Future Uncertainty

Often called emerging risks. Going back to Knight’s definitions of Risk and Uncertainty, there is very little risk contained in these potential situations.  Emerging risks are often pure uncertainty.  Humans are good at finding patterns.  Emerging risks are breaks in patterns.

What to Do about Emerging Risks…

Emerging risks are defined by AM Best as “new or evolving risks that are difficult to manage because their identification, likelihood of occurrence, potential impacts, timing of occurrence or impact, or correlation with other risks, are highly uncertain.” An example from the past is asbestos; other current examples could be problems deriving from nanotechnology, genetically modified food, climate change, etc. Lloyd’s, a major sufferer from the former emerging risk of asbestos, takes emerging risks very seriously. They think of emerging risks as “an issue that is perceived to be potentially significant but which may not be fully understood or allowed for in insurance terms and conditions, pricing, reserving or capital setting”.

What do the rating agencies expect?

AM Best says that insurers need “sound risk management practices relative to its risk profile and considering the risks inherent in the liabilities it writes, the assets it acquires and the market(s) in which it operates, and takes into consideration new and emerging risks.” In 2013, Best has added a question asking insurers to identify emerging risks to the ERM section of the SRQ. Emerging Risks Management has been one of the five major pillars of the Standard & Poor’s Insurance ERM ratings criteria since 2006.

How do you identify emerging risks?

A recent report from the World Economic Forum, The Global Risks 2012 report is based on a survey of 469 experts from industry, government, academia and civil society that examines 50 global risks. Those experts identified 8 of those 50 risks as having the most significance over the next 10 years:

•   Chronic fiscal imbalances
•   Cyber attacks
•   Extreme volatility in energy and agriculture prices
•   Food shortage crises
•   Major systemic financial failure
•   Rising greenhouse gas emissions
•   Severe income disparity
•   Water supply crises

This survey method for identifying or prioritizing risks is called the Delphi method and can be used by any insurer. Another popular method is called environmental scanning which includes simply reading and paying attention for unusual information about situations that could evolve into future major risks.

What can go wrong?

Many companies do not have any process to consider emerging risks.  At those firms, managers usually dismiss many possible emerging risks as impossible.  It may be the company culture to scoff at the sci fi thinking of the emerging risks process.  The process Taleb describes of finding ex post explanation for emerging Black Swan risks is often the undoing of careful plans to manage emerging risk.  In addition, lack of imagination causes some managers to conclude that the past worst case is the outer limit for future losses.

What can you do about emerging risks?

The objectives for emerging risks management are just the same as for other more well-known risks: to reduce the frequency and severity of future losses. The uncertain nature of emerging risks makes that much more difficult to do cost effectively. Insurers can use scenario testing to examine potential impact of emerging risks and to see what actions taken in advance of their emergence might lessen exposures to losses. This scenario testing can also help to identify what actions might lessen the impact of an unexpected loss event that comes from a very rapidly emerging risk. Finally, insurers seek to identify and track leading indicators of impending new risk emergence.

Reinsurance is one of the most effective ways to protect against emerging risks, second only to careful drafting of insurance contract terms and conditions

Many of the largest insurers and reinsurers have developed very robust practices to identify and to prepare for emerging risks.  Other companies can learn from the insurers who practice emerging risk management and adapt the same processes to their emerging risks.

Normal risk control processes focus on everyday risk management, including the management of identifiable risks and/or risks where uncertainty and unpredictability are mitigated by historical data that allow insurers to estimate loss distribution with reasonable confidence. Emerging risk management processes take over for risks that do not currently exist but that might emerge at some point due to changes in the environment. Emerging risks may appear abruptly or slowly and gradually, are difficult to identify, and may for some time represent an ill formed idea more than factual circumstances. They often result from changes in the political, legal, market, or physical environment, but the link between cause and effect is fully known in advance. An example from the past is asbestos; other examples could be problems deriving from nanotechnology, genetically modified food, climate change, etc. 
For these risks, normal risk identification and monitoring will not work because the likelihood is usually completely unknown. Nevertheless, past experience shows that when they materialize, they have a significant impact on the insurers and therefore cannot be excluded from a solid risk management 
program. So insurers have implemented unique specific strategies and approaches to cope with them properly.

Identifying emerging risks

Emerging risks have not yet materialized or are not yet clearly defined and can appear abruptly or very slowly. Therefore, having some sort of early warning system in place, methodically identified either through internal or external sources, is very important. To minimize the uncertainty surrounding these risks, insurers will consistently gather all existing relevant information to amass preliminary evidence of emerging risks, which would allow the insurer to reduce or limit growth of exposure as the evidence becomes more and more certain.  However, Insurers practicing this discipline will need to be aware of the cost of false alarms.

Assessing their significance

Assess the relevance (i.e. potential losses) of the emerging risks linked to a company’s commitment— which classes of business and existing policies would be affected by the materialization of the risk—and continue with the assessment of the potential financial impact, taking into account potential correlation with other risks already present in the firm. For an insurer, the degree of concentration and correlation of the risks that they have taken on from their customers are two important parameters to be considered; the risk in question could be subject to very low frequency/high intensity manifestations, but if exposure to that particular risk is limited, then the impact on the company may not be as important. On the other hand, unexpected risk correlations should not be underestimated; small individual exposures can coalesce into an extreme risk if underlying risks are highly interdependent. When developing extreme scenarios, some degree of imagination to think of unthinkable interdependencies could be beneficial.

A further practice of insurers is to sometimes work backwards from concentrations to risks. Insurers might envision risks that could apply to their concentrations and then track for signs of risk emergence in those areas. Some insurers set risk limits for insurance concentrations that are very similar to investment portfolio credit limits, with maximum concentrations in specific industries in geographic or political regions. In addition, just as investment limits might restrict an insurer’s debt or equity position as a percentage of a company’s total outstanding securities, some insurers limit the percentage of coverage they might offer in any of the sectors described above.

Define appropriate responses

Responses to emerging risks might be part of the normal risk control process, i.e., risk mitigation or transfer, either through reinsurance (or retrocession) in case of insurance risks, through the financial markets for financial risks, or through general limit reduction or hedging. When these options are not available or the insurer decides not to use them, it must be prepared to shoulder significant losses, which can strain a company’s liquidity.  Planning access to liquidity is a basic part of emerging risk management.  Asset-selling priorities, credit facilities with banks, and notes programs are possible ways of managing a liquidity crisis.

Apart from liquidity crisis management, other issues exist for which a contingency plan should be identified in advance. The company should be able to quickly estimate and identify total losses and the payments due. It should also have a clear plan for settling the claims in due time so as to avoid reputation issues. Availability of reinsurance is also an important consideration: if a reinsurer were exposed to the same risks, it would be a sound practice for the primary insurer to evaluate the risk that the reinsurer might delay payments.

Advance Warning Process

For the risks that have identified as most significant and where the insurer has developed coherent contingency plans, the next step is to create and install an advanced warning process.  To do that, the insurer identifies key risk indicators that provide an indication of increasing likelihood of a particular emerging risk.

Learn

Finally, sound practices for managing emerging risks include establishing procedures for learning from past events. The company will identify problems that appeared during the last extreme event and identify improvements to be added to the risk controls.  In addition, expect to get better at each step of the emerging risk process with time and experience.

But emerging risk management costs money.  And the costs that are most difficult to defend are the emerging risks that never emerge.  A good emerging risk process will have many more misses than hits.  Real emerged risks are rare.  A company that is really taking emerging risks seriously will be taking actions on occasion that cost money to perform and possibly include a reduction in the risks accepted and the attendant profits.  Management needs to have a tolerance for these costs.  But not too much tolerance.

 

This is one of the seven ERM Principles for Insurers

Getting Paid for Risk Taking

Consideration for accepting a risk needs to be at a level that will sustain the business and produce a return that is satisfactory to investors.

Investors usually want additional return for extra risk.  This is one of the most misunderstood ideas in investing.

“In an efficient market, investors realize above-average returns only by taking above-average risks.  Risky stocks have high returns, on average, and safe stocks do not.”

Baker, M. Bradley, B. Wurgler, J.  Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly

But their study found that stocks in the top quintile of trailing volatility had real return of -90% vs. a real return of 1000% for the stocks in the bottom quintile.

But the thinking is wrong.  Excess risk does not produce excess return.  The cause and effect are wrong in the conventional wisdom.  The original statement of this principle may have been

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Marshal has it right.  There are only “hopes” of great gains.  These is no invisible hand that forces higher risks to return higher gains.  Some of the higher risk investment choices are simply bad choices.

Insurers opportunity to make “great gains” out of “risks of great losses” is when they are determining what consideration, or price, that they will require to accept a risk.  Most insurers operate in competitive markets that are not completely efficient.  Individual insurers do not usually set the price in the market, but there is a range of prices at which insurance is purchased in any time period.  Certainly the process that an insurer uses to determine the price that makes a risk acceptable to accept is a primary determinant in the profits of the insurer.  If that price contains a sufficient load for the extreme risks that might threaten the existence of the insurer, then over time, the insurer has the ability to hold and maintain sufficient resources to survive some large loss situations.

One common goal conflict that leads to problems with pricing is the conflict between sales and profits.  In insurance as in many businesses, it is quite easy to increase sales by lowering prices.  In most businesses, it is very difficult to keep up that strategy for very long as the realization of lower profits or losses from inadequate prices is quickly realized.  In insurance, the the premiums are paid in advance, sometimes many years in advance of when the insurer must provide the promised insurance benefits.  If provisioning is tilted towards the point of view that supports the consideration, the pricing deficiencies will not be apparent for years.  So insurance is particularly susceptible to the tension between volume of business and margins for risk and profits,
and since sales is a more fundamental need than profits, the margins often suffer.
As just mentioned, insurers simply do not know for certain what the actual cost of providing an insurance benefit will be.  Not with the degree of certainty that businesses in other sectors can know their cost of goods sold.  The appropriateness of pricing will often be validated in the market.  Follow-the-leader pricing can lead a herd of insurers over the cliff.  The whole sector can get pricing wrong for a time.  Until, sometimes years later, the benefits are collected and their true cost is know.

“A decade of short sighted price slashing led to industry losses of nearly $3 billion last year.”  Wall Street Journal June 24, 2002

Pricing can also go wrong on an individual case level.  The “Winners Curse”  sends business to the insurer who most underimagines riskiness of a particular risk.

There are two steps to reflecting risk in pricing.  The first step is to capture the expected loss properly.  Most of the discussion above relates to this step and the major part of pricing risk comes from the possibility of missing that step as has already been discussed.  But the second step is to appropriately reflect all aspects of the risk that the actual losses will be different from expected.  There are many ways that such deviations can manifest.

The following is a partial listing of the risks that might be examined:

• Type A Risk—Short-Term Volatility of cash flows in 1 year

• Type B Risk—Short -Term Tail Risk of cash flows in 1 year
• Type C Risk—Uncertainty Risk (also known as parameter risk)
• Type D Risk—Inexperience Risk relative to full multiple market cycles
• Type E Risk—Correlation to a top 10
• Type F Risk—Market value volatility in 1 year
• Type G Risk—Execution Risk regarding difficulty of controlling operational
losses
• Type H Risk—Long-Term Volatility of cash flows over 5 or more years
• Type J Risk—Long-Term Tail Risk of cash flows over 5 years or more
• Type K Risk—Pricing Risk (cycle risk)
• Type L Risk—Market Liquidity Risk
• Type M Risk—Instability Risk regarding the degree that the risk parameters are
stable

See “Risk and Light” or “The Law of Risk and Light“

There are also many different ways that risk loads are specifically applied to insurance pricing.  Three examples are:

• Capital Allocation – Capital is allocated to a product (based upon the provisioning) and the pricing then needs to reflect the cost of holding the capital.  The cost of holding capital may be calculated as the difference between the risk free rate (after tax) and the hurdle rate for the insurer.  Some firms alternately use the difference between the investment return on the assets backing surplus (after tax) and the hurdle rate.  This process assures that the pricing will support achieving the hurdle rate on the capital that the insurer needs to hold for the risks of the business.  It does not reflect any margin for the volatility in earnings that the risks assumed might create, nor does it necessarily include any recognition of parameter risk or general uncertainty.
• Provision for Adverse Deviation – Each assumption is adjusted to provide for worse experience than the mean or median loss.  The amount of stress may be at a predetermined confidence interval (Such as 65%, 80% or 90%).  Higher confidence intervals would be used for assumptions with higher degree of parameter risk.  Similarly, some companies use a multiple (or fraction) of the standard deviation of the loss distribution as the provision.  More commonly, the degree of adversity is set based upon historical provisions or upon judgement of the person setting the price.  Provision for Adverse Deviation usually does not reflect anything specific for extra risk of insolvency.
• Risk Adjusted Profit Target – Using either or both of the above techniques, a profit target is determined and then that target is translated into a percentage of premium of assets to make for a simple risk charge when constructing a price indication.

The consequences of failing to recognize as aspect of risk in pricing will likely be that the firm will accumulate larger than expected concentrations of business with higher amounts of that risk aspect.  See “Risk and Light” or “The Law of Risk and Light“.

