By
Professor Michael Mainelli
Published by Journal of Risk Finance, Volume 9, Emerald Group Publishing Limited, Number 502-508 (December 2008).
The Problem Of Wicked Finance
There is a huge problem in the world. It’s responsible for the upheaval of the entire global economy, the displacement of populations, the loss of significant assets and the likely impoverishment of future generations. No, not climate change – I refer to the global financial system. In today’s world we are supposed to reflect on the big global risks, of which there are a tremendous number. In past pieces I’ve discussed the Copenhagen Consensus issues, among them malaria, AIDS/HIV, corruption, armed conflict, governance, pandemics and climate change. We have many scarcity issues - water, cropland, living space or fish. We have many quality of life issues, such as obesity, longevity, genetic modification, access to medicine or employment opportunities.
Given that financial markets are more and more frequently the mechanism by which global risks and rewards are transmitted, e.g. micro-finance, internalisation of carbon emissions, or motivations for drug companies to research tropical diseases, the robustness and resilience of financial markets themselves is a global risk. The 2007 Credit Crunch has led more and more people to believe that financial markets are a problem needing a solution. The ‘wicked’ nature of financial markets needs to be controlled. There are numerous proposals for action. But can we predict the outline of the likely outcome and what it might mean for financial firms?
Global risks are events or circumstances that are beyond any particular party’s capacity to control, that may adversely impact multiple parties across geographic borders, industries, and/or sectors. However abstract they may be, global risks affect enterprises, even those not apparently involved, in different ways – disruption to a distribution channel, impairment of facilities, network interruption, reputation harm, higher commodity costs, and more – that are concrete enough to manage but still beyond any particular enterprise’s capacity to control. Some risks have their origins in business activity, such as accounting misconduct, but entail a broader threat to society.
Commercial enterprises strive to create value for shareholders and other stakeholders, and have mechanisms that allow them to respond both to their existing environment and to anticipate change. Enterprises specifically work to reduce risk, i.e. they attempt to reduce the likelihood of adverse events or the impact on the enterprise if the risk materialises. Enterprise risk management systems focus on competitive advantage for the individual enterprise. Global risks are characteristically low probability and high impact, rendering them too complex and uncertain for any single entity, working in isolation, to manage. Kunreuther and Heal [2002] point to the threat of systematic underinvestment in risk management where "the incentive to invest in protection approaches zero as the number of unprotected agents increases.”
Because organisations have a bias toward assigning greatest importance to those risks that are within the enterprise’s control and their risk systems classify global risks as "beyond our control”, they give insufficient attention to global risks. In the case of Wicked Finance, it’s not just the threat to the world from finance, but the threat to Finance from global society. Are risk managers thinking about how societal reaction to the Credit Crunch is likely to affect their firms’ reputations, freedom to manoeuvre, likely odds in court cases, repayment rates or insurability, just to name a few immediate risks to financial firms.
What We Have Here Is A Failure To Allocate
But what can we actually do about these risks? Aren’t they all too complex? Isn’t the globalisation of finance increasing linkages among these risks? Alexander Evans and David Steven point out that the international system’s increasing complexity is due to a "growing number of actors confronted by fluid and interlinked threats”. They believe that "Two drivers of change stand out: scarcity, limits to the sustainable consumption of highly strategic commodities such as energy, land, water, food and ‘atmospheric space’ for emissions; and instability, the tendency for complex systems to experience unpredictable and unsettling shifts." Arguably, population growth is at the root of many of our scarcity problems. Huge populations combined with rapid communications give us a number of feed-forward/positive feedback problems that increase the instability Evans and Steven fear.
Doyne Farmer of the Santa Fe Institute observes that "One of the most fundamental principles in financial economics is called market efficiency. This principle takes many forms: A market is informationally efficient if prices reflect all available information; it is arbitrage efficient if it is impossible for investors to make "excess profits”, and it is allocationally efficient if prices are set so that they in some sense maximize everyone’s welfare.” [Farmer et al 2005, page 3]
Markets are self-organising information processing systems that direct societies. Markets can and do help to set goals through prices. These three types of efficiency imply certain goals. Information efficiency should mean that prices aren’t predictable but that prices help to communicate values through society and therefore direct commercial efforts. You need no further proof than to look at various manias and panics such as tulip bulbs or credit crunches. The goals may be odd, but markets set them. Good markets should provide information that permits improved decision-making. Arbitrage efficiency should mean that it is impossible to make money without taking risks. Good markets encourage people to take risks that other people are prepared to reward. One can argue that a market is incomplete if all relevant risks can’t be hedged. Finally, allocation efficiency should mean that it’s impossible to make somebody better off without making someone else worse off. Markets satisfy the goal of helping to allocate risks and rewards through society. Markets should maximise social welfare.
