Archive for April 2011

Is Your Company HQ located in Denial?

April 29, 2011

Denial is a popular place for companies to locate.  That is because Denial is a much more economical location than living in reality.

Companies who are headquartered in Denial do not have to think consciously about risk management.  It is inherent in their everyday business practices.  They do not need to appoint anyone to be their risk officer.  They do not need to schedule sessions with their board to ever talk about risk.  They always talk about risk with their boards.

True ERM has a very difficult time getting started in a firm headquartered there.  That is because of the cost structure in Denial.  Those firms are used to paying exactly zero for risk management.  They get to realize ALL of the profits of their choices, without deduction for risk management drag.

If you propose ERM to a firm that is located in Denial, you will have them ask for you to:

Show me how ERM adds to value.

Usually, with a smirk on their face, because they are sure that you cannot.

But for those who live outside Denial, they might ask the opposite question:

Show me how ignoring risk adds to value.

To them it is pretty obvious that a firm that has gone out of business has zero value.  So any strategy that reduces the chance of going out of business has the potential to have a positive impact on firm value.

Some prefer to live all the time in Denial, some just visit occasionally.

Football is about more than just Shoes

April 28, 2011

Of course it is. The equipment never wins the game. It never runs the game.  But a team that shows up without proper equipment has only a slim chance of prevailing.

And ERM is about more than just models.  Some people have mistakenly equated ERM with Economic Capital or VAR models.  That makes no more sense than the idea that football is all about the shoes.

Football is about having the right team, assigning the the right roles, setting the strategy and finally mostly about execution.  If you asked 1000 experts about football, few if any of them would even list the shoes.

But for ERM, you do need to also find the right people, assign the the right roles, set the risk strategy and execute.

So why have models found their way into the debate about ERM in financial affairs?

Models in general and Economic Capital in specific has become central to the ERM process because insurers and banks have traditionally used very crude and very different approaches to measuring risks, when they actually did try to measure them.  It is difficult to believe that an industry that exists by taking on risks from others like insurance would not have a clear tradition of measuring how much risk it was taking on in any clear and consistent way.

The methods that tended to be employed by insurers worked when the risks that they were taking stayed the same over time.  When the risks could be adequately tracked by reference to something that indirectly tracked with the level of the risk.  But when businesses and people and markets are changing the nature and level of risk constantly, those old relationships completely broke down.

The promise of economic capital and VaR models is to replace the old rules of thumb with timely and consistent scientific assessments of risk.

But even if that promise is achieved, the insurer or bank has only then got to the point of buying shoes for their football team.  Now they need to start training and coaching the team and watching to see how the team performs, providing feedback and constantly making adjustments as the other teams adjust their teams and strategies.

So the model is a start but it is the start of the football season, not even the start of the playoffs.

You have the shoes now play the game.

Lucas Fayne Highly Recommends this Blog

April 24, 2011

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)

Do we always underprice tail risk?

April 23, 2011

What in the world might underpricing mean when referring to a true tail risk? Adequacy of pricing assumes that someone actually can know the correct price.

But imagine something that has a true likelihood of 5% in any one period.  Now imagine 100 periods of randomly generated results.

Then for each of three 100 period trials look at 20 year periods. The tables below show the frequency table for the 80 observation periods.

20 Year Observed Frequency Out of 80
0 45
5% 24
10% 12
15% 0
20% 0
20 Year Observed Frequency Out of 80
0 9
5% 28
10% 24
15% 8
20% 7
20 Year Observed Frequency Our of 80
0 50
5% 11
10% 20
15% 0
20% 0

if the “tail risks” are 1/20 events and you do not have any information other than observations of experience, then this is the sort of result you will get. The observed frequency will jump around.

If that is the situation, how would anyone get the price “correct”?

But suppose that you then set a price for this tail risk. Let’s just say you picked 15% because that is what your competitor is doing.

And you have a very patient set of investors. They will judge you by 5 year results. So then we plot the 5 year results.

And you see that my profits are quite a wild ride.

Now in the insurance sector, what seems to happen is that when there are runs of good results people tend to cut rates to pick up market share. And when the profits run to losses, people tend to raise rates to make up for losses.

So again we are stymied from knowing what is the correct rate since the market goes up and down with a lag to experience.

Is the result a tendency to underprice?  You be the judge.

Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis

April 22, 2011

A second series of essays from the actuarial profession about the financial crisis.  Download them  HERE.

