Why risk minimization mind-set is hindering progress

Lin Che Wei, President Director

Let's say that one day you are standing at a railway junction where a runaway train is about to pass and go all the way to a tunnel where forty men are working. At that point, it is within your power to pull the lever to divert the train to another tunnel where 'only' five men are working.

You need to make a swift decision between doing nothing and letting forty people die -- but you will not be faulted for it -- or pulling the lever and killing five men instead. So, will you kill or let die? (Baggini, 2006)

Most people in Indonesia would choose to do nothing -- even though this is suboptimal -- for fear of being blamed or worse, penalized. Why? Because our society tends to adhere to asymmetric profiles of risk and reward.

Losses suffered as a result of taking risk are severely punished; while on the other hand gains received from risk-taking activities are not adequately rewarded.

Hence, we often seek to minimize risk instead of maximizing risk-adjusted return.

The act of minimizing risk is prevalent among bureaucrats and commercial bankers. The Indonesian economy is a commercial bank-dominated economy. In a bureaucratic system, the decision-making process is often laborious and time consuming, and therefore people often choose to only consider low-risk projects despite the relatively lower anticipated returns.

The same mentality also reigns in commercial banks, which operate in the so-called "belt and suspender mode". These banks will only disburse loans if there collateral is offered as a guarantee, and if the project can provide a steady stream of revenue and predictable cash flow.

That is why, micro, small, and medium enterprises face serious difficulties in securing loans from the commercial banks.

Excessive risk aversion leads to suboptimal economic development for three reasons.

First, it limits the universe of possible investment projects. The risk minimization mind-set prevents financial providers and decision-makers from considering projects outside their risk comfort zone.

Consequently, so many frontiers are left unexplored. The failure to venture into uncharted waters means limited possibilities of promoting creativity and fostering innovation. In the end, the finance industry and the economy as a whole become static.

The second reason is a concentration of liquidity in only traditional commercial banks, even though these commercial banks only cater to a limited range of clients.

As shown by the chart, there is substantial demand for financing among industries outside the scope and coverage of the commercial banks, which are constrained by their "belt and suspender mode".

With limited collateral, these riskier sectors are deprived of the financing necessary to develop their business. In the end, the nation's economic growth is hampered as fledgling industries are unable to fully develop to their full potential.

The final reason is that the risk minimization mentality stunts the development of advanced risk management techniques in financial institutions. Lenders that never bother to consider risky projects will not invest time and energy in quantifying and mitigating risks.

Within the government, the current excessive anticorruption drive and political witch-hunts exacerbate the risk-aversion problem. As a result, decision-makers often choose the easy way out. They pick the "safe" decisions instead of committing to "risky" decisions that could end up losing money.

In order to reform the mind-set and remedy the situation, there are three things that need to be done.

First, there needs to be a distinction between business risk and fraud. Losses suffered as a result of fraud should be penalized heavily as these losses originate from the dishonest intention to take advantage of the company or country for individual gain.

By contrast, however, losses arising from business risks should be addressed appropriately without excessive penalties or unnecessary scrutiny that could scare people from making necessary business decisions.

Second, there must be clear legal and operational frameworks so that private companies, SOEs and the different branches of the government understand the appropriate risk appetite for their business and the desired risk-adjusted return.

Third, there needs to be a sustained and far-reaching public information campaign on this issue. Without public education, it will be almost impossible to achieve satisfactory results.

If we take these three steps, the banks will expand their lending and jumpstart the real sector; SOEs will partake in profitable ventures based on management's best business judgment so as to optimize shareholder value; and eventually the country will benefit from faster economic growth.

The fear of taking risks is part of human nature. However, Ambrose Redmoon is correct in saying that courage is not the absence of fear but rather the judgment that something else is more important than fear. In this case, it is our nation's development.

Neda Tanaga and Driya Amandita contributed to this article
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