An address by Charles S. Sanford, Jr.
We live in interesting times, and interesting times make it especially important to price risk appropriately. There are macro factors that will affect the future, and there are micro factors. Risk managers need to keep in mind that macro factors by far have the most weight. That is why this article is taking a macro view of both current and future conditions. The U.S., the world's military and economic leader, is now subject to conflicting pressures — a move one way or the other will have very different ramifications for risk managers. Will the world continue toward globalization or respond to a groundswell of separatism? And speaking of swelling, company growth can be a good thing ...or a bad thing. If growth is through ever new forms of innovation and resulting products and services, it's good. If growth is simply to squelch competition through artificial barriers of entry, the result is the government/corporate equivalent of what Eisenhower called a military/ industrial complex, an environment in which innovation ends and behemoths are in control. And this can lead to stagflation and political unrest.
The premium for equity risk currently is low by historical standards — it has dropped dramatically from 7% (or 4%, depending on how you measure it) to as low as 1%. Is this justified? Should it be lower or higher? Risk has two sides — you can make money or lose money. And looking at all sides, from within both historical and forward thinking contexts, the message of this article is that we're at a crossroad, where risk managers need to be especially wary. The path forward is not clear. The answer is not obvious.
The U.S. as World Leader
The U.S. in today's world is the keystone to the world's economy, culture, and politics. New York City serves as the world's financial capital, Hollywood as the cultural capital — at least for the young, and Washington, D.C., as the political capital. The strength and influence of the U.S. today are unprecedented:
- The basis of much of our power and influence is our military strength, and, by extension the strength of our currency. For evidence of our military might, Europe need look no further than Kosovo. At the same time, the U.S. currency is the standard of the world. And there is plenty of precedent for this combination: You can go all the way back to ancient Rome to see that no country can have a strong currency without military might.
- The US. economy is so strong, in both a relative and absolute sense, it drives the world's economy. We dominate world liquidity because of our capital markers as well as our strong influence over policy at the IMF and the World Bank. Emerging market countries, dependent on the US., know they must listen to us.
- The U.S. culture has permeated the world, in terms of fast foods, movies, music, and dress. The effect is most pronounced among the young, who can be found everywhere clad in blue jeans, listening to American popular music, and, much to the chagrin of their elders, no longer taking part in a three-course family dinner every Sunday.
Back in the early 1990s, an American academic, political commentator, and government advisor, Francis Fukuyama, argued that society had entered a new and lasting phase. Basing his argument on readings of Kant Hegel, and a critical reading of Marx, Fukuyama said we've gone through all the ideological battles of history, and it's over: liberal democracy and capitalism win. We're not going any further.
The Internet reinforces this victory, linking the world as never before and making information accessible both quickly and inexpensively. Strong central governments have lost some control, courtesy of the Internet. In cyberspace, people are able to act without government approval and build power bases through e-mail.
Through Trial and Error
But how should risk managers form their macro view of current and future conditions? Many people still see the U.S. through a snapshot of the world taken after World War II, a world of Keynesian economics and the Cold War. But that's not the world we're in today. Any analysis of the situation today would be better based on the British experience from the time Napoleon was defeated in 1810 to the Franco-Prussian War of the 1870s. During that time, there were more wars than at any other time, but they were relatively small, with the British clearly in control. And there was huge market volatility along with very low inflation and even deflation. The British had their own money culture, just as the U.S. does today, and fortunes were won and lost then, too.
The real lesson from the 20th century is that trial-and-error is superior to planned design and execution. The failure of fascism, communism, and socialism is that a planned economy and social engineering couldn't win against a market economy. And the central component of a market economy is, quite simply, human nature. It may not be the better part of human nature, but it is, nonetheless, human nature, and is works. This was Adam Smith's argument, which came out of the Scottish enlightenment of his period. He said, "The local actions of individuals, rather than the ordering of a planner, can create an ordered world." Darwin observed and reported this phenomenon while developing his theories of natural selection, and he saw natural selection as a creative force, not a destructive force.
So trial-and-error brought the U.S. to where we are today. And its evolution continues. Computer programmers now use generic algorithms, a way of letting programs evolve by trial?and?error, as opposed to having a programmer design it. The result The program comes out better than if is had been designed.
