eFinancialCareers

What causes crashes and crises? Conventional wisdom used to be that markets reflected fundamental shifts in economic realities. When the economy steamed ahead too rapidly, stresses and strains in the system would eventually trip us up and the market would crash. But never too far. When it looked overdone, reality would kick in and markets would turn around. It all made sense in a comforting, reassuring way.

Today we’re more cynical. Media comment is all about bankers and hedge fund managers and the distorting effect of the bonus system. Journalists with annual earnings that barely make it into six figures and their noses pressed against the glass stare into the Square Mile and seem to think that greed, testosterone and lack of accountability combine to make people take risks that common sense and prudence might suggest are unwise. As if.

Granted, individual institutions and the people within them can exert far greater influence than anyone dreamed of, say, 20 years ago. Derivatives, leverage, synthetics, off balance sheet trades, Special Purpose Investment Vehicles – let’s call them SPIVs – have developed exponentially, so that a single rogue trader at a major firm can lose more money than you and I could spend in a lifetime. Or 10 lifetimes.

And what have we standing between us and the abyss, allowing us to sleep safely at night? Risk management. A dedicated team of specialists who apply reporting systems and impose order – we like to think of it as control – in areas where geriatrics like me would otherwise feel terrified that the firm was spinning crazily along the edge of the cliff. Phew.

But should we feel safe, or are risk managers the equivalent of a three year old’s comfort blanket? To begin with, who gets paid the most? The risk committee or the front-line revenue generators presenting their reassuringly well crafted proposals? And once you know who gets paid the most, you know who the smartest people in the room are.

The fact is that we have a system that incentivises short-term risk taking, and at a lot of firms that risk taking activity is inadequately supervised. It doesn’t matter when market conditions are benign: big bets pay off, and the risk takers start to think they really do walk on water.

But when the music stops and those same risk takers get a terrible wake-up call, all they lose is their annual bonus and maybe their jobs (though even being fired isn’t guaranteed, given how most firms prefer to paper over the cracks and hide their shortcomings). The real tab gets picked up by shareholders, customers and eventually – in the worst case – by the taxpayer.

So for once maybe the press are right. Human nature causes crashes and crises. Forget the system, the global economy, the blah-blah. It’s the greed, stupid. And it won’t change until every firm pays its people on a multi-year basis linked to long-term performance. That’s the real risk management that we all need, and that’s what would allow us to get back to good old-fashioned real crashes and crises.

David Charters’ latest book, The Ego Has Landed, is published by Elliott and Thompson, price £9.99.