Archive for April 2010

Your Mother Should Know

April 29, 2010

Something as massive as the current financial crisis is much too large to have one or two or even three simple drivers.  There were many, many mistakes made by many different people.

My mother, who was never employed in the financial world,  would have cautioned against many of those mistakes.

When I was 16, I had some fine arguments with my mother about the girls that I was dating. My mother did not want me dating any girls that she did not want me to marry.

That was absolutely silly, I argued. I was years and years away from getting married. That was a concern for another time. My mother knew that in those days, “shotgun marriages” were common, a sudden unexpected change that triggered a long-term commitment. Well, as it happened, even without getting a shotgun involved, five years later I got married to a girl that I started dating when I was 16.

There are two different approaches to risk that firms in the risk-taking business use. One approach is to assume that they can and will always be able to trade away risks at will. The other approach is to assume that any risks will be held by the firm to maturity. If the risk managers of the firms with the risk-trading approach would have listened to their mothers, they would have treated those traded risks as if they might one day hold those risks until maturity. In most cases, the risk traders can easily offload their risks at
will. Using that approach, they can exploit little bits of risk insight to trade ahead of market drops. But when the news reveals a sudden unexpected adverse turn, the trading away option often disappears. In fact, using the trading option will often result in locking in more severe losses than what might eventually occur. And in the most extreme situations, trading just freezes up and there is not even the option to get out with an excessive loss.

So the conclusion here is that, at some level, every entity that handles risks should be assessing what would happen if they ended up owning the risk that they thought they would only have temporarily. This would have a number of consequences. First of all, it could well stop the idea of high speed trading of very, very complex risks. If these risks are too complex to evaluate fully during the intended holding period, then perhaps it would be better for all if the trading just did not happen so very quickly. In the case of the recent subprime-related issues, banks often had very different risk analysis requirements for trading books of risks vs. their banking book of risks. The banking (credit mostly) risks required intense due diligence or underwriting.  The trading book only had to be run through models, where the assignment of assumptions was not required to be based upon internal analysis.

From 2008 . . .

Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications

Lots more great stuff there.  Check it out.

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Assumptions Embedded in Risk Analysis

April 28, 2010

The picture below from Dour VanDemeter’s blog gives an interesting take on the embedded assumptions in various approaches to risk analysis and risk treatment.

But what I take from this is a realization that many firms have activity in one or two or three of those boxes, but the only box that does not assume away a major part of reality is generally empty.

In reality, most financial firms do experience market, credit and liability risks all at the same time and most firms do expect to be continuing to receive future cashflows both from past activities and from future activities.

But most firms have chosen to measure and manage their risk by assuming that one or two or even three of those things are not a concern.  By selectively putting on blinders to major aspects of their risks – first blinding their right eye, then their left, then by not looking up and finally not looking down.

Some of these processes were designed that way in earlier times when computational power would not have allowed anything more.  For many firms their affairs are so very complicated and their future is so uncertain that it is simply impractical to incorporate everything into one all encompassing risk assessment and treatment framework.

At least that is the story that folks are most likely to use.

But the fact that their activity is too complicated for them to model does not seem to send them any flashing red signal that it is possible that they really do not understand their risk.

So look at Doug’s picture and see which are the embedded assumptions in each calculation – the ones I am thinking of are the labels on the OTHER rows and columns.

For Credit VaR – the embedded assumption is that there is no Market Risk and that there is no new assets or liabilities (business is in sell-off mode)

For Interest risk VaR – the embedded assumption is that there is no credit risk nor new assets or liabilities (business is in sell-off mode)

For ALM – the embedded assumption is that there is no credit risk and business is in run-off mode.

Those are the real embedded assumptions.  We should own up to them.

Dangerous Words

April 27, 2010

One of the causes of the Financial Crisis that is sometimes cited is an inappropriate reliance on complex financial models.  In our defense, risk managers have often said that users did not take the time to understand the models that they relied upon.

And I have said that in some sense, blaming the bad decisions on the models is like a driver who gets lost blaming it on the car.

