Entrepreneurs, Risk Managers, and Uncertainty
Tuesday, February 5, 2013
Thomas Stanton’s 2012 study of comparative organizational performance during the great 21st-century financial crisis, Why Some Firms Thrive While Others Fail, cites Frank Knight’s 1921 classic, Risk, Uncertainty, and Profit. I consider Stanton’s theme to be how to address the unavoidable reality stated thus by Knight: “Uncertainty is one of the fundamental facts of life. It is … ineradicable from business decisions.”1
As Stanton says, "Knight long ago distinguished risk, which can be quantified, from uncertainty, which requires judgment. Successful firms used judgment to add more protection than quantitative modeling would have suggested."2
Edmund Phelps reflects on Knight’s dictum as follows:
Knight … took the unprecedented position … that most business decisions, especially strategic ones, are to varying degree steps into the unknown. Each of the possible outcomes of a business venture can be considered to have some probability of occurring, but those probabilities are not known.
To be precise, “those probabilities are not and cannot be known.”
Continuing to quote Phelps:
The economic future is, in large part, not even probabilistic — it is to an important degree indeterminate. ... The arrival of finance capitalism, with its restless experimentation. ... radically increased the unknowability that the actors in these economies had to confront.3
Drawing from many interviews conducted by the Financial Crisis Inquiry Commission, Stanton’s book considers how various important firms dealt successfully with such uncertainty (or failed to do so with disastrous results) and the severe organizational stresses and dynamics involved as financial events that were considered impossible by many or most people nevertheless became reality. The personal accounts of discussions, arguments, and decisions about riskiness, often enough career-ending ones, instructively display the uncertainty always involved.
However, this fundamental problem confronts not only financial companies, but any and all organizations — including governments, government regulatory bodies, and notably, central banks. How, for example, should the Federal Reserve in the early 2000s have dealt with the uncertainty of the effects of its own actions, as it set out to encourage a boom in housing? The Fed had a plausible theory: a housing boom would create a “positive wealth effect” (so indeed it did) which would offset the recessionary impact of the mistakes of the dot-com bubble. But what were the risks and uncertainties of this central bank strategy to inflate the housing sector? Could one imagine that this strategy would help induce a bubble of catastrophic proportions? Did the Fed imagine this possibility? Was it discussed and debated? Did the “CEOs” of the Fed get good advice about the financial risks of their actions?
In their proper roles, entrepreneurial drive and bankerly prudence balance each other.
There are inherent tensions between the need to make decisions and act in the face of uncertainty, and the need to worry about the risks of any action. This makes me remember my old friend, Hyman Minsky, and his thoughts about the economic dialectic between, as he characterized it, “entrepreneurs and bankers.” Minsky’s writings on financial cycles become popular each time we have a financial crisis, but Minsky told me this particular idea in person — I do not think he ever published it.
Entrepreneurs, Minsky said, are emotionally warm, optimistic, risk-taking, self-confident, ready to take action, undaunted by obstacles and doubts, driven to create something new. Bankers, on the other hand, should be emotionally cool, pessimistic, skeptical or cynical, risk-averse, focused on the pitfalls, preferring wide margins for error. In their proper roles, entrepreneurial drive and bankerly prudence balance each other. If we replace Minsky’s term “entrepreneurs” with Stanton’s “CEOs,” and Minsky’s “bankers” with Stanton’s “risk managers,” we get the same idea.
Knight considered the nature of entrepreneurs in this way:
Most men have an irrationally high confidence in their own good fortune, and that this is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves. Moreover, there is little doubt that business men represent mainly the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.4
These characteristics of entrepreneurs as described by Knight are precisely what enable them sometimes to achieve truly great things, often against daunting ex-ante odds. Entrepreneurs or CEOs may have a long record of successfully ignoring naysayers and fearful risk advisers. Of course, we recognize the risk managers embedded in Knight’s paragraph: they are the “critical and hesitant individuals.”
In 1769, it was suggested to the manufacturing entrepreneur, Matthew Boulton, that he should seek to produce James Watt’s new steam engine for one region of England. He replied that instead, “he wanted to make it for the whole world [italics added].”5 Economic historian Charles Kindleberger described this response as “exalted commercial ambition.”6
Such exalted commercial ambition may lead to spectacular and even world-changing achievements — it may equally lead to going broke. In the notable case of the housing-finance entrepreneur Angelo Mozilo and Countrywide Financial, over four decades it led to both achievement and failure: first to 30 years of success in building from nothing the preeminent independent mortgage banking company in the United States; then to utter corporate and personal disaster in the housing bubble.
Entrepreneurial ambition needs dialectical balance with Minsky’s “bankers.” But what happens when the banks themselves are taken over by entrepreneurial personalities, as must happen in the course of time? Then, to avoid having the banks go broke, you must reproduce the Minskian dialectic within the bank, between the bank and others outside, or both. Stanton’s book discusses cases where this was successfully done and others where its lack contributed to the financial collapse and humiliation of the formerly self-confident, driving executives.