To get Consideration right you need to (1)regularly get a second opinion on price adequacy either from the market or from a reliable experienced person; (2) constantly update your view of your risks in the light of emerging experience and market feedback; and (3) recognize that high sales is a possible market signal of underpricing.

This is one of the seven ERM Principles for Insurers

During a Crisis – A Lesson from Fire Fighters

The fire cycle: “The action-cycle of a fire from birth to death follows a certain pattern.  The fire itself may vary in proportion from insignificance to conflagration, but regardless of its proportions, origin, propagation or rate of progression, the cycle or pattern of controlling it includes these phases:

1. the period between discovery and the transmittal of the alarm or alerting of the fire forces;

2. the period between receipt of alarm by the fire service and arrival of firemen at the scene of the fire; and, finally,

3. the period between arrival on the fire ground and final extinguishment of the fire itself.

It is important to fire fighting to make sure that the right things happen during each phase and that each step takes as little time as possible.  For the first phase, that means having fire detection equipment in place and working properly that produces a signal that will be noticed and conveyed to the fire forces.  In the second phase, the fire fighters need to be organized to respond appropriately to the alarm.  And the third phase includes the process of diagnosing the situation and taking the necessary steps to put out the fire.

That is a good process model for risk managers to contemplate.  Ask yourself and your staff:

1. This is about the attitude and preparedness of company staff to accept that there may be a problem.  How long will it be before we know when an actual crisis hits the company?  How do our alarms work?  Are they all in functioning order?  Or will those closest to the problems delay notifying you of a potential problem?  Sometimes with fires and company crises, an alarm sounds and it is immediately turned off.  The presumption is that everything is normal and the alarm must be malfunctioning.  Or perhaps that the alarm is correct, but that it it calibrated to be too sensitive and there is not a significant problem.  As risk manager, you should urge everyone to err on the side of reporting every possible situation.  Better to have some extra responses than to have events, like fires, rage completely out of control before calling for help.
2.  This is about the preparedness of risk management staff to begin to respond to a crisis.  One problem that many risk management programs face is that their main task seems to be measuring and reporting risk positions.  If that is what people believe is their primary function, then the risk management function will not attract any action oriented people.  If that is the case in your firm, then you as risk manager need to determine who are the best people to recruit as responders and build a rapport with them in advance of the next crisis so that when it happens, you can mobilize their help.  If the risk staff is all people who excel at measuring, then you also need to define their roles in an emergency – and have them practice those roles.   No matter what, you do not want to find out who will freeze in a crisis during the first major crisis of your tenure.  And freezing (rather than panic) is by far the most common reaction.  You need to find those few people whose reaction to a crisis is to go into a totally focuses active survival mode.
3. This is about being able to properly diagnose a crisis and to execute the needed actions.  Fire Fighters need to determine the source of the blaze, wind conditions, evacuation status and many other things to make their plan for fighting the fire.  They usually need to form that plan quickly, mobilize and execute the plan effectively, making both the planned actions and the unplanned modifications happen as well as can be done.  Risk managers need to perform similar steps.  They need to understand the source of the problem, the conditions around the problem that are outside of the firm and the continuing involvement of company employees, customers and others.  While risk managers usually do not have to form their plan in minutes as fire fighters must, they do have to do so quickly.  Especially when there are reputational issues involved, swift and sure initial actions can make the world of difference.  And execution is key.  Getting this right means that the risk manager needs to know in advance of a crisis, what sorts of actions can be taken in a crisis and that the company staff has the ability to execute.  There is no sense planning to take actions that require the physical prowess  of Navy Seals if your staff are a bunch of ordinary office workers.  And recognizing the limitations of the rest of the world is important also.  If your crisis effects many others, they may not be able to provide the help from outside that you may have planned on.  If the crisis is unique to you, you need to recognize that some will question getting involved in something that they do not understand but that may create large risks for their organizations.

 

Watch Your Back! The Machines are Coming!!!

Did you see the 2004 movie I Robot?  Do you remember the scene where the hoards of silver robots came down the streets and started to take over?

Where is Robot Take Over on your risk list?

In Artificial intelligence – can we keep it in the box? two writers from Cambridge argue that the threat from AI is not an “if?” question, but a “when?” question.

The authors are part of a group at Cambridge (actually, there are three members of the group) who are interested in studying threats from technology.  “Many scientists are concerned that developments in human technology may soon pose new, extinction-level risks to our species as a whole.” says their website, The Cambridge Project for Existential Risk.

Go back and watch I Robot again.  The only reason that the robot rebellion was foiled was because there was one robot who was designed to be independent enough to disagree.

If the “group” from Cambridge is correct, we need to get working on designing that robot that will save the day.

But first, we should ask them what they mean by “many scientists”?

How Much Resilience Do We Need?

Much too much of what we do relies upon the simplest idea of linear extrapolation.  It must be hard wired into human brains to always think first of that process.  Because we frequently seem to miss when extrapolation does not work.

Risk managers desperately need to understand the idea of system capacity.  The capacity of a system is a point beyond which the system will fail or will start to work completely differently.

The obvious simple example is a cup with a small hole in the bottom.  If you pour water into that cup at a rate that is exactly equal to the rate of the leak from the hole at the bottom, then the water level of the cup will be in equilibrium.  A little slower and the cup will empty.  A little faster and it will fill.  Too long in the fill mode and it will spill.  The capacity will be exceeded.

The highly popular single serving coffee machines are built with a fixed approach to cup capacity.  The more sophisticated will allow for two different capacities, but usually leave it to the human operator to determine which limit to apply.

For the past several years, there have been a number of events, the latest a hurricane that damaged an area the size of Western Europe, that have far exceeded the resilience capacity of our systems.  The resilience capacity is the amount of damage that we can sustain without any significant disruption.  If we exceed our resilience capacity by a small amount, then we end up with a small amount of disruption.  But the amount of disruption seems to grow exponentially as the exceedance of resilience capacity increases.

The disruption to the New York area from Hurricane Sandy far exceeded the resilience capacity.  For one example, the power outages still continue two weeks after the storm.  The repairs that have been done to date have reflected herioc round the clock efforts by both local and regional repair crews.  The size of the problem was so immense that even with the significant outside help, the situation is still out of control for some homes and businesses.

We need to ask ourselves whether we need to increase the resilience capacity of our modern societies?

Have we developed our sense of what is needed during a brief interlude of benign experiences?  In the financial markets, the term “Great Moderation” has been used to describe the 20 year period leading up to the bursting of the dot com bubble.  During that period, lots of financial economics was developed.  The jury is still out about whether those insights have any value if the world is actually much more volatile and unpredictable than that period of time.

Some weather experts have pointed out that hurricanes go in cycles, with high and low periods of activities.  Perhaps we have been moving into a high period.

It is also possible that some of the success that mankind has experienced in the past 50 years might be in part due to a tempory lull in many damaging natural phenomina.  The cost of just keeping even was lower than over the rest of mankind’s history.

What if the current string of catastrophes is just a regression to the mean and we can expect that the future will be significantly more adverse than the mild past that we fondly remember?

We need to come to a conclusion on those questions to determine How Much Resilience Do We Need?

The Risk of Paying too much Attention to your Experience

The Drift into Failure idea from the Safety Engineers is quite valuable.

One way that DIF occurs is when an organization listens too well to the feedback that they get from their safety system.

That is right, too much attention.  In the case of a remote risk, the feedback that you will get most days, most weeks, most months is NOTHING HAPPENS.

That is the feedback you are likely to get if you have a good loss prevention system or if you have none.

This ties to the DIF idea because organizations are always under pressure to do more with less.  To streamline and reduce costs.

So what happens?  In Safety and Risk Management, someone studies the risks of a situations and designs a risk mitigation system that reduces the frequency or severity of problem situations to an acceptable level.

Then, at some future time, the company management looks to reduce costs and/or staff.  This particular risk mitigation system looks like a prime candidate.  The company is spending time and money and there has never been a problem.  Doubtless, the same “nothing” could be achieved with less.  So the budget is cut, a position is elimated and they get by with less mitigation.

Then time pass and they collect the feedback, the experience with the reduced risk mitigation process.  And the experience tells them that they still have no problems.  The budget cutters are vindicated.  Things seem to be just fine with a less costly program.

If the risk here is highly remote, then this process might happen several times.

Which may eventually result in a very bad situation if the remote adverse event finally happens.  The company will be inadequately unprepared.  And no one made a clear decision to dilute the defense to an ineffective level.  They just kept making small decisions and eventually they drifted into failure.

And each step was validated by their experience.

A Learning Break

Riskviews has been taking a learning break.

Some times we are refreshed and invigorated by getting away from anything relating to their primary occupation.

But other times the most refreshing thing that you can do is to learn about how people faced with seemingly different, but fundamentally similar problems approach their work.

Riskviews has been learning small bits about Resilience.  That topic is usually associated with physical systems failures.  We are fooled into thinking that physical systems failures are all about engineering questions about the failures of metals or breakdown of lubricants.

But just as most failures in financial firms are directly related to human systems issues, so are most physical systems failures.  Studies about resilience are mostly studies of the human systems that are tightly linked to the physical systems that fail.

Here is a definition of resilience:

Resilience is the intrinsic ability of a system
to adjust its functioning prior to, during, or
following changes and disturbances, so that
it can sustain required operations under both
expected and unexpected conditions.

Already, Riskviews is learning something.  In much risk management literature, it is assumed that the system is determined via rules and that there is not necessarily ANY adjusting happening.  But from experience, we know that in almost all cases, systems will adjust to most significant changes and certainly will adjust to “disturbances”.

At the highest level, banks found out that a capital regime under which they held capital for a 1 in x event worked for absorbing the large loss, but it did not work for providing needed capital after the large loss.  They had a plan that worked up until the day after the event.

What both banks and insurers also found in the crisis was that their systems did adjust as things got insanely adverse.  But what they found was that in some cases, their systems adjusted so that they reduced the impact of the crisis and in other cases, made things worse.

One of the concepts that Resilience Engineers have developed is what they call “Drift into Failure.”  What they mean by that is that in many cases, complex systems fail, not because of some single part of person’s failure, but because of a series of small problems that in the end cause an avalanche type failure.

Here are four ideas that were discussed at a Resilience Engineering conference in 2004 from the notes of C Nemeth:

. Get smarter at reporting the next [adverse] event, helping
organizations to better manage the processes by which they decide
to control risk
. Detect drift into failure before breakdown occurs. Large system
accidents have revealed that what is considered to be normal is
highly negotiable. There is no operational model of drift.
. Chart the momentary distance between operations as they are,
versus as they are imagined, to lessen the gap between operations
and management that leads to brittleness.
. Constantly test whether ideas about risk still match reality. Keeping
discussions of risk alive even when everything looks safe can serve
as a broader indicator of resilience than tracking the number of
accidents that have occurred.

Resilience is a big topic and Riskviews will continue to share further learnings.

Why isn’t Strategic Risk included in ERM?

Many ERM systems exclude Strategic Risk.   The ERM systems usually include Market, Credit, Insurance and Operational Risk.  But not Strategic Risk.

Perhaps the assumption is that the ERM systems are about managing capital for the fluctuations and extreme losses of the business.

More likely, strategic risk is left out for two reasons.  First of all, the CEO and senior officers probably do not want to delegate this work.  Concerns about strategic risk are quite high in the priorities of a senior management team.  It is also a major concern of boards.

The second reason is that ERM has been highly focused on “measurable” risks and few feel that they can measure things like reputation risk and strategic risk.  So it may well be that risk managers are not asking to be given responsibility for helping with strategic risk.

But CROs need to remember that strategic risk is real, is very large and is not on their list of risks.  Because when they go to the board and top management with their “holistic” risk presentations, they will have a difficult time if the fail to ever even mention strategic risks.

In a the average company, their risk of failure averages between 2% for the largest and most secure firms and 5% for all other firms.  (Based upon studies of corporate longevity.  Fortune 500 firms have an average lifespan of about 40 years and an average firm only14.5 years.)

When other studies look at cause of major problems for firms, strategic risk make up about 70% of the events that result in a stock drop of 20% or more and operational risks, 20% and financial risks only 10%.

While those statistics are not widely known, it seems likely that a risk presentation that totally ignores strategic risk will strike board members who are generally aware of what causes problems for firms to wrinkle their brows with disbelief.

Now insurers, for example, have a different risk profile.  Their Financial and insurance risks are thought to be about 4 times as large as their operational risk.  Making a rough just ice adjustment to the figures above, one migh estimate that Insurance and Financial Risks are perhaps 55% of the total risk profile, Operational risk about 12% and Strategic risk about 33%.

So there is a range for thinking about strategic risk for insurers – between 33% and 70% of total risk.

Think about that before the next time you talk to your board about the firm’s risk profile.

What’s Your Risk Attitude?

The HBR Blog has picked up a piece by Ingram and Thompson on the dynamics of Risk Attitudes and Risk Environment.

Check it out HERE.

 RISKVIEWS has featured these ideas many times. 

See http://riskviews.wordpress.com/plural-rationalities/

What do risk officers worry about?

Read Max Rudolph’s comments on the Reuters Blog.

