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.

Although the subject is mostly Mary Adams’s purview at Hybrid Vigor, I wanted to post the link to my Strategy+Business column on intangibles in this quarter’s issue of the magazine.

Unfortunately I was not able to quote either Mary or Henrik Martin, the CEO of Intellectual Capital Sweden, in the article, despite the fact that they both gave me terrific interviews, in order to avoid the appearance of conflict of interest: I’ve been talking to both of them about becoming a licensee/practitioner of the IC Rating method, which I think is one of the most sensible intangibles rating systems I’ve seen so far.

At the recent conference on Intangible Assets at the National Academies, the discussion “Intangibles in the Firm” consisted of two presentations, one by Baruch Lev, Professor of Accounting and Finance at the Stern School at NYU, and the other by Ron Bossio, Senior Project Manager from the Financial Accounting Standards Board.

It is not surprising that the organizers of the conference turned to two accountants to explain the “state of the art” of intangibles in the firm. It was a natural decision. We rely on accountants to provide objective information about our organizations. Who better to help us understand this new “asset” class that makes up 80% of the valuation of the average company and fuels competitive advantage?

But the problem is that accountants have not been able to answer this question. Accounting was designed 500 years ago to track the movement of tangible goods. The system worked well throughout the industrial revolution because it provided a way to keep track of the full value chain of a tangible business—from construction of a factory to purchase of raw materials, creation and sale of finished goods, and collection of accounts receivable.

The value chain of an intangibles-intensive business, however, is much less visible in traditional financial statements. Continue reading »

I just finished this book by two consultants from McKinsey, Lowell L. Bryan and Claudia I. Joyce. Even if you haven’t read Mobilizing Minds, you may have been exposed to one of its key recommendations: that corporations use profit per employee as the “primary metric of profitability.” I disagree with this simplistic recommendation: it seems like a number that could be endlessly manipulated and it ignores the contribution of external partners who play an important role in more and more businesses.

However, it is worth reading the analysis that led them to this conclusion. Their examination of the largest 150 companies in the world showed that after growing at 3% from 1970 to 1994, their total market capitalization grew at 11% per year through 2004, even taking into account the bursting of the internet bubble in 2001. They then separate the companies into two groups: “labor-intensive” and “thinking intensive,” looking at net income per employee. It probably won’t surprise you that the thinking intensive companies had much higher income per employee. (Note that this data is in the Introduction to the book which is available as a free download)

The authors go on to state that “almost all of today’s companies…were built primarily to mobilize their labor and capital assets—not the intangible assets that enable profits per employee to rise to levels never seen before.” And further that this model leads to “massive, unnecessary, unproductive complexity.” They also imply that many of the companies that have succeeded at this game have done so more by intuition and luck than by deliberate strategies. Continue reading »

More of my observations on the U.S. National Academies conference on Intangible Assets: Measuring and Enhancing Their Contribution to Corporate Value and Economic Growth. and the presentations  made that day.

There were two panel discussions on the role of government around intangibles. Many of the presentations were rich with data, and I recommend them to those interested in the macroeconomic aspects of intangibles.

Douglas Lippoldt, Organization for Economic Cooperation and Development (OECD) made a clear case for governments and organizations like the OECD to focus on intellectual assets as:

• They are central to value creation, economic growth and competitiveness in a modern economy.
• Continued shortfalls in measurement and understanding of intangibles has implications for decision making
• IA relationship to innovation, as inputs and outputs needs to be understood
• There are significant possibilities to leverage these assets for acceleration in development

R&D was the focus of presentations by John Jankowski, Science Resources Statistics Division of the National Science Foundation, and Steve Landefeld, Bureau of Economic Analysis at the Department of Commerce. Continue reading »

More of my observations on the U.S. National Academies conference on Intangible Assets: Measuring and Enhancing Their Contribution to Corporate Value and Economic Growth. and the presentations  made that day.

This was the discussion of the day closest to my experience and practice so I was especially interested in these presentations.

I recommend the discussions by Laurie Bassi, McBassi & Company, and James Malackowski, Ocean Tomo, whose companies are encouraging market development for intangibles. McBassi offered data on the value of investment in human capital. Malackowski’s firm made its name by developing public auctions of patents and is now developing investment units tied to licensing rights. The work of companies like this will provide an important validation to markets and managers of the value of intangibles in business.

Baruch Lev of New York University’s Stern School, reported that “shares of intangibles-intensive companies are systematically undervalued, causing excessive cost of capital as well as suboptimal investment and growth.” Lev rejects the value of many intangibles indicators and advocates Continue reading »

More of my observations on the U.S. National Academies conference on Intangible Assets: Measuring and Enhancing Their Contribution to Corporate Value and Economic Growth. and the presentations made that day.

The discussion of the challenges and approaches to macroeconomic measurement of intangibles was greatly strengthened by the presentations of perspectives from not only the U.S., from Carol Corrado, The Conference Board and Brent Moulton, Bureau of Economic Analysis, but also from Jonathan Haskel from Queen Mary College, University of London, and Kyoji Fukao of Hitotsuboshi University and RIETI. I recommend the individual presentations for more detail but thought I would highlight a couple points that struck me.

