Financial Darwinism

Just as global climate change has increasingly brought us more frequent “once in a century” weather events, increased competition and economic globalization have resulted in lower margins, increased commodification, and increased risk – leading to a similar pattern of economic volatility centered around our financial institutions. Leo M. Tilman’s Financial Darwinism: Create Value or Self-Destruct in a World of Risk paints a rather bleak picture. He sees systemic financial crises as a “permanent feature of the dynamic new world.”

This isn’t a book for those looking for ideas aimed at governments attempting to reregulate the financial industry, although they would certainly benefit from the reading. Instead, the book offers very practical advice to bankers, institutional investors, and other businesses on how to build risk analysis into strategic decision-making.

In the old paradigm, the risk manager was brought in after major strategic decisions had already been made. In the new paradigm, “risk management becomes the very language of enterprise-wide strategic decisions going forward and that the chief risk officer becomes an executive who gets an equal seat at the table where corporate strategy is decided.”

Tillman identifies at least ten forces contributing to this shift, including:

• Globalization
• Inflation targeting and control by central banks
• Disintermediation
• Greater availability of information
• Greater financial market efficiency
• Alternative investment vehicles
• Financial deregulation
• Convergence of traditional financial businesses
• Increasingly complex instruments, such as derivatives and structured products
• Advances in technology, financial theory, analytics and risk management 

In the simplest formulaic terms we have gone from: Economic performance = return on assets – cost of liabilities + fees – expenses – cost of capital

To: Economic performance = balance sheet arbitrage + principal investments + systematic risks + fees – expenses – cost of capital

Of course, that’s just the beginning of the complexity. Tilman does an excellent job of explaining this paradigm shift, how we got here, what factors need to be examined going forward, and how they can be understood in relatively simple formulaic terms.

Financial Darwinism recognizes that our growing toolbox includes leverage, product design debt management, capital structure, M&A, insurance, securitization, hedging, asset strategies, etc. Each tool must be considered in developing and implementing strategy.

As the world places increasing emphasis on fair valuation, risk-based financial disclosure and risk-focused regulation, Tilman’s guide becomes more important for CEOs, directors and fiduciaries who must build risk evaluation into all fundamental decisions. For another perspective, download Putting risk in the comfort zone: Nine principles for building the Risk Intelligent Enterprise™ from Deloitte. See also Prudent Practices in a Bad Economy, advice from David B. Gail, Mary R. Korby and Michael A. Saslaw for corporate boards.