“Truth be told, risk management is an ever-evolving discipline. The Great Recession pointed out both the shortcomings of implementation at many companies, as well as the potential for a strong risk culture driving the risk management process. As time passes from this crisis to the next (as there is always another one around the bend), recurring trends are becoming apparent and companies across the world are getting smarter about the essential need to move risk management from the back room to a position influencing strategic decisions.”

Very High cost for Asset Allocation Advice

Most investors in hedge funds must be looking at them totally marginally.  Certainly that is the way that hedge fund managers would suggest.

What that means is the ther investor should not look at the details of what the hedge fund is doing, it should only look at the returns.  Those returns should be looked upon as a unit.

Certainly that is the only way to think of it that matches up with the compensation for hedge fund managers.  They get paid their 2 and 20 based solely upon their performance.

But think for a moment about how an investor probably looks at the rest of their portfolio.  They look at the portfolio as a whole, across all asset classes.  The investor will often make their first investment decision regarding their asset allocation.

While hedge fund managers have argued for treating their funds as one or even several asset classes, they are almost always made up of investments, long and short, in other asset classes.  So if you are an investor who already has positions in many asset classes, the hedge fund is merely a series of moves to modify the investors asset mix.

So for example, if the hedge fund is a simple leveraged stock fund, the hedge fund manager is lowering the investor’s bond holdings and increasing the stock holdings.

So if an investor with a 70% 30% Stock bond mix changes their portfolio to 65%, 25%, 10% giving 10% to a hedge fund manager who varies runs a leveraged stock fund that varies from all cash to 4/3 leveraged position in stocks, then they have totally turned their asset mix over to the hedge fund manager.

When the hedge fund is fully levered in stocks then their portfolio is 65% long Stocks, 25% long bonds, plus 40% long stocks and 30% short bonds.  Their net position is 105% stocks with  5% short bonds.  But that is not quite right.  If you only get 80% of your performance, your position is 97% stocks and 1% bonds.  That is right, it is less than 100%.  Only it is really worse than that.  That is the allocation when performance is good.  When the stock market goes really poorly, you get the performance of the 105%/(5%) fund. 

Other funds go long and short large and small stocks.  The same sort of simple arithmetic applies there. 

It is really hard to imagine that anyone who thinks that there is any merit whatsoever to asset allocation would participate in this game.  Because they will no longer have any say in their asset allocation.  What you have done is to switch to being a market timer.  In the levered stock example, you now have a portfolio that is 65% long stocks and 35% market timing.  

So in most cases, what is really happening is that by investing in a hedge fund, the investor is largely abandoning most basic investment principles and shifting a major part of their portfolio asset allocation to a market timer. 

At a very large fee.

Beach Risk

The risk that your risk manager will not come back from the beach.

Check back next week to see if Beach Risk has taken over the RISKVIEWS Blog.

The Most Dangerous Idea

Enterprise Risk Management is about taking actions to enhance the sustainability of an organization.

No one would think seriously about building their company headquarters on the edge of an active volcano.

But what if one day you are hired to run an organization that is located in the expected path of the volcano lava flow?  To reduce your risk and enhance your organization’s sustainability, you could decide to move.  Sounds fairly sensible doesn’t it?

However, in many cases, the organization that expends its resources to move away from their volcanoes is seen to be LESS valuble than the organization that ignores its volcanoes!

That is the most dangerous idea.

The organization that moved away from their volcano is seen to be making a bet that the volcano will erupt.  And if the volcano does not erupt, they are seen to be losing their bet.  Management is seen to have poor judgment.

Meanwhile, their next door neighbor who did not move away from the volcano is seen to be managed by astute businessmen.  They did not waste the organization’s resources.  They can instead put the money to a share buy back.

Evaluation of organization’s value rarely takes anything into account except upside potential.  There is an implicit assumption that the risk of all firms is similar.  Mostly unfathomable acts of god.  And you can’t blame management for missing those.

But that is mostly a problem with bad framing.  Re-read the short discussion above.  There is a huge framing problem here.  Building on the lip of a volcano is seen to be massively over risky.  No one would do it.  But moving away from a volcano, which involves walking away from a sunk cost, is thought of completely differently.  Almost totally opposite.

That mindset mainfests itself inside an organization as well.  Invariably, anyone who has in the past not done anything about a risk finds that actually treating the risk is too expensive.

There is a conceptual issue about risk here.  Some believe that not recognizing and not managing a risk is the “natural” state of operating and recognizing and managing a risk is unnatural, exceptional behavior.

That is the Most Dangerous Idea.

Price and Value

With a house, you always hear that the value is whatever someone is willing to pay for it.  But with a house, that value setting transaction is usually for the whole thing.  Partial shares of houses do not usually trade on the market.  So with a house, there are long periods of time when the actual value of the house is an unknown value.  It is usually reasonable to use a process of comparables to value the house.

Partial shares of companies, on the other hand, are traded on open markets.  That gives us a Price to use to impute a value to the ownership shares that are not traded.  The theory is that the shares are all worth the same amount.

The total reliance of modern finance and accounting on traded Price is credited with major improvements in the way that we understand business activities.

But there are unintended consequences of this shift.  And traded Price has never been a perfect measure.

The major fact that should make users of finance and financial statements pause is that when there is an acquisition of a company, the buyer does not rely upon finance theory about market values to set the final price of the transaction.  They rely upon boots on the ground fundamental analysis of the firm through the process called due diligence.

And at the end of that process, there is almost zero record of any firm selling for anything like the market price that existed before the acquisition process became known.

The buyer of a firm knows more than the market and pays a different price than the market. But if traded Price was really what the proponents of its ubiquitous usage say, then the wisdom of the market crowd should have arrived at the same amount.  But it never does.

You can think of it as the market spinning its own myth of the value of a firm and running around trading small lots of stocks that may not have any real impact on the actual transactions for the control of listed firms.

What does that mean for a risk manager?  It means that reliance on traded price is risky.  Traded price is more like a mock casino night.  Everyone pretends like the traded price is the real value of the firm but everyone knows that at the end of the night it is all just a game.  Why is that risky?  Because, like any game, trading shares can be suddenly discontinuous.

The value of a firm is the amount of profits that it can create in the future.  Don’t let any traded price enthusiast tell you anything different.

Those traded price folks tried to sell the idea that a house was worth whatever someone would pay (with someone else’s money).  But in reality, the house can only be worth an annuity on a fraction of the earnings of the folks who live there.  Traders can temporarily come to a different conclusion.  And they can give each other Nobel Prizes for creating clever math around their mock casino night.

What is Risk?

from Max Rudolph

As I deal with a variety of industries, professionals, investors and even risk managers, it has become obvious that the first issue that needs to be addressed from a risk management context is to define the term “risk”. I generally get pushback on this, but what I find is that everyone has a strong definition in their own mind that varies from person to person. How you define risk drives both risk appetite and risk culture. One of the keys in many of the management classes I have attended over the years has been to recognize that others tend to not think like I do. This is important here too. Before reading further, how do you define risk? Let me know if you don’t see your personal high level definition below.

Knightian Risk

Probably the most interesting risk definition I have seen, and the one I had never considered in its extreme, was put forth by Frank Knight in his 1921 book Risk, Uncertainty and Profit. Risk is defined as uncertainty. It is best explained by an example. If you were to launch yourself into space with no protection against the cold and lack of oxygen that defines space, you know you would die. By this definition there is no risk. If there is no uncertainty, in any direction, there is no risk. Sure to fail, no risk. Sure to win, no risk. Most people consider this definition in moderation when managing risk, although most would override it with one of the definitions we will consider next.

Downside Risk

When managing a business or portfolio, many managers consider risk only with respect to something bad that could happen. Outcomes can be defined numerically as more of something is either good or bad, and less of something is the opposite. An additional nuance is needed, and it has been mentioned by others. I like to look at “good” outcomes and “bad” outcomes. To follow an example earlier in this thread, higher sales might initially be called a good outcome, but often it eventually becomes a bad outcome as it outstrips capital availability or flags a pricing issue. Keep in mind that what is important is the overall impact on the entity, so a good overall outcome should be encouraged even if some lines of business would call it a bad outcome for their silo. High mortality is an example of this, with a life insurance line saying it is a bad outcome and a payout annuity considering it a good outcome. This is an example of a natural hedge, provided by two lines with offsetting risks in their portfolio.

Most companies today are looking at risk from a one sided perspective to meet their regulatory compliance needs. Risk management is viewed as a fixed cost under this paradigm. This approach is useful and helps the company avoid bankruptcy. It also provides a base from which you can leverage your ERM efforts.

Volatility Risk

I often think of traders when considering a volatility driven definition of risk. Opportunities abound if prices move, no matter which direction. Those who look at risk from a two sided perspective, and are good at it, can provide an organization with a competitive advantage as enterprise risk management becomes a major part of the strategic planning process. Everything is on the table. This helps an organization grow and prosper, in addition to lowering the probability of ruin. Incorporating risk into decision making provides a competitive advantage in all environments. The downside of this approach is that many who think of volatility as risk also believe that risk can be modeled accurately. They are more prone to model risk.

Not everyone is capable of the two sided risk approach. Risk culture can get in the way, but you also need the right people in place to drive risk management opportunities to senior team members. A risk manager should try to nudge their firm in this direction, but trying to leap there all at once is not likely to work.

Which risk definition is the best one?

It will depend on firm culture and risk appetite to know which definition is most consistent within an entity, and employing people with each definition can help a firm avoid overfocusing on one of the definitions. This will allow the firm to make better decisions. Risk is Opportunity!

©2011 Rudolph Financial Consulting, LLC

Warning: The information provided in this post is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Good luck!

Are you Risk Competent?

Find out by taking the Risk Competency Quiz.

Then come back here and let RISKVIEWS know what questions you would put onto a Risk Competency Quiz for people in Banks?  In Insurance Companies?

Is Social Security a Ponzi Scheme?

The name calling involved is a distraction from the real problem – the problem of how to keep our entire economic system working with the massive shifting of people into the non-productive retirement ages. Besides the imbalances in pay as you go programs like social security and medicare, there is the problem of who is going to buy the securities that the retirees will need to sell to pay for living expenses? What usually happens when the market knows that someone MUST sell something? What percentage of the stock market’s total holdings MUST be sold over the next 30 years?

Everyone keeps pretending that this is some sort of marginal change situation.  It is definitely not.

What happens if the Boomers sell off causes the market to drop by another 25 – 30%?

Sounds crazy?  But the charts below from the San Fran FRB tells a story…

The solid line represents the ratio of middle aged people (40 – 49) to Old Agers (60 – 69).

This picture shows a 30% drop in PE.  If earnings are also challenged by the low or negative population growth during the same time period, the massive drop is stock prices is quite possible.

So even the people who did save for retirement may be woefully surprised that their money does not save them.

The stock market is but a large and often somewhated distorted mirror of the economy.  If the stock market is challenged by the low growth of the population and the shift from production to consumption of the large retiree population, then that is a reflection that the economy could be challenged in just the same manner.

That is the REALLY BIG problem that needs to be solved.

The Social Security problem is not at all difficult to solve.  According to the most recent actuarial report to the trustees, the shortfall in Social Security is 14% of projected benefits or 17% of projected revenues.  So anyone who can do arithmetic can work out some combination of increases to taxes and decreases to benefits that would bring the program into balance over the 75 year projection period.  Split it down the middle and decrease benefits by 7% and increase social security taxes by 8.5% and it is solved.  But the fact of the matter is that there is no serious consideration being given to any solution, let alone a straightforward solution like the above that anyone could understand.

Time to Ban RISK FREE!

Perhaps the very act of declaring something a RISK FREE ASSET guarantees that it will not be such. 

Underneath that declaration of RISK FREE is a presumption that the RISK FREE entity can absorb an unlimited amount of debt.  When in fact, the thing that we are seeing over and over again is that it is the debt itself that causes the risk!

In insurance, if insurers allowed someone to insure a building that they own for five times its value in the event of a fire, we all understand that a fire becomes highly likely.

In banking, it is also a basic tenet of lending that if you lend someone much, much more than they could ever possibly repay, that they will not repay.  But in banking, we have let the concept of RISK FREE creep into our heads and let that overcome the basic tenet about lending and repayment.  Banks are actually encouraged to put more of their money into RISK FREE securities to make them more secure.  But in the case of both the sub prime and the sovereign crises, the problem comes from assets that were improperly designated RISK FREE.

But what if it is the designation of RISK FREE itself that leads to the problems?

In the US Life insurance sector, the regulators provide a Risk Based Capital (RBC) regime.  It assigns a level of capital based upon the regulators understanding of the risk of various activities.  Most life insurance products at the time of the creation of the RBC regime in the early 1990′s involved a guarantee from the general account of the insurer to the beneficiaries of the insureds.  Life insurers traditionally took large amounts of credit risk to support those guarantees.  The RBC originally was focused first on the largest risk of the life insurers, credit.

Variable Annuities did not involve a guarantee from the general account and were therefore considered RISK FREE.  Many insurers wrote that business and did not attribute any capital because the products were RISK FREE.  From the start, insurers paid a fixed commission to brokers who wrote the business.  Insurers did not directly charge the customers for those commissions, but instead recovered those payments from the accounts over time.  Later, life insurers started to also add guarantees from the general account of the benefits from the variable annuities.  The variable annuities were still considered to be RISK FREE so there was still no RBC charge.

