With the ‘08 meltdown fresh in mind, are we any better at assessing risk?

  • By James McCusker Herald Columnist
  • Wednesday, April 16, 2014 2:46pm
  • Business

Have we fixed the problem? Is the risk of a financial system failure lower now than it was before the 2008 meltdown?

One of the things that distinguishes human beings from, say, fruit flies or even most animals is the awareness of risk. Most life forms seem to recognize danger and harm, but the perception of risk involves another level of abstraction.

In the chain of human development, our awareness of risk was eventually followed by our ability to calculate its probability. Isn’t evolution wonderful? Thousands of years of human development and what we get out of it is a math problem.

Actually, humans and their faithful computer companions have the math of probabilities pretty much nailed down these days. The problem is in figuring out what the important variables are and defining them in such a way that math’s power can be applied. Economics isn’t the only place where this problem comes up, but it certainly provides some ready examples.

The near-collapse of the financial system in 2008, for example, could not have happened if investors had not chosen to ignore the risk probabilities of lending large sums of money to people who could not pay it back, unless they found someone who would pay more for their house than they did. It was a Wall Street dream: the marriage of the “greater fool” theory into the illustrious Ponzi scheme family.

Without the mass psychology of risk-denial, the lo-doc, no-doc, and zero-down-payment mortgages would never have come to dominate the mortgage market. Some lenders and some investors might have been willing to make and underwrite these loans, but only at interest rates that accurately reflected the risk.

The other important risk factor, systemic risk, was different: It was not ignored; it was invisible. Both regulators and financial institutions were blissfully unaware of the systemic risk that the real estate bubble posed for our banking and financial system. When one large financial institution collapsed, as Lehman Brothers did, it could bring down others with it.

Perhaps on some psychological level the federal regulators and the markets themselves lacked awareness because they did not want to think about it. Maybe the symbolic sculpture of the bull that stands in front of the New York Stock Exchange is missing something. It should be fitted with three riders, bronze replicas of Mizaru, Mikazaru and Mazaru, the three monkeys who hear no evil, see no evil and speak no evil.

In the world of finance and economics, risk is an ever-present but elusive concept. In the private sector, business world, for example, there is a strong tendency to underestimate risk. This probably has its origins in the belief of most CEOs and entrepreneurs that they achieved success by ignoring the risks. It is the corporate version of Admiral Farragut’s “Damn the torpedoes. Full speed ahead.”

That attitude has carried over into today’s corporate boardrooms and decision-making processes in ways that muffle concerns over risk and keep risk assessment officers distanced from any real influence on strategic decisions.

Thomas J. Curry, the Comptroller of the Currency, made note of these tendencies in the large, complex banking corporations that present regulators and the U.S. economy with its most worrisome and most challenging risks. In a recent speech to the American Banking Association’s Risk Management Forum he said that in the past, operational issues such as risk management, “…were not viewed as core functions of the banking business.”

Just as banking has become more complex, risk management has become equally complicated. In the olden days before the crash pulled back the curtain and revealed the reality of our financial system, banks could keep themselves out of trouble by managing credit risk. Banks today, though, especially the large ones, also have to consider their exposure to systemic, third-party, cybersecurity and internal control risks — any of which has the power to destroy the institution.

The response of Congress to the risk problem has been to order up thousands of pages of new regulations. The Comptroller of the Currency’s approach to the problem focuses on the big banks’ awareness of risk and how they manage it. The Federal Reserve, one of the other organizations regulating banks, has thus far concentrated on banks’ capital adequacy as the primary defense against risk, although it is now raising liquidity standards as well. The adequacy of these balance sheet elements as risk defense, however, is more complex than it seems at first, and we are still on a long-distance learning curve regarding this issue.

Have we fixed the problem with our regulations and our balance sheet requirements? Is our financial system less fragile than before the 2008 near-collapse? Maybe; just a little. But the risks aren’t standing still, either.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.

Talk to us

> Give us your news tips.

> Send us a letter to the editor.

> More Herald contact information.

More in Business

Black Press Media operates Sound Publishing, the largest community news organization in Washington State with dailies and community news outlets in Alaska.
Black Press Media concludes transition of ownership

Black Press Media, which operates Sound Publishing, completed its sale Monday (March 25), following the formerly announced corporate restructuring.

