Sunday, July 11, 2010

Too big to fail ... Too big to exist

Dear Colleagues

The idea of "too big to fail" is talked about a lot in connection with the implosion of the financial sector ... but the idea of too big to exist and the issue of risk as bigger and bigger entities are created and bigger and bigger activities are implemented needs to be taken into consideration.

Modern scale is impressive ... but I am of the view that the management of risk associated with this huge modern scale is downright primitive. I am concerned that the way risk is researched at the famous business schools and taught to students is more mathematical than real ... and this has me very concerned.

The issues of risk were very much on policy makers minds when nuclear possibilities were emerging ... on the one side the military aspects of risk, and on the other the risk of malfunction in a nuclear power system. The solution was not mathematical but was in practical safety engineering that has served the industry and society quite well.

The risk that was mismanaged in the financial sector and caused immense global economic damage was handled simply with mathematical constructs and models that seem to me to be based on ridiculous assumptions. Risk was moved around ... risk was not reduced to a manageable matter. Too big big banks are a risk ... they are not part of an efficient market but are really part of an oligopoly that makes markets and may or may not have conflicting interests at any one time!

The same is going on in the "big oil" sector. The technology is different, but the issues of risk management are similar. A better profit performance by one company was achieved by pushing risk to the limit ... or maybe beyond the limit. As the technology pushes into new areas ... deeper and deeper drilling ... risk may be increasing or not ... but likely to be increasing with no technology available to mitigate damage quickly. No oil company is making financial provisions for the potential damage their operations might have on society ... and this has come as a surprise to all of us, though we should not be surprised given corporate behavior in the face of profit reporting pressures. The oil industry has very big projects ... the industry should have risk provisions fully funded and available!

I have a concern that there may be other industries heading in the same direction. Maybe "big food" is setting itself up for a disaster. The documentary "Food Inc" suggests that maybe the structure of food processing could end up with food contamination that would sicken millions of people ... and I think there is a risk dimension in this that is not being provided for in our modern society.

The various "big" organizations have become big because there are economies of scale and big is better at using power and influence than little organizations. But in the end "big" may not be so good because the risks are also growing and the ability to manage risk economically gets more and more dysfunctional with scale.

In the value system of metrics many "big" things do not turn out to be quite so good. Many of the "big" successes are only profit successful and not at all value successful. This is a potentially very important outcome from value accounting and puts added pressure on getting value accounting ready for broader use as fast as possible.

Stay tuned

Peter Burgess

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