It was not a surprise that valuable risk protection that was highly underpriced was attractive to buyers and these products became very heavy sellers for a dozen or more companies.  So much so that attempts to later change the RBC to require proper capital amounts for the product were potentially critically damaging to some of those firms. Eventually, when the financial crisis hit, some of those dozen insurers that wrote large amounts of these products were looking for help from the TARP program

So perhaps we should be rethinking this concept of RISK FREE.   When the activity deemed as RISK FREE starts to become risky, it starts (or in the case of the sub prime backed CDOs always) pays a higher return than the lowest risk activities.  When the denominator for RISK FREE is zero or very near zero, very tiny amounts of excess returns from growing risk of the activity which is now designated RISK FREE in error will look to be fantastically profitable.  A firm that is trying to optimize its return on capital will shift as much activity as possible into the improperly designated assets class.

As long as there is a RISK FREE class, there will be an incentive to shift as much activity as possible into any security in that class that is misclassified. 

And because the capital requirements for risk free are zero, there is no limit to how much banks can move into that class.  They actually look good if they leverage up to increase activity in RISK FREE.

We need to stop even saying that any class of investments is RISK FREE.  As we see where that idea has led us, we need to leave it in the universities where it belongs and keep it out of the business world.  They can keep it on a shelf right next to their bottles of perfect vacuum and along side their frictionless surfaces.  That is where it belongs.

In the real world, there are no RISK FREE assets.  The capital requirements need to be floored with a positive number and graded up with the level of returns.  The market really is telling us something about risk when returns are higher, not about the brilliance of the companies that are able to find the misclassified RISK FREE investments.

 

What Can You Control?

Framing is of vital importance in identifying risks.
Risks need to be framed in a way that you CAN actually control them.  If you say that your major risk is a drop in the stock market, then you are framing that risk as something that you cannot control.

If instead, if you frame it as a sudden drop in the value of your investments, then you are very highly in control of your risk.  You can choose your investments.  Your choice to manage the risk becomes a tractable risk reward trade-off.  You can buy hedges to mitigate the amount of your losses.

The same goes for Hurricanes or other acts of nature.  If you say that your risk is hurricanes, then you cannot control hurricanes and you are done.  The risk management committee can go home early.  But if you say that your risk is “damage caused by hurricanes”, suddenly you are in charge.  You have options and you have responsibilities.  You have the option to move some of your activities out of the path of hurricanes.  You have the option to make sure that the construction of your building can withstand some or all hurricanes and the concurrent storm surge.  You have the option of buying insurance to make sure that your damages are reimbursed.

So look at your list of risks.  Make sure that even if it says Hurricane, that you are treating it as a manageable risk.  As if it said “damage caused by hurricanes” that you can manage and you are not just throwing up your hands because you cannot stop a hurricane.

 

Maybe it is not as obvious as you think…

Do you have any bad instructions risk?

Solar Risk

At least 75% of the US has experienced some Solar Risk this summer. Temperatures were into triple digits.

(in Fahrenheit. Fahrenheit is a part of the ancient measuring system that only America uses. 100F is 37.7C. Not so magical stated that way.  But it is still exceptional.)

But very different solar risk is thought to be on the way.  Solar Storms are thought to entering a busy season and to have the capability of wrecking havoc on various electromagnetic broadcast and receiving systems.  GPS systems are thought to be particularly vulnerable.

The last major storm to hit earth reportedly caused the emerging telegraph systems in the US and Europe to encounter problems.  We now depend upon many, many complex electronic systems.

But see what happens if you try to get your firm to prepare for violent solar storms.  The best that may happen is that you would be laughed out of the room.

So do your own preparation.  Carry a map.

Is there a “Normal” Level for Volatility?

Much of modern Financial Economics is built upon a series of assumptions about the markets. One of those assumptions is that the markets are equilibrium seeking. If that was the case, it would seem that it would be possible to determine the equilibrium level, because things would be constantly be tugging towards that level.
But look at Volatility as represented by the VIX…

The above graph shows the VIX for 30 years.  It is difficult to see an equilibrium level in this graph.

What is Volatility?  It is actually a mixture of two main things as well as anything else that the model forgets.  It is a forced value that balances prices for equity options and risk free rates using the Black Scholes formula.

The two main items that are cooked into the volatility number are market expectations of the future variability of returns on the stock market and the second is the risk premium or margin of error that the market wants to be paid for taking on the uncertainty of future transactions.

Looking an the decidedly smoother plot of annual values…

There does not seem to be any evidence that the actual variability of prices is unsteady.  It has been in the range of 20% since it drifted up from the range of 10%.  If there was going to be an equilibrium, this chart seems to show where it might be.  But the chart above shows that the market trades all over the place on volatility, not even necessarily around the level of the experienced volatility.

And much of that is doubtless the uncertainty, or risk premium.  The second graph does show that experienced volatility has drifted to twice the level that it was in the early 1990′s.  There is no guarantee that it will not double again.  The markets keep changing.  There is no reason to rely on these historical analyses.  Stories that the majority of trades today are computer driven very short term positions taken by hedge funds suggest that there is no reason whatsoever to think that the market of the next quarter will be in any way like the market of ten or twenty years ago.  If anything, you would guess that it will be much more volatile.  Those trading schemes make their money off of price movements, not stability.

So is there a normal level for volatility?  Doubtless not.   At least not in this imperfect world.  

Cascading Failures

Most of the risks that concern us exist in systems. In massively complex systems.

However, our approach to risk assessment is often to isolate certain risk/loss events and treat them totally marginally.  That works fine when the events are actually marginal to the system but it may put us in a worse situation if the event triggers a cascading failure.

Within a system cycles are found.  Cycles that can ebb and flow over a long time.  And cycles that are self dampening or cycles that are self reinforcing.

The classic epidemiological disease model is an example of a self dampening system.  The dampening is caused by the fact that disease spread is self limiting.  Any person will have so many contacts with other people that might be sufficient to spread a disease were they infected.  In most disease situations, the spread of the disease starts to wane when enough people have already been exposed to the disease and developed immunity so that a significant fraction of the contacts that a newly infected and contagious person might have are already immune.  This produces the “S” curve of a disease. See  The Dynamics of SARS: Plotting the Risk of Epidemic Disasters.

The behavior of a financial markets in a large loss situation is a self reinforcing cycle.  Losses cause institutional investors to lose capital and because of their gearing the loss of capital triggers the need to reduce exposures which means selling into a falling market resulting in more losses.  Often the only cure is to close the market and hope that some exogenous event changes something.

These cascading situations are why the “tail” events are so terribly large compared to the ordinary events.

Each system has its own tipping point.  Your risk appetite should reflect how much you know about the tipping point of the system that each of your risks exists in.

And if you do not know the tipping point…

Playground Risk

Some of us are old enough to remember going to a playground without an adult trailing along to make sure that we played safely. Oh, there were always a few parents there, but they were with the pre-k aged kids. Anyone old enough to go to school was generally thought to be old enough to be able to play.

Well, thanks to the immense safety movement that has caused everything to be swathed in bubble wrap and foam padding, all of the risk is now gone from playgrounds. AND if you did go to a playground (and almost no one ever does anymore – they are no fun at all) you find that there is usually at least one and probably two adults supervising each child.

Thanks to Claire Wilkinson at the Terms and Conditions Blog of the III, we find that a new study of childhood risk taking suggests that risk taking is a necessary part of growing up to face the world as an adult. Children’s Risky Play from an Evolutionary Perspective: The Anti-Phobic Effects of Thrilling Experiences is the article.  The article says

we may observe an increased neuroticism or psychopathology in society if children are hindered from partaking in age adequate risky play

Roll the experiences of the last generation of kids forward twenty years, when they start to run the world.  They have been deprived of any chance at risk taking as kids.  Not safe enough.  They will also be living in a world dominated by the aged baby boomers.

Apply that picture to future risk appetites.  Any discussion of risk appetite talks about the amount of risk that someone is comfortable taking.

The lesson that we have taught our kids is that ZERO risk is the only level that they should be comfortable with.

I imagine that it would be a good thing to invest in a company that makes that rubber stuff that lines the floor of the playground.  That is much safer than concrete for sidewalks. It will be everywhere.

And business risk taking – forget about it.  Your business may fall and skin its knee.

Kids and adults and businesses and current and future business leaders need to experience risks and get comfortable with the losses that sometimes come from risk taking.  They need to learn that it is not the end of the world if they skin their knee.  Or even break a leg.  Maybe when that happens, we learn something new about ourselves and our ability to take risks in the world. 

Because if someone believes that they are not taking any risks then the only risks that they have are risks that they are not aware of.

How Not to Handle a Crisis

News International has been the news for several days now.  ABC News says that they are an example of How not to Handle a Phone Hacking Crisis.  It seems that nearly every year hands us another example of how a company should NOT handle a crisis.  The ideas of how TO handle one are pretty simple:

1. Get all the news out.  Don’t withhold.  The constant drip, drip of additional revelations makes many people skeptical about whether they ever hear the whole story.
2. Don’t just take advice from your lawyer.  It is quite possible to be totally safe in a legal sense and totally ruined in the court of public opinion.
3. Have a plan and practice.  Most company CEO’s that are faced with a crisis do not give the impression that they have ever given a minute of thought to what they might say in a crisis up until the very minute that they open their mouths.  They also seem to be totally surprised by the questions that they get.  There is no upside to knowing how to handle a crisis, but the downside to not knowing is a large fraction of the total net worth of the company.  If the CEO cannot be bothered to prepare, then they must assign a very senior person to be prepared to be the spokesperson in a crisis.  And also be prepared to hand over the top job to that person if there is a crisis and they handle things well.
4. Speed of response is Key.  And once you have a crisis, every new item needs a response.  In normal times, most items will blow over.  Ignoring them is the best policy.  In a crisis, the opposite is true.  Everything, no matter how trivial or inaccurate, needs a response.  You need to target getting as much airplay as your detractors.
5. Crisis management is not just talking.  The actions that you take need to be as clear and decisive as your words.  In many problem situations, early mitigation can be much more effective than a late mitigation, and less costly, and less troublesome to talk about.  Imagine someone trying to make a big deal of a problem that you have already solved.  Being ready to fix lots of things is not cheap, however.  But imagine how much money BP would have saved if ANYONE would have had the equipment right there in the Gulf that was needed to fix that leak.

What in the end it takes is to focus some time and attention and money to being prepared for your worst nightmare.

The Risk Embedded in Competitive Advantage

The term Competitive Advantage is popular with management gurus.  On the website, QuickMBA, they describe Michael Porter’s ideas on the topic as:

A Competitive Advantage exists when a firm is able to deliver the same benefits as competitors but at a lower cost (cost advantage) or deliver benefits that exceed those of competing products (differentiation advantage).  Thus a competitive advantage enables the firm to create superior value for its customers and superior profits for itself.

This is a major objective of most firms in a capitalist system, an objective far more desirable than risk and reward.  Going into the competitive marketplace and taking risks to get profits is a commodity approach to business.  That is why Market Consistent accounting regimes seek to show this activity as less desirable by recognizing those profits later.  Profits created by competitive advantage are reported immediately.

Once a firm has found a competitive advantage, they will seek to make it a sustainable advantage.  If the advantage is significant enough, they will also seek to eliminate all risk; turning it into a pure rent seeking activity.  In many cases, the managers of the business start to think of this as a PERMANENT RISK FREE BUSINESS.  

And that is risk that is embedded in Competitive Advantage.  It is a risk that comes with long experience with a favorable outcome.  Every day that goes by collecting those rents makes it harder and harder for employees and management to even imagine that there is any risk that the gravy train will stop.

Henry Ford had that sort of position until Sloan’s General Motors took advantage of Ford’s inability to imagine a different way of doing business than his “any color you want as long as it is black” approach.  IBM had that permanent risk free look 30+ years ago when everyone said that “no one ever got fired for recommending that the company buy IBM” for its computer needs.  Microsoft looked that way 10 years ago as well.  At the time that Microsoft was losing suits about their monopolistic behaviors, Gates was predicting Microsoft’s competition.  And he was right.

A business is not safe from this just because it is not a world dominating franchise.  Companies with small niches where they dominate have the exact same situation.

this does not mean that such competitive advantages are not a good goal for a business.  But it does mean that once you find one and you do the natural thing of eliminating risk to turn that business in a pure rent collection, there is always that one risk that you cannot eliminate.

Focusing on the Extreme goes Against the Grain

It is very common that people just totally discount risks that are remote.

There is only a 1% chance of that happening so I am just not going to worry about it.

Is commonly how that might be expressed, or even suggesting that something remote is “never going to happen”.

Buying a lottery ticket is seen as simply playing.  Almost no one makes serious plans around the possibility of winning the lottery.  But many will dream.

Life insurance is an unattractive product in most of Europe and the interest in it wanes in the US, supported only by a large tax incentive.  Perhaps that is possibly due to the remote likelihood that is being insured against.  For most ages of working people the mortality rate is less than 1 in 1000.  A very remote event.

