Profits and tail risk

There's a link between RBS's big IT failure this week and Aditya Chakrabortty's complaint about the "corporate myopia" that has led big UK firms to reduce basic research. Both highlight a trade-off between short-term and long-term profit maximization and show that this trade-off is affected by exposure to tail risk, the small chance of a disastrous failure.

For example, RBS's troubles are due to many years of under-investing in IT systems. Such under-investment helped raise profits; as Frances says, "profits don't come from upgrading basic infrastructure". But these came at a price, of increased exposure to the tail risk that a major IT failure will lead to an exodus of customers.

This is not the only example of how short-term profit optimization increases downside tail risk. BP under Lord Browne held down spending on maintenance. That looked like sensible profit maximization - until the Texas City refinery blew up. And Equitable Life did great business in the 80s and 90s by holding reserves low and selling guaranteed annuities - until disaster struck.

Under-spending on basic research is both like and unlike these cases. It's like them, in that such under-spending raises current profits. It's unlike them in that such under-spending actually reduces exposure to good tail risk - the slim chance of making a brilliant massively profitable innovation.

All these cases show that increasing short-term profits can come at the expense of more exposure to bad tail risk, and less exposure to good.

Now, this isn't necessarily irrational. Tail risk doesn't often materialize - that's why it's called tail risk. And if RBS can cause inconvenience to customers without them withdrawing their business, then it is a rational strategy, of monetizing consumer surplus.

Instead, I'm making two points here. One is that tail risk doesn't just matter for financial investments. It's also an issue for non-financial firms.

The other is that this makes it even harder to identify good management. BP under Browne, RBS under Goodwin and Equitable Life were for a long time among the most esteemed companies in the country. But they weren't as well-run as their profitability suggested. Instead, their reputations were inflated by taking on exposure to tail risk. Which poses the question: how can you be sure what's good management, and what's dangerous but (so far lucky) risk-taking?