In this lesson from Big Think+, former U.S. Secretary of the Treasury Timothy Geithner teaches the fundamentals of risk management, based on lessons learned during the 2008 Financial Crisis.
Establish a strong risk culture
You need some counterbalance to the forces that lead people to take more risk than they understand. And that requires you bring a sort of an independent pair of eyes and go through the experiment of saying, but what if things were really bad? What if your optimism is not justified? What if you lose the capacity to fund your positions easily? What if liquidity evaporates? What if there’s a terrible recession? The critical thing in finance in particular, but it’s true in many parts of life, is to make sure that you have people with the right incentives to think about the dark scenario, with power and influence and the ability to constrain and lean against the incentives other people face to take risk.
And the core of that judgment is the recognition that the world is inherently uncertain. It’s very hard to judge what the relative probabilities are of a growing economy or a recession. Very hard to judge. They’re not really knowable with perfect confidence. And the right way to deal with that uncertainty is to build in a greater cushion against the risk of the bad event.
Build in a cushion to protect against the low probability event
What we found in the – during the boom, during that period of optimism that house prices wouldn’t fall – is that firms were not building in enough of an expectation or enough of a cushion, again, against the extreme event. They viewed it as so improbable, so outside the memory of experience – no recent memory, again, of panics. It was so improbable, there was no reason to pay the resources it takes to build a cushion against that.
I mean, again, think about it: If you think about the United States in 2005, 2006, 2007 and you told people, “We’re going to force you to prepare for a great depression,” they’d think it was inconceivable. You know, it’s like, as I say in the book, it’s like in a modern highway system with airbags and antilock brakes, which people thought were buying a huge measure of security, “We’re going to force people to drive at, you know, 35 miles an hour.” I mean, they found it inconceivable. That would be – that wouldn’t make sense. And we didn’t force them to do that.
We ultimately forced them to do that in the crisis. One way we broke the panic was to force them to hold resources, prove to people they could raise resources to cover the losses in the great depression. But again, it’s just a way of thinking about trying to build into the culture of decision-making a greater sense of humility about what you can’t know and a greater sense of caution about the uncertain future, to look at, yeah, maybe the low probability event but the event that can be existential in its cost.
Prepare for the worst when confidence is high
When you’re trying to think about how you manage a financial crisis or how you manage a financial institution, how you manage a business, how you manage your personal finances, it’s a pretty similar lesson in the sense that you want to make sure that, since there are lots of things that can affect your fortunes that you can’t control, that you try to think through carefully what could go wrong and how can you protect yourselves against that.
It’s the most important thing to do when there seems like the least reason for doing it. So when people are around telling you that there’s no risk of a crisis, our financial system’s invulnerable to crisis, recessions are going to be mild and unlikely. When you’re in a period where the power of those beliefs of optimism are so widespread, that’s the most important point, in some sense, to decide that you’re going to put aside, save a little bit of that, of the returns from optimism and build yourself a better margin of safety.