Managing Risk is Not Enough
Late last year, I sat in a meeting in which several bankers were present. During the meeting, one of the bankers said something that in retrospect belongs in the highlight reel of “famous last words.” The comment went something like this: “We’re bankers! We understand risk, because it’s our business. We know how to manage risk. That’s why industry and government are looking to us to solve risk-related problems.”

As ridiculous as this statement now seems (especially to those of us whose retirement funds have been decimated) I’d argue that the statement holds true—even in a grizzly market. Yes, good bankers do know how to manage risk—their own risk. Which is why the best investment bankers view a recession more like a sabbatical, while the rest of us have to figure out how to keep food on the table. And even as the government is coming to the rescue, the Fed won’t be doing the risk management part: they’re paying bankers to figure out how to get out of the mess they’ve created. Talk about a win-win!
Not that these guys aren’t suffering. Here’s a bit of anecdotal evidence of how bad things have gotten:

This is a finance guy making a ton of money and he was trying to decide whether he should sell the country home in Connecticut, the apartment here in the city or the 8,000-square-foot dream home in Oregon that he just finished…  (from “End of an Era on Wall Street: Goodbye to All That“)

A dilemma for sure, but global financial crises demand desperate measures.

Markets Transfer Risk, Not Trust

The foundation of modern financial markets is seeped in the mathematics of probability. Over the years, rules and regulations have been piled on to promote competition and reduce overall risks. The results are compelling. And something in the human psyche tells us that since these guys are so much better at managing their own risk—and they obviously are, since they have several luxury houses at their disposal—then maybe we should trust them to manage our risk too. A market allows us to transfer our assets to someone who can navigate a risky terrain better than we might ourselves.

But risk management in itself doesn’t guarantee collaborative outcomes—that is, outcomes in which gains and losses are shared proportionally—nor does risk management inexorably produce social trust.

Clearly, the current crisis is as much about a breakdown in social trust and a loss of social capital as it is about debt ratios and credit freezes. We’ve already seen how even an injection of more than a trillion dollars won’t allay lenders’ anxieties. If you’re not an actuary, the reason is obvious: anxiety isn’t a risk equation, it’s a human emotion. Anxiety is symptomatic of a collapse of trust.

The problem with words like “anxiety” and “trust” of course is that they’re mystical to the mathematical mind. How’s a actuary to calculate the value of trust futures? or social trust default swaps?

Restoring Social Trust

What the world needs now is a renewed social trust. Until recently, social trust seemed like an intangible commodity with a will of its own; it couldn’t be systematically cultivated, measured, forecasted, or valued. But a growing canon of research into successful resolutions of social dilemmas demonstrates that collaborative arrangements are more likely to emerge when certain conditions are met. It’s time to develop mechanisms that foster pro-social behaviors by supporting natural processes of recognition, reciprocity, and community awareness. Most of the fundamental research is available to build such a system, so it’s more a matter of applying these ideas to real world relations, institutions, and markets.

Laws of Relation Revisited: Codifying Pathways to Trust

A few years ago, I challenged the software industry to take ideas about trust from various branches of science (such as game theory, social science, evolutionary biology, and psychology) and produce a system that greatly improved the likelihood of collaborative outcomes and improvement in social trust. The system could then be applied to trust-related problems on the Internet, such as spam, identity theft, and credit fraud. If such a “trust leavening” could be invented, it might even be applicable to a wider range of problems, including stronger trust in financial markets.

To design a trust system, there needs to be some workable theory on trust that explains how it’s created, how it’s maintained, and how it’s used. The theory needs to be intellectually accessible to a wide range of professionals. Just to get the conversation started, I offered three “Laws of Relation” (which are really more like postulates at this point). They are:

Law of Relational Symmetry

The party in control of the terms of a relationship controls the relationship and, in the absence of symmetrical countervailing controls, will eventually exploit the other participants.

Law of Relational Risk

Contribution to the relationship that is not met proportionally by the other participants is a loss to the contributor.

Law of Relational Projection

Any party with more than an informational interest in a relationship is a participant in the relationship.

As it turns out, financial markets illustrate these laws rather well.