This is one way of thinking about risk tolerance.  If people (including the people who run companies) are not concerned about events with a 1/100 or 1/1000 likelihood, then the risk tolerance should be stated in terms of a likelihood that they are concerned about – say 1/20.  Then the risk tolerance can be the amount of loss that they can tolerate at the level of likelihood that they are willing to actively consider.

Part of the barrier to forming a risk tolerance statement may be the focus on the remote – on a remote level that is beyond the concerns of the people who are being asked to form this opinion.

Resilience Realism

There are two parts to identifying and understanding whether something is a risk to your organization. The first part is to understand what might happen in the world and within your organization that might cause an adverse result. The second part is to understand the resilience of your organization to the adversity.

Consider the situation of New Orleans. For the Big Easy to be properly prepared for a major hurricane, they need to have both a realistic view of what sorts of hurricanes could hit the city AND they needed to be realistic about the resilience of their city to the impact of the hurricane.

Riskviews has featured the Plural Rationalities view that there are four different views of risk many times.  In addition to the view of risk, resiliency can follow the pattern of four different points of view.  In fact, it may well be a combination of the view of resiliency and the view of risk that makes up the four risk paradigms.

Conservators believe that the world is risky AND they are not very resilient.

Maximizers believe that the world is low risk AND that they are very resilient.

Managers believe that the world is moderately risky AND that they can be appropriately resilient if the work at it and apply the correct expertise.

Pragmatists believe that they do not know how risky that the world is and they also cannot tell whether they will be sufficiently prepared.

Consider the residents of the Atchafalaya Spillway area where the water from the flooding Mississippi River was diverted by the Army Corps of Engineers.  Some of those folks fled immediately when asked to evacuate.  They doubted that they had the resilience to face the flood.  Others stayed put because they had always survived floods before and they felt that their resilience was fine.  A few folks stayed and built up their own defenses.  You may have seen the TV footage of homes in their own little islands of recently added sandbags.  The Pragmatists may have been in any one of those three groups but for entirely different reasons.)

The feeling of resilience comes from experience – from the feedback that people get from their experiences.  And it helps to form their current approach to risk.

Cavalcade of Risk

If you, like Riskviews, enjoys reading about risk, you will love the Cavalcade of Risk.  The Cavalcade of Risk focuses on how people and businesses deal with the element of uncertainty in their lives, weekly presenting a wide ranging list of links to blogs and other places where all different aspects of risk are being discussed.

 

Cavalcade of Risk 133

Cavalcade of Risk 56 

Cavalcade of Risk  131

Cavalcade of Risk 128

With a little effort, you can track down all of them.

 

 

 

 

 

 

 

 

 

Hedging Longevity Risk might be the least of our worries

From a mechanical perspective, finding something to “hedge” against longevity risk, i.e. the risk that pension payouts will increase due to improving mortality, is not particularly difficult.  It is necessary to determine investment possibilities that will benefit from increased life expectancy.

Businesses that serve the aged such as nursing homes and medical products companies will be some of the sorts of things that will prosper in an increasingly aged economy.

Clever quants will be able to show that while the hedge is far from perfectly effective, it can be used to reduce the capital requirements of pensions and annuity exposures.

But there is a much larger question that is not likely to be addressed in looking at capital requirements for insurers and pension plans.

That is the issue of whether the economy will be able to sustain the aggregate effects of the aging of the populations in Japan, the US, Europe and China.  Those investments in elderservice providers and elderproduct firms will provide a relative hedge.  Those firms may do relatively better than the rest of the economy.

But on the whole, the economy might well be in the dumps, making the potential to earn the returns on investment needed to support the base level of pensions extremely difficult.  We may well find out that it is not viable for an economy to both maintain its base promises to elders AND maintain a healthy economy at the same time.

Robert Schiller has described this problem well in a NYT Op Ed piece last spring.  He describes an autonomous family farm where they must decide how to treat the family elders who are no longer able to work.  If the farm has a bad year and harvest is poor, do they continue to feed the elders the same as in the good years and therefore starve the working members of the family?  Or would that create a spiral that brought the entire family to ruin?

It would be good if we knew what happens to an economy that doubles the amount of total resources that are directed towards its non-productive elders.  If there is a point where an economy would stop being viable, then the concerns about minor increases to pension benefits due to longevity increases are immaterial.  The ruined economy sill simply not be able to pay the basic benefits.

It seems highly likely that the systems that were imagined in the last 100 years will not stand up to the pressures of the aging Baby Boomers.  The discussion that at least in the US is not happening about funding for retiree medical and income needs may well be the wrong discussion.  The discussion that is needed is to ask how the economy will survive the strain of the very large pool of elders.

Schiller’s family farm example leads to an immediate suggestion.  One that many people are coming to privately, even if there is little public discussion.  That suggestion is a complete rethinking of retirement and employment for elders.  An honest evaluation of the real economic impact of the exploding numbers of elders is very likely to reveal that it is just not practical for an economy to provide for 20 – 25 years of leisure to a large fraction of its population.

This is a situation where our simple extrapolatory approach to assessing risk is inadequate.  The future will most certainly be different from an extrapolation of the past.

Cellphone Danger

The WHO has just released a statement about possible cancer risk from cell phones.

Cell Phones are definitely dangerous.  Just try walking down any street.  Watch people suddenly stop walking or erratically change their pace of walking, even in a crowded sidewalk.  Invariably they have a cell phone up to their ear.  It is clear that cell phones suck the self preservation part of the brain right out of the ear.

And much more risky is the effect of cell phones on driving.  Some safety experts attribute as many as half of the auto accidents in the US to cell phones.  Cell phones seem to prevent people from noticing red lights, stop signs, stopped vehicles and pedestrians in their way. Thousands of deaths and millions of damage.

The cancer risk is the least part of the risk of cell phones.

Was Lindberg really Lucky?

Charles Lindberg made the fist solo transatlantic flight in 1927.

He was called Lucky Lindy because he succeeded at something that was judged to be highly unlikely.  In fact, by analyzing prior experience you would give his solo trans Atlantic flight a ZERO likelihood.

So his flight was a freak occurrence.  A Black Swan.

Six years later, Italo Balboa led a group of 24 planes across the Atlantic.  By the 1940′s, flights across the Atlantic were a very regular thing.

Think about Lucky Lindberg when you imagine the next major catastrophe.  You may not be able to get the event right, but there will be something that never happened that will be significantly worse that we imagined.  And after it happens, there will be a few more larger events until events of that magnitude become commonplace.

Now instead of assigning that sequence a zero probability, figure out how to include that in your risk management system.

Imminent Risk – Employee Turnover

Many risks go in cycles.  And While it makes some sense to keep an eye on them during the part of the cycle when they are low, it makes much more sense to concentrate on them when they are imminent.

A recent report from Metlife “Study of Employee Benefits Trends” diverts from its primary topic to spend an entire chapter on The Erosion of Employee Loyalty.  One startling statistic that they report is that over one third of employees say that if they have the choice, they will change employers in 2011!

Risk managers often think of risks like employee turnover as being “soft” risks that are difficult to measure and model.  But that may be mostly due to lack of familiarity.  In this case, people have measured the costs.  The Society of Human Resources Management (SHRM) has estimated that turnover costs vary by the level of employee.  For minimum wage employees, the costs are 30% to 50% and goes up for more skilled employees – up as high as 400% of salary for the most skilled employees.

And that does not take into account that the people who are most able to leave are the most competent and productive of your employees.

So your firm has an imminent risk that will emerge when the job market in your industry opens up.  You will know exactly when that risk is going to hit.  You will know because your firm will start to hire more after several years of low or zero hiring.  Once you notice the actual turnover, it will be too late. So monitoring hiring by your own firm and in your part of the economy is your key risk leading indicator.

The risk treatment steps to take would be those that might impact either the frequency or severity of the losses from this risk.  (duh)

Metlife includes this discussion in their report on employee benefits so that they can make the case that more employee benefits would be an effective preventative.

But before setting out to define risk treatment plans, the risk manager will want to look at the loss estimates.  That SHRM study points to costs from the hiring process, from training costs as well as productivity losses.  Each firm should examine their practices and experience to refine the general estimate to their situation.  Some firms will always choose to hire highly experienced employees to minimize the training and lost productivity costs.  Other firms will go to the other extreme, hiring mostly at the entry level and expecting to promote from within to replace any higher level losses.

Salary costs are a large percentage of financial businesses costs.  The management of this cost could probably benefit from some good quantitative analysis, if that is not already the practice.

If the SHRM costs are correct and even half the people identified by Metlife are able to change jobs, then firms on the average are facing extra costs of as much as 20% of payroll.

Do the math, where does this put employee turnover risk in terms of your top ten risks list?

Looking at Risk through a Telescope, Reading Glasses or a Wide Angle Lens

Risk managers need to be looking at the risks that may nibble away at the firm, risks that may deliver swift killing blows as well as risks that will slowly strangle the firm.

Risk managers need to use the Telescope to look for risks that are remote.  The Emerging Risks.  Those risks may be tiny specks in the far distance.  The risk manager may need to use their imagination to see what harm those tiny specs might do.  They need to arrange things appropriately to prepare for the day when the speck might turn into a real threat.  The firms who use the telescope to view those risks will be able to take the actions far in advance that will make their eventual defense against the risk more effective and economical.

Risk managers also need to use the Reading Glasses to look at the fine details of the things that go by each and every day.  By a careful detailed review, the risk manager may find cracks in the structure or activity that appeared very sturdy up until then.  They can take actions to patch those cracks and to look for alternatives.

Risk managers should also look with a wide angle lens for risks coming at them.  The wide angle lens allows them to see risks coming at them from every direction.  When the risk manager crosses the one way street, they will often quickly look in the “wrong” direction to make sure that nothing is coming from that direction either.  They know that risk is not bound by any rules.  In fact, risk is often most dangerous when it moves directly in the opposite direction that the rules would have you think to look.

Risk managers who have built up processes with a fixed focus that look in only the directions that are required will find that the largest risks are not going to congregate in the spots where they have focused.

Risks will move out of those bright spots where the risk managers are focusing into the dark.  And they will move closer and closer and get larger and larger as long as no one looks at them.

Lucas Fayne Highly Recommends this Blog

The New York Times reported today that Lucas Fayne can be found on over 50 websites around the web endorsing the services of home remodeling contractors.  Riskviews did intensive research (i.e. a single Google search) and found a dozen references to the syndicated NYT article AND some of those endorsements.  Riskviews found that Fayne had home remodeling work done in Lexington Kentucky, San Marcos Texas, Irving Texas, Belmont Tennessee, Belmont New Hampshire, Minneapolis Minnesota before getting tired of researching.

So Riskviews decided to post his recommendation of this Blog.

Reality can be a much better teacher than Blogs.  Maybe there really is a Lucas Fayne who has had some much home remodeling work done all over the country.  Maybe he is such a consistent speaker that he has exactly the same thing to say about each and every contractor.

And maybe this story is a good lesson about due diligence.  And letting someone else provide your due diligence.

Riskviews seems to have actually done a little more research than the NYT.  Because Riskviews has discovered that there are other serial recommenders.  Nan Carlisle and Gillian Lee have also made statements about contractors in multiple states.  Lucas’ brother William seems to like the work that he had done also.

In this particular case, it was easy enough to find that these recommendations are probably bogus.  But you might want to keep this story in mind whenever you are tempted to be satisfied with a simple web based reference for someone or some service.

In the early days of computers, many unsophisticated managers were fooled into thinking that computer reports were by nature more accurate than hand typed reports.   More than one computer savvy person took advantage of that by getting the computer to simply print whatever they wanted a report to say, rather than doing what was assumed – getting the computer to actually determine an answer with its vast calculation power.

Few people who know how the internet works would fall for that sort of trick nowadays.  But how many people actually understand how the internet works?

Overreliance on the internet as an unchecked source of information is a risk to every business.  The risk manager should make sure that there are protocols to eliminate recommendations from the Faynes, Carlisles and Lees.

But in case you are someone who does not worry about things like that, here is the recommendation of this Blog:

We were very satisfied with the service and efficiency of your blog.  Getting the quote was quick and easy, and your staff started on time each day and worked hard. We are very confident with the job you did and have been recommending you to all our neighbors. Riskviews became a good friend to our family by the end of our project. He is a class act all the way!    Lucas Fayne (yourtown, yourstate)

Modeling Uncertainty

The message that windows gives when you are copying a large number of files gives a good example of an uncertain environment.  That process recently took over 30 minutes and over the course of that time, the message box was constantly flashing completely different information about the time remaining.  Over the course of one minute in the middle of that process the readings were:

8 minutes remaining

53 minutes remaining

45 minutes remaining

3 minutes remaining

11 minutes remaining

It is not true that the answer is random.  But with the process that Microsoft has chosen to apply to the problem, the answer is certainly unknowable.  For an expected value to vary over a very short period of time by such a range – that is what I would think that a model reflecting uncertainty would  look like.

An uncertain situation could be one where you cannot tell the mean or the standard deviation because there does not seem to be any repeatable pattern to the experience.

Those uncertain times are when the regular model – the one with the steady mean and variance – does not seem to give any useful information.

