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January 11, 2008

Prediction is hard, especially about the future – guru department

How wrong can a guru be?  Every so often, I run across some confident—but wrong statement regarding the state of something or other, and just this afternoon (while hunting for something else) ran across one that I simply can’t resist sharing.  In a way, it’s sad, because the poor prediction was shared by the entire financial services industry, yielding a crisis of massive proportions. 

image  The guru in question is Adrian J. Slywotzky, best-selling author of a number of good books, among them The Profit Zone.  The wrong prediction has to do with how the banking industry has managed risk, and it appeared in no less an authoritative publication than the Harvard Business Review.  The article is entitled “Countering the biggest risk of all” and it appeared in the April, 2005 edition. 

The article opens with the following paragraphs:

WHATEVER YOUR BUSINESS, consider for a moment the remarkable turnaround over the past decade in the U.S. banking industry. In the early 1990s, the industry—rocked by the Latin American debt crisis, a major real estate bust, and economic recession- suffered massive loan losses, erratic earnings and the highest rate of bank failures since the Depression. A decade later, as much of the economy reeled from the dot-com bust and another recession, banks were generally flourishing. The number of bad loans was down, earnings were relatively stable, and the banking industry was outperforming the market as a whole.

The turnaround occurred in large part because banks were able to develop new tools and techniques to counter risk, in the process giving birth to an entirely new discipline of financial risk management. Sophisticated credit-scoring measures reduced banks’ credit losses. New forms of options, futures, and counter-party agreements allowed banks to redistribute their financial risks. In fact, banking regulations now require companies to employ financial models that quantify their market risks.

We cite this example because the risks that plagued banks 15 years ago are emblematic of the challenges that companies across all industries increasingly face today. What if these companies could also employ tools and techniques that would provide some protection against a broad set of high-stakes risks?

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