A few paradoxes arise. If information efficiency is strong, then innovation should be kept secret. If one firm is successful but grows too large, secrecy is lost. If arbitrage efficiency is high, then there are few ways to make large amounts of money and interest in work and innovation might collapse. Finally, highly efficient allocation may not be equitable and may lead to reallocation outside the market, e.g. by force or taxation. While nodding towards Rawls and Nozick, I would like to quote from an online conversation I’ve had with Doug Sunshine. "in any ‘immaculately conceived’ initial distribution of resources, normal activity will take place until there is some exogenous change that will inevitably benefit some and hurt others. All political evidence, however, points to the fact that the ‘losers’ of said change prefer to be compensated by the ‘winners’ than to bear their loss silently. If their numbers are great enough, they will agitate for political action to be compensated – you are now exiting Nozick’s Utopia.” [Doug Sunshine, 7 April 2008]
Anticipation 1: enviable losses. Societal discomfort with financial services compensation and pay (allocative efficiency) will continue to intensify. Society is also likely to continue to seek to reduce arbitrage opportunities, as has already happened on short selling. This leaves financial services firms needing to make the most out of information efficiencies. Unfortunately, this rational action firm-by-firm could be seen by society as an industry becoming more secretive, at just the time it needs to be perceived as a societal enhancer.
Wicked Problems
My colleague, Alexander Knapp, directed me to the concept of "Wicked Problems". The term was originally proposed by Horst Rittel (a pioneering theorist of design and planning at the University of California, Berkeley) and Melvin Webber in a treatise for planning. Rittel explored ill-defined design and planning problems which he termed "wicked", i.e. messy, circular and aggressive. These problems are not the comparatively tame problems most decision theorists study, for example chess, game theory or puzzle solving. The real world is messy, circular and aggressive. According to Laurence J Peter of The Peter Principle fame, "Some problems are so complex that you have to be highly intelligent and well informed just to be undecided about them.” Jeff Conklin summarises Horst Rittel’s problems with wicked problems:
Wicked problems are not just about global risks. Building a new power station or credit risk system can be a wicked problem. Wherever the problem affects the solution and vice versa, where solutions are enmeshed in society and everyone cares, you probably have a wicked problem. Certainly most global risks, with long timescales, distant countries and, when it grabs their attention, everyone wanting to do something immediately, qualify as wicked problems. People want solutions that don’t damage economic growth at home, but if it didn’t cost anything it would be happening now. The rare few who state "if we want it so much let’s pay for it" are considered either scuppering realists or unrealistic idealists.
One of the big problems with wicked problems is determining how much it matters to act now. When people talk about risks, I often contend that something isn’t a risk if no one is prepared to pay to avoid it or its effects. Take a frivolous example, the risk that the sky might turn from blue to purple. Assume that if the sky turns purple there are no other physical dangers, just a colour change. Assume too that people can make a payment to reduce the chance of the sky turning purple. If no one wants to pay, then I call the sky colour change an event, not a risk. On the other hand, perhaps people are prepared to pay to avoid having to adjust to new colour schemes or to keep cultural continuity with old masters’ paintings, then the sky colour change is a risk. You may find it frivolous that people will spend money to avoid something that has no negative effects, but if they pay to avoid it, it’s a risk.
Wicked problems are plagued with a tension between the room for action versus uncertainty. As uncertainty decreases over time, the room for action diminishes. But as the room for action diminishes, people are more certain about what to do. This tension is why things are frequently left so late. It can be difficult to distinguish "waiting for enough information to act responsibly" from "acting because our backs are against the wall". If you wait, you may find new ways of solving problems, but the problem also grows in scale.
Anticipation 2: plus ça change. It is unlikely that all of the proposals and discussions about how to reform the world of finance are going to bring about radical change. There is little willingness to pay for large-scale changes directly. There are already ‘hidden’ charges mitigating awareness, e.g. taxpayers bearing risks without compensation on Freddie Mac and Fannie Mae and Northern Rock, yet not understanding the scale. There are also ‘hidden’ ways of making financial services firms pay for change such as regulatory costs or transaction taxes or punitive, compulsory insurance schemes.
Resilient Or Robust Solutions?
Actions are of two types, resilient actions or robust actions. Resilient actions get by – resilient systems perform within the range of historic volatility. Robust actions try to solve the problem or handle a previously unreasonable scale – robust systems handle step changes in volatility. A lot of the difficulty with global problems is people getting used to them. A resilient approach to famine is to establish a reasonable disaster relief programme. Let’s just get by for now. A robust approach to famine is to overhaul everything from agriculture to transportation to markets to governance to try and prevent famine from happening. Let’s solve it once and for all. In some cases, robust approaches aren’t attempted because of lack of confidence. In other cases, robust approaches are overdone, e.g. seeking a silver bullet technology such as nuclear fusion these many years. In some cases, robust approaches have achieved wonders, such as the eradication of smallpox. But solving wicked problems via robust approaches involves a lot of different activities, acting in some degree of concert.