Corrado pointed out that many of the expenditures in intangibles are co-investments in IT. This emphasizes the role of technology as a catalyst for change in organizations as well as a tool for accomplishing that change. Process improvement, increased employee competencies, improved customer service, are all inter-related. This comment was also interesting in light of Wladawsky-Berger’s presentation based on his experience at IBM on the role of intangibles in business.

Using the approaches developed by Corrado, Hulten and Sichel in 2006 on Intangible Capital and Economic Growth, it appears the intangibles investment in the UK and Japan is much lower than in the U.S. But then Fukao dug into the numbers. Continue reading »

I have been following the story of the Tata Nano car for a number of years now. Tata is an amazing Indian conglomerate that operates in seven business sectors through dozens of companies.

The goal of the Nano team is to develop the world’s lowest cost car with a sticker price of roughly $2,500. A recent peak Inside the Tata Nano Factory in Business Week explains the role that diverse suppliers have played in creating component parts of the car that are better and cheaper than those used in other cars. Bosch supplies the computer inside the engine. Rane, the steering system. Ran, the driveshaft. Coordinating with vendors to bring together all these innovations in a coherent whole is a big part of the work of the Tata team.

This story is similar to the story about the Boeing 787 recounted in Wikinomics by  Don Tapscott and Anthony D. Williams. To build this next generation of the 700 series, Boeing made a radical shift from the past. Power to innovate and design the components of the 787 was pushed down to the vendors as never before. As with Tata, Boeing’s role is more focused on coordination of the design and production than on doing it all themselves.

Networks of suppliers are one of the critical intangibles in almost every business today. Computing power and the internet itself are the drivers of this trend. The easier it is to connect with partners and vendors, the less important it is to keep a function inside the corporation. With growing importance, networks become something that must be managed as carefully as internal businesses. The health, performance and results of network partners are all relevant. But this kind of information is not picked up by management information systems that are built to monitor internal operations. Are you monitoring the health of your network?

Ken Jarboe at the Athena Alliance has had two great posts recently about manufacturing. In Reversing the Offshoring Trend,he makes the point that high energy costs and the knowledge intensity of manufacturing are important factors that can outweigh the low labor costs that have moved so much production out of the U.S. In Workforce as an Intangible Asset he describes how the experienced workforce of Danville, Virginia was a key factor that, along with energy prices, recently has lead to the decision by two companies to open two new furniture plants in Danville.

Jarboe’s arguments made me think of the wonderful cases laid out in Lean Solutions a few years ago by James P. Womack and Daniel T. Jones. The book looks at value from the customer’s point of view—one that is getting increasing attention in today’s Web 2.0 world. Although the analysis of the management of doctors’ offices is also memorable, I call your attention to the case of shoe manufacturing. This type of manufacturing was moved off shore long ago and certainly yields a lower cost per shoe.

But the authors point out potential limits to the total cost and earnings related to offshoring. The distances and complexities of offshoring usually imply long lead times so product mix and quantities have to be decided as much as a year in advance. Long lead times mean that new product cannot be produced if a shoe turns out to be a bestseller or if one size sells out before others. Shoes that don’t turn out well end up being sold off through discounting channels. This leads to an overall profit that is lower than that which might be obtained with more flexible, shorter-run production were available. I don’t remember energy costs being part of this argument but they would certainly tip the balance in favor of looking at more creative production that is closer to home.

This is yet another illustration of the power of intangibles to turn business models on their head. Cost of production was paramount in the industrial economy. Although factors like flexibility, quality and customer service are intangible, they can have real bottom line impact. The faster we learn to evaluate intangibles, the better off our economy will be.

Thanks to a Mumblr blog posting by an Indian management consultant, I recently read the Infosys annual report. Most of the report looks like the average annual report. But tucked in the back, they include what they call an “intangible assets score sheet.”

The score sheet (found on page 135) uses numerical proxies to try to get to the core of the three major categories of intangibles, including:

1. External structure – They focus exclusively on clients, using metrics such as growth in revenue, numbers of clients and revenue from repeat business.
2. Internal Structure – They focus on R&D, technology investment and efficiency. Efficiency is measures through sales and G&A expenses compared against staff and revenue levels
3. Competencies – They focus on staff levels, age of employees, attrition and value added for different kinds of employees.

This is an amazing start that begins to show make intangibles more tangible to the average analyst. Given the power of intangible information shown in the contest I described in a recent post on XBRL, companies need to learn how to “show” their intangible value to their stakeholders.

Some additional things that I would like to see in this kind of report:

• External – Metrics around key external relationships with suppliers and partners
• Internal – Metrics around internal process strength
• Competencies – Metrics around training expenses and recruiting costs

Infosys is not the first to do this. I will profile others in the future. Do you know of other cases of intangibles reporting to shareholders? Post a comment or send me an email and I will add them to future posts.