Leo Tilman, president of New York-based strategic advisory firm L.M. Tilman & Co., sees much to be learned from the collective blindness that led to the economic meltdown. Author of Financial Darwinism: Create Value or Self-Destruct in a World of Risk (Wiley 2008), Tilman says the first steps to recovery are humility and innovation. He spoke recently with Alpha Contributing Writer Udayan Gupta.
How did we get into this mess?
The ongoing crisis is a culmination of long-term evolutionary changes in finance. Basic financial services became commoditized by globalization, advances in technology, informational availability, reduced trading commissions and underwriting fees and decreased margins. Many institutions, in response, took on huge amounts of risk to replenish declining earnings.
You write about the “old regime” and static versus dynamic risk. What do you mean by that?
The basic deficiency of static investment styles and business models is that they respond to return and earnings pressure with blind leverage. This is a sure way to self-destruct, to become extinct.
On the opposite end of the spectrum are institutions where risk management is the centerpiece of strategic decision making. Dynamic business models rebalance capital allocations, assets and risk exposures as business and market opportunities change.
You cite three kinds of executive failure. What are they?
The first is leadership by routine, the refusal to acknowledge change and adapt. The second is leadership by delusion; trying to adapt without requisite skills and personnel.
The third is leadership by musical chairs, which says that while the music is playing you have to be dancing.
Would better industrywide policies have prevented the crisis?
Risk-based transparency could have greatly mitigated the impact. If capital markets had seen the dramatic increase in leverage and risk that different kinds of financial firms were engaging in to replenish earnings, price-earnings ratios would have declined and credit spreads would have widened. Lower valuations and higher borrowing costs would have discouraged executives and institutions from blindly leveraging up to deliver these earnings. Both the magnitude of the leverage and the pernicious circle of deleveraging would have been less vicious.
Do you favor systemic change?
This crisis is an opportunity to redesign financial institutions, rethink their business models, reconnect risk management to strategic decisions. Meanwhile, policymakers need to find the right balance between risk-based regulation and risk-based transparency.
Instead of focusing on prohibiting risk-taking and reducing executive compensation, proper regulation must go hand in hand with providing capital markets with the right information to properly do their job, which is to allocate capital to wherever it is most needed -- and in the process generate risk-adjusted returns for investors.
