Cass Knowledge

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Copyright Cass Business School 2012

Cass Knowledge

www.cassknowledge.com

Early Warning Systems – Building Human Capital Risk Assessment

Capabilities in Financial Regulators

Author(s):

Professor Chris Rowley, Cass Business School and Director of Centre

for Research in Asian Management and Research and Publications,

HEAD Foundation;

Dr Carol Royal, Honorary Visiting Fellow, Cass Business School;

Australian School of Business, University of New South Wales;

Dr Loretta O’Donnell, Australian School of Business, University of New

South Wales

Topic: Human Resource Management

Industry: All

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Early Warning Systems – Building Human Capital Risk

Assessment Capabilities in Financial Regulators

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Abstract

This paper recognises the need for robust early warning systems for financial markets, and identifies one method for creating such systems as being through qualitatively based regulation of human capital.

Full paper

Writing from Geneva on 11 April 2012, David Singh from the United Nations Office for Disaster Risk Reduction noted:

“Following a massive earthquake earlier today in the Indian Ocean and the threat of a tsunami, Indonesian President… Susilo Bambang Yudhyono, told the press, "Our early warning system is working well".

…In the aftermath of the 2004 tsunami the IOC (comprising UNESCO and other partners) began coordinating efforts to create an Indian Ocean tsunami early warning system…Today there is a large network of seismographic centres, national warning centres, agencies, coastal and deep-ocean stations in place across the Indian Ocean to detect potential tsunamis and pass on warnings to communities.

"Yes there are gaps," said Aaarup, "But the Indian Ocean is much better prepared than it was in 2004. The tsunami early warning systems are like the atmospheric systems used by meteorologists which are constantly being improved by new technology...".

These early warning systems have been triggered several times in recent years, and while communities in Thailand, Hawaii and Sydney have been on high alert at times, damage has been minimised or averted.

We need equally robust early warning systems for our financial markets. One way to create these systems is through sophisticated, qualitatively based regulation of human capital. Financial market regulators have not traditionally focused on this form of risk, so a capacity building program is required for regulators themselves. This has to be based on rigorous analysis of current practice and a clear vision of an ideal future.

Human capital risk has ripple effects beyond the internal functioning of listed companies - Enron, Lehman Brothers and Barclays have affected entire financial systems. When regulators fail to take account of human capital risk, listed companies and entire financial systems are at risk of breakdown.

While the finance community is increasingly aware of human capital risk as a key component of future value creation and destruction (Shiller, 2012), there is a danger that regulators may respond with more technical, quantitative, superficial regulation, rather than with an eye to

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the transformational role they are now required to perform.

The momentum behind “big data” (Barton and Court, 2012), the ability to quickly analyse extraordinary amounts of highly targeted information, while initially seductive for analysis of financial markets will not explain the generative human capital systems which help to predict future market behaviour. Qualitative analysis often needs to precede quantitative analysis (Kvale, 1996). Qualitative analysis, drawing on complex systems theory, is required to gain insight into the underlying human capital systems which generate positive and negative market behaviours.

Even as “regulation is a growth industry” (Jenkins, 2012), the professional knowledge base of regulators may be limited by a classic performance management paradox. They are at risk of being “rewarded for A, while hoping for B” (Kerr, 1975), that is, rewarded for creating technical, quantitative responses to financial risk, while hoping that the underlying human capital risk will somehow be addressed.

So, what is the solution?

The Global Reporting Initiative (GRI, 2012) and the United Nations Principles for

Responsible Investment (UNPRI, 2012,) and related organisations provide a rich context for a future research agenda into capacity building within regulators. This research will need to incorporate:

1. An investigation of the design and structure of regulatory institutions in

terms of their response to human capital risk management, within a

sample of jurisdictions which illustrate different success factors e.g. Australia (APRA), United Kingdom (FSA), Germany and Spain.

2. An analysis of the decision making processes within regulatory institutions

related to early warning human capital risk management mechanisms

to predict corporate and financial market collapse. This would clarify adjustments to regulatory agency decision making processes to improve regulatory responses to possible large scale financial crisis.

3. An analysis of the organizational structure and the design of these sample

regulatory institutions to ascertain human capital risk management

strategies for increasing market stability.

4. A process for recommending how these regulatory institutions could take

human capital risk management into account through their different prudential frameworks.

Change management within financial regulators

Traditionally, financial regulators have had to operate within a highly secure environment, where confidentiality is paramount. This means it will be culturally more difficult for regulators to be prepared to participate, for instance, with academic researchers, to conduct interviews with front line and strategic level international and domestic regulatory staff to investigate current practices in analysis of human capital risk management, including governance, leadership capability, supervision, disclosure and human capital decision making processes and the regulators’ own capacity to adapt to changing market conditions to enhance

prudential global regulatory frameworks.

However, this kind of deep level interview data will be required to clinically assess the role of human capital risk as one early warning sign of potential organisational and market failure. David Singh from the UN Office for Disaster Risk Reduction (April, 2012) concluded:

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were observed to be calmly following evacuation routes to safe zones.

While it is impossible to regulate and predict all forms of risk, regulators can build their own capacity to regulate human capital risk, so that when the inevitable market ebbs and flows occur, we will have key finance regulators stating, with conviction: “Our early warning system is working well”.

References:

Barton, D. and Court, D. (2012) “Making Advanced Analytics Work for You”, Harvard

Business Review, October, pp. 79-83

Global Reporting Initiative (2012) https://www.globalreporting.org/Pages/default.aspx Jenkins, R. (2012), “Let’s Make a Deal”, Speech by Member of the Financial Policy

Committee, Bank of England, London,10 July

2012http://www.bankofengland.co.uk/publications/Pages/speeches/default.aspx

Kerr, S. (1975) “On the Folly of Rewarding A While Hoping for B , Academy of Management

Journal, 18: 769-783.

Kvale, S. (1996). InterViews: An Introduction to Qualitative Research Interviewing, Sage,

London pp. 67-8.

Shiller, R. (2012) “Do Geniuses Make Better Investment Decisions?” New York Times,

February 25.

Singh, D. (2012) “Indian Ocean Tsunami Early Warning Systems Passes Test”, United

Nations Office for Disaster Risk Reduction.http://www.unisdr.org/archive/26170

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