The first law says that exploitation will occur in asymmetrical relations. Who controls the playing field in financial markets? The SEC? The Fed? It seems in many cases, the large investment banks who continually added exotic financial instruments, pushed for rule changes, and lobbied for reduction in government oversight. The prevailing belief in Washington was that these are smart guys who know how to manage risk. As it turns out, they were easily the smartest guys in the room and they were exceptional at managing their own risk, but not motivated at all to think of market risk. The average investor has almost no say in matters regarding market rules, so the relation was systematically slanted in favor of the rule makers.

The Law of Relational Risk predicts that collaborative outcomes are more likely when all parties experience a loss proportionally. The losses on Wall Street have been catastrophic, but not for everyone. Many of the people directly involved in creating this mess won’t suffer from the crisis the way some of the shareholders or general public will.

And the Law of Relational Projection distinguishes participants from on-lookers. One thing that has been a surprise to everyone is how interrelated and interdependent we’ve all become. Interdependency can be a vital pro-collaborative element to relations (per the Law of Relational Risk). In fact, it’s our agreement on a shared conflict, our mutually assured financial destruction–that has formed the basis for cooperation in congress and among world banks. But the strategy only works well when these relations are explicit. Instead, as our home loans have been sold, resold, hedged, and bet on through derivatives of derivatives, it’s no longer clear to anyone who is a participant and who’s a bystander. So what’s happened is that people who were believed to be bystanders have brought the house down with little or no accountability.

Designing Pro-Collaborative Systems
Few of society’s existing institutions are set up to support collaborative outcomes, and so exploitation is inexorable. With an informed understanding of elements that promote collaboration and trust, we can greatly improve our institutions, including financial institutions. I’ll continue to present my ideas on how to do this in follow-on posts, but I hope that professionals from a wide range of disciplines will contribute their ideas as well.

Today, there was some interesting discussion in the New York Times on human instincts for punishment and forgiveness. According to the article, researchers have found that within a population, some percentage of people (between 10 and 40%) are attuned to following their “referee instincts” by ensuring evil-doers get their due. This instinct has clearly come into play during the wide-spread financial crisis:

The public urge for punishment that helped delay the passage of Washington’s economic rescue plan is more than a simple case of Wall Street loathing, according to scientists who study the psychology of forgiveness and retaliation. The fury is based in instincts that have had a protective and often stabilizing effect on communities throughout human history. Small, integrated groups in particular often contain members who will stand up and — often at significant risk to themselves — punish cheaters, liars and freeloaders.

But allowing such impulses to play out on a grand scale can also exacerbate a crisis. The article continues:

Some experts believe that Japan’s disastrous delay in bailing out its banks in the early 1990s was caused in part by a collective urge to punish corrupt bankers, and they fear a similar outcome today.

Game theory suggests alternative approaches to resolving social dilemmas. In running various gaming scenarios in which participants respond to each others’ uncooperative behaviors, the best outcomes for all players are achieved when players follow simple tit-for-tat strategies and allow for forgiveness. On this subject, the article states:

Fortunately for the economy, researchers say, a strong countervailing psychological force is also at work: the instinct to forgive, and to cooperate…. Running thousands of computer variations … scientists have found that the strategies that pay off the most are tipped toward cooperation.

Agreed. But we’re not in a laboratory, so the quaint models of game theory aren’t so readily applicable. In real life things are so much messier, if only for the phenomenal scale on which the current crisis is playing out. It’s not even clear how the average person can actively participate in responding to the crisis. I imagine most just want to board up their windows, live off of food storage, and wait for the hurricane to pass. I imagine the average person won’t be quick to take advice from financial advisers or government officials, because so much trust has been lost in these relationships. If so, the result would be an even worse situation for everyone.

The financial crisis highlights our need for greater social trust. Humanity has learned to stitch societies into a globally integrated economy, but our natural pathways to trust have languished. The explosions in the size of the organizations and communities we associate with, the amount of information we need to process, and the complexity of the system of trade we must rely on for our well being have overwhelmed our native, instinctual ability to form relationships based on trust. How to construct a basis for trust in the modern era is, in my mind, the most important issue of our time.

Yesterday, Olivia Judson published a piece in the New York Times about how human beings are almost incapable of being objective, particularly when it comes to the subject of themselves. This creates severe difficulties for studying humans as individuals, cultures, and civilizations. She points out:

The literature from psychology shows that, as individuals, we are good at seeing other people clearly, but poor at seeing ourselves. Most people, for example, describe themselves as being better drivers than average, and consider themselves better looking than other people consider them.

