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Sunday, 13 May 2012

More Risk, More Trials, More Error, More Success

I was at a Coadec event for encouraging tech start-ups in London on Wednesday. Much of the focus was on demonstrating why London and the UK are better locations for starting businesses than elsewhere. Certainly the Polish and Turkish entrepreneurs seemed to think so, although the Turkish guys did point out they'd tried the US and couldn't get a visa ;-).

That's nice to hear, but a bit underwhelming.

Research from the IEA has already shown it's easy enough to start a business in the UK, though the insistence on the 'employment' model still makes it a bit awkward for small businesses to take on staff. 

The real point is that we can't pick which businesses are going to be successful. The best that we - and government - can do is to ensure "a climate in which enterpreneurship can thrive". In other words, we have to encourage more trial and error. We have to welcome failure in order to see success.

Actually, I think we're okay with failure in the context of genuine innovation. It's a long time since anyone went to prison just being unable to pay their debts as a result of an honest small business failure. A lot has been done to make it easier to clean the slade and start afresh. And UK figures referred to at the Coadec event suggest that entrepreneurs fail an average of 3.5 times before succeeding (although the IEA also suggests that an entreprenuer is more likely to be successful if he or she has been successful before). 

Where we do have a problem, quite rightly, is with failure in the management of our major institutions. In this context, trial and error is acceptable. But running an established business process in a way that results in significant errors or outright disaster is not. Unfortunately, concerns here tend to drive higher levels of (fairly ineffective) regulation, which in turn stifles innovation and competition where it's needed most. Indeed, the European Commission Consumer Scoreboard suggests that the more highly regulated a consumer market is, the worse reputation its suppliers have with consumers - lowest of the low being financial services. In March, the FSA listed the key risks to consumers from FSA-regulated providers as being pressure selling; failing to provide ongoing service to existing customers; poor complaints handling; inefficient day-to-day business processes; cancellation blockages; lack of proper infrastructure; complexity and volume of communications; excessive and/or unfair charges; and changes in terms and conditions without notice or appropriate reasons. The FSA concluded:
"... on the whole, financial service providers were seen to generally fall short on their promises, to the extent that the majority of consumers in the study considered that there had been an erosion of trust between them and their financial providers. In particular, they cited an inability on the part of financial service providers to offer the most appropriate solutions for them."
How do we get these businesses "to offer the most appropriate solutions" to their customers' problems?

It seems to me that our heavily regulated institutions are too risk averse. As a result, genuine innovation among those institutions is virtually non-existent.

The sub-prime crisis, for example, was not caused by banks intending to take on more risk. A shortage of 'safe' assets - a deposit crisis - meant they were actually trying to transform high risk mortgages into low risk bonds, by bundling the mortgages together and cutting them up in different ways, repackaging them and so on. The bank that invented the process way back in the mid-1990's actually did sensibly trial it first, before deciding that it ultimately wasn't sustainable. So the huge errors and bank failures over a decade later resulted from imitators who had adopted the faulty process without adequate monitoring, controls and due diligence procedures that would have told them when to stop. Evidence of this has emerged in the resulting 'fraudclosure' scandal, where no one was sure who owned many of the underlying mortgages when they were called in.

There is no room for complacency on this front, but there's still plenty going around. Even the bank that realised the potential for the sub-prime crisis was recently caught out by its own process failures, allegedly while trying to hedge its existing financial exposures (i.e. reduce risk). These institutions are so smug that they pay half their 'profits' in bonuses even while failing to maintain adequate risk monitoring systems.  

Maybe if they committed themselves to taking more risk to solve their customers' problems instead of their own, these institutions would organise themselves to be better at monitoring and managing that risk than just selling the same old stuff. In doing that, however, they would need to engage in lots of little trials and ensure they had a good understanding of why each trial did or didn't work. We don't need big rolls of the dice. 

But where's the pressure to do this? Governments and regulators the world over are 'clamping down on risk-taking', after all. 

Perhaps the same effect will be achieved by the many start-ups focused on financial services. But again we run into the headwind of regulation and tax incentives, ironically designed to benefit consumers, which only serve to perpetuate the status quo. As recently discussed at the Finance Innovation Lab, regulators and policy-makers will need to improve their understanding of how the innovation process needs to work before customers will be better off.


Image from TVTropes.

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