A few single approaches to solving global risk problems can be ruled out. We can start with government on its own. For many wicked problems dinner party answers start with the phrase "somebody ought to…"Of course we really mean some omniscient, omnipotent being who will come down and make everyone else act properly, pay to fix things and avoid all future problems. In the financial markets right now, everyone awaits the coming of new super-regulators who won’t make the credit crunch mistakes of those who came before them. Sadly, neither that government nor that regulator exist, nor to the dismay of Pastafarians, does the Flying Spaghetti Monster exist. Less flippantly, Muhammad Yunus, founder of Grameen Bank and winner of the 2006 Nobel Peace Prize, says:
"Governments can do much to address social problems. They are large and powerful, with access to almost every corner of society, and through taxes they can mobilize vast resources … So it is tempting to simply dump our world’s social problems into the lap of government and say, ‘Here, fix this’. But if this approach were effective, the problems would have been solved long ago … governments can be inefficient, slow, prone to corruption, bureaucratic and self-perpetuating. These are all side effects of the advantages governments possess: Their vast size, power, and reach almost inevitably make them unwieldy as well as attractive to those who want to use them to amass power and wealth for themselves." [Yunus 2007, page 8]
Another truism is that solutions to wicked problems are not "top-down" imposed solutions. Jeremy Hunt, the UK Conservative’s Shadow Secretary of State for Culture, Media and Sport remarked at a City event in March on philanthropy – "If you want to solve the big social problems of the day you can’t just do it through money and targets”.
Likewise we must brake a slide towards the idea that wicked solutions are just about Commerce; that today’s problems are all caused by poor government and we can just sit back and wait for the free market to save the day. The invisible hand will arrive and all will be cured. Rischard of the World Bank makes an extremely pointed warning. He talks of four stresses in the "new world econom", 1 - "adapting to the new rules of the game" (speed, boundary-free, knowledge intensive, hypercompetitive), 2 – "growing disparities”, 3 – "turbulence and fragility" "… fourth stress associated with the new world economy is subtler. It has to do with excessive trust in the market, and the complacency that results from it." [Rischard 2002, page 34].
Wicked problems involve many policy issues, many political issues, many commercial issues, many project management issues and many implementation issues. We have to recognise "everything, everywhere at all times" – ownership, enforcement, multiple players, multiple player interactions. Complex global risks imply messy diverse solutions, no silver bullet. I group mechanisms into four general methods:
Anticipation 3: messy interventions. Solutions to wicked problems are likely to be wickedly complex - give markets a chance, but alongside everything else, sharing knowledge, developing standards and setting policies.
Credit Crunch 2007 is, so far, a ‘diffuse’ crisis - no single baddy, no single incident, no single owner. Without a clear problem, a wicked problem such as financial services reform elicits a series of messy answers. It is likely that some smaller, more pointed reforms may get through, but then there is the danger that piecemeal reforms often don’t work because the environment hasn’t changed enough. "My Reform X would have worked, but I was counting on reforms Y and Z as well.”
One may start with economics and rationality, but at the end of all social science is contingency theory. Credit Crunch 2007 is not likely to lead to major reforms, just a muddle through. The financial services industry is neither wicked nor good and, despite the designs some of us may have on radical reform, it isn’t an abject failure. As Deng Xiaoping pointed out: "It doesn’t matter if a cat is black or white, so long as it catches mice.” The financial services industry has had a series of major failings and needs major reforms at some point, but Credit Crunch 2007 was not crisis enough to jolt radical reform, yet.
Note: Readers interested in joining a wider debate on reform in financial services are welcome to participate at www.sustainablefinancialmarkets.net.
Further Reading
Professor Michael Mainelli, PhD FCCA FSI, originally undertook aerospace and computing research, followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen (Michael_Mainelli@zyen.com). Michael is Mercers’ School Memorial Professor of Commerce at Gresham College (www.gresham.ac.uk).
Z/Yen operates as a commercial think-tank that asks, solves and acts on strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (www.zyen.com), such as developing an award-winning risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks. Z/Yen’s humorous risk/reward management novel, Clean Business Cuisine: Now and Z/Yen, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as "surprisingly funny considering it is written by a couple of accountants”.
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[An edited version of this article first appeared as "The Wicked Problem Of Good Financial Markets", Journal of Risk Finance, Volume 9, Number 502-508, Emerald Group Publishing Limited (December 2008).]