“prudence L. prudentia, foresight, sagacity skill, prudence…The quality of being prudent. 1. Ability to discern the most suitable, politic, or profitable course of action, esp. as regards conduct; practical wisdom, discretion. …2. Wisdom, knowledge of, or skill in a matter. …3. Foresight, providence” (Oxford English Dictionary)
This post is an appeal to restore prudence as one of the guiding virtues in management, public policy, and daily life. In a buoyant business climate, the word evokes overweening hesitancy to seize an opportunity, take market share, or exploit an advantage—a hesitancy that bold leaders might be reluctant to practice. Yet in history, prudence meant something richer, qualities that the Oxford English Dictionary suggests. Such qualities have deep roots in Western Civilization, extending back to Plato and Aristotle. I think it is time to talk frankly again about the importance of prudence as a quality of good leaders.
The recent runs on regional banks, rescues of pension funds, crash in cryptocurrency values, and alleged frauds (FTX) have stimulated a host of commentaries that these outcomes were foreseeable. In my recent blog post over at Quillette.com, I argued that the surprise at financial crises is surprising. We’ve seen versions of the financial crisis movie before—in fact, many times. But what have we learned? What can we learn from the history of financial crises? They seem so idiosyncratic as to bar generalization. However, I argued that one can learn a lot.
For instance, in The Panic of 1907: Heralding a New Era in Finance, Capitalism, and Democracy (2023), Sean Carr and I tell the story and present new findings by us and some four dozen studies published since our first edition in 2007. Such a look into the past helps to inform the present and one’s outlook to the future. My course on financial crises at Darden (now ably led by Scott Miller) and my collection of case studies on crises[i] widen the lens to look at three centuries of crises. They seem so idiosyncratic: they don’t repeat, only rhyme, as Mark Twain allegedly said. Yet several “rhymes” stand out:
- Banking is a fragile and complex business because the mismatch in maturity of liabilities and assets risks runs by depositors if they fear the solvency of the bank. And the complexity of banks makes it difficult to know exactly the condition of the bank at any moment. Furthermore, banks are linked to each other through transactional commitments: this linkage means that trouble can travel from one bank to another. The architecture of the system sets the stage for contagion. What makes such a system prone to crisis is the lack of resilience due, for instance, to inadequate shock absorbers such as cash reserves (to maintain liquidity) and capital (to maintain solvency).
- Booms fueled by rapid growth in credit seem to incubate crises. Economic booms seem so nice: they create jobs, expand businesses, and juice the financial markets. But booms that are fueled by excessive credit growth can incubate financial crises. Preceding 2023 was the flood of fiscal and economic stimulus during the pandemic years that then had to be countered by monetary tightening by the Fed to fight inflation. Rapid credit growth, banks’ declining cash reserves, vaulting optimism, and rising speculation in the stock market foster vulnerability to economic shocks.
- Shocks are all around us, but only certain kinds of economic shocks matter. Pandemics, natural disasters, wars, and revolutions have destabilized financial systems in the past. A true economic shock such as these is real (not merely financial), large and costly, unambiguous, and surprising.
- The shadows erupt first. Crises tend to originate in the periphery of the financial system among firms that are smaller, marginal, and/or new, not in the center where the big well-established firms are. In 1907, 2008 and 2023, crises began somewhat beyond the gaze of the guardians of prudence and stability—not only regulators, but also accountants, securities analysts, journalists, and even shareholders, few of whom were material influences on corporate governance. From the shadows, crises spread into the center of the financial system.
- Quelling crises is hard. It takes speed, flexibility, and clout. Speed helps to forestall contagion. Flexibility responds to the unique attributes of a crisis. And clout in the form of immense commitments of money is necessary to persuade market participants that the crisis will end. But at the heart of crisis-fighting is the need to align the efforts of politicians, regulators, business leaders, and the public. And the Panic of 1907 demonstrated that mobilizing collective action is hard. Most of the amplifying moments in the histories of financial crises stem from failures of collective action.
- Financial crises have long coattails. Ripples from financial crises extend for years. The Panic of 1907 led to a massive restructuring of the U.S. financial system in 1913. The crisis of the Great Depression led to extensive regulation of the financial sector. More major reporting, governance, and anti-fraud regulations (the Sarbanes-Oxley Act) were enacted following the crash of the dot-com bubble in 2000-2001. And even more regulations were imposed after the crisis of 2008: the Dodd-Frank Act. Economic and political orthodoxies tend to shift following financial crises.
These six lessons are what I call “regularities” that crisis histories tend to display. To be sure, there is plenty of idiosyncrasy in crises. But these regularities stand behind the perennial question, “Why didn’t they see it coming?” The memoirs of the crisis of 2008 by Timothy Geithner, Ben Bernanke, and Henry Paulson poignantly confess failures of imagination and detection. The investigation of regulatory lapses here in 2023 will probably add more to such stories.
