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What Risks Remain in the Financial System?

Author Zachary Karabell on risk-taking in the financial-services sector and the folly of trying to predict the next crisis.

Brown Brothers Harriman, the subject of Zachary Karabell’s new book, has long prioritized risk avoidance and staying out of the spotlight. That posture stands in contrast to many of its competitors, especially publicly traded firms. In a recent conversation on “The Long View” podcast, Karabell discussed the legacy of the firm, risks in the financial system at large, and why investors shouldn’t try to predict the next financial crisis.

Jeff Ptak: We want to ask you to reflect on the global financial crisis at the center of which one could argue sat very large, publicly traded financial institutions. Do you think the system has been shored up since then? Or do you think similar risks remain?

Karabell: I think there's a lot of work to do culturally. I do think that in the large banks, Dodd Frank and a whole series of other rulemaking by the Federal Reserve, rulemaking by the Comptroller of the Currency, rulemaking by the bank regulators, really has constrained a lot of the financial world in its exposure to risk, in the kind of traditional money centers and big banks, let alone asset managers. Hedge funds are a little different, although they, too, rely on the capital and credit extended by those large banks, which every now and then seems to get out of hand. I mean, there was a huge blowup of a hedge fund in 2021--Archegos, which most people had never heard of--because they had been presumably extended a level of credit based on past performance that proved unwise.

I don't think there's the level of risk, systemic risk, within the financial system. I do think there is still an ethos of the huge payday--again, somewhat less so within the large banks, more so on the periphery and private institutions and hedge funds and private equity, venture capital. And I'm admittedly guilty of painting with a broad brush. There are always exceptions to every rule. But I don't think that the culture in the financial world has changed. I think the constraints have increased. I think the risk is less.

Christine Benz: In the book, you wrote about how Brown Brothers Harriman endured multiple economic and market shocks. And the catalysts were certainly all different, but the underlying conditions were the same, where the system would build up these excesses and they would eventually have to be wrung out. I know that you're a student of economic history; you've written about many of these issues. Do you spot any underdiscussed risks in the system today?

Karabell: What's interesting about Brown Brothers and if you read Alexander Brown's letters, which I doubt most people will, but you could at least read the book and read a few of them. His general take was: There is always a crisis looming, but you're never going to know what it is, and the time to be prepared for it is before and not during and certainly not after. Meaning the only surety is that something will happen. Everything else is unclear: when, how much, to whom, what the catalysts will be? You can never really be--again, this is the Alexander Brown and Brown Brothers’ approach to risk, right--you can't really be specifically prepared, you can only be generally prepared. And again, the time to be genuinely prepared is now. We certainly found this in spades during the pandemic, the time to have enough personal protective equipment is before, not during when everybody needs it.

The reason why it's called “stockpiling” is you do it in anticipation of needing it at some future date when everything goes to hell, not scrambling around while it's going to hell, trying to figure out what to do. And I think that's the right approach to our present and future in that there are the risks that everybody looks at that sometimes come to bite you. I mean, everybody knew there was a housing bubble in 2006, 2007. But everybody didn't know the derivative exposure being held by these large financial institutions on their own books. They knew there was going to be a housing bubble that would pop, but you couldn't really have known that it would almost trigger a global financial meltdown. I mean, yes, after the fact, the four guys in their underwear who were warning about this in their basements in 2007, suddenly became heroic figures. But there's always like four people in their basements warning about some Armageddon. And if we listen to each one of them each time, you'd be wrong a lot more than you'd be right.

I don't know what the next crisis is going to be, and I don't know what's going to trigger it, and I don't know what's going to cause it, and I don't think anybody does. And I think trying to inoculate yourself from those specifics means you're probably going to spend a lot of money and a lot of energy trying to protect yourself against something that might happen and not necessarily protecting yourself against that which inevitably will happen. And again, the only way to do that is to think about your risk tolerance and figure out what you can lose and what you can't and how much and when and what your time duration is. Rather than trying to figure out like, “Oh, my God, I saw that it's actually going to be a meteor shower in 2026. That's going to knock out the power grid throughout the northeastern part of the United States. And so I'm going to buy up a lot of wind farms in Tulsa.” I mean, if that were true, that'd be great. Right? And more power to you if you believe that to be true. But I think that's an awfully hard one to fully game out.