Financial Notes: Upside, Downside and a sense of regret

WHEN SWISS banks recently settled with Holocaust survivors, there was a sense that an episode of acute embarrassment for the banks was finally over. An important essence of this story went almost entirely unmentioned: that the Swiss banks had achieved one of the great risk management blunders of recent years. Given their behaviour during the Second World War it was perhaps impossible for them to escape some censure. But the extent of the vilification and the economic cost to their reputations; these could largely have been mitigated by better risk management.

We all face risk in our lives. Simplified, the Swiss banks faced a decision about risk which had much in common with humdrum issues that concern us as individuals. Should they settle or remain obdurate? How much insurance should we buy? What type of mortgage will work out best? Should we buy shares or bonds with a pounds 5,000 windfall? Is it worth playing the National Lottery? We are constantly asking and answering such questions. When we decide, we more or less intuitively weigh our attitude to risk. If we feel risk-averse, then we will take the safer option, particularly if we cannot afford the costs of being wrong. In this sense, we place greater weight on the consequences of being wrong than we do on the chance of being wrong.

A few simple rules can help us to make better decisions by reducing our reliance on intuition. First, list the positive reasons for a decision - call this the "Upside". Then list the negatives, the "Downside" outcomes that could hurt you. Does the Upside clearly outweigh the Downside? If so, then you should make the decision. But there is an important twist to bear in mind. When things go wrong, we each suffer from regret. We need to factor our unique personal or professional regret into our decisions. This means thinking hard about what could go horribly wrong and seeking to avoid it.

Now apply this to the Swiss banks' dilemma when they were first aware during 1995/96 of a concerted effort to pursue the issue of Holocaust survivors' assets. They initially viewed their Downside as limited - hence their arrogant and dismissive attitude when American pressure was applied. Rather than graciously settle on a modest amount, the banks put their reputations at risk by arguing that the matter was closed for ever. Throughout 1996 they simply failed to see that a very nasty scenario was unfolding.

As protesters' voices grew louder, the banks' image began to slide. One bank was caught destroying potentially incriminating documents. Before too long, Swiss banks were being excluded from regular financial business with large US borrowers. Too late, they realised that their Downside was immense. Avoiding a settlement had exposed them to reputational and financial losses that could run into billions. Small wonder that they eventually agreed to hand over more than $1bn in compensation.

Large institutions as well as individuals can get simple risk calculations badly wrong. But, with a better set of tools for analysing decisions which expose us to risk, we can all get more to grips with this most slippery of dangers. Using Upside and Downside tempered by our unique sense of regret will not allow us to avoid bad things altogether. Things will always go wrong in life. But we can at least feel better protected against disaster.

Andrew Freeman is co-author, with Ron Dembo, of `Seeing Tomorrow: rewriting the rules of risk' (Wiley, pounds 19.99)