The Evidence is all Around

In October 2008, Alan Greenspan had the following exchange during testimony before a Congressional committee:

Representative HENRY WAXMAN (Committee Chairman, Democrat, 30th District of California): You found a flaw in the reality…

Mr. GREENSPAN: Flaw in the model that I perceived is a critical functioning structure that defines how the world works, so to speak.

Rep. WAXMAN: In other words, you found that your view of the world, your ideology was not right. It was not working.

Mr. GREENSPAN: How it – precisely. That’s precisely the reason I was shocked, because I’ve been going for 40 years or more with very considerable evidence that it was working exceptionally well.

One of the things in that model was an assumption that the self interest of the bankers was a more important factor in containing their risks than regulations.

But the evidence that self interest is insufficient to control excessive risk taking is all around us and has been for many, many years.  It takes a massive amount of selective blindness to ignore it.

All it takes it to take your car out of the driveway and drive on the roads.  Driving involves risk management decision making.  For one thing, almost everyone drives a car that is capable of traveling much faster than the speed limit.  And the speed limits are only very occasionally enforced.  So it is an individual risk management decision of how fast to drive a car.

Now, I happen to live in an area of the New York City suburbs where many of the folks who work on Wall Street firms live.  And the evidence is all around.  Many drivers do not put long term safety self interest above short term time advantage of speeding.  In many cases, they are deliberately trying to take advantage of the folks who are trying to be safe and driving extra recklessly under the assumption that they will not run into someone who is driving as recklessly as they are.

Now it is quite possible that none of the reckless drivers are Wall Street executives.  But the reckless drivers are all people.  And the readily available evidence with 50 years or more of accident statistics to back up shows that self interest is NOT sufficient motivation for safety.

Perhaps economists and especially central bankers do not own cars.

To the rest of us who do, the theory seems to be from another planet.  The people that are risk takers and the people who drive safely are two different sets of people.

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No Risk Management is Betting

So many times, the financial press gets it exactly backwards. (See Bloomberg) Firms who manage their risks by hedging or insurance are reported to be betting and firms who do not are simply subject to the normal fluctuations of uncontrollable events.

But Risk Management offers a real alternative to either betting or being tossed around by the frothy seas of misfortune.  Risk management offers the possibility of identifying and mitigating the most extreme negative events and trends of the world.

Imagine your business owns a building worth $100,000,000.  There is a 1 in 250 chance that a storm will hit your building and destroy the building leaving you with a $10 million piece of empty property and a $10 million clean up bill.  (ignore the business interruption for now).

So the expected cost of that loss is $400,000.  You get an insurance quote for $600,000.  There are two ways you can tell the story of purchasing insurance:

1. The firm can place a bet that its building will be destroyed by a storm.  If there is no storm, then they lose their bet.
2. The firm can manage its risk from a severe storm by buying an insurance policy.

Now if the storm does not happen, the story can be:

1. The firm lost its bet that its building would be destroyed.
2. The firm incurred a fixed cost of managing its storm risk and avoided the volatility of an uninsured situation.

And if the storm does one day hit, the story is:

1. The firm won its bet that a storm would destroy its building and was rewarded by a $100 million gain from insurance.
2. The losses from the storm were covered by the firms insurance.

Risk Management just is not a good story for the reporters, if told right.  For the firm, that may just be one more reason to consider risk management.

Now if the firm chooses not to buy the insurance, the coverage is twisted.  Again read two ways that it might be reported if there is no storm:

1. No story.  Nothing happened.
2. The firm got lucky and did not take a loss on its uninsured building.  They took a bet that had a huge downside for their shareholders for a very small payoff.

ANd if the storm hits, the story is reported as:

1. Tragedy strikes.  Unfortunate event causes $100 M loss.  CEO say “We are just not able to control the weather.”
2. The bet that management took went bad.  That bet was just not necessary.  Now shareholders have experienced large losses because the management was trying to save a little on insurance.  The CEO should be fired.

Unless the firm’s was in the business of long term weather forecasting they had no business making the bet when they did NOT buy the insurance.  THey had no expertise to tell them that they shouldn’t buy the insurance.

They were just gambling.

Risk Adjusted Compensation Analysis

Game Theory suggests that you can get pretty far simply looking at expected values.  But the expected values need to be done right, looking at both upside and downside.

Looking at the consequences of the compensation paid by financial institutions suggests that boards who approved the compensation did not do their Game Theory homework.  Management is given a huge share of the upside and their incentives are thought to be aligned with shareholders because of a stock component to their compensation.

Maybe that works, maybe not.  The math is simple enough.  They should check.  A Game Theory, risk adjusted compensation analysis (simplified for this post) would look like this:

Proposed Transaction:

Upside:  $100,000,000 – likelihood 60%

Downside:  ($100,000,000) – likelihood 40%

Expected Value: $20,000,000

So far so good.  Now the firm already has a risk adjusted compensation system.  Under that system, there is a cost of capital charge assessed against profits before calculating bonus.  In this case, the capital is based upon the $100,000,000 downside.  The cost of capital is 5%, so the “risk adjustment” is 5%.  The bonus formula will pay out 40% of the risk adjusted gain, half in cash and half in stock.  In the past, the compensation committee has seen this process and stopped there. It seems that they took care of every angle.