Maygen Hetherington, executive director of the Historic Downtown Snohomish Association, laughs during an interview in her office on Thursday, Feb. 15, 2024, in Snohomish, Washington. (Ryan Berry / The Herald)
Maygen Hetherington: tireless advocate for the city of Snohomish

Historic Downtown Snohomish Association receives the Opportunity Lives Here award from Economic Alliance.

FILE - Washington Secretary of State Steve Hobbs poses in front of photos of the 15 people who previously held the office on Nov. 22, 2021, after he was sworn in at the Capitol in Olympia, Wash. Hobbs faces several challengers as he runs for election to the office he was appointed to last fall. (AP Photo/Ted S. Warren, File)
Secretary of State Steve Hobbs: ‘I wanted to serve my country’

Hobbs, a former Lake Stevens senator, is the recipient of the Henry M. Jackson Award from Economic Alliance Snohomish County.

Mark Duffy poses for a photo in his office at the Mountain Pacific Bank headquarters on Wednesday, Feb. 14, 2024 in Everett, Washington. (Annie Barker / The Herald)
Mark Duffy: Building a hometown bank; giving kids an opportunity

Mountain Pacific Bank’s founder is the recipient of the Fluke Award from Economic Alliance Snohomish County.

Barb Tolbert poses for a photo at Silver Scoop Ice Cream on Thursday, Feb. 29, 2024 in Arlington, Washington. (Annie Barker / The Herald)
Barb Tolbert: Former mayor piloted Arlington out of economic brink

Tolbert won the Elson S. Floyd Award, honoring a leader who has “created lasting opportunities” for the underserved.

Photo provided by 
Economic Alliance
Economic Alliance presented one of the Washington Rising Stem Awards to Katie Larios, a senior at Mountlake Terrace High School.
Mountlake Terrace High School senior wins state STEM award

Katie Larios was honored at an Economic Alliance gathering: “A champion for other young women of color in STEM.”

The Westwood Rainier is one of the seven ships in the Westwood line. The ships serve ports in the Pacific Northwest and Northeast Asia. (Photo provided by Swire Shipping)
Westwood Shipping Lines, an Everett mainstay, has new name

The four green-hulled Westwood vessels will keep their names, but the ships will display the Swire Shipping flag.

A Keyport ship docked at Lake Union in Seattle in June 2018. The ship spends most of the year in Alaska harvesting Golden King crab in the Bering Sea. During the summer it ties up for maintenance and repairs at Lake Union. (Keyport LLC)
In crabbers’ turbulent moment, Edmonds seafood processor ‘saved our season’

When a processing plant in Alaska closed, Edmonds-based business Keyport stepped up to solve a “no-win situation.”

Angela Harris, Executive Director of the Port of Edmonds, stands at the port’s marina on Wednesday, Jan. 24, 2024, in Edmonds, Washington. (Ryan Berry / The Herald)
Leadership, love for the Port of Edmonds got exec the job

Shoring up an aging seawall is the first order of business for Angela Harris, the first woman to lead the Edmonds port.

The Cascade Warbirds fly over Naval Station Everett. (Sue Misao / The Herald file)
Bothell High School senior awarded $2,500 to keep on flying

Cascade Warbirds scholarship helps students 16-21 continue flight training and earn a private pilot’s certificate.

Rachel Gardner, the owner of Musicology Co., a new music boutique record store on Thursday, Jan. 18, 2024 in Edmonds, Washington. Musicology Co. will open in February, selling used and new vinyl, CDs and other music-related merchandise. (Olivia Vanni / The Herald)
New Edmonds record shop intends to be a ‘destination for every musician’

Rachel Gardner opened Musicology Co. this month, filling a record store gap in Edmonds.

MyMyToyStore.com owner Tom Harrison at his brick and mortar storefront on Tuesday, Sept. 6, 2022 in Everett, Washington. (Olivia Vanni / The Herald)
Burst pipe permanently closes downtown Everett toy store

After a pipe flooded the store, MyMyToystore in downtown Everett closed. Owner Tom Harrison is already on to his next venture.

Support local journalism

If you value local news, make a gift now to support the trusted journalism you get in The Daily Herald. Donations processed in this system are not tax deductible.