It seems the observer’s paradox applies also to self-observation. Who knew?

A story in today’s New York Times discusses how the media has struggled to explain the financial crisis to audiences. Admittedly, many industry experts are dumbfounded by the events of the last few weeks. Where the media has faltered, my good friend and former colleague Bob Blakley has succeeded with his down-to-earth post on “Wall Street’s Governance and Risk Management Crisis.” Thanks, Bob!

I particularly liked Bob’s phrasing of the “collective margin call” on the banks. It indicates that part of what’s happened is a failure in coordination: banks have cash on hand as long as only a few percent of their patrons want to withdraw their cash. This echoes a theme of a post I wrote about the credit crunch back in June. Here’s an excerpt from that post:

Clearly, a great crime has been committed. An entire nation has been robbed. World markets are shaken. But who’s responsible? Nobody. And everybody. The insidious nature of this crime is that we all collaborated to commit it and without a master plan. Can such collective action crimes be avoided? Or is the commons forever doomed to be the scene of tragedy?

Bob’s comments on risk management are also strongly reminiscent of Denise’s work on risk management in the biotech industry. Bob writes:

Risk management failures created the current financial crisis, and risk management failures have also created the personal information disclosure crisis, and the malware crisis, and a bunch of other problems which are not yet crises. We do risk management poorly in all disciplines. We do it poorly for a bunch of reasons: executives don’t understand their own businesses well enough to understand their risks; risk managers don’t know how to talk to executives about risk; incentives favor creating long-term risks in order to accrue short-term profits; the list goes on and on.

Denise’s main assertion in her book, “Intervention: Confronting the Real Risks of Genetic Engineering and Life on a Biotech Planet,” is that the biotech industry is similarly awash in poorly managed risk. Genetic engineering is another impending crisis that, once it reaches crisis levels, people will be dumbfounded to explain.

As an avalanche of new laws and regulations hit Wall Street over the next few years, I fear that we’ll lose sight of the most important learning to take away from this disaster. Again, Bob Blakley explains:

A final thought.  The financial crisis exists because of a failure of risk management. There will be a temptation to fix the problem using compliance mandates. Compliance mandates, however, don’t fix risk management problems. All they do is prevent specific risk management failures from happening over and over again. Organizations whose risk management is weak will find new ways to fail - and these new ways will circumvent compliance regulations. The right way to fix a risk management problem is to do a better job of risk management.

Karl Giberson wrote a piece for Salon a few weeks ago entitled “What’s wrong with science as religion?” The piece was largely in reaction to antics by PZ Myers, including his “great desecration” of a Communion wafer. But Giberson avoids being goaded into the “whose is bigger” contest of religionists and instead explores whether science can offer a suitable replacement for religion.

It’s a topic I’ve written on before (most recently in discussing Denise Caruso’s book, “Intervention”), but Giberson boldly goes where I didn’t dare in suggesting that “Science … has the raw material for a new religion.” But then he asks some hard questions of a scientifically rooted religion:

What would this new religion be like once it became institutionalized? After all, if religion fills a genuine human need, something has to fill the hole created by its passing — something that appeals to billions of people.

Could we be sure, for example, that this new scientific religion would not give rise to the extremism and aberrant behavior that plague conventional religions? Would concern for the diversity of life, for example, inspire vegetarians to blow up slaughterhouses, and run the local butcher through his or her own meat grinder? Would reverence for the cosmos reinvigorate astrology? Would appreciation for natural selection bring eugenics back out of the closet? In other words, if science dismantles the traditional religious content that people use to satisfy their impulses — many of which are quite passionate — will we really be better off?

Great questions. The questions remind the reader that religious exercise isn’t just about getting the facts. They suggest that those who insist on literalism in religion miss the point, as if strict literalism among a group of human beings is either possible or desirable.

So rather than attacking religions, I’d prefer to see biologists (such as PZ Myers) and other scientists approach religion as an evolutionary phenomenon. Clearly, religion is itself an important evolutionary adaptation for the survival of our species. The religions in the world today exist because they are the ones that enabled cultures to survive. Religions have been successful in coordinating activities and building foundations for trust for millions of people across the globe. And they have done this without requiring the laity to have Ph.D.’s or IQ’s over 150. Whether the stories today’s religions tell are “true” in the scientific sense is irrelevant; what can’t be disputed is that these religions have enabled cultures to survive and civilizations to thrive where others have failed.