The U.S. is the birthplace of much of the discontinuous technological innovation, especially biotech and digital electronics. To be fair, U.S. efforts were in no small way stimulated by Soviet Russia's launch of Sputnik in the late 1950s. However, capitalism reinforced technological innovation through our money culture. The key motivation for much of our influence, after all, is money. This is not to say money hasn't always been a major reason for working, but the U.S. has taken the importance of money to a new level of materialism and self-serving value systems.
I was speaking with a German executive whose company provided many services but nothing near the salaries seen in the U.S. And he said, "I don't care about having my lawn mowed, I want to be rich like all of you." This is a very different stance for a country that has been socialist for years. It's a dramatic change for the German people, as well as others throughout Europe and Asia, even to openly desire the wealth they see in the U.S. But that stance is becoming increasingly accepted. According to the New York Times, Kanwal nRekhi, a 54-year-old Indian, said he came to America so his brain would not go down the drain in socialist India He made $300 million as an entrepreneur, executive and private investor in Silicon Valley and retired five years ago. He periodically returns for what he calls his "missionary work in India," that is, to persuade others of the benefits of the U.S. modus operandi.
A New Tension
Yes, countries outside our borders are envious of us because they want our material wealth. But they are not able to afford the luxury of such things as our trade deficits and our current account deficits. Remember, the strong military and strong currency, in combination with our trial-and-error progress, is what brought the U.S. its current level of power and influence.
The French today refer to us as a hyper-power, not as a superpower. That term is not meant as a compliment. They also referred to the British as a hyper-power in the 1800s. In many respects, they hate the cultural changes they feel they are being forced into, and I don't think they are alone in Western Europe. They want the technology and the money, but they are not sure if the cultural price tag is worth it.
The speed of change as well as change itself offsets economic benefits to some, especially egalitarians. "Stop the world, I want to get off" is heard both outside and inside our borders. In fact, few governments outside the western world are comfortable with the culture accompanying free markets, including the governments of Singapore, Malaysia, China, India, and Indonesia, which account for the majority of the world's population. Yet the views of many individuals within those countries mirror those of Kanwal Rekhi.
So, worldwide, people are being pulled in two directions, and two camps are emerging. Points of view vary within each nation from a desire for globalization and integration of economies to a desire to be nation/state separatists. Some subscribe to winner-take-all; others are for a larger, social safety net — those desiring the social safety net, the egalitarians, are the nation/state separatists. And these people are most frustrated, because there is a lack of income to redistribute.
There are doubts, even within the U.S., about the current economic policies. President Bush referred to the Reagan-era economics as "voodoo economics." President Clinton was elected on a tax-and-spend philosophy, as manifested in his healthcare plan. Although he reversed himself after the Democratic party lost in the 1994 election, philosophically he leans toward central planning. Vice President Gore has historically been to the left of Clinton. Congressman Dick Gephart, the potential Speaker of the House, is a protectionist. Bureaucrats, lawyers, and regulators fundamentally distrust the free market, even though the records show that no tightly regulated industry has prospered.
Yes, a huge tension has developed from the current conditions of deregulation and new technology. Today's environment is in one way reminiscent of the U.S. West during the highly romanticized cowboy cry. The cowboy on his horse, with nothing in view but rattle and the horizon, was the symbol of freedom. But what did the cowboy do after the cattle drive? Eventually, he always had to go back to Laramie or Tombstone, where he came upon a deeply felt need for social order. So even in the most romantic environments, there's a need for order. And that's the basis for this tension.
Consider just two examples:
- Free trade.
Most of us agree that free trade, which is part of this trial-and-error initiative, has resulted in a huge benefit to the world. But think about Seattle and the World Trade Organization meeting, where the fast trade stopped dead as those on the far left and those on the far right merged on a single issue. Globalization will be revived, but the people demonstrating in Seattle stopped it, at least temporarily. As another symptom, Europeans have stopped genetically altered foods. Yet recently AFL-CIO President John Sweeney, no friend of free trade, said the country should give illegal immigrants amnesty. No union leader has ever said chat, but Sweeney, looking ac the lowest percentage of union members eves sees growth coming from the immigrant population.
- The Test Ban Treaty.