An extended boom, as discussed in the book, presents a severe problem in maintaining the needed dialectic. The investment mania, or price and credit bubble, can last a long time. So much money can be made — or seem to be being made — out of the long-lasting boom, that all the early doomsayers are brought into disrepute. For the skeptics, who will be right in the long term, betting against the enthusiasm can be expensive in the meantime, both in money and in reputation. As the famous line of John Maynard Keynes goes, “Markets can remain irrational longer than you can remain solvent.”
Related to this problem are the pressures of market analysts and so-called “shareholders” — who are actually the hired managers of other peoples’ money, rather than shareholders themselves — for short-term share price gains in line with their benchmark return measures, which may themselves reflect an irrational market.
Stanton discusses how under CEO Edmund Clark, Canada’s Toronto-Dominion Bank decided in 2005 to withdraw from global structured products — taking early losses to do so — and thus constrained its exposure to the U.S. housing bubble. But “Clark recalled that stock analysts did not encourage his long-term perspective”:
You have to sit in marketplaces, as we did in the U.S., for a couple of years and grow our loan book less quickly than the market. It did mean that you had to exit structured products in 2005 and 2006 and have analysts write that you’re an idiot.7
There is personal risk in taking such long-term, ultimately correct decisions, because it may also be true that “markets can remain irrational longer than you can remain employed.”
Now, for example, we have a remarkable bubble in bonds, promoted by the Federal Reserve’s manipulation of the government bond and mortgage-backed securities markets. It has already gone on a long time. How many times can you be crushed betting on higher long-term interest rates before you give up and start contributing to inflating the bubble further?
So in a long-lasting boom, the risk warnings from the prudent Minskian bankers or risk managers may come to seem like “crying wolf.” However, we must remember that in this great old fable, as in a bubble, the wolf really does come in the end.
What happens when the banks themselves are taken over by entrepreneurial personalities, as must happen in the course of time?
The challenge to the chief executive of keeping a balance of sound judgment among competing voices is not a new one. As he reflected on the difficulties of being a king in his memoirs for the year 1666, Louis XIV described “the number of desires, importunities, and murmurings to which kings are exposed.” Thinking “of men who pay their court to us, of ministers and servants who give their counsel,” he observed, “there is hardly one who has not already formed in his mind some claim; and … each one of them is applying himself wholly to give an appearance of justice to what he is seeking.” Therefore, “Force of character assuredly is required to keep always the correct balance between so many people.”8
In 1700, writing to his grandson, Louis added some great advice, consistent with Stanton’s recommendations: “Esteem those who for a good cause venture to displease you; these are your real friends.”9
As Stanton also recommends, consistent with this is the imperative for a robust organization to have the right inner circle around the CEO (or entrepreneur, chairman, director, or king). Such a circle must include “those who will tell the truth, are not awed by your drama and rhetoric, and fill in your gaps and mistakes.”10 That is quite different from multiplying, complex, and backward-looking regulatory rules. “Thousands of pages of laws and regulations … are unlikely to forestall another financial crisis in the future,” as Stanton has suggested.11
What is truly needed, and what Stanton’s book so interestingly explores, is how organizations can facilitate the Minskian dialectic of enterprise and prudence, and how they can improve their chances of making sound judgments in the face of ineluctable uncertainty.
Alex J. Pollock is a resident fellow at the American Enterprise Institute. This article is based on his discussion at a recent Cato Institute book panel, “Why Some Firms Thrive While Others Fail.”
FURTHER READING: Pollock also writes “Central Bank Dreams, Monetary Realities,” “Does Interest Rate Risk Matter If You’re the Fed?” and “The Federal Reserve: The Biggest Systemic Risk of All.” James Pethokoukis says “Global Bank Regulators Go for Growth over Safety, Keep Fingers Crossed.” David Shaywitz explains “America's Healthy Infatuation with Entrepreneurs.” John H. Makin discusses “Financial Crises and the Dangers of Economic Policy Uncertainty.”
1. Frank H. Knight, Risk, Uncertainty, and Profit, 1921, p. 347.
2. Thomas H. Stanton, Why Some Firms Thrive While Others Fail, 2012, p. 15.
3. Edmund S. Phelps, Foreword to Leo M. Tilman, Financial Darwinism, 2009, p. ix.
4. Knight, p. 366.
5. Charles P. Kindleberger, “The Historical Background: Adam Smith and the Industrial Revolution,” in Thomas Wilson and Andrew S. Skinner, eds., The Market and the State, 1976, p. 7.
7. Stanton, p. 53.
8. Louis XIV, A King’s Lessons in Statecraft, 1970, p. 111.
9. Ibid., p. 173.
10. Alex J. Pollock, “10 Commandments of Leadership,” Memorandum, 1987.
11. Stanton, “Strengthening Our Public and Private Institutions: A National Imperative,” presentation at Cato Institute, October 18, 2012, p. 11.
Image by Dianna Ingram / Bergman Group