he right more often than not?  Yes. 

According to a December 12, 2009 Wall Street Journal article, when approached by all these companies, Buffett personally reviewed their financial information.  Why is this important?  It is a classic example of intelligent risk-taking.  He did his research and drew on insights gained from past experiences. 

You might say that declining every opportunity is easy and you would be right.  But that is not what Buffett did.  During the same time period, he took advantage of opportunities he was presented to invest in or purchase Burlington Northern Santa Fe Corporation, Goldman Sachs and General Electric. 

So how does this illustrate intelligent risk-taking?  In two ways.  First, Buffett did significant research so he knew what he was considering.  Second, he drew on past experience and hard earned insights.  An example was his review of mortgage giant Freddie Mac.  He quickly concluded that their problems where too severe.  “I said no fast on that one,” was his comment on that opportunity. 

You might be thinking that anyone with money to invest during the last few years could have done well with so many companies undervalued due to the global downturn.  However, that is not the case.  TPG made a disastrous $1.35 billion investment in Washington Mutual Inc. and investors in Abu Dhabi invested billions of dollars Citigroup before their share price plummeted.

Was every decision Buffett made during the financial crisis correct.  No.  But be being thoughtful and methodical, he appears to have risked intelligently. 

Some blame risk-taking for the recent economic downturn.  To them I would say there is risk-taking and intelligent risk-taking.  The former gives the later an undeserved bad name.

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The Risk Overhang – Which Can Lead to the Risk Hangover

In The Risk Paradox on November 20, 2009 by Jim McCormick Tagged: ,

As discussed in the last post, corporate, organizational and personal risk profiles are dynamic and situational.  Dynamic in that they change often.  By the nature of organizations having a more gradual decision-making process than individuals, their risk profile change less often.  Individuals, on the other hand, may change their risk-profile much more often based on successes, set-backs, access to capital, financial security – or lack of it – and countless other variables.

 A Reuters article today on the British banking system makes the comment that there is a “tendency for banks to become overly risk-seeking in an upswing and risk-averse in a downswing.” 

 This is accurate and affirms both that risk-inclination is situational and organizational decision-making is often gradual.  Call it the risk overhang, which can lead to the risk hangover.  It is a function of excess.  Excessive risk-inclination during the upswings.  Excessive risk-aversion during the downswings.  A risk posture that is no longer in alignment with the business and economic environment.  It overhangs the change in conditions.

 It is all a matter of balance – or lack of it.  A successful risk posture always is.

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House Panel Debates Systemic-Risk Measure

In The Risk Paradox on November 9, 2009 by Jim McCormick Tagged: , , , ,

So read the headline in the November 5 Wall Street Journal.  The House Financial Services Committee is trying to divine a way to prevent future failures of large financial institutions while not hobbling them to the point of being ineffective. 

I think we would all agree that finding that balance point is a daunting challenge.  Why?  Intelligent risk-taking is conditional.  Whether it is a large financial institution, a small business or an individual, the appropriate risk posture at any given time is always changing.  It is influenced by numerous factors including availability of capital and talent.  The risk characteristics of existing organizational or personal commitments are also a factor.  Market conditions and the competitive environment should and do influence risk posture.  This is just the beginning of the factors that shape an appropriate risk posture. 

With in being so changeable, legislating an appropriate risk threshold is exceedingly difficult.  There is no way that all permutations of conditions can be addressed or even anticipated.  And we haven’t even gotten to the innate discomfort with risk that may be present in some of the legislators and could profoundly influence their approach to regulating risk. 

Risk is powerful and can be frightening.  But we have to find a way to live with it and utilize it or we all will suffer by its suppression.

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So, What’s the Paradox?

In The Risk Paradox on November 2, 2009 by Jim McCormick Tagged: , ,

Now that we have a more expansive – and accurate – definition of risk, let’s take a look at the other side of the equation: the paradox.  What is a paradox?  Let’s go back to the Merriam-Webster Online Dictionary and see what they have to offer us – slightly paraphrased: 

paradox

1: a tenet contrary to perceived opinion

2: a statement that is seemingly contradictory or opposed to common sense and yet is perhaps true

3: a situation or action having seemingly contradictory qualities

I didn’t have much use for the Merriam-Webster definition of risk, but they a home run with their definition of paradox.  “A situation or action having seemingly contradictory qualities” really nails it.  The risk paradox is all about the desire for safety and certainty provided by avoiding risk, yet the knowledge that we need to risk in order to meet goals, make the sale, expand revenues, grow your talents or start a new relationship – to provide just a few examples.  “Contradictory qualities” is exactly right – both uncertain and even threatening, yet necessary.

I can’t go on without a quick comment on the concept presented in the first definition: “a tenet contrary to perceived opinion.”  As mentioned before, a core element of the risk paradox is the need to take actions that may conflict with the norm – at least the norm for many.  I guess the real question here is whose norm will be yours – the achievers’ or the non-achievers’?

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How About this for a Definition of Risk?

In The Risk Paradox on October 29, 2009 by Jim McCormick Tagged: ,

Risk touches all aspects of our professional and personal lives.  At its core, business is about managing risk.  It is about risking time and resources in search of a positive return.  A company that stops risking will soon no longer exist. 

Achievement is about managing risk.  A risk-free existence does not exist.  Trying to create one will just result in frustration and suppressed performance. 

So, what is a good definition for risk?  One that captures both the positive and negative implications of taking risks?

How about this:

Risk – Any action with an uncertain outcome.

Simple and straight forward.  The clear implication is that nearly any action has some degree of risk.  Exactly.

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Common Definitions of Risk

In The Risk Paradox on October 28, 2009 by Jim McCormick Tagged: , ,

Since this blog is about risk, let’s start by looking at common definitions of risk.  The definition of risk from the Merriam-Webster Online Dictionary is most insightful: 

risk

1: possibility of loss or injury

2: someone or something that creates or suggests a hazard

3 a: the chance of loss or the perils to the subject matter of an insurance contract; also: the degree of probability of such loss b: a person or thing that is a specified hazard to an insurer c: an insurance hazard from a specified cause or source

4: the chance that an investment (as a stock or commodity) will lose value

 Is it any wonder that many of us have a conflicted relationship with risk and risk-taking?  Look at these definitions.  They are uniformly negative.  Stunning.  The thought that a risk could have a positive outcome is entirely absent. 

Couldn’t the first definition read:  possibility of loss, injury, success or accomplishment and indeed be accurate? 

Wouldn’t the fourth definition be more accurate if it read:  the chance that an investment (as a stock or commodity) will lose or gain value?  Certainly an investor, entrepreneur or company does not put capital at risk unless there is a reasonable chance of an increase in value.

 This definition illustrates the common societal bias against taking risks – even thoughtful, intelligent ones.

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The Risk Paradox

In The Risk Paradox on October 19, 2009 by Jim McCormick Tagged: ,

Let’s be honest here.  Given a choice, most of us would rather keep risk at a distance.  The whole idea of taking risks, of most any type, is disconcerting.  Risk connotes uncertainty and danger.  The problem is that we also know that without some risk in our careers, business plans or personal lives, we severely limit what we can achieve.  This is the risk paradox – we would rather avoid it but we know we need it.

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