"The Need for Failure" is a recent Forbes article on why it is bad – really bad – to prop up failing institutions. The author is an esteemed economics professor at NYU. He says "too big to fail is dangerous. It suggests there is an insurance policy that says, no matter how risky your behavior, we will make sure you stay in business." Rightly said, only it creates a conundrum. Large organizations are not known for taking risky actions. Large organizations are known primarily for lethargic decision-making which weeds out all forms of risk – right down to how people dress and what they can say in the office. When you think of a big bank, like Bank of America or Citibank, you don't think of risk. You think just the opposite. Of risk aversion so great they cannot do anything new or different.
What I'd add to the good professor's article is recognition that large organizations stumble into risk they don't recognize, by trying to do more of the same when that behavior becomes risky due to market changes. My dad said that 100 years ago when my grandfather was first given pills by a doctor he decided to take the whole bottle at once. His logic was "if one pill will help me, I might as well take the whole lot and get better fast." Clearly, an example where doing more of the same was not a good idea. Then there was the boy who loved jumping off the railroad bridge into the river. He did it all the time, year after year. Then one month there was a draught, the river level fell while he was busy at school, and when he next jumped off the bridge he broke his leg. He did what he always did, but the environmental change suddenly made his previous behavior very risky.
Big corporations behave this way. They build Lock-ins around everything they do. They use hierarchy, cultural norm enforcement, sacred cows, rigid decision-making systems, narrow strategy processes, consistency in hiring practices, inflexible IT systems, knowledge silos and dependence on large investments to make sure the organization cannot flex. The intent of these Lock-ins is to make sure that historical decisions are replicated, to make sure past behaviors are repeated again and again with the expectation that those behaviors will consistently produce the same returns.
But when the market shifts these Lock-ins create risk that is unseen. Bankers had built systems for generating their own loans, and acquiring loans from others, that were designed to keep growing. They designed various derivative products as their own form of insurance on their assets. But what they did not recognize was that pushing forward in highly unregulated product markets, as the quality of debtors declined, created unexpected risk. In other words, doing more of the same did not reduce risk – it increased the risk! Because the company is designed to undertake these behaviors, there is no one who can recognize that the risk is growing. There is no one who challenges whether doing more of the same is risky – only those who would challenge making a change by saying change is risky!
Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and AIG all created a much higher risk than they ever anticipated. And they never saw it. Because they were doing what they always did – and expecting the results would take care of themselves. They were measuring their own behaviors, not the behavior of the market. And thus they missed recognizing that the market had moved – and thus doing more of the same was inherently risky.
(The same is true of GM, for example. GM kept doing what it always did, refusing to see the risk it incurred by ignoring market shifts brought on by changing customer behaviors, rising energy costs and offshore competitors.)
That's why big company CEOs feel OK about asking for a bail-out. To them, they did not fail. They did not take risk. They did what they had always done – and something went wrong "out there". Something went wrong "in the market". Not in their company. They need protection from the marketplace.
Of course, this is just the opposite of what free markets are all about. Free markets are intended to allow changes to develop, forcing competitors to adapt to market shifts or fail. But those who run (or ran) our big banks, and many of our big industrial companies, haven't see it that way. They believe their size means they are the market – so they want regulators to change the market back. Back to where they can make money again.
So how is this to to be avoided? It starts by having leaders who can recognize market shifts, and recognize the need for change. In an companion Forbes article "Jamie Dimon's Straight Talk Has A Good Ring" the author takes time to review J.P. Morgan Chase's Chairman's letter to shareholders regarding 2008. In the letter, surprisingly for a big organization, the JPMC Chairman points out market shifts, and then points out that his organization made mistakes by not reacting fast enough – for example by changing practices on acquiring mortgages from independent brokers. He goes no to point out that several changes have happened, and will continue happening, at JPMC to deal with market shifts. And he even comments on future scenarios which he hopes will help protect investors from the hidden risk of companies that take actions based on history.
Mr. Dimon's actions demonstrate a willingness to implement The Phoenix Principle. For those who don't know him, Mr. Dimon has long been one of the more controversial figures in banking. He is well known for exhibiting highly Disruptive behavior, yet he has found his way up the corporate ranks of the traditional banking industry. Now he is not being shy about Disrupting his own bank – JPMC.
- His discussion of future scenarios clearly points to expected changes in the market, from competitor shifts, economic shifts and regulatory shifts which his bank must address.
- He sees competitors changing, and the need for JPMC to compete differently with different sorts of institutions under different regulations. Mr. Dimon clearly has his eyes on competitors, and he intends for JPMC to grow as a result of the market shift, not merely "hang on."
- He is espousing Disruptions for his company, the industry and the regulatory environment. By going public with his views, excoriating insurance regulators as well as unregulated hedge funds, he intends for his employees and investors to think hard about what caused past problems and how important it is to change.
- He keeps trying new and different things to improve growth and performance at the company. It's not merely "more of the same, but hopefully cheaper." He is proposing new approaches for lending as well as investing – and for significant changes in regulations now that banking is global.
Very few leaders recognize the risk from doing more of the same. Leaders often feel it is conservative to not change course. But, when markets shift, not changing course introduces dramatic risk. People just don't perceive it. Because they are looking at the past, not at the future. They are measuring risk based upon what they know – what they've failed to take into account. And the only way to overcome this problem is to spend a lot more time on market scenarios, competitor analysis and using Disruptions to keep the organization vital and connected with the market using White Space projects.