But this year, one comp committee member hears a lecture on Game Theory and asks for additional analysis:

Risk Adjusted Expected Value Analysis:

Management:

Upside:  40% of $100,000,000 less $5,000,000 equals $38,000,000.  Pay $19,000,000 cash and $19,000,000 stock.  Stock is purchased at time of award.  Likelihood 60%

Downside:  Zero Current award.  Loss in value of stock holdings from past awards.  Back to that in a minute.

Shareholders:

Upside:  $62,000,000 of gains plus risk charge times 10 equals $620 million. Likelihood of 60%

Downside $$100,000,000 of losses times 10 equals ($1 Billion). Likelihood of 40%

Expected value:  ($2.8 million)

Now back to the employees…

The downside from their 0.1% of stock is ($1 million) so their expected value is $22 million positive.

So a real Game Theory based risk adjusted analysis would show that there is huge upside to management for risky deals and much smaller risk adjusted expectation for the shareholders. (In this example an expected loss).

Perhaps every deal should be presented on this risk adjusted basis.  It might take a few of these presentations, but sooner or later the lopsided deal will sink in.

But then the game will shift.  Already, the game is to present these deals optimistically, so that the likelihood of upside is overstated and the downside is underestimated.  If compensation is skewed as drastically as the above example, highly risky deals look just fine on a risk adjusted expected value basis to employees.  If the board insists that the shareholders really have a positive expected value, then the deals will need to be much less risky – at least on paper.

The stress testing that is being promoted as a major risk management tools (in part because of this very problem of over optimistic risk models) needs to then also be done to the risk adjusted compensation analysis.  The stress tests for this purpose do not need to be as drastic as the stress tests for solvency management.  What you should be looking for is the inflection point where the deal starts to fall into the situation where the management and shareholders are no longer on the same side, where their expected values are of opposite signs.  If that inflection point is found with a stress test that is somewhat close to the base model assumptions, then that is a flashing red light for the risk manager and the board.

Is ERM Ethical?

Or more properly, must ERM be based upon an ethical position?

If so, is it possible that the ethical position that underlies many ERM programs is different from the ethical system of the firm?

One school of ethics, Utilitarianism, suggests that we should pursue the “greatest good for the greatest number”.   Unknown to many who subscribe to this ethical school, Utilitarianism is a close cousin to Hedonism, that has the famous motto “Eat, Drink and be Merry for Tomorrow we may Die”.

In fact Adam Smith provides a direct link between those two mottoes with his invisible hand.  If each individual follows the Hedonism rule, then the Utilitarianism objective will be met according to Smith.

Risk Management is based more on an Epicurean ethic. Philosophical Epicureans are not the art and wine connoisseurs of popular definition.  They pursue tranquility that is achieved through banishment of fear.

Epicureans observed that indiscriminate indulgence sometimes resulted in negative consequences. Some experiences were therefore rejected out of hand, and some unpleasant experiences endured in the present to ensure a better life in the future. The summum bonum, or greatest good, to Epicurus was prudence, exercised through moderation and caution. (Wikipedia)

Interestingly, Thomas Jefferson spoke of himself as a Epicurean.  The arguments between factions expressed in the Federalist Papers among other places among the US founders was in part an argument between Utilitarians and Epicureans.

And that is the same argument that plays itself out between Risk Management and business leaders in today’s firms.  Some Risk Managers would argue that Risk Management is Ethical whilst their opponents are simply greedy.  But looking behind the surface of that argument reveals that there are simply two different ethical schools.

Risk Managers need to find the common ground and show the value of their ethic to the Utilitarian/Capitalist school of ethics.  Not an easy sale.  But as a result of the Financial Crisis, more and more folks are coming to doubt the ultimate infallibility of that Invisible Hand.  Epicurean thought is gaining traction.

The Risk Management Wager

Many people will look at Risk Management actions as “bets” that they either win or lose.  To those people, Risk Management is a good bet if there is an actual net increase to profits from the risk management activities.

That is a backwards looking approach to Risk Management.  Under that approach, many risk management actions will “lose” money for the firm.  That is because if the risk management action involves a transaction that creates a risk offset, the counterparty will expect to be paid a margin over the expected cost of the risk, which will mean that on the average, people who transfer risks will lose money to at least the amount of that margin.

But that backwards look is not the whole story about Risk Management’s value.  The rest of the story is about how Risk Management changes the forward looking prospects of the firm.

Think about it this way, if your business is to run lit sticks of explosives into a building to be demolished, how would you feel about a longer fuse?

For as long as you have been in this business, the fuse has been long enough.  So without the longer fuse, you have always been ok.  And so far, you have never, ever tripped and fallen on the way in or out of a building.

And more fuse is expensive.  Probably a dollar per inch.  If you had added a few extra inches in the past for the hundreds of times you had run the dynamite into the buildings, all of that extra money would have been wasted.

All that extra fuse adds is a chance to get up and run out of the range of the blast if you should stumble.  And if you never stumble that is a waste of money.

So what do you bet?