A World Too Tightly Wired
April 12 2007 by Robert Lawrence Kuhn
That a drop in the Shanghai Stock Market could trigger a worldwide sell-off exposes, I now believe, a deeper and more insidious problem. It’s suddenly clear. All the efficiencies and luxuries of a tightly wired world have come at a price. The price is fragility, and we are vulnerable.
Here’s the scary part: Nothing fundamentally bad or even unexpected caused the stock drop in
Take what happened as a warning and get prepared for worse. This column is not a happy one.
I write from
Second, as editor in chief of a just-published book,
Third, I am in the
Why are We Vulnerable?
So we are vulnerable, our financial markets even more so. Consider three underlying causes.
Competitive Pressure for Returns. The increasingly fierce competition among investment funds, especially hedge funds and private equity, to generate above-average returns-the holy grail of investment managers-threatens to distort portfolio theory and warp relationships between risk and return. At the margin, more units of increased risk must be assumed in order to generate a single unit of increased return, so that inordinate risks are taken. High risk is doubly encouraged since managers of these funds are betting other people’s money, and while they are incentivized to receive a generous percentage of profits they may make, they are not punished by absorbing any of the losses they may incur.
Financial Interconnectivity. World financial systems have become so ecologically interconnected that any perturbation can shake the entire system. Financial institutions are like mountain climbers inextricably attached by belts; while in most circumstances such linkage provides safety, under some conditions it can pull them all down together.
Instant and Pervasive Communications. Conflicts exist among religions, ethnicities and contiguous states; and isolated individuals, consumed by misguided mission or media-massaged hate, can cause great damage. Television and the Internet personalize problems, feeding frustrations and heating emotions to the point of combustion. Indeed, with intense competition among news organizations, the sensational, the lurid and the horrid is often emphasized, even exaggerated. There is no time for digestion of news, for absorption, consideration and amelioration of events, for hotheaded feelings to dissipate. Reaction must be instant and instant reaction facilitates runaway reaction.
What Can Be Done?
Astute business executives should consider the following precautions and preparations.
Develop Redundancies. Think redundant. Get redundant. Do not be dependent on any one thing: not on one location, not on one product, not on one person, not on one system. For example, even if
Mitigate Risks. Do not take on too much debt and do not place bets that are too large. Deleverage your balance sheet; while this reduces returns under most market conditions, it makes the enterprise much more robust under extreme conditions.
Scenario Planning. Take simulation seriously. Require your enterprise to run, and to keep current, detailed scenarios of strategy and operations under different hypothetical external conditions, including those resulting from capital market disruptions. Even though reality will not conform precisely to any one of your firm’s specific scenarios, the fact that you have prepared the scenarios and thought carefully about each will enable you and your team to react more intelligently and with less panic to any real exigency.
Disaster Planning. Review your disaster plan on a regular basis; keep it current by embedding recent corporate changes. In most companies, managing the disaster plan is not a career-enhancing task, but CEOs can make sure it is taken seriously by giving those people responsible proper recognition and reward.
What I am advocating may not sound very exciting and in normal times may reduce profitability and constrain enterprise value. But when unexpected events cause markets to shudder, your company will be rewarded for its relative strength. I say “when,” not “if,” because I am no longer sanguine about our collective future. I tell myself that people of every generation have thought their times to have been special and that, though tragedies have happened, in the end things always seemed to have worked out well. I do not think that this pattern is any longer reliable or predictive. The world is now wired too tightly; there is no slack in the system, no give for sudden movement. And sudden movements, I fear, will come.
Robert Lawrence Kuhn, an international investment banker and corporate strategist, is senior adviser at Citigroup where he focuses on