The Test Ban Treaty offers a great benefit?if everyone plays by the roles. But is was soundly defeated in Congress and the issue will not be seen again for a while. Dr. Henry Kissinger, former Secretary of State, is associated with realpolitikwhich is in opposition to the one-world point of view: He urged Congress to vote against the treaty.
Senator Jesse Helms gave a speech before the U.N. Security Council in 1999 (www.senate.gov). He stressed the need for reform, he showed his position as a nation/state separatist. "The American people want the U.N. to serve the purpose for which is was designed," Helms said "They want it to help sovereign states coordinate collective action by `coalitions of the willing,' (where the political will for such action exists); they want it to provide a forum where diplomats can meet and keep open channels of communication in times of crisis; they want it to provide to the peoples of the world important services, such as peacekeeping, weapons inspections and humanitarian relief." If the U.N. seeks to move beyond these core tasks, Helms continued, "if it seeks to impose the U.N.'s power and authority over nation-states, I guarantee that the United Nations will meet stiff resistance from the American people." Helms says the U.S. will do whatever is in its own best interest, and no U.N. vote one way or the other will contradict it. Many Americans may be quick to discredit Senator Helms, but, at heart, they agree with many of his individual points.
The Clinton Administration, by relaxing antitrust constraints and pushing free grade, has endorsed post-nationalism and its one-world view. We are now willing to have one commercial airline manufacturer — Boeing. We are now willing to move towards unprecedented consolidations of our financial institutions. Antitrust officials say consolidation is the order of the day, and the net result will be very few companies dominating their industries. This is all in the name of globalization. The only thing that will keep these companies innovative and responsive is competition from abroad — assuming we become truly globalized.
The Clinton Administration's view is definitely at odds with Kissinger's realpolitik. Kissinger believes countries will ignore the Test Ban Treaty and further says that when we have a downturn in the economy, free trade will be responsible for one very serious mess. So Kissinger is saying the world is a dangerous place, because income and cultural differences are so stark. Globalization does not just mean shopping on the Internet; is also means threats of terrorism. In Clash of Civilizations, Samuel Huntington said religion, not nationality, will determine dividing lines.
One very tangible legacy of the Clinton polity is the emergence of super-power corporations — the huge institutions we see today. Is this a good thing or a bad thing? Depends. Some companies look to be practically a black hole of merger and consolidation. Others grow for very different reasons.
Flight to Size
Current U.S. policy has allowed — even pushed — a flight to size. There is a basic question we must ask pertaining to size of a corporation: How did it become big? If size is the result of innovation — discontinuous innovation, not marginal/tactical innovation, as evidenced in 1980s Japan — then it is positive. Great firms are usually built by innovation. They are part of the virtuous cycle of innovation that reduces prior innovations to commodities, and so on — creative destruction. They deserve the successes they reap. And a we innovator can command a lower risk premium.
So sometimes flight to size is good, because new products or services constantly answer new demands. But some isn't, and that has very different implications for risk managers. The other type of growth is not born of innovation; rather, it is born of a need to overpower the competition by artificial barriers of entry. Such companies aren't producing anything new that will, in itself, create demand. These companies became so powerful that along with unions and politicians, the virtuous circle of innovation/commoditization is stopped and they are simply commodity companies, with commodity products and services. They merge companies to choke the competition — and then raise prices (unless global competition forestalls price hikes). The mindset of this group is reregulation. And, as a matter of fact, the government and regulators are generally sympathetic to this mindset, because, together, they basically write the rules that make things "more manageable." Yes, big is powerful. But consider what happens in a global economic community if Boeing or Lockheed Martin goes out of business. Will we be willing to rely on a foreign supplier for these critical skills?
Less competition can lead to a focus on "reduction" of expense, versus revenue generation. Employee downsizings and resulting bonuses given to senior executives have taken their roll on worker loyalty. Thomas Harris is well known as author of Silence of the Lambs. In his sequel, Hannibal, Harris had his title character say to an FBI agent, "You may love the FBI, but the FBI never loves you." Without a motivated work force, innovation is virtually impossible. The virtuous cycle is broken.
So we see disillusioned workers, which is one component of the lack of loyalty seen today. Another part is the baby boomer culture. Adults can take care of just so many people. If there are too many teenagers and too few adults, you have the inmates running the institution. Such a thing occurred with the baby boom generation. And what ensued is a lack of discipline. The "me generation" added to a lack of loyalty and ushered in "free agency," from athletics to corporations. Even if there is a contract, what is it worth? It is simply torn up and renegotiated.
