Somewhere down the road when business schools study why the global economy was so ill prepared to handle a disruption of activity, one of the obvious conclusions will be that business models were optimized for the median. In other words, companies tried to maximize profits for the 95% of the distribution and run the risk of ruin in the tail scenarios.

Why, the thinking went, would someone be foolish enough to sacrifice some profit over the cycle to prepare for an unlikely disaster? If you were naive enough to do this, why some activist would come along and show you the light…or replace you with a CEO who understood the mission.

And thus we found ourselves living in a period of global supply chains and lean inventories…and when the storm came we had no reserve to draw down (masks, toilet paper, puzzles, you name it) to absorb the blow.

One thing CEOs and Boards forgot is that to maximize profit over the cycle you need to survive the bottom of the cycle…ideally without diluting earnings at the bottom by raising expensive desperation capital. It’s better to earn $4.00/sh for nine out of ten years and $2.00 in the tenth than $4.40 for nine years and lose $2.00 in the tenth.

Unfortunately, companies became blind to the tails and could only see the median. That is, except in one industryinsurance. Oh, don’t get me wrong…insurance companies used to think the same way. And then Hurricane Andrew came along.

Risk Management to the Rescue

After Andrew, insurers realized they needed to pay more attention to tail risk. While the industry also struggled after Katrina, over the last ten years the industry has fared remarkably well when catastrophe strikes. Years with cat losses well over $100B have been taken in stride without any carriers facing distress.

It’s been a remarkable improvement in risk management. Insurers took to heart the idea that it was worth sacrificing some earnings today to maximize earnings over the long term, even if arguably the incentive for an individual CEO might be to roll the dice and hope the big loss happens on their successor’s watch.

One other factor that drove behavior change was the role of regulation. While the state regulators play a role, arguably the biggest reason insurers took risk management more seriously was the rating agencies implemented much stricter capital measures for catastrophe risk after Katrina. Managements to some degree had the option to manage to the median taken out of their hands.

Notice how the same thing happened to banks post the financial crisis. The government stress tests force banks to focus more on tails and less on the median. It is no surprise that banks are now considered a source of strength for the economy rather than a risk.

Does that mean we should regulate all industries to encourage more long term thinking? I’m generally hesitant to advocate regulation, especially when it always has to chase its own tail to find the newest threat. However, there is probably a role for some kind of business continuity stress test.

A Corporate Stress Test

This test would force businesses to demonstrate that if there were a sudden shock to their supply chain or an inability to sell product for a period of time that they wouldn’t be at risk of failure. Examples of things to test would be an attack on the electrical grid, a large scale trade war that disrupted access to supplies, or some event that disrupted air or ground transportation.

Unfortunately, there is a risk that any test like this becomes politicized and changed in ways that are adverse to the purpose. Insurance standards work because they are designed by the ratings agencies. Banks work because they are controlled by the Fed. The regulator is an umpire, not a fan of one of the teams.

The closest entity we have to that for non-financials would be the SEC. Require the disclosure in Annual Reports and have auditors sign off that the disclosures are adequate. Maybe even roll back some of the more useless parts of Dodd-Frank as a carrot and substitute this requirement in its place.

Unintended Consequences

It is worth noting that these regulatory burdens are not without consequences. The “alternative capital” industry arose as a response to the tighter capital standards that they viewed as “uneconomic” which drove regulated returns to lower levels than they would have faced otherwise.

Similarly, banks have lost share to non-banks post the crisis and perhaps seeded new systemic risks which aren’t being monitored. Regulation isn’t perfect and the invisible hand will always seek new ways to make money while evading the regulations.

Monetary Policy Encourages Taking Tail Risk

It’s not only corporations who are too focused on maximizing the short term. Let’s turn our eyes to the Fed. One consequence of abnormally low interest rates is a low savings rates. Why save when you can’t earn anything on your money (unless you lever it up 10X and assume you’ll never have a margin call – yet another example of ignoring tails!)?

So not only do corporates not think about their tail risk, households don’t either. Or even if they do think about it, they realize it is punitive to save because the Fed wants to reward debt and punish savings in order to keep the leverage cycle buoyant.

Put it all together and we have the entire economy (aside from the financial sector) with no ability to withstand a 100 year flood. While regulation can help on the corporate side, it’s unclear what can be done to help household balance sheets aside from normalizing interest rates to create an incentive to save.

Tragedy of the Commons

One of the clear roles for regulation is when there is a tragedy of the commons situation. In other words, when individuals or companies act in their own best interest but ignore the implications to society.

Managing to the mean while ignoring the precarious foundation of a just in time, highly levered economy certainly qualifies as an example of tragedy of the commons and invites regulation. While there is certainly the risk of something more draconian once Pandora’s Box is opened, an SEC stress test would be a good first attempt to try to modify corporate behavior to improve the overall outcome for everyone.