A Tale of Two Density Functions
By Dick Joss

The Systemic Risk of Risk Capital (Or the "No Matter What" Premise)
By C. Frytos &I.Chatzivasiloglou

Actuaries and Assumptions
By Jonathan Jacobs

Managing Financial Crises, Today and Beyond
By Vivek Gupta

What Did We Learn from the Financial Crisis?
By Shibashish Mukherjee

Financial Reform: A Legitimate Function of Government
By John Wiesner

The Economy and Self-Organized Criticality
By Matt Wilson

Systemic Risk Arising from a Financial System that Required Growth in a World with Limited Oil Supply
By Gail Tverberg

Managing Systemic Risk in Retirement Systems
By Minaz Lalani

Worry About Your Own Systemic Risk Exposures
By Dave Ingram

Systemic Risk as Negative Externality
By Rick Gorvette

Who Dares Oppose a Boom?
By David Merkel

Risk Management and the Board of Directors–Suggestions for Reform
By Richard Leblanc

Victory at All Costs
By Tim Cardinal and Jin Li

The Financial Crisis: Why Won't We Use the F(raud) Word?
By Louise Francis

PerfectSunrise–A Warning Before the Perfect Storm
By Max Rudolph

Strengthening Systemic Risk Regulation
By Alfred Weller

It's Securitization Stupid
By Paul Conlin

I Want You to Feel Your Pain
By Krzysztof Ostaszewski

Federal Reform Bill and the Insurance Industry
By David Sherwood

Leave Something on the Table

April 19, 2011

What was the difference between the banks and insurers with high tech risk management programs that did extremely poorly in the GFC from those with equally high tech risk management programs who did less poorly?

One major difference was the degree to which they believed in their models.  Some firms used their models to tell them exactly where the edge of the cliff was so that they could race at top speed right at the edge of the cliff.  What they did not realie was that they did not know, nor could they know the degree to which the edge of that cliff was sturdy enough to take their weight.  Their intense reliance on their models, most often models that focused like a lazer on the most important measure of risk, left other risks in the dark.  And those other risks undermined the edge of the cliff.

Others with equally sophisticated models were not quite so willing to believe that it was perfectly safe right at the edge of the cliff.  They were aware that there were things that they did not know.  Things that they were not able to measure.  Risks in the dark.  They took the information from their models about the edge of the cliff and they decided to stay a few steps away from that edge.

They left something on the table.  They did not seek to maximize their risk adjusted returns.  Maximizing risk adjusted return in the ultimate sense involved identifying the opportunity with the highest risk adjusted return and taking advantage of that opportunity to the maximum extent possible, then looking to deploy remaining resources to the second highest risk adjusted return and so on.

The firms who had less losses in the crisis did not seek to maximize their risk adjusted return.

They did not maximize their participation in the opportunity with the highest risk adjusted return.  They spread their investments around with a variety of opportunities.  Some with the highest risk adjusted return choice and other amounts with lesser but usually acceptable return opportunities.

So when it came to pass that everyone found that their models were totally in error regarding the risk in that previously top opportunity, they were not so concentrated in that possibility.

They left something on the table and therefore had something left at the end of that round of the game.

Rents vs. Risk and Reward

April 16, 2011

Many people talk and write as if risk and reward were the true trade-offs in a capitalist system.  It certainly makes risk management important if that were true.

But unfortunately for us risk managers, and fortunately for business managers, choosing among risky alternatives is not the best choice for business success.

In fact, the natural tendency of capitalism is directly away from risk and towards Competitive Advantage.  If a business can find a competitive advantage, their first choice forever after is to strengthen that advantage and to reduce their risk.

A business with a total competitive advantage, also called a monopoly, is crazy to then take any risk.  Economists call their income a rent.  The income from risk taking is called a risk premium.  All businesses prefer rents to risk premiums under that definition.

So the risk managers who talk all of the time about the risk and reward continuum and about the efficient frontier of risk taking are talking nonsense to any business person who knows the story of any of the most successful businesses.  The most successful businesses all made fortunes for their founders by collecting rents.

What we should be talking about is the Rent / Risk continuum.  If you want to be really successful, you need to find a way to collect rents.  If you want to get mediocre returns, then you can go out and take risks.

Many years ago, Riskviews was producing risk reports for return on risk capital for an insurer.  The insurer had some fee for service business.  This business did not fit into the risk reward framework.

