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Who’s in The Crow’s Nest?

“Right now, we don’t have an entity, an oversight entity, a government entity, that thinks to itself: What happens if this institution gets into trouble and is going to fail? What would we do about it at that time? The primary focus of most supervision is to prevent them from getting into trouble…”

Ron Feldman of the Federal Reserve Bank of Minneapolis and co-author of “Too Big to Fail”, on Planet Money, podcast #29, 13 April, 2009.

Most supervision, no matter what the field, is focused on ensuring that rules and guidelines are being followed. This is natural. It is, after all, what supervisors do. They ensure that existing rules are followed in order to prevent bad things happening. Sometimes, however, the rules are not enough.

Sometimes, the purpose of the regulations – to ensure that bad things do not happen – is not sufficiently provided for by the existing rules. Current regulation is based mostly on experience and the basis which that experience provides for predicting the future. Predictions are notoriously difficult to make, however, and we are prone to rely too heavily on extrapolating the past into the future.

Assuming that the future will look exactly like the past is a dangerous decision. Extrapolation is only one tool among several for estimating future events. The “sin” of over-reliance on extrapolation is compounded when we only make one forecast for the future – or limit ourselves to a narrow band.

At a minimum, we need two versions of the future on which to base our plans – a “most probable” and a “most dangerous”. We need a “most probable” forecast because over-caution can be just as costly as the lack of caution. We need to base our plans on the best estimate possible.

We need the “most dangerous” forecast, because we at least need to consider what to do if things go wrong. Reacting to more favorable conditions than expected is much less dangerous than being unprepared for the opposite.

Rules and regulations are useful tools, but they are not a guarantee by themselves. Someone must assess vulnerability. An exposure to risk is dangerous even if it has not led to a loss, and the mere fact that something has not gone wrong, does not mean that it won’t. What is your organization’s vulnerability? Are you prepared for the worst – or just what you expect? Who do you have on look out?

Planet Money podcasts:

http://www.npr.org/rss/podcast/podcast_detail.php?siteId=94411890

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