Religions will continue to evolve, but they won’t follow a rational or scientific path. Religions are also unlikely to completely overpower the human propensity for “extremism and aberrant behavior.” So before rushing off to take scientific communion, consider this: if survival in nature depends on making rational, scientifically founded decisions, how did we ever come to be?

Today’s USA Today features two cover stories that are interesting in their own right, but even more telling taken together.

One headline reads, “Report: Feds need better privacy protection for data.” The article states that “the government does not have adequate privacy protections for the personal information it collects, shares and stores as part of the effort to fight terrorism, according to a new report by a U.S. watchdog agency.” This revelation is neither shocking nor newsworthy to anyone familiar with subject matter. But thankfully, the significance of privacy problems are now disturbing to the popular consciousness as well. The article continues:

Committee Chairman Joe Lieberman, I-Conn., says citizens can be left vulnerable to identity theft, stalking, discrimination, unwarranted surveillance or loss of employment if their personal information isn’t properly secured.

The second article discusses how credit card issuers encouraged consumers — particularly in lower income households — to spend with their credit cards and then pay off the debt with equity (which turned out to be “phantom equity”) in their homes. Things have gotten severe. Sen. Robert Menendez is cited in the article saying, “We cannot allow the credit card problem to become the next foreclosure crisis.”

This situation, as stated in the article, “was no accident.” Card issuers have become expert at targeting their prey. They’re also exceptional at managing their own risk, while ignoring others’. The article cites several examples of this behavior; here’s one of them:

When banks extend more credit, younger consumers and the financially inexperienced are more likely to take on debt, a 2002 study by Amar Cheema, of Washington University in St. Louis, and Dilip Soman, of the University of Toronto, found.

Subprime borrowers, many of whom have little experience with credit, tend to use more of their available credit than others do. “Generally, these are consumers who have (greater) need for credit,” says Myra Hart, a senior vice president at Equifax.

During the boom, banks focused on getting more plastic into these borrowers’ hands: New cards issued to subprime consumers rose 137% from 2003 through 2006, Experian data show.

Ironically, companies like Experian helped target consumers in the first place.

In the face of the market upheaval, it’s easy just to throw one’s hands in the air in frustration. Clearly, a great crime has been committed. An entire nation has been robbed. World markets are shaken. But who’s responsible? Nobody. And everybody. The insidious nature of this crime is that we all collaborated to commit it — and without a master plan. Can such collective action crimes be avoided? Or is the commons forever doomed to be the scene of tragedy?

If such outcomes are to be averted, we must first acknowledge to role of the “stage” or “playing field” on which such tragedies play out. Game theorists use games like “prisoners’ dilemma” to demonstrate how the structure of a game largely determines its outcome. By adjusting the rules of the game, researchers can alter participants’ tendency to collaborate or defect. On a societal scale, it’s clear that the playing field in current use promotes an atmosphere of exploitation rather than cooperation.

A lot can be done to improve this situation. As a society, we need to insist on rules that promote stable relationships with cooperative outcomes. As I discussed on the Burton blog, exploitation is a predictable outcome of asymmetrical relations. But so much of mankind’s modern economic and social growth has come at the sacrifice of time-honored ceremonies for instinctual trust and establishing equilibrium in relations. In the context of the mortgage crisis and credit crunch, processes for empathy, reciprocity, signaling, reputation, demonstrations of skill and other natural pathways to trust are decidedly anachronistic. In the absence of such ceremonies, institutions instead rely heavily on your digital information as the basis for trust. And in doing so, as Sen Lieberman put it, make you “vulnerable to identity theft, stalking, discrimination, unwarranted surveillance or loss of employment.”

The issue here is not data protection: that approach attempts only to steady a playing field that is highly flawed. The issue is how to reintroduce pathways to social trust into today’s globalized, diverse, and complex civilization.