Lack of loyalty to an organization leads to a short-term mentality, and a short-term mentality does not reinforce good risk management policy. Good risk management functions much better if the risk manager has been there for a long time and believes that he or she will continue to be with that company for a long time. Spending 35 years with a company, as I did with Bankers Trust, gives you a much different view of managing risk than someone who has been with a firm for a couple years and is already looking. You're looking to recruit good people and you're looking to train them. A short-timer does not have that commitment.
So free agency can harm a company by having short-timers override a prudent existing risk management system that considers the long term. It can also cause harm when the equity in a company is valued. At a time in which people more and more equate the talent in a firm with its value of a firm, a free agency system negatively affects valuation. What is the equity value in such a firm? Along those lines, intellectual property is fast becoming the overwhelming asset of a firm; how are we valuing intellectual property? Is it on the balance sheet? And is it going to remain with the firm? So the stability of any equity valuation is questionable under the free agency system. And this pushes the equity risk premium up, while equity value is driven down.
With the availability of sophisticated technology, consolidation today also drives people to a technology mentality. While good for efficiency, subconsciously, we are programming people. One of the keys to a great firm is a phalanx, the closed-rank company formation, because we can see things and ensure that nothing slips between the cracks. With each of us "programmed" to focus solely on one area, the phalanx breaks down. It leads to a situation where if you ask an employee a question in his or her particular discipline, the answer is readily available. However, ask something two degrees to the right the employee is lost. And an employee will see a ball drop and say, "The ball didn't drop here, is dropped there. Let somebody else worry about it" A major airline is now undertaking a massive retraining project to help rediscover that phalanx that can ensure help to customers and safety to a company.
Too Big to Fail
This leads to the notion of being too big to fail. We can't have a Merrill Lynch fail; we can't have a Chase Manhattan fail. We already saw that we couldn't have Chrysler fail. Politicians are determined not to see their people out of work and they're not going to allow huge numbers of people to lose their investments.
Size can and often does lead to a too-big-to-fail mentality. So why buy Treasury bills and CDs? As mentioned before, what do we do if Boeing or Lockheed Martin go under? The U.S. military production capability would be seriously hurt. You could see us fall from our position of power in a nanosecond. Thus, is the commercial paper of a Boeing as safe as a Treasury bill?
Who else is too big to fail? How about the stock market (as opposed to any individual stock)? Half the households have mutual funds; 80 million people own stocks and that number is growing. It's as common to see middle-class families with savings in the stock market as in insured savings accounts. Suppose equities become as ubiquitous as bank deposits were in the 1930s?
What then would we say to a 50% market decline, as son in the early 1970s? Do we have the discipline in our rights over responsibilities-oriented society? A number of banks tout their own stock on the basis of equity investments. So there will be increasing pressure on senior management to take greater and greater risk as banks consolidate. If a significant portion of bank earnings are from equity investments, and banks are too big to fail, then the stock market also could become too big to fail.
Of course, the government will have no more success at shoring up the stock market than they have had in the past with their currencies. But they may try, and in doing so, they may do much damage.
Influence of Science and Technology
We're in the midst of an upheaval in the transition from a manufacturing economy to a service/information economy, which is not unlike the upheaval in the transition from agriculture to manufacturing at the turn of the century.
The S&P went up 21% in 1999, but if you delete technology stocks from the mix, that growth was about 3%. So it appears obvious that technology — specifically, technology companies — is the key to profits. But do we really know what today's technology companies do? We have a passing understanding of car manufacturing, but how many of us understand what is happening with genetics technology? For example, there's a new enzyme identified that has an impact on Alzheimer's disease. But how many of us even know what an enzyme is? Lots of us have money in companies dealing in this area, but few of us have any idea whatsoever what that company is really doing. And how do you repossess an enzyme? Bottom line: Have you truly risk-adjusted the individual companies with this transition in mind?