The flip side of the uncertain times and the model with unsteady mean and variance that represents those times is the person who expects that things will be unpredictable.  That person will be surprised if there is an extended period of time when experience follows a stable pattern, either good or bad or even a stable pattern centered around zero with gains and losses.  In any of those situations, the competitors of that uncertain expecting person will be able to use their models to run their businesses and to reap profits from things that their models tell them about the world and their risks.

The uncertainty expecting person is not likely to trust a model to give them any advice about the world.  Their model would not have cycles of predictable length.  They would not expect the world to even conform to a model with the volatile mean and variance of their expectation, because they expect that they would probably get the volatility of the mean and variance wrong.

That is just the way that they expect it will happen.   A new Black Swan every morning.

Correction, not every morning, that would be regular.  Some mornings.

Risk Manager Survey of Emerging Risks

“There is currently an upsurge in management’s willingness to listen to risk managers.”   But Risk Managers consistently show a disturbing tendency towards projecting the next crisis from the last.  Now in its fourth year, the Emerging Risks Survey from the Joint Risk Management Section and conducted by Max Rudolph.

Emerging risks are risks that are evolving in uncertain ways, have been forgotten in their dormancy, or are new.  Emerging risks typically do not have a known distribution, that is their frequency is unknown.

In 2007, a shock to oil prices was seen as the top “emerging risk” in the first survey of risk managers.  That year had seen a major spike in oil prices.  In 2008, a blow-up in asset prices was identified as the top “emerging risk” immediately following the melt down of the sub prime market and a major drop in stock prices.  In 2009, a fall in the value of the US dollar was identified as the top “emerging risk” at the end of a year when many major currencies had strengthened against the dollar.  The new 2010 survey, released this week, indicates again that a fall in the US dollar is the top “emerging risk”.

If in fact these risk managers are advising their employers in the same way that they answer surveys, firms will continue to be well prepared for the last crisis and unprepared for the next one.

However, when asked to identify the single top emerging risk concern, a Chinese economic hard landing was the top pick with 14% of the respondents selecting that choice.  That is certainly a scenario that has not just recently happened.  So at least 14% of the respondents are doing some forward thinking.

Download the entire survey report here.

Risk Appetite and Risk Attitude

Riskczar writes about differing risk appetites this week.

I want to introduce a nuance to his discussion.  He mentions that his risk appetite is less than both his brother and his significant other.

The Risk Doctor presents a view of risk attitude that tracks directly with what Trevor calls differing risk appetites.  They both look at it as a spectrum of higher risk appetites to lower.  David suggests that anyone with a higher risk appetite has one risk attitude while someone with a lower risk appetite has another risk attitude.  Which is consistent with the digestive term appetite that is used.

However, another way of looking at this is possible and is suggested by the Plural Rationalities approach to risk that is often featured here on Riskviews.

With the Plural Rationalities approach, it is suggested that folks with an apparent higher risk appetite may well simply perceive that there is less risk than someone with a lower risk appetite.  The people who perceive that risk is very high are called Conservators.  The people who perceive that risk is very low are called Maximizers and the people who perceive that risk is moderate are called Managers. Finally Plural Rationalities suggests that there is a fourth risk attitude that is possessed by folks who just do not think that they can know how risky that something really is.  They are called Pragmatists.

These Pragmatists do not fit onto the spectrum of risk appetites.  However, plenty of these people exist.  They are the undecideds in the polls about risk.  They do not feel that the future is highly predictable, so they choose not to try.  They therefore seem to be less convinced about likelihood of favorable outcomes as well.  Or lack of likelihoods either.  Lottery tickets are appealing to some Pragmatists.  Pragmatists may take on situations that are seen to be high risk by the Conservators and pass up on situations that are seen as low risk to the Maximizers.  Pragmatists are also often frustrating to the Managers because they fail to follow the logical conclusions reached by the Managers.

But Pragmatists are well suited for the situation that seems to have settled over many economies in the world in the recent past.  The Uncertain economy.  Modern economics does not even officially have that as a phase of an economic system, though some economists have repeatedly described the current situation with that exact word.  Their approach the the Uncertain economy is to try to get it to change into one of the other stages that they do think that they understand.

So the Maximizers and Conservators are not choosing more risk or less risk as the Rational Expectations theory suggests, they are actually believing that the world is less risky (Maximizers) or more risky(Conservators).

They are not acting irrationally, they are acting according to their own rationality.

This would be irrational, except for the fact that in some periods of time, they are correct.

Once they start to notice that their view of risk is no longer correct, slowly but surely they eventually change their risk attitude to adjust to the current reality.

This process explains the market cycles without having to assume irrationalities.  Instead we need to acknowledge Plural Rationalities.

Getting a Handle on Uncertainty

Frank Knight looked for the reason why firms are able to make a profit (in perfect competition situations that is) and he ultimately decided that firms were paid for UNCERTAINTY.  He then went on to distinguish uncertainty from risk.  Risk is the toss of the dice.  With risk, the frequency & severity distribution of possible outcomes is known.  Uncertainty differs fundamentally from risk because with uncertainty, the future likelihoods are unknown.

You are uncertain, to varying degrees, about everything in the future; much of the past is hidden from you; and there is a lot of the present about which you do not have full information. Uncertainty is everywhere and you cannot escape from it. Dennis Lindley

In risk management, we tend to treat everything as if it were a Knightian RISK and totally ignore UNCERTAINTY. We do our best job of estimating the frequency distribution of gains and losses and treat every best estimate the same.  See Sins of Risk Measurement.

But we can and should make an effort to identify the uncertainty that lurks, to vastly differing degrees within our risk measures.  A simple start to such an effort would be to develop a classification system for UNCERTAINTY.

1. Almost Totally Certain – like a prediction of time of sunrise.  No experience contrary to predictions and good reason to believe that there will not be a regime change in the event.  Highly unlikely that any human activity will fall into this category.  Humans are just not this predictable.
2. Highly certain – like a prediction of the Cubs not winning the World Series.  Never happened, but it is possible, but highly unlikely that there will be a regime change.  Things in this category will be things that there is a long amount of historical evidence.  The possibility of a fall in home prices were felt to fall into this category, but the historical evidence turned out to be from one single cycle.  To put something in this category, a firm should have direct experience with the activity in question so that there is insight within the firm about the reasons for the historical drivers of the seemingly highly certain event.
3. Conditionally certain – Apple will stay successful as long as Jobs stays healthy (oops).  For these sorts of uncertain events, the firm should have a that clear idea of the drivers of a string of predictable experience and an understanding that the driver(s) are not themself highly certain events.
4. Somewhat uncertain – “Bill says that it takes him 20 minutes to get to the airport” or “it usually takes me 20 minutes to get to the airport but sometimes it is an hour.” Here the firm either has only moderate amounts of experience to judge the actual uncertainty and the event seems to be fairly certain or else the firm has experience and knows that the event is somewhat uncertain.
5. Unknown uncertainty – “this is the first time I am parachute jumping and I plan to land in my backyard lawn chair.”  Something new.  With only limited knowledge of other people’s experiences and not enough experience to know whether there are significant differences in the drivers.

The first time a firm does an economic capital model, they might classify the result as having Level 5 uncertainty.  Over time, some calculations might move up to Level 4 or Level 3.  In a few areas, the firm might have been doing risk calculations for a particular risk over much longer time and could move up to Level 2 uncertainty there.

But change the question from an estimation of a 1-in-200 risk to a “will this project make money or not” question and is is quite possible that many of the answers might have Level 2 or Level 3 uncertainty.

But firms should try assigning Uncertainty ratings to their efforts.  And track over time the degree to which the firm is devoting resources to projects with Level 5 Uncertainty.

Riskviews has worked for several firms that were over 100 years old at the time and those firms usually were very uncomfortable taking on any Level 5 Uncertainty.  Most often they kept those activities small until they gained experience.  When they went for long periods of time with no Level 5 Uncertainty, however, they tended to shrink relative to the rest of the industry.

On the other hand, the financial crisis was touched off by Banks and other institutions who committed to enough Level 4 and Level 5 uncertainty to send them over the edge.  Investors would certainly be interested to know how much Level 5 Uncertainty that a firm is taking at any point in time.

Using an Uncertainty scale like this and discussing the reasons for changes to the level of commitment to higher uncertainty projects will be a healthy and productive exercise for many firms.

Liquidity Risk Management for a Bank

A framework for estimating liquidity risk capital for a bank

From Jawwad Farid

Capital estimation for Liquidity Risk Management is a difficult exercise. It comes up as part of the internal liquidity risk management process as well as the internal capital adequacy assessment process (ICAAP). This post and the liquidity risk management series that can be found at the Learning Corporate Finance blog suggests a framework for ongoing discussion based on the work done by our team with a number of regional banking customers.

By definition banks take a small Return on asset (1% – 1.5%) and use leverage and turnover to scale it to a 15% – 18% Return on Equity. When market conditions change and a bank becomes the subject of a name crisis and a subsequent liquidity run, the same process becomes the basis for a death chant for the bank.  We try to de-lever the bank by selling assets and paying down liabilities and the process quickly turns into a fire sale driven by the speed at which word gets out about the crisis.

Figure 1 Increasing Cash Reserves

Reducing leverage by distressed asset sales to generate cash is one of the primary defense mechanisms used by the operating teams responsible for shoring up cash reserves. Unfortunately every slice of value lost to the distressed sale process is a slice out of the equity pool or capital base of the bank. An alternate mechanism that can protect capital is using the interbank Repurchase (Repo) contract to use liquid or acceptable assets as collateral but that too is dependent on the availability of un-encumbered liquid securities on the balance sheet as well as availability of counterparty limits. Both can quickly disappear in times of crisis. The last and final option is the central bank discount window the use of which may provide temporary relief but serves as a double edge sword by further feeding the name and reputational crisis.  While a literature review on the topic also suggest cash conservation approaches by a re-alignment of businesses and a restructuring of resources, these last two solutions assume that the bank in question would actually survive the crisis to see the end of re-alignment and re-structuring exercise.

Liquidity Reserves: Real or a Mirage

A questionable assumption that often comes up when we review Liquidity Contingency Plans is the availability or usage of Statutory Liquidity and Cash Reserves held for our account with the Central Bank.  You can only touch those assets when your franchise and license is gone and the bank has been shut down. This means that if you want to survive the crisis with your banking license intact there is a very good chance that the 6% core liquidity you had factored into your liquidation analysis would NOT be available to you as a going concern in times of a crisis. That liquidity layer has been reserved by the central bank as the last defense for depositor protection and no central bank is likely to grant abuse of that layer.

Figure 2 Liquidity Risk and Liquidity Run Crisis

As the Bear Stearns case study below illustrate the typical Liquidity crisis begins with a negative event that can take many shapes and forms. The resulting coverage and publicity leads to pressure on not just the share price but also on the asset portfolio carried on the bank’s balance sheet as market players take defensive cover by selling their own inventory or aggressive bets by short selling the securities in question. Somewhere in this entire process rating agencies finally wake up and downgrade the issuer across the board leading to a reduction or cancellation of counterparty lines.  Even when lines are not cancelled given the write down in value witnessed in the market, calls for margin and collateral start coming in and further feed liquidity pressures.

What triggers a Name Crisis that leads to the vicious cycle that can destroy the inherent value in a 90 year old franchise in less than 3 months.  Typically a name crisis is triggered by a change in market conditions that impact a fundamental business driver for the bank. The change in market conditions triggers either a large operational loss or a series of operation losses, at times related to a correction in asset prices, at other resulting in a permanent reduction in margins and spreads.  Depending on when this is declared and becomes public knowledge and what the bank does to restore confidence drives what happens next. One approach used by management teams is to defer the news as much as possible by creative accounting or accounting hand waving which simply changes the nature of the crisis from an asset price or margin related crisis to a much more serious regulatory or accounting scandal with similar end results.

Figure 3 What triggers a name crisis?

The problem however is that market players have a very well established defensive response to a name crisis after decades of bank failures. Which implies that once you hit a crisis the speed with which you generate cash, lock in a deal with a buyer and get rid of questionable assets determined how much value you will lose to the market driven liquidation process. The only failsafe here is the ability of the local regulator and lender of last resort to keep the lifeline of counterparty and interbank credit lines open.  As was observed at the peak of the crisis in North America, UK and a number of Middle Eastern market this ability to keep market opens determines how low prices will go, the magnitude of the fire sale and the number of banks that actually go under.

Figure 4 Market response to a Name Crisis and the Liquidity Run cycle.

The above context provides a clear roadmap for building a framework for liquidity risk management. The ending position or the end game is a liquidity driven asset sale. A successful framework would simply jump the gun and get to the asset sale before the market does. The only reason why you would not jump the gun is if you have cash, a secured contractually bound commitment for cash, a white knight or any other acceptable buyer for your franchise and an agreement on the sale price and shareholders’ approval for that sale in place.  If you are missing any of the above, your only defense is to get to the asset sale before the market does.

The problem with the above assertion is the responsiveness of the Board of directors and the Senior executive team to the seriousness of the name crisis. The most common response by both is a combination of the following

a)     The crisis is temporary and will pass. If there is a need we will sell later.

b)    We can’t accept these fire sale prices.

c)     There must be another option. Please investigate and report back.

