What Oil Spills and Financial Crashes Have in Common: Gambling with Other Peoples Money

What do the Gulf oil spill and the recent financial crisis have in common? Both of them are the result of risk-taking gone wrong.

Gambling--more politely called risk taking--is an inherent part of business life. Entrepreneurs do not, and should not, try to avoid risk. Their job is to manage risk responsibly. Whether they do so depends on the incentives that key decision makers face.

If you are an entrepreneur risking your own money, you look for a certain type of risk. You can tolerate some uncertainty, but you want to invest in projects that have an expected value of revenue that exceeds your costs. You win some, you lose some, but on average you make a profit.

If you buy lottery tickets or otherwise gamble for fun, you often look for a different kind of risk--one that has a small chance of a huge gain, but a moderate maximum loss that is no greater than you can afford. These are called positively skewed risks. You are willing to take such risks even knowing that the expected value of your winnings is less than the cost of a ticket because you enjoy the game, and because you like to dream about the pot of gold at the end of the rainbow.

The real trouble comes when you have a chance to gamble with other people's money. Then you start looking for strategies that usually give you at least a modest payout even though they involve a small chance of catastrophic loss. These are called negatively skewed risks. You take these risks, even if you know they have a negative expected value, because you think you will pocket a gain most of the time. You expect that when disaster finally strikes, you will be able to walk away with your past winnings in the bank while sticking someone else with the loss.

Several common situations in business life give rise to the temptation to gamble with other people's money. Executive compensation plans that emphasize short-term bonuses, include golden parachutes, and lack clawback provisions are one example. Not only top executives face such incentives--mid-level traders, engineers, and analysts may also take risks in the hope of bonuses or promotions, with the expectation that the worst that can happen in case of catastrophe is that they lose their jobs. Stockholders may condone such risk taking because they are protected by limited liability.

Both the Gulf oil spill and the financial crisis had their origins in negatively skewed risks. Investigators in the Gulf disaster are looking at whether BP and its contractors underplayed downside risks when they made technical choices, ignored warning signs, and neglected preparations for dealing with a worst-case spill. In the financial crisis, negatively skewed risks involved excessive leverage, manipulation of ratings, design of complex securities, and several other factors.

What can be done? Regulations can be made stricter, but who will regulate the regulators? Who will ensure they are not captured by special interests? Compensation plans can be changed--but if shareholders do not take the initiative, can outsiders fix the system for them? Corporations can be held to strict standards of legal liability, but individuals who make bad decisions are not necessarily the ones to pay when their corporate employers are found liable.

There is no magic bullet. We can only hope that after a couple of really big disasters, people will be more alert to early warning signs the next time.

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