{"id":2081,"date":"2023-04-13T10:27:26","date_gmt":"2023-04-13T14:27:26","guid":{"rendered":"https:\/\/blogs.darden.virginia.edu\/brunerblog\/?p=2081"},"modified":"2023-04-13T10:27:28","modified_gmt":"2023-04-13T14:27:28","slug":"financial-crises-and-prudence","status":"publish","type":"post","link":"https:\/\/blogs.darden.virginia.edu\/brunerblog\/2023\/04\/financial-crises-and-prudence\/","title":{"rendered":"Financial Crises and Prudence"},"content":{"rendered":"

\u00a0<\/em><\/p>\n

\u201c<\/em>prudence<\/strong> L. prudentia, <\/em>foresight, sagacity skill, prudence\u2026The quality of being prudent.\u00a0 1.\u00a0 Ability to discern the most suitable, politic, or profitable course of action, esp. as regards conduct; practical wisdom, discretion.\u00a0 \u20262. Wisdom, knowledge of, or skill in a matter.\u00a0 \u20263. Foresight, providence\u201d <\/em>(Oxford English Dictionary<\/em>)<\/p>\n

\u00a0<\/strong><\/p>\n

T<\/span>his post is an appeal to restore prudence as one of the guiding virtues in management, public policy, and daily life.\u00a0 In a buoyant business climate, the word evokes overweening hesitancy to seize an opportunity, take market share, or exploit an advantage\u2014a hesitancy that bold leaders might be reluctant to practice.\u00a0 Yet in history, prudence meant something richer, qualities that the Oxford English Dictionary <\/em>suggests.\u00a0 Such qualities have deep roots in Western Civilization, extending back to Plato and Aristotle.\u00a0 I think it is time to talk frankly again about the importance of prudence as a quality of good leaders.<\/p>\n

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.\u00a0 In my recent blog post over at Quillette.com<\/a>, I argued that the surprise at financial crises is surprising.\u00a0 \u00a0We\u2019ve seen versions of the financial crisis movie before\u2014in fact, many times.\u00a0 But what have we learned?\u00a0 What can <\/em>we learn from the history of financial crises?\u00a0 They seem so idiosyncratic as to bar generalization.\u00a0 However, I argued that one can learn a lot.<\/p>\n

For instance, in The Panic of 1907: Heralding a New Era in Finance, Capitalism, and Democracy<\/em><\/a> (2023),<\/em> 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.\u00a0 Such a look into the past helps to inform the present and one\u2019s outlook to the future.\u00a0 My course on financial crises at Darden (now ably led by Scott Miller) and my collection of case studies on crises[i]<\/a> widen the lens to look at three centuries of crises.\u00a0 They seem so idiosyncratic: they don\u2019t repeat, only rhyme<\/em>, as Mark Twain allegedly said. Yet several \u201crhymes\u201d stand out:<\/p>\n

    \n
  1. Banking is a fragile and complex business <\/strong>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.\u00a0 Furthermore, banks are linked to each other through transactional commitments: this linkage means that trouble can travel from one bank to another.\u00a0 The architecture of the system sets the stage for contagion.\u00a0 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).<\/li>\n
  2. Booms fueled by rapid growth in credit seem to incubate crises. <\/strong>Economic booms seem so nice: they create jobs, expand businesses, and juice the financial markets.\u00a0 But booms that are fueled by excessive credit growth can incubate financial crises.\u00a0 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.\u00a0 Rapid credit growth, banks\u2019 declining cash reserves, vaulting optimism, and rising speculation in the stock market foster vulnerability to economic shocks.<\/li>\n
  3. Shocks are all around us, but only certain kinds of economic shocks matter. <\/strong>Pandemics, natural disasters, wars, and revolutions have destabilized financial systems in the past.\u00a0 A true economic shock such as these is real (not merely financial), large and costly, unambiguous, and surprising.<\/li>\n
  4. The shadows erupt first. <\/strong>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\u2014not 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.<\/li>\n
  5. Quelling crises is hard.<\/strong> It takes speed, flexibility, and clout.\u00a0 Speed helps to forestall contagion.\u00a0 Flexibility responds to the unique attributes of a crisis.\u00a0 And clout in the form of immense commitments of money is necessary to persuade market participants that the crisis will end.\u00a0 But at the heart of crisis-fighting is the need to align the efforts of politicians, regulators, business leaders, and the public.\u00a0 And the Panic of 1907 demonstrated that mobilizing collective action is hard.\u00a0 Most of the amplifying moments in the histories of financial crises stem from\u00a0 failures of collective action.<\/li>\n
  6. Financial crises have long coattails. <\/strong>Ripples from financial crises extend for years. The Panic of 1907 led to a massive restructuring of the U.S. financial system in 1913.\u00a0 The crisis of the Great Depression led to extensive regulation of the financial sector.\u00a0 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.\u00a0 And even more regulations were imposed after the crisis of 2008: the Dodd-Frank Act.\u00a0 Economic and political orthodoxies tend to shift following financial crises.<\/li>\n<\/ol>\n

    These six lessons are what I call \u201cregularities\u201d that crisis histories tend to display.\u00a0 To be sure, there is plenty of idiosyncrasy in crises.\u00a0 But these regularities stand behind the perennial question, \u201cWhy didn\u2019t they see it coming?\u201d\u00a0 The memoirs of the crisis of 2008 by Timothy Geithner, Ben Bernanke, and Henry Paulson poignantly confess failures of imagination and detection.\u00a0 The investigation of regulatory lapses here in 2023 will probably add more to such stories.<\/p>\n

    High reliability.<\/strong><\/p>\n

    In my book Deals from Hell<\/em><\/a>, I advocated the adaptation of \u201chigh reliability\u201d practices to the field of financial management.\u00a0 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]<\/sup><\/a>\u00a0 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.\u00a0From the standpoint of disaster avoidance, important cultural attributes that distinguish error-prone firms from reliable firms are<\/p>\n