Investment Banks had at one time been mostly fee for services businesses.  Then for a time, they decided that they could make more money taking risks.  It turns out that they were largely wrong.  The “profits” that they were recording on their risk taking were risk premiums for taking very large risks that were “in the dark“.  According to Taleb, they were being massively underpaid for those large but infrequent risks.

Some reinsurers that make their business taking on large amounts of catastrophe risks can be shown to be taking a significant amount of their value from the “default put” that is created because they collect premiums for all expected claims under their reinsurance contracts, but they do not intend to pay off on the largest catastrophes because they will have defaulted.

Risk taking is a questionable way to make profits.

So risk managers need to work to identify rents and properly reflect the superior place that rents should have in business goals.  Risk managers should be slow to claim that any risk taking behavior will make a profit and not just mistaken accounting of risks that are waiting in the dark and growing stronger to take back all of the so called profits from risk taking.

Not About Capital

April 13, 2011

The reality is that regulatory capital requirements, no matter how much we try to refine them, will always be a blunt tool.  Certainly they should not create the wrong incentives, but we cannot micromanage firm behavior through regulatory capital requirements.  There are diminishing returns to pursuing precision in regulatory capital requirements.

Terri Vaughan, NAIC

These remarks were made in Europe recently by the lead US regulator of the insurance industry.  In Europe, there has never been a regulatory capital requirement that was risk related.  But the Europeans have been making the discussion all about capital for about 10 years now in anticipation of their first risk based capital regime, Solvency II.

The European assumption is that if they follow as closely as possible the regulatory regime that has failed so spectacularly to control the banking system, Basel II, then everything will be under control.

The idea seems to be that if you concentrate, really concentrate, on measuring risk, then insurance company management will really take seriously the idea of managing risk.   Of course, that conclusion is also based upon the assumption that if you really, really concentrate on measuring risk that you will get it right.

But the Law of Risk and Light tells us that our risk taking systems will lead us to avoid the risk in the light and to load up on the risk in the dark.

That means the risks that are properly measured by the risk based capital regulatory system will be managed.

But whatever risks that are not properly measured will come to predominate the system.  The companies that take those risks will grow their business and their profits faster than the companies that do not take those poorly measured risks.

And if everyone is required to use the same expensive risk measurement system, very, very few will invest the additional money to create alternate measures that will see the flaws in the regulatory regime.

The banking system had a flaw.  And many banks concentrated on risks that looked good in the flawed system but that were actually rotten.

What is needed instead is a system that concentrates on risk controlling.  A firm first needs a risk appetite and second needs a system that makes sure that their risks stay within their appetite.

Under a regulatory risk capital system, the most common risk appetite is that a firm will maintain capital above the regulatory requirement.  This represents a transfer of the duty of management and the board onto the regulator.  They never need to say how much risk that they are willing to take.  They say instead that they are in business to satisfy the regulator with regard to their risk taking.

The capital held by the firm should depend upon the firm’s risk appetite.  The capital held should support the risk limits allowed by the board.

And the heart of the risk control system should be the processes that ensure that the risk stays within the limits.

And finally, the limits should not be a part of a game that managers try to beat.  The limits need to be an extremely clear expression of the fundamental way that the firm wants to conduct business.  So any manager that acts in a way that is contrary to the fundamental goals of the firm should not continue to have authority to direct the activities of the firm.

Dissappointment

April 12, 2011

Michael Thompson often describes the situation where a person or group does not get the experience that they expect as Surprise. I have also heard that called Disappointment.

Probably Surprise is a better term.

What is going on is that people expect one sort of experience and get another.

In a recent published article, Ingram and Thompson describe the expectations of various environments as:

  • Boom Environment – High Drift, Low Volatility
  • Moderate Environment – Moderate Drift, Moderate Volatility
  • Bust Environment – Negative Drift, Low Volatility
  • Uncertain Environment – Unpredictable Drift, Unpredictable Volatility

With those descriptions, Surprise/Disappointment is easier to describe.  If you believe that the environment is in a Boom and the experience you get is moderate drift and volatility, then you will be surprised and probably disappointed.  And similarly, if you expect a Bust environment and you experience high drift, then you will certainly be Surprised, but probably not Disappointed.  Unless you were really counting on complaining and  are disappointed about good fortune spoiling that.

