Turbulent Times are Next.
At BusinessInsider.com, a feature from Guillermo Felices tells of 8 shocks that are about to slam the global economy.
#1 Higher Food Prices in Emerging Markets
#2 Higher Interest Rates and Tighter Money in Emerging Markets
#3 Political Crises in the Middle East
#4 Surging Oil Prices
#5 An Increase in Interest Rates in Developed Markets
#6 The End of QE2
#7 Fiscal Cuts and Sovereign Debt Crises
#8 The Japanese Disaster
How should ideas like these impact on ERM systems? Is it at all reasonable to say that they should not? Definitely not.
These potential shocks illustrate the need for the ERM system to be reflexive. The system needs to react to changes in the risk environment. That would mean that it needs to reflect differences in the risk environment in three possible ways:
- In the calibration of the risk model. Model assumptions can be adjusted to reflect the potential near term impact of the shocks. Some of the shocks are certain and could be thought to impact on expected economic activity (Japanese disaster) but have a range of possible consequences (changing volatility). Other shocks, which are much less certain (end of QE2 – because there could still be a QE3) may be difficult to work into model assumptions.
- With Stress and Scenario Tests – each of these shocks as well as combinations of the shocks could be stress or scenario tests. Riskviews suggest that developing a handful of fully developed scenarios with 3 or more of these shocks in each would be the modst useful.
- In the choices of Risk Appetite. The information and stress.scenario tests should lead to a serious reexamination of risk appetite. There are several reasonable reactions – to simply reduce risk appetite in total, to selectively reduce risk appetite, to increase efforts to diversify risks, or to plan to aggressively take on more risk as some risks are found to have much higher reward.
The last strategy mentioned above (aggressively take on more risk) might not be thought of by most to be a risk management strategy. But think of it this way, the strategy could be stated as an increase in the minimum target reward for risk. Since things are expected to be riskier, the firm decides that it must get paid more for risk taking, staying away from lower paid risks. This actually makes quite a bit MORE sense than taking the same risks, expecting the same reward for risks and just taking less risk, which might be the most common strategy selected.
The final consideration is compensation. How should the firm be paying people for their performance in a riskier environment? How should the increase in market risk premium be treated?
See Risk adjusted performance measures for starters.
More discussion on a future post.
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