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.
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.