Surprise is very different for those expecting an Uncertain environment.  For them, it is surprising that they are able to notice any pattern, whether it be high, low or moderate drift and volatility.  They are expecting unpredictable results, a high volatility as well as a high volatility of volatility.  For them, a surprise would be if the experiences did have a reliable volatility.

The Surprise that many of us have been experiencing started out as a Disappointment.  We thought that home prices had a large positive drift and low volatility.  So as many of us started to count upon that expectation, the system reached its carrying capacity for home real estate.  Which is hard to imagine, since with the loans that were over 100% of value, people were being paid by the financial sector to take new homes.

Suddenly, house prices stopped rising.  Most stories about the financial crisis do not even try to give any explanation for that happening.  But it is easy to picture that everyone who was willing to move had already done so recently.  Even in a pay to take, there is a high personal time cost to move.  So the hot market encouraged anyone who might be willing to move and move a year or two or three earlier than they would have otherwise.  But not enough people were willing to do that year after year.  And not enough people were crazy enough to take out mortgages that they had absolutely no chance to pay back.  So the turnover faltered.  Prices simply stopped rising.  And the Surprise hit everyone.

After an extended period of freefall, the market has settled into a much longer period of uncertainty.  No discernable pattern to drift or to volatility.  There is a large and uneven volume of foreclosed real estate in the system.  It comes to market and disrupts prices.  Because the real estate market had relied upon a rather primitive price discovery mechanism, the foreclosures are very disruptive to the pricing of non-foreclosed housing.  This is a major factor in the level of uncertainty of housing and it ripples through the entire financial system and the entire economy.

With this uncertainty, people who are expecting any of the three other patterns of risk are irregularly Surprised, and often Disappointed.  As there are more and more disappointments, more and more people shift their coping strategy to one that makes sense in an Uncertain economy, the strategy of Diversification.  That might sound to be a good thing, but in practice, it ends up meaning avoiding any large or lengthy commitments.  It means a slow down in basic investment and usually a deferral of any of the major investments that would start to fuel the next positive economic cycle.

This Uncertain cycle will end slowly because of the immense amount of extra home real estate that is still in the foreclosure pipeline.

Such cycles usually end when the flip side of the process described above that drove the stoppage in the real estate boom.  What stopped the boom was that people wore out of moving up in housing.  What will stop the Uncertain market will be that people will wear out of not changing houses.  The people who have had one more child will be fed up with the crowding in their smaller house and the people whose kids have moved away will get fed up with maintaining more house than they need.  The people who do well enough to afford a bigger and better house will be fed up with waiting for things to settle down.  And when that happens to enough people, the backlog of existing real estate will finally sell down and a new boom will start again.

And people who had adapted to uncertainty will be Surprised, but not disappointed that their house again finally starts to appreciate.

PaPaTaCom

April 11, 2011

In some situations, things go better if you can explain them in plain language. In others, having lots and lots of unintelligible pseudo scientific jargon is what is needed.

If your situation is the former and someone wants to know about risk management, tell them

PaPaTaCom

That is short for:

  • Plan Ahead
  • Pay Attention
  • Take Action
  • Communicate

Really, that is what is involved in risk management.  Saying it is very, very simple.  Doing it is difficult.

Plan Ahead means that you need to know in advance how much risk you expect to take and how much mor or less than that you are willing to take.  Very easy to say, but not very easy to do.  But maybe if you just say it in plain language like this, instead of calling it risk appetite and risk tolerance, folks will understand and do that.

Pay Attention means that you need to know at all times, how much risk you are actually taking and how that compares to your plan.  It means that you really do know what your risks are and what your plan is.

Take Action means that if your plan says that you active manage your risks as you go along, that you actually do that.  If your risk positions grow much faster or much slower than your plan, that you do something about that also.  Take action means that you never just sit there unless that is what you planned to do.  (See Risk Management Entertainment System)

Communicate means that everyone tells each other what is planned, what the find when they are paying attention and what they do when they are taking action.

All of the fancy words around risk management are all a long winded and complicated way to say these four simple ideas.

But if your risks are complicated, as many, many organizations’ risk are, then this is only simple to say but never simple to do.

  • If your risks produce troublesome losses infrequently, it is very difficult to tell how much risk that you can or want to take.  It is also difficult to tell what your risk actually is at any point in time.  It is difficult to know whether to do something or not.  And so it sometimes seems like there is nothing that needs to be communicated.
  • If your risks are complicated and variable, then it is also difficult.  Knowing how much risk that you have been taking is slippery.  Knowing how much you might want to take is difficult and paying attention, that is measuring, is also tricky.  Taking actions might just fix one aspect of a risk and expose you to large dose of another aspect (see Risk and Light).  So what exactly do you communicate?

