Is Your Risk System Too Good: The Principle of Risk Homeostasis Claims That Strong Risk-Prevention Mechanisms Lead to Riskier Behavior, Leaving the Overall Risk Level Unchanged. What Can Financial Institutions Do to Fight It?
Nason, Rick, The RMA Journal
Have you ever noticed that most cars involved in accidents during a snowstorm appear to be SUVs and all-wheel-drive vehicles supposedly best suited to adverse driving conditions?
Isn't it curious that wearing a helmet while riding a bicycle supposedly leaves you at a higher risk of an accident with a car?
What are we to make of the fact that promoting condom use has apparently not helped in reducing the spread of HIV/AIDS in Africa? (1)
Isn't it amusing that a whole generation of MBA students learned prudent risk management practices from studying an Enron case study? (2)
How disturbing is it that Bankers Trust, the institution that created most of the best practices of financial trading, essentially faded away because of a risk debacle?
Isn't it the ultimate irony that the bank whose risk team literally wrote the book on risk management (3) was deemed by one newspaper to be "the bank most likely to walk into a sharp object"? (4)
These and many other examples are outcomes caused by risk homeostasis. Simply put, the principle of risk homeostasis claims that the stronger the risk-prevention mechanisms, the riskier the behavior of individuals, resulting in the overall level of risk remaining constant. A consequence of risk homeostasis is that institutions that develop strong risk management systems are likely to be exposed to a much greater degree of risk than they believe they are.
This article describes risk homeostasis, outlines its symptoms and side effects, and develops suggestions that managers should implement for prevention and cure.
What Is Risk Homeostasis?
Risk homeostasis, also called risk compensation, is a phenomenon observed in many different areas of risk management--health care, accident prevention, biology, sociology, and business. The core premise is that organisms or systems will find an acceptable level of risk (perhaps implicitly or even unconsciously) and undertake actions to maintain that level of risk, regardless of the level or strength of the risk mitigants put in place to lower the risk level. In simpler terms, there are unintended consequences to implementing risk mitigants that, ironically, induce actions that may increase the overall level of risk.
Examples of risk homeostasis abound. For instance, motorists tend to give cyclists not wearing helmets a wider berth when passing. Thus, the act of wearing a helmet increases the chance that a cyclist will be hit by an automobile or suffer a near miss. Meanwhile, the use of condoms is widely known to prevent the spread of HIV/AIDS, but the unintended consequence of widespread condom use seems to be the increased practice of riskier sex. (5)
Similar studies show evidence of risk homeostasis in the use of antilock brake systems, seat belts, ski helmets, and so on. The point is that risk systems or tools give users a feeling of overconfidence that ultimately leads them to be less vigilant about risk and more likely to engage in or tolerate practices that otherwise would be considered too risky.
Risk Homeostasis in Business
It's not difficult to find financial examples where risk homeostasis likely played a role. Long-Term Capital Management (LTCM) immediately comes to mind. That well-known hedge fund, the subject of the best-selling book When Genius Failed, (6) had several high-profile Wall Street figures as partners, including Myron Scholes and Robert Merton, who won the Nobel Prize for their work in options pricing theory and risk management.
Employing state-of-the-art risk management techniques, LTCM enjoyed several years of well-documented success, only to succumb to market volatility following the Thai baht crisis and Russian default. Following a bailout by a consortium of LTCM's banking counterparties in an effort coordinated by the Federal Reserve Bank of New York, LTCM was wound down after suffering catastrophic losses. …