But we risk managers and risk modelers do need to be careful with the words that we use.  Some of the most common risk management terminology is guilty of being totally misleading to someone who has no risk management training – who simply relies upon their understanding of English.

One of the fundamental steps of risk management is to MEASURE RISK.

I would suggest that this very common term is potentially misleading and risk managers should consider using it less.

In common usage, you could say that you measure a distance between two points or measure the weight of an object.  Measurement usually refers to something completely objective.

However, when we “measure” risk, it is not at all objective.  That is because Risk is actually about the future.  We cannot measure the future.  Or any specific aspect of the future.

While I can measure my height and weight today, I cannot now measure what it will be tomorrow.  I can predict what it might be tomorrow.  I might be pretty certain of a fairly tight range of values, but that does not make my prediction into a measurement.

So by the very words we use to describe what we are doing, we sought to instill a degree of certainty and reliability that is impossible and unwarranted.  We did that perhaps as mathematicians who are used to starting a problem by defining terms.  So we start our work by defining our calculation as a “measurement” of risk.

However, non-mathematicians are not so used to defining A = B at the start of the day and then remembering thereafter that whenever they hear someone refer to A, that they really mean B.

We also may have defined our work as “measuring risk” to instill in it enough confidence from the users that they would actually pay attention to the work and rely upon it.  In which case we are not quite as innocent as we might claim on the over reliance front.

It might be difficult now to retreat however.  Try telling management that you do not now, not have you ever measured risk.  And see what happens to your budget.

Lessons for Insurers (5)

April 26, 2010

In late 2008,  the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis.  This report featured nine key Lessons for Insurers.  Riskviews will comment on those lessons individually…

5. It is important to develop a counterparty risk management system and establish counterparty limits.

Insurers need to fully understand several things about both credit and reinsurance to get this right.

First of all, in a credit or reinsurance situation, the insurer is usually trading uncertainty in the “expected” range of probabilities for a potential loss at a very high attachment point, the failure point for the counterparty.

Second of all, the insurer needs to recognize that the failure of their counterparty usually does not in any way change their obligation.  When an insurer buys a bond, they are usually responsible to make payments to their policyholder regardless of whether the bond is good.  When an insurer buys reinsurance they are still responsible to pay claims whether or not the reinsurer is able to meet its obligations.

Recognize that in almost all cases, the standard risk management terminology is flawed.  Risk is usually not transferred.

The other consideration that is important to insurers is that they need to look for counterparty exposures everywhere in their operations.  In each of their insurance lines as well as in every part of their investment portfolio.  In firms where traditionally insurance and investments are treated as completelyt separate silos, risk managers are finding that both sides of the house are sometimes dealing with the exact same counterparties.  Aggregation and management of these concentrations is key.

And finally to scare you completely, a good way to think of counterparty risk is that you are bring a fraction of the entire balance sheet on to your balance sheet in return for a contingent payment.  So that should make you very interested in transparency.  Or maybe not.  Maybe you close your eyes when you drive around sharp curves also.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Volcano Risk (3)

April 25, 2010

Adverse events are all learning labs for risk managers.  We should not look at the event and say “We do not fly to Europe so we are not involved” and change the channel when it is being discussed.  We should be very actively listening of reports of how the event develops and what the impact on various businesses and markets has been.

One big thing that many of us are learning is that we have not been imaginative enough in our emerging risk scenarios.

Many are busy learning that their business interruption insurance policies do NOT pay out for this event.  Business interruption is usually triggered by physical damage to a business.  (Seems like a perverse incentive – if preventing physical damage causes business interruption, the business interruption is not covered because the physical damage did not happen?)

Learn about health risks from Volcanic Ash .  As well as preparation:

  • Essential items to stock before an ashfall
  • Actions to be taken in preparedness
  • What to do if volcanic ash is falling
  • Why should we clean up the ash?
  • What precautions should be taken before cleaning up ash?

Seems like a very good list.  Not just for Volcanic Ash.  For any emergency situation.  How would you fill it in for each emerging risk that you envision?

Skating Away on the Thin Ice of the New Day

April 23, 2010

The title of an old Jethro Tull song.  It sounds like the theme song for the economy today!

