Profits and tail risk

There's a link between RBS's big IT failure this week and Aditya Chakrabortty's complaint about the "corporate myopia" that has led big UK firms to reduce basic research. Both highlight a trade-off between short-term and long-term profit maximization and show that this trade-off is affected by exposure to tail risk, the small chance of a disastrous failure.

For example, RBS's troubles are due to many years of under-investing in IT systems. Such under-investment helped raise profits; as Frances says, "profits don't come from upgrading basic infrastructure". But these came at a price, of increased exposure to the tail risk that a major IT failure will lead to an exodus of customers.

This is not the only example of how short-term profit optimization increases downside tail risk. BP under Lord Browne held down spending on maintenance. That looked like sensible profit maximization - until the Texas City refinery blew up. And Equitable Life did great business in the 80s and 90s by holding reserves low and selling guaranteed annuities - until disaster struck.

Under-spending on basic research is both like and unlike these cases. It's like them, in that such under-spending raises current profits. It's unlike them in that such under-spending actually reduces exposure to good tail risk - the slim chance of making a brilliant massively profitable innovation.

All these cases show that increasing short-term profits can come at the expense of more exposure to bad tail risk, and less exposure to good.

Now, this isn't necessarily irrational. Tail risk doesn't often materialize - that's why it's called tail risk. And if RBS can cause inconvenience to customers without them withdrawing their business, then it is a rational strategy, of monetizing consumer surplus.

Instead, I'm making two points here. One is that tail risk doesn't just matter for financial investments. It's also an issue for non-financial firms.

The other is that this makes it even harder to identify good management. BP under Browne, RBS under Goodwin and Equitable Life were for a long time among the most esteemed companies in the country. But they weren't as well-run as their profitability suggested. Instead, their reputations were inflated by taking on exposure to tail risk. Which poses the question: how can you be sure what's good management, and what's dangerous but (so far lucky) risk-taking?

Comments

[richardarnatt]

Tragedy is alpha plus time.

[Luke]

Is a story here about management incentives?

If XYZ PLC invents something vastly profitable, does the boss who authorised the research get much for it? And maybe the boss is earning so much that doubling his/her salary is much less than twice the utility of keeping the job. So management will do pretty much anything to keep the appearance of steady earnings and dividends. Blue sky research which may never pay off (and which may not benefit him much if it does) is irrational from the boss's perspective. [Doesn't really fit with the usual story of overconfident bosses.]

Not sure how that works on the downside if I'm right that management has an overly strong incentive to keep their jobs. Maybe it's rational to try to keep your job by keeping steady/increasing earnings at all costs because (a) you may get away with cutbacks or (b) they may bite your successor.

[Blissex]

«All these cases show that increasing short-term profits can come at the expense of more exposure to bad tail risk, and less exposure to good.

Now, this isn't necessarily irrational. Tail risk doesn't often materialize - that's why it's called tail risk. And if RBS can cause inconvenience to customers without them withdrawing their business, then it is a rational strategy, of monetizing consumer surplus.»

What I call the base Blissex Second Principle is that all non-trivial financial fraud is a form of under-depreciation, either of capital or of risk; the extended Blissex Second Principle is that viceversa is usually true, that is under-depreciation is usually not a mistake but deliberate financial fraud.

And it is almost always currently something that the beneficiaries get away with.

Under-depreciation of capital or risk is a way to reclassify some chunk of explicit or implicit capital as profit.

Astute and self-dealing business manager, especially in the financial sector, are usually looking hard for the opportunity to under-depreciate capital or risk, as it is the easiest way to huge personal riches. Slight variants of this enrichment model even have their own nicknames, "capital decimation partners" or "picking up pennies in front of steamrollers".

[D]

Transparency. Businesses publish their profits but not their other key metrics which might indicate vulnerability. For obvious reasons! But this mis-sells to shareholders and also makes workers vulnerable.

The ability of companies to silence their employees, preventing them from discussing company and industry practice should be curtailed.

[Guano]

"Businesses publish their profits but not their other key metrics which might indicate vulnerability."

And the majority of media commentary is about businesses' profits and their other key metrics.

[Samuel Conner]

Someone much wiser than me wrote that we need to kill the microeconomist that lives inside each of our heads.

At an aggregate level, investment in basic infrastructure does produce profit; someone is producing the things invested in.