The debate over propriety in the blogosphere got just a bit nastier recently in reaction to an article in The New York Times Magazine by Emily Gould. In the article, Emily recounts the experiences that led to both fame and infamy during her stint with Gawker. The piece apparently galvanized a nation. As Simon Dumenco puts it:

A May 25 New York Times Magazine cover story about the hazards of oversharing titled “Blog-Post Confidential” by former Gawker blogger (circa 2006 to 2007) Emily Gould, inspires such vitriol that the Times shuts down the comments function on the online version of her piece after accruing hundreds of frequently vicious comments.

The thing about blogging is that it’s always fun until someone looses an eye… or their identity.

In reflecting on Gould’s and her own experiences, Melissa Lafsky muses whether blogging about your life unavoidably ruins your life–an astute restatement of the observer’s paradox for the Internet age.

One of the best treatments of this topic in publication today is Daniel Solove’s book, “The Future of Reputation.” It’s available online free of charge, so I encourage anyone with even passing interest in this topic to read the book. And you might also want to think twice before mentioning those little details about your life!

Friday’s Wall Street Journal included an interesting article by Robert Lee Hotz entitled “Revenge of the Freeloaders.” Hotz discusses the findings of a study that used an economics game to explore the social dynamics of anonymous groups. Apparently, attitudes of free-loaders (those that chose to go-it-alone, rather than join a group) differ widely across cultures. Notably, the study showed how people are often more interested fairness than monetary gain (a concept at the heart of the Law of Relational Risk.) And faced with limited resources, when a loners retaliate against group pressure, they generally target the most generous contributors of the group, assuming them to be the ringleaders.

At first reading, the results of the study may seem foreboding for those of us interested in anonymous (or pseudonymous) online interactions. But in fact I’m thrilled to see this kind of primary research into our instinctual preconditions for collaboration. As I understand it, the researchers in this study used a basic public-good game as the basis for social interactions. So it would be of great value to devise more sophisticated games that can help scientists delve further into the psyches of collaborators and freeloaders. It’s also nice to see this kind of research getting such high level of media attention.

I’ve just finished reading Denise Caruso’s book, Intervention: Confronting the Real Risks of Genetic Engineering and Life on a Biotech Planet. I absolutely love it! As the book’s subtitle suggests, Denise recounts the tragedy of how hubris in the biotech industry — compounded by sub-standard risk assessment methods used by government regulators — has blinded us to potentially catastrophic consequences of releasing billions of living, reproducing, evolving man-made organisms the environment, the long-term effects of which are completely unknown.

But Intervention delivers a much broader message, about how the human propensity for hamartia isn’t miraculously expunged by mathematics, statistics, or the scientific method.

In proving her point about assessing the risks of genetic engineering, Denise calls into question the seemingly unassailable position of science in our culture. The book suggests we desperately need “a new kind of science” (to borrow Steven Wolfram’s phrase) — one that accounts for the nature of the beings (i.e., us) who are wielding its increasingly powerful tools. Try as we might, whatever model we create to try and describe reality, our scientific models inescapably say much more about human beings than they do about some objective reality. In the book, Denise exposes our lapses in rationality due to cognitive, social, and technological realities. Such lapses are everywhere in the areas I cover (technology, social trust, and privacy).

So while reading the book, I decided present my views on these issues in a blog post. Admittedly, going into some depth on Denise’s book on the Hybrid Vigor blog (which is Denise’s creation) seems almost self-congratulatory. But I think the larger themes in Intervention are relevant to most of the really difficult problems we’re trying to solve globally today, and understanding these issues will help focus our discussion at Hybrid Vigor. Continue reading »

This post isn’t about Eliot Spitzer. Yes, of course I’m as outraged as anyone over how this scandal takes the wind out of Cathouse: the Musical. But something else about the Spitzer incident really hit home: The confirmation that my financial institution is a federal agent.

According to this USA Today article, financial institutions reported 17.6 million transactions to the Federal Crimes Enforcement Network in 2006. Does this fact imply that 17.6 million transactions in 2006 were criminal in nature? No, they were simply “transactions of interest” (my term). In addition, financial institutions filed about 1 million “suspicious activity” reports in 2006 (up from 413,000 in 2003) to government agencies. Allegedly, it was the suspicious activity reports that linked Spitzer to the prostitution ring.

But most of the people behind the other 17.59 million financial transactions aren’t accused of any crime. Still, their spending habits are monitored, and if anything sketchy turns up they’ll then be accused of a crime. This seems afoul of the Fourth Amendment, Continue reading »