High reliability.
In my book Deals from Hell, I advocated the adaptation of “high reliability” practices to the field of financial management. Developed in the wake of major industrial accidents, the concept of the high reliability organization (HRO) aims to produce quality outcomes repeatedly even though working conditions produce possibly dangerous variations.[ii] They do this by building a vigilance in everything they do, from recruiting employees, to the greeting of customers, the fulfillment of orders, the design of products, and quality of manufacturing. From the standpoint of disaster avoidance, important cultural attributes that distinguish error-prone firms from reliable firms are
- Tolerance for unsafe conditions and practices.
- “Methodism,” the reliance on rituals, tradition, what has succeeded before. Dietrich Dorner notes that a wide range of research shows that people tend to act in terms of pre-established patterns.
- A focus on the condition of a narrow department rather than on the whole system—this is “Silo” thinking. Such thinking fails to see side-effects of actions and unintended consequences.
- A focus on symptoms rather than root causes. Surface problems are relatively easier to fix than deeper problems. Fixing the surface problems helps a worker to show activity and accomplishment. Dietrich Dorner calls this “repair service” behavior, searching for things that are malfunctioning and fixing whatever seems broken without a sense of priorities. He notes, “A mayor who is guided by a randomly generated list of complaints risks giving far too much attention to relatively unimportant problems and either overlooking the truly important ones or failing to assess them properly.”[iv]
Society offers various examples of high reliability organizations, enterprises that regularly face serious risks, have a low tolerance for error, and deliver reasonably reliable performance over time. Such organizations include hostage negotiation teams, hospital emergency rooms, flight decks on aircraft carriers, nuclear power plants, and teams of fire fighters. From the study of such organizations, Karl Weick and other scholars found a number of common attributes:
- A preoccupation with failure. HROs are obsessive about the potential for things to go wrong. These organizations do not relax under threatening conditions; they do not trust that somehow things will work out OK.
- A reluctance to simplify. HROs take little for granted. As Perrow and others have noted, looking for simplistic explanations in the context of a complex system is dangerous. HROs make redundant checks of conditions.
- A continuous sensitivity to operations. HROs do not let themselves get distracted from their central mission and the operations it requires. The entire organization is focused on the critical operations. The operational leaders are present, visible, and in continuous communication with the front line.
- A commitment to resilience. HROs take surprise as a given and prepare to respond flexibly to it, tailoring a response often at the front line.
- A deference to expertise. HROs trust that the people closest to the problem are better informed and more capable of dealing with it. This implies a decentralization of decision-making.
Weick and Sutcliffe wrote, “[I]t is impossible to manage any organization solely by means of mindless control systems that depend on rules, plans, routines, stable categories, and fixed criteria for correct performance. No one knows enough to design such a system so that it can cope with a dynamic environment. Instead, designers who want to hold dynamic systems together have to organize in ways that evoke mindful work.”[v]
Mindfulness is a focus on updating one’s information. One looks for anomalies, the unexpected, the disconfirming, and the disagreeable. The aim is to correct for possible blind spots. Thus, HROs encourage error reporting and the analysis of close calls. For instance, high performance medical units report more errors, not because they make more errors, but because they are more vigilant. I think this kind of mindfulness, vigilance, and resilience boils down to prudence.
Elevate prudence.
One way to promote prudence is to advance the use of high reliability as a management virtue. Financial crises begin with a mental mindset of imprudence and fixed systems of oversight. Warren Buffet said that “Only when the tide goes out do you discover who has been swimming naked.” In the years before 2023, regional banks loaded up on long-duration bonds, knowing that interest rates had only one way to go (up). Unpreparedness for the arrival of a crisis means that the response is slow, rather rigid, and weak, rather than speedy, flexible, and with clout.
Can participants in the financial markets afford not to practice these attributes? The history of financial crises over the past three centuries shows that we got to where we are today by a process of steady adaptation in pursuit of prudentia, the management of financial systems through virtuous qualities. Progress over the years has been a matter of two steps forward and one step back. It remains to be seen what steps lie ahead of us in 2023.
End notes
[i] Bruner, Robert F., Case Studies About Financial Crises and Civic Reactions (December 18, 2020). Available at SSRN: https://ssrn.com/abstract=3752061 or http://dx.doi.org/10.2139/ssrn.3752061
[ii] For a fuller discussion of this definition, see Weick et alia 1999, page 86.
[iii] Schein (1985), as adapted from Chapter 1 in Weick and Sutcliffe (2001).
[iv] Dorner (1996) page 59.
[v] Weick and Sutcliffe (2001) page 49.