This happens especially when the liquidity policy process was run as a compliance checklist and did not run its full course at the board and executive management level.  If a full blown liquidity simulation was run for the board and the senior management team and if they had seen for themselves the consequences of speed as well as delay such reaction don’t happen. The board and the senior team must understand that illiquid assets are equivalent of high explosives and delay in asset sale is analogous to a short fuse. When you combine the two with a name crisis you will blow the bank irrespective of its history or the power of its franchise. When the likes of Bear, Lehman, Merrill, AIG and Morgan failed, your bank and your board is not going to see through the crisis to a different and pleasant fate.

Momentum Risk

How many times have you heard this

If it isn’t broken don’t fix it.

As a risk manager, momentum risk is one of the most difficult risk to overcome.  (I wonder how many times on these posts I have claimed this?)

But this is the aspect of the Horizon disaster that led to millions and millions of barrels of oil spilling into the Gulf.  Before that the oil companies claimed that there had never been a failure of an oil rig in the Gulf.  So that was the Momentum assumption.  It had never failed so it never would fail.

Standing against that is the seemly endlessly negative point of view of the risk manager:

If anything can go wrong, it will.

Murphy‘s Law is usually taken as the ultimate statement of negative pessimism.  But instead you the risk manager need to use Murphy’s law as he did.  As a mantra to keep repeating to yourself as you look for ways to stress test a system.

Looking to engineering (Murphy was an engineer you know) for some thinking about stress to failure, we find this post:

When a component is subject to increasing loads it eventually fails.   It is comparatively easy to determine the point of failure of a component subject to a single tensile force. The strength data on the material identifies this strength.   However when the material is subject to a number of loads in different directions some of which are tensile and some of which are shear, then the determination of the point of failure is more complicated…

Some of your stress to failure tests will have to be tensile, some compressive, some shear, in different directions and in different combinations.  You should do this sort of testing to know the weakest points of your system.

But there is no guarantee that the system will fail at the weakest points either.  In fact, you may put in place methods to reduce stresses to those weakest points.  Remember that now elevates other points to be the new stresses.

And do not let Momentum thinking define your approach to likelihood of these stresses.  In physical systems, the engineer knows how the system is supposed to be used and can plan for the stresses of those uses.  But in many cases, the systems designed and tested by engineers are not used in the conditions planned for or even for the exact uses that the engineer anticipated.

Sound familiar?

Human systems are not so fixed as physical systems.  Humans react to the system that they are experiencing and adjust their actions according to the feedback that they are receiving from the system.  So human systems will almost always change as they are used.

Human systems will almost always change as they are used.

That is what makes it so much more difficult to be a risk manager for a financial firm than for a firm that deals mainly with physical risks.  As noted above the humans that interface with the physical risks system do change and adapt, but there are usually a larger portion of possibilities that are fixed by the constraints of the physical systems.

With financial risks, the idea of adapting and using a type of transaction or financial structure for alternate purposes has become the occupation of a large number of folks who command a large amount of resources.

So if, for example, you are using a particular type of derivative to accomplish a fairly straightforward risk management purpose, it is quite possible that the market for that instrument will suddenly be taken over by folks with lots and lots of money, fast computers and turnover averages in the thousands per week.  Their entry into a market will change pricing and the speed of changes in pricing and then one day, suddenly, they will decide, perhaps little by little, but possibly all at once, to abandon that trade and the market will snap to being something different still.

The same sort of thing happens in insurance, but at a different speed.  Lawyers are always out there looking to “perfect” an argument to create a new class of claimants against different businesses and their insurers. THis results in a sudden jump in claims costs.

Interestingly, the strategies for those two examples might be the exact opposite.  It might be best to move on from the market that is suddenly overtaken by high speed hedge fund traders.  But the only way to recover extra losses from a newly discovered and “perfected” cause of tort is to stay with the coverage.

But in all cases, the risk manager is faced with the problem of overcoming Momentum Risk.  Convincing others that something that is not broken needs attention and possibly even fixing.

The Year in Risk – 2010

It is very difficult to strike the right note looking backwards and talking about risk and risk management.  The natural tendency is to talk about the right and wrong “picks”.  The risks that you decided not to hedge or reinsure that did not develop losses and the ones that you did offload that did show losses.

But if we did that, we would be falling into exactly the same trap that makes it almost impossible to keep support for risk management over time.  Risk Management will fail if it becomes all about making the right risk “picks”.

There are other important and useful topics that we can address.  One of those is the changing risk environment over the year. In addition, we can try to assess the prevailing views of the risk environment throughout the year.

VIX is an interesting indicator of the prevailing market view of risk throughout the year.  VIX is in indicator of the price of insurance against market volatility.  The price goes up when the market believes that future volatility will be higher or alternately when the market is simply highly uncertain about the future.

Uncertain is the word used most throughout the year to represent the economic situation.  But one insight that you can glean from looking at VIX over a longer time period is that volatility in 2010 was not historically high.

If you look at the world in terms of long term averages, a single regime view of the world, then you see 2010 as an above average year for volatility.  But if instead of a single regime world, you think of a multi regime world, then 2010 is not unusual for the higher volatility regimes.

So for stocks, the VIX indicates that 2010 was a year when market opinions were for a higher volatility risk environment.  Which is about the same as the opinion in half of the past 20 years.

That is what everyone believed.

Here is what happened:

	Return
December	6.0%
November	-0.4%
October	3.5%
September	8.7%
August	-5.3%
July	6.8%
Jun	-5.2%
May	-8.3%
April	1.3%
March	5.8%
February	2.8%
January	-3.8%
Average	1.0%
Std Dev	5.6%

That looks pretty volatile.  And comparing to the past several years, we see below that 2010 was just a little less actually volatile than 2008 and 2009.  So we are still in a regime of high volatility.

So we can conclude that 2010 was a year of both high expected and high actual volatility.

If an exercize like this is repeated each year for each important risk, eventually insights of the possibilities for both expectations and actual risk levels can be formed and strategies and tactics developed for different combinations.

The other thing that we should do when we look back at a year is to note how the year looked in the artificial universe of our risk model.

For example, when many folks looked back at 2008 stock market results in early 2009, many risk manager had to admit that their models told them that 2008 was a 1 in 250 to 1 in 500 year.  That did not quite seem right, especially since losses of that size had occurred two or three times in the past 125 years.

What many risk managers decided to do was to change the (usually unstated) assumption that things had permanently changed and that the long term experience with those large losses was not relevant. Once they did that, the risk models were recalibrated and 2008 became something like a 1 in 75 to 1 in 100 year event.

For the stock market, the 15.1% total return was not unusual and causes no concern for recalibration.

But there are many other risks, particularly when you look at general insurance risks, that had higher than expected claims.  Some were frequency driven and some were severity driven.  Here is a partial list:

• Queensland flood
• December snowstorms (Europe & US)
• Earthquakes (Haiti, Chile, China, New Zealand)
• Iceland Volcano

Munich Re estimates that 2010 will go down as the sixth worst year for amount of general insurance claims paid for disasters.

Each insurer and reinsurer can look at their losses and see, in the aggregate and for each peril separately, what their models would assign as likelihood for 2010.

The final topic for the year in risk is Systemic Risk.  2010 will go down as the year that we started to worry about Systemic Risk.  Regulators, both in the US and globally are working on their methods for inoculating the financial markets against systemic risk.  Firms around the globe are honing their arguments for why they do not pose a systemic threat so that they can avoid the extra regulation that will doubtless befall the firms that do.

Riskviews fervently hopes that those who do work on this are very open minded.  As Mark Twain once said,

“History does not repeat itself, but it does rhyme.”

And for Systemic Risk, my hope is that the resources and necessary drag from additional regulation are applied, not to prevent an exact repeat of the recent events, while recognizing the possibility of rhyming as well as what I would think would be the most likely systemic issue – that financial innovation will bring us an entirely new way to bollocks up the system next time.

Happy New Year!

Eggs and Baskets

Andrew Carnegie once famously said

“put all your eggs in one basket. and then watch that basket”

It seems impossible on first thought to think of that as a view consistent with risk management.  But Carnegie was phenomenally successful.  Is it possible that he did that flaunting risk management?

Garry Kasparov – World Chess Champ (22 years) put it this way…

“You have to rely on your intuition.  My intuition was wrong very few times.”

George Soros has said that he actually gets an ache in his back when the market is about to turn, indicating that he needs to abruptly change his strategy.

Soros, Kasparov, Carnegie are not your run of the mill punters.  They each had successful runs for many years.

My theory of their success is that the intuition of Kasparov actually does take into account much more than the long hard careful consideration of a middling chess master.  Carnegie and Soros also knew much more about their markets than any other person alive in their time.

While they may not have consciously been following the rules, they were actually incorporating all of the drivers of those rules into their decisions.  Most of those rules are actually “heuristics” or shortcuts that work as long as things are what they have been but are not of much use when things are changing.  In fact, those rules may be what is getting one into trouble during shifts in the world.

Risk models embody an implicit set of rules about how the market work.  Those models fail when the market fails to conform to the rules embedded in the model.  That is when things change, when your thinking needs to transcend the heuristics.

So where does that leave the risk manager?

The insights of the ultra successful types that are cited above can be seen to refute the risk management approach, OR they can be seen as a goal for risk managers.

The basket that Carnegie was putting all of his eggs into was steel.  His insight about steel was correct, but his statement about eggs and baskets is not particularly applicable to situations less transformational than steel.  It is the logic that many applied during the dot com boom, much to their regret in 2001/2002.

The risk manager should look at statements and positions like those above as levels of understanding to strive for.  If the risk managers work starts and remains a gigantic mass of data and risk positions without ever reaching any insights about the underlying nature of the risks that are at play, then something is missing.

Perhaps the business that the risk manager works for is one that by choice and risk tolerance insists on plodding about the middle of the pack in risk.

But the way that the risk manager can add the most value is when they are able to provide the insights about the baskets that can handle more eggs.  And can start to have intuitions about risks that are reliable and perhaps are accompanied by unmistakable physical side effects.

Risk means Loss Potential

Definition of Risk from Merriam-Webster online dictionary:

Definition of RISK

1: possibility of loss or injury :peril

2: someone or something that creates or suggests a hazard

3: the chance of loss or the perils to the subject matter of an insurance contract; also: the degree of probability of such loss b: a person or thing that is a specified hazard to an insurer c: an insurance hazard from a specified cause or source <war risk>

4: the chance that an investment (as a stock or commodity) will lose value

These are the only four definitions offered.

So if you build an ERM system and want to use the definition of risk that is popular with ERM folks:

Risk is a deviation from expected.

It is almost certain that among an English speaking non-risk manager management audience, your program will start out with at one count of DOUBLESPEAK against you.

The definition of DOUBLESPEAK, per Wikipedia is:

Doublespeak (sometimes called doubletalk) is language that deliberately disguises, distorts, or reverses the meaning of words. Doublespeak may take the form of euphemisms (e.g., “downsizing” for layoffs), making the truth less unpleasant, without denying its nature. It may also be deployed as intentional ambiguity, or reversal of meaning (for example, naming a state of war “peace”). In such cases, doublespeak disguises the nature of the truth, producing a communication bypass.

You start your discussion of Risk Management by telling everyone that UP is DOWN and HOT is COLD.  That OPPORTUNITIES are RISKS.

There is a common English meaning of the word risk that works very well to support Risk Management activities.

The objective of that other DOUBLESPEAK meaning of the word risk is to convey that risk managers can help to find and support opportunities.

Just say that. Say that you can help to find and support opportunities.

It will come off much better than redefining words that everyone knows the meaning of at the outset of your discussion.

Really Different

What if the future is really different from the past? What does that do to the whole approach of quantitative risk management? When do you give up on the models that just do not help?

Here is a scenario of a Really Different Future

Farrell suggests that the economy will go through chaos for 10 years until things get so bad that we decide to actually do something about it.

We talk about stress testing for our companies.  What I am trying to suggest here is stress testing our risk management approach.

How well does your risk management system hold up to the scenario described in that article?

I am not asking for a top of the head answer.  I am suggesting that you walk through 10 years of economic bad times, alternating with uncertain times like the past 18 months.

Does your ERM system give good advice throughout?  Or do your models continually give bad signals as they very slowly incorporate the emerging world mess?  And then when things come back in 10 years, will the models be wrong again on the low side for another 10 years or more as you incorporate better experience?

So is there another choice?  I think so.  The choice is multiple risk models of different regimes.  You need a model of high volatility and low drift, a model of high drift and low volatility, a model of moderate volatility and moderate drift and a model of negative drift and low volatility.

Think about it.  If those four models reflect states of the world, is there any point in using a model that combines all four sets of experience?  It will always be wrong.  A Bayesian model that is constantly updating for experience assumes a stable underlying distribution.  Otherwise it is just wrong all the time.

Think about it.  If the next 10 years will be years of high volatility and low drift interspersed with periods of negative drift with low volatility, what good is a model with moderate volatility and moderate drift?  Or the combined all regime model of slightly higher volatility with slightly lower drift.