So these simple words do not help too very much.  Because even if you can tell the boss that risk management is easy to describe, you will be in big trouble when it is not easy to do.

So this is perhaps another one of those posts that you might have been better of if you did not read……

When is a Risk Premium Earned?

April 7, 2011

This is a difficult question.  One that challenges our accounting systems.

Think of two insurance contracts.  One lasts for one minute, the other for an hour.  They are both sold for residents of Antartica.  They cover the risk of being hit with a snowball.  On the average, residents of Antarctica are hit with a snowball 3 times per day.  The contracts pay out $10 every time the insured is hit with a snowball.  Premiums are $5 for the one hour policy and $0.10 for the one minute policy. The policies are renewable.

On Antarctica it is the custom of insurers to publish quarterly financials, that is every quarter hour.

Right now, there are 4 people on Antarctica and two of them have policies.  One bought the one minute policy and the other bought the one hour policy.

After the first quarter hour, there have been no claims.  What are the profits from the two policies?

The answers are completely different depending upon whether you decide to look at earning risk premium over the maximum holding period for the policies or the minimum holding period.

Our accounting systems tend to take the minimum holding period approach.  However, the maximum holding period approach might give a more useful answer.

The maximum holding period approach would be to think of the risk over the effectively infinite maximum holding period.  To determine profits, look forward and consider the amount needed for future losses.  You expect to have lumpy losses that average to a certain level.  The maximum holding period approach would then tend to reflect the excess over the expected losses as the profits in a period as profits and allow a build up of reserves to take care of the lumpy losses.

The minimum holding period approach suggests that at the end of the minimum holding period, you are done and reflect any revenue not needed to pay losses as profits.

So if no snowballs were thrown that quarter hour, all premiums (less expenses, which are very high for insurers operating in Antarctica) as profits.  If during any quarter hour there are snowballs, then there will be losses.  Very lumpy results.

This is not just an insurance consideration, it applied to any risks, such as credit or any far out of the money derivatives where losses are not expected in every period.

The minimum holding period approach will tend to encourage risk taking.  The maximum holding period approach would tend to make risk takers realize that they do expect losses sometimes.

Then if someone wants to recognize all of their profits from exposure to an infrequent risk during no loss periods, they would need to totally exit that position.

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The following chart is referenced in the comment from Robert Arvanitis…

Risk Management for Three Times

April 6, 2011

Experience tells us over and over again that there are three times that are important for risk managers.

1. Before a major loss event
2. Immediately following a major loss event
3. Longer term after the major loss event

Most of the discussion and literature about risk management focuses on the first of these times. We focus on identifying, measuring and mitigating risks in advance of events.

But for each of an organization’s major risks, it is extremely important to think about the other two times. Over and over, we see examples of situations where the second period is mishandled, often multiplying the size of the loss.

The most common first reaction seems often to be to hope for the best assuming that the loss is minimal and postponing taking any significant actions. For those events that turn out to be really major, this can have two very negative consequences. Often, if the right steps are taken right after the event, the eventual loss is significantly reduced. In addition, those early moments after a loss are when the most effective actions to reduce reputation impact must be taken.

For the longer term recovery from a major loss event, the organization needs to quickly develop a plan to cover the losses and to get the organizational capabilities back as close as possible to the state before the loss event.

In both “after” times, the actions taken might be very different if the loss event is one that impacts many others in the same space or is an event that impacts the organization alone.

What the risk manager needs to do is to use the contingency planning process to put together response plans to large loss events arising from every major category of exposure. Start with the extreme loss scenario itself. Imagine a two black swan event. Then develop your responses for such an event if (a) it is just your problem or (b) if it strikes most others in your area of operation.

When it is your loss alone, the reputation risk is high and their needs to be a major effort to managing the perceptions about your organizations. When the event strikes everyone in your area of operation, the issue will be resources to support recovery. When everyone is out looking to use those same resources, availability and or price are likely to become adverse.

Risk managers will often report on their top risks to their board monitoring the risk position. Those reports are all about Time 1. There should also be reports for Times 2 and 3. Having this discussion with the board in advance also makes it more likely that management will be able to implement the Time 