Gamblers in Disguise

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In this article, Prof. Yedidia Z. Stern examines the ongoing financial crisis, and tries to explain how such a rational industry gets carried away with reckless decision-making procedures. Here he uncovers a contradiction: the same people perceived to be rational and calculating acted systematically and persistently in a dangerous manner that eventually led to the collective suicide of some of the most established financial institutions on the planet.

Insurance and banking are two industries that rely on the calculation of probability and risk, based on mathematics and economics. Bankers and insurance providers are commonly characterized as "conservative" and "rational" and are perceived as square, meticulous, careful and composed. They are supposedly boringly circumspect.

The ongoing financial crisis, however, has confronted us with a very different reality: the people most engaged in calculation – whom we entrusted with the responsibility of managing every aspect of our lives, from retirement to natural disasters – acted systematically and persistently in a dangerous manner that eventually led to the collective suicide of some of the most established financial institutions on the planet. Just like Superman, these people disguised themselves as preppy nerds, armed with laws, accounting formulas and columns. But in their board meetings, unobserved, they adorned their capes of adventure and took a path of daring speculation, risking billions of others people's dollars, succeeding at first, but eventually failing.

How can we explain this phenomenon? How did a rational industry get carried away with such reckless decision-making procedures? One of the answers lies in the management of today's corporate capitalism, which encourages excessively risky economic policy. The decision-making process has been perverted at all levels – from the shareholders to the managing echelon:

In the corporate world, it is commonly assumed that a business corporation's principle objective is to maximize the shareholders' profit. Everyone else involved in the corporation's activity – such as employees and creditors – are nothing but instruments of production assembled to allow the shareholders to realize their yields and returns. This attitude can be disastrous: typical shareholders are very fond of risk because they tend to invest in diverse portfolios and because their personal liability for corporate acts is limited. If the risky activity of the corporation pays off – the shareholders make a profit; if it fails – their own personal responsibility is limited to the amount that they invested in the company. That is why shareholders tend to demand extremely risky courses of action.

One might expect that the high level executives would act as a balancing factor: failure of the corporation, resulting from the risky course of action, may cause their dismissal (as has indeed been the case). It is their own interest to push the corporation to act in a risk averse manner.  In order to prevent this from happening, shareholders work tirelessly to convert the executives to join their own community of risk-lovers. Firstly, they are given stock options, thus, increasing their own personal interest in taking high risks. Secondly, executives are rewarded with unreal bonuses when their companies succeed, which they are not obligated to return if and when the corporation fails. If executives' salaries were dependant upon success and failure, their main concern would be to retain their posts, and they would consequently be true risk haters. The current system, which encourages risk taking by directly rewarding executives when the outcome is successful, but does not hold them financially accountable in the event of failure, has transformed boardrooms into gambling parlors.

The problem is even worse in the case of financial corporations. Financial markets are extremely competitive and the pressure to take risks plays a more dominant role. Financial corporations trade in abstract, theoretical commodities of a dynamic nature and, therefore, there is room for a wide range of high risk activity. The conclusion is obvious: the rewards offered to corporate high echelon have created a market failure. If we refrain from changing the system, we may wake up to find our savings rolling atop casino tables instead of deposited in a secure vault. Banks and insurance companies are the safeguard of human uncertainty. They are supposed to be boring.