A Posteriori Creation

The hunters had come back to the village empty handed after a particularly difficult day. They talked through the evening around the fire about what had happened. They needed to make sense out of their experience, so that they could go back out tomorrow and feel that they knew how the world worked well enough to risk another hunt. This day, they were able to convince themselves that what had happened was similar to another day many years ago and that it was an unusually bad day, but driven by natural forces that they could expect and plan for in the future.

Other days, they could not reconcile an unusually bad day and they attributed their experience to the wrath of one or another of their gods.

Risk managers still do the same thing.  They have given this process a fancy name, Bayesian inference.  The very bad days, we now call Black Swans instead of an act of the gods.

Where we have truly advanced is in our ability to claim that we can reverse this process.  We claim that we can create the stories in advance of the experience and thereby provide better protection.

But we fail to realize that underneath, we are still those hunters.  We tell the stories to make ourselves feel better, to feel safe enough to go back out the next day.  Once we have gone through the process of a posteriori creation of the framework, the past events fit neatly into a framework that did not really exist when those same events were in the future.

If you do not believe that, think about how many risk models have had to be significantly recalibrated in the last 10 years.

To correct for this, we need to go against 10,000 or more years of human experience.  The correction can be summed up with the line from the movie The Fly,

Be afraid.  Be very afraid.

There is another answer.  That answer is

Be smart.  Be very smart.

That is because it is not always the best or even a very good strategy to be very afraid.  Only sometimes.  So you need to become smart enough to:

1. Know when it is really important to mistrust the models and to be very afraid
2. Have built up the credibility and trust so that you are not ignored.

While you are doing that,be careful with the a posteriori creations.  The better people get with explaining away the bad days, the harder it will be for you to convince them that a really bad day is at hand.

Why Successful Forecasts are not an indicator of good Risk Management

from Adventures in probability, market forecasting edition

Read the post at http://blogs.reuters.com/felix-salmon/2010/09/20/adventures-in-probability-market-forecasting-edition/

Thanks to Evan.

General Knowledge – Brain and Bond Conference

Vienna 3,4 September

This has been the most unusual conference. Presentations by Anthropologists, Philosophers, Biologists, Psychologists, Neuro Biologists and Riskviews. We presented the Plural Rationalities and ERM story. Here are some ERM related ideas that we took away from the event…

1. Cooperation vs. autonomy is usually the trade-off. How humans choose how to decide where to come out on that trade-off depends upon the amount of co-dependency is needed for survival. And that depends upon the treats to survival.

If the threats are severe and intense, we need to choose a highly cooperative mode.

If the threats are highly complex, then we need a highly organized mode.

If the threats are highly unpredictable then we need a highly adaptive mode.

If the threats are benign, then we can opt for a low cooperation mode.

Those four modes of cooperation align with the four organizing ideas of Plural Rationalities.  Conservators, Managers, Pragmatists and Maximizers.  The ideas of some fanatics that their particular brand of organizing, whether it be the Individualism of the Maximizers or the Bureaucracy of the Managers or the Sustainability of the Conservators is just not correct in all environments.  (Pragmatists are among other things never fanatics.  That is one of their defining characteristics.)

Humans have evolved to be much more adaptive than different animals.  That is our advantage.

Relaxation of stress (a benign environment) is when diversity can expand.  [Though it is quite possible that much of the diversity that developed during the most recent benign period was wasted on dysfunctional adaptations to selling and reselling mortgages.]  It really is the Individualistic/ Maximizer phases when mankind is able to create the new things that power the future success during future threats.

How does that apply to Risk Management?  It tells you that when times are good and Risk Management is not as important or taken as seriously, Risk Management needs to be creating new tools.  The firms that survive the next crisis will be the firms that had those new tools working and had the insight to use them at the right time.

2.  Game theory tells that in groups of cooperators and defectors, the defectors will usually replace the cooperators.  But the resulting all defector group will be less robust than the all cooperator group had originally been.  This is an insight from biology that applies to firms as well.  The firms that are taken over by the defectors (pure self interest) will eventually be diminished because those defectors need the cooperators.

That tells the risk manager that they need to figure out how to control the risk from the defectors and help to create a system where they will not be allowed to take over.  This is an argument for the CEO as CRO.

3.  People have four ways to decide to divide resources:  Sharing, Ranking, Equality or Market.  Sharing and Ranking are the primitive ways.  Equality and Market both require the use of symbols to work, while Sharing and Ranking do not.  Resources are divided in a firm using mostly the first two more primitive methods.  Advanced management systems, like ERM, seek to use Equality and Market methods that require risk measurement systems.

4.  People in many cultures and languages can identify the basic choices of organizing of Plural Rationalities from simple groupings of circles.  (Not sure exactly how this is helpful, that may require someone who is more spatially oriented than Riskviews to understand.)

Which image represents a hierarchical social organization and which and egalitarian?  These pictures seem to evoke those ideas in several different groups that were tested.

5.  Kids express the thinking of the four plural rationalities groups when candy is distributed in a merit based system:

• I deserve what I got.
• We should all get some
• Can he do that? (Directed towards the authority)
• I never get any

6.  Each Plural Rationalities groupings would have their own virtues:

• Courage = Risk Taking
• Justice
• Fairness
• Forbearance

7.  Are there really any people who use expected value as a decision making criteria?  Economics says that it is THE most important criteria.  But do business leaders play lip service to the concept because they have been taught that it is what Homo Economicus does?  Oh, I forgot, Economics grad students must use it.  Otherwise they cannot get a PhD.

8.  People with Authority tend to believe that the system is fair and that their own dominance and extra rewards are fair.

9.  Information about cooperation (i.e. the opposite of anonymity) tends to change the level of cooperation completely.  Think about putting a decal of an eye on the corner of every computer screen.

10.  Game theory shows that people will abuse shared resource and that eventually all will abuse shared resource if there are no consequences.  (Of course in Game Theory, all are Homo Economicus.)  Adding a punishment for abusing shared resource, but only if that punishment is public.

11. “the reason that the invisible hand often seems invisible is that it is often not there.” Joseph Stiglitz

12.  Primates do not organize into Plural Rationalities species.  Good to know if you were thinking of selling insurance to apes.  Primates may tolerate injustice in private but protest loudly if there is a witness.

13.  In the “Ultimatum Game” the rational expectations prediction is of a minimal offer and universal acceptance.  What in fact happens is that the offers average over 40% and offers below 20% are usually rejected.  Offers generally increase when there is increased perception that the offer is public.  Self interest is greater in private.  Fairness in public.

14.  In some primate groups there is no active sharing, but theft of small amounts of food is tolerated 90% of the time.

http://rossier.usc.edu/faculty/mary_helen_immordinoyang.html

15.  Emotion is a vitally important part of risk decision making.  That is why attempts to create totally quantitative systems for risk decision making have so much trouble gaining acceptance.  People from different cultures evidence a different reaction pattern to emotional situations.  Possible explanation is that in cultures that are more highly communal, the emotional reaction is slowed while the brain processes the expectation of how the others in the group will react.  Application to risk management  – think about the issue of interaction of the emotional reactions of people to a risk or loss situation as well as well as the timing of those reactions.  In some situations, the person with the strongest and most intense reaction might set the tone and agenda for the discussion of responses.  That person may well be the one with the least regard for the reactions of others.

16. Human population growth has followed three major waves that followed major technological advancements, first with the advent of tools, then with agriculture and more recently with machines.  If the future follows the past in this regard, it is time for a new transformative technological advance.

17.  Individualism as a major group in society correlates highly with low incidence of infectious diseases.  (See comment 1)  Collectivism to a low incidence of disease.

18.  An Ethical investment program may tend to select firms that are more egalitarian dominated because the egalitarian ideals best meet the ethical criteria.  However, the egalitarian approach to risk is not necessarily best suited to superior performance in most environments.  To get better performance out of ethical investing, the investment managers need to look for firms that have the ability to adapt their risk approach to the environment without losing their adherence to the ethical criteria.  A difficult task.

19.  The Plural Rationalities risk ideas are so tightly linked to the Grid & Group relationship criteria as well as the other attitudes that are linked to those groups because those ideas all form a set of beliefs that are internally consistent and that all work together to make sense of all of the positions.

20.  Is Democracy inherently a Clumsy decision making system?  A true democrat believes in the system even when they do not win.  So they are agreeing that a different theory than their preferred theory might well be good, or at least ok, for the organization from time to time.

21.  Bounded Rationality is the concept that people are unable to make perfectly rational decisions due to limits to actual knowledge or time available to make the decisions.  In addition, there is a second order effect of the concept of bounded rationality.  Decisions that include considerations of the decisions and actions of other humans can assume that they are able to be fully rational or that they operate under bounded rationality.  Highly rational people will sometimes try to suggest that the “best” solution to a problem involves everyone else making more rational decisions.  An alternate approach would be to acknowledge the degree of bounded rationality that exists within the actual system and to reflect that reality into the solution. The former approach is a projection of ones self onto others, while the later is an attempt at realistic assessment of others.

22.  As a corollary to 21, it is important to recognize the way that bounded rationality exists in one’s own decision making.  In financial modeling, this manifests itself in the embedded assumptions and in the choice of model.  All models are perfect examples of bounded rationality.  They are always simplifications of reality and the process of deciding upon the simplifications is the process of applying one’s biases and decision making criteria to the nearly infinite number of practical and impractical possibilities for model construction.

23.  Many human behaviors evidence mirroring – that is one person will be copying the expressions or gestures or acts of another.   This is important to remember when using a model that does not include any recognition of that idea.  The other main type of human reactions are complementary behaviors.  These are reactions that are different but the result of the actions of the first person.  Most financial models assume that one can act based upon an analysis of other people’s actions and those other people will go on doing what they did before.  Instead, we need to be looking to see what would happen if others either mirror ow choose complimentary actions after we choose a different path as a result of our model.

24.  The Relational Models approach suggests four approaches, Communal Sharing, Authority Ranking, Equality Matching, Market Pricing.  It was suggested that these are different from Plural Rationalities, but Riskviews thinks not.  Clearly, Market Pricing matches up to Individualism, Equality Matching to Egalitarianism, and Authority Ranking matches to Egalitarianism.  So the only question is about whether there is a difference between Communal Sharing and Fatalism or not.  The most common description of both seem to be totally at odds.  But there are several things that the two ideas have in common.  Under both Communal Sharing and Fatalism, there is a lack of rigidity about the means or outcome of dividing resources.  Fatalists are described as not caring because of apathy, whilst Communal sharing is described as being motivated by extremes of caring.  But those seeming opposites may be closer than one might think.   The descriptions of the two ideas might just be focusing upon different aspects of the situation.  In a Communal Sharing situation, the person is indifferent to their share of the communal group resources because of a high degree of linkage to the communal group.  This might be seen as a lack of distinction between the individual and the communal group, seeing oneself as so integral to the group that the idea of an individual share does not really exist.  The Fatalist is indifferent to their share of the resources because they have no belief in a sharing process that has a predictable outcome.  The Fatalists are near total isolates in the Plural Rationalities definitions.  So it appears that the two are not the same in their motivation, but they may be the same in terms of their expectations or lack thereof.

All this seems to be quite a jumble of unrelated ideas.  They are a tiny extract of the presentations from the two day conference. It was amazing to see so many people from so many different areas coming together to actually listen intently to each other and seek to make sense of it all, to gain from this discussion some General Knowledge.

If the ideas are abstract, whose agreement or disagreement we perceive, our knowledge is universal. For what is known of such general ideas, will be true of every particular thing, in whom that essence, i.e. that abstract idea is to be found: and what is once known of such ideas, will be perpetually, and for ever true. So that as to all general knowledge, we must search and find it only in our own minds, and ‘tis only the examining of our own ideas, that furnishes us with that.  John Locke

Survival of the Firm is not Mandatory

Is that idea really understood by top management and the board?

Does the board leave every meeting certain that the firm will still be in business when the next scheduled board meeting comes around?  How did they get to that certainty?

Can management tell them the likelihood that the firm will experience a fatal loss and how much that likelihood has changed since the previous board meetings?

Can management tell them exactly what sorts of events could put the firm out of business?  Have they discussed the sorts of “highly unlikely” events that might take the firm down if they suddenly did happen?

Those are, of course, the conversations that the board might well demand to have if they really understood that Survival is not Mandatory.

Post Pandemic Period

10 August 2010 – the WHO declares that the Swine Flu Pandemic has ended.

Or rather they say that we have entered the Post Pandemic Period.

The H1N1 Pandemic is an example of what happens when you do a good job of risk management.  Because of the preparations that were made to develop and distribute vaccines as well as other measures to reduce possible transmission of the virus, and to the fact that the virus did not mutate in a way to become either lethal or resistant to the vaccine, the impact of the Pandemic was not severe.

This is what should happen with good risk management of an emerging risk like that.  Many companies created and/or tested their emergency plans and are now much better prepared for the next emergency.  The plans to prevent systemic failure did go into effect and they worked.

But one of the reactions to effective risk management is disbelief that there ever was a threat.

So it goes.  Do not be discouraged.  Keep up the good fight.

The firms that are run by the skeptics who refuse to take heed of such warnings will at some point get what they haven’t prepared for.

Meanwhile, we now get to learn what Post Pandemic Period means.