Now we all know.  The correlations that we used for our risk models were not reliable in the one instance where we really wanted an answer.

In times of stress, correlations go to one.

That is finally, after only four or five examples with the exact same result, become accepted wisdom.

But does that mean that Diversification is dead as a strategy?

I would argue that it certainly puts a hurt to diversification as a strategy for finding risk free returns.  Which is how it was being (mis) used in the Sub Prime markets.

But Diversification should still reign as the king of risk management strategies.  But it needs to be real diversification.  Not tiny diversification that is observable only under a mathematical microscope.  Real Diversification is where risks have completely different drivers.  Not slightly different statistical histories.

So in Uncertain Times, and these days must be labeled Uncertain Times (or the thin ice age), diversification is the best risk management strategy.  Along with its mirror image twin, avoidance of concentrations.

The banks had given up on diversification as a risk strategy.  Instead they believed that they were making risk free returns by taking lots and lots of concentrated risk that they were either fully hedging or moving the risk off their balance sheets very quickly.

Both ideas failed.  Hedging failed when the counter party was Lehman Brothers.  It succeeded when the counter party was any of the other institutions that were bailed out, but there was an extended period of severe uncertainty about that before the bailouts were finally put into place.  Moving the risks off the balance sheet failed in two ways.  First it failed because they were really playing hot potato without admitting it.  When the music stopped, someone was holding the potato.  And some banks were holding many potatoes.  It also failed because some banks had been offloading the risks to hedge funds and other investors who they were lending funds to finance the purchase.  When the CDOs soured, the loans secured by the CDOs were underwated and the CDOs came back onto the bank balance sheets.

The banks that were hurt the least were the banks who were not so very concentrated in just one major risk.

The cost of the simple diversification strategy is that those banks with real diversification showed lower returns during the build up of the bubble.

So that is the risk reward trade off of real diversification – it will often produce lower returns than the mathematical diversification but it will also show lower losses in proportion to total revenue than a strategy that concentrates in the most profitable risk choices according to a model that is tuned to the accounting or performance bonus system.

Diversification is the risk management strategy for the Thin Ice Age.

Five Stages of Rapid Decline

April 22, 2010

Jim Collins wrote the popular book “Good to Great” at the peak of the Dot Com boom.  His latest book is titled “How the mighty Fall” and features the five stages of rapid decline:

Stage 1: Hubris Born of Success

Stage 2: Undisciplined Pursuit of More

Stage 3: Denial of Risk and Peril

Stage 4: Grasping for Salvation

Stage 5: Capitulation to Irrelevance or Death

Strategic failure of a firm – which could come from a hubris fueled rapid decline or simply a shift of your customers when you are not paying enough attention is really a risk that for most firms dwarfs the risks that are measurable and that are managed through the techniques of quantitative risk management.

According to a study conducted by Royal Dutch Shell the average life expectancy of Fortune 500 firms is 40 to 50 years.  That implies a 2% to 2.5% average annual failure rate.

Firms that are holding capital for measurable risks at a 1/200 level are pretending to protect their firm at a 0.5% annual failure rate.

But are quantitative risk management programs focusing too much resources on the things that can be measured and creating the Hubris, the false sense of invulnerability that is number one on the list above.

Certainly at some banks and some insurers that was the case.

Once you are convinced that you “know how to control risk” you are likely to go for it – the Undisciplined pursuit of More of the second item.  Even if quantitative risk management is doing most of what is needed, successful risk management can and will lead to Hubris and undisciplined growth.

Of course, sooner or later that lack of discipline will result in a misstep.  And here is where risk management needs to be ready to make it real.  The most common reaction to a problem in this situation is to assume that (a) this is not real, (b) this could not be happening to us – we are too good for this and when the bad news persists and grows in size and scope (c) this will turn around soon, it is only a temporary blip.  Those attitudes result in waiting too long to start doing anything.  That is where risk management must be ready to step in again with realisim and good plans for what to do next.

Unless risk management is caught up in the Hubris and Denial.

So try to make your move, risk managers, before it is to volunteer as a pall bearer.


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