There is the possibility of serious accidents. The most serious problem for the economy is loss of confidence, which usually arises from unforeseen events or accidents. Think back to the oil embargo of the 1970s, resulting in President Carter's speech on malaise. The technology sector must be examined, especially the biotech and digital electronics sector. As just one example, should the public lose confidence in the security of the Internet complex and fear for their privacy in matters ranging from medical records to credit card numbers, there would be a problem of such proportion as to seriously derail the low equity risk premium.
The denouement of these conflicting forces is the Gordian knot. World prosperity depends on U.S. economic and military strength, yet military expenditures reduce economic wealth. The energy powering the U.S. economy is innovation born of a liberal democratic/capitalistic/money culture not widely applauded throughout the world and with detractors in the U.S. Adoption of a post-nationalism globalization policy is leading to unprecedented concentrations of finance and industry in the U.S. Yet few political leaders openly support the one-world view that fosters the competition necessary to stop the new behemoths from erecting artificial barriers of entry and the resulting stagflation and political unrest. Knowledge from science and technology have been essential to our unprecedented prosperity and military might, yet few understand its monetary value nor the potential for an accident.
I cannot cut the Gordian knot, but I know money will be made and money will be lost, whatever the outcome. I do have a few suggestions for your consideration.
The Year 1820
In 1993, I delivered a speech to the Kansas City Federal Reserve Bank Symposium, "Financial Markets in 2020." In the year 2000, its predictions continue to be valid. This validity was recently affirmed in letters I received from Professor William F. Sharpe of Stanford, the Nobel Laureate in Economics, and Professor Peter F. Drucker of the Claremont Graduate School, who is practically the dean of management consulting. The following comments are drawn from that Presentation.
How far have we come in the Information Age? It's been here longer than we may think. During the mid-1970s, Bankers Trust introduced RAROC. We tried to measure liquidity by determining how long it would take us to get out of a certain position and then determining the greatest volatility during that time period. While refinements have subsequently been made, I would concentrate on liquidity risk.
Derivatives are definitely a part of our future. You can think of derivatives in banking like impressionism in art. Impressionism actually was a derisory term applied to the artists whose works came to be valued at millions of dollars. I think the same is true of derivatives. (Federal Reserve) Chairman Alan Greenspan and (Secretary of the Treasury) Lawrence Summers have recently testified in favor of derivatives in general and complex derivatives in particular.
But what might be most important to our future has been discouraging in its progress to date: the adoption of mark-to-market. A key to tomorrow's successful systems will be wealth accounts, in which companies and individuals will hold their assets and liabilities. These accounts will contain today's relatively illiquid assets, such as buildings and vehicles, as well as what we know today as stocks, bonds, other securities, and new types of financial claims. Key to managing these accounts in very risky times is using mark-to-market price times volatility (the largest price variation during time it would take to exit a position). Industrialists as well as many financial executives are likely to shoot you on sight if you talk about mark-to-market with them. Intellectually you can bring them grudgingly around; but when it comes right down to implementation, they will refuse to do it. I always ask people to hand in their firearms before I talk about mark-to-market, because attitudes are just that serious about it.
The particle finance movement continues in the right direction as derivatives on different risks, for example, the weather, are examined and marketed. Most classical finance models looking at a company would concentrate on the "beta" of its stock — the stock's volatility relative to the market. These models would have great difficulty dealing with the multitude of underlying critical risk factors that produce beta, such as changes in financial market volatility, changes in global product, the volumes of our transaction processing, an earthquake in Japan, changes in consumer confidence in the U.K., or a change in a company's corporate strategy. These critical factors are called "financial attributes." Classical models ignore them or grossly summarize them as homogeneous packets of white noise. Theoreticians, however, did not ignore them and the Theory of Particle Finance was launched to help them better understand an asset's financial attributes.
So if I were a risk manager today, I would seek to exert influence in further understanding liquidity risk, using a RAROC system, and promoting mark-to-market, the sine qua non of risk management That is, if I still wanted my institution to be around in 2020.
Charles S. Sanford, Jr., a 1958 graduate of the University of Georgia, is the retired chairman and chief executive officer of Bankers Trust Corporation. In 1997, the Terry College of Business dedicated Sanford Hall in recognition of the significant contributions made to the Terry College and the University of Georgia by Charles and Mary Sanford. He has served as a trustee of the University of Georgia Foundation since 1986, and his family's association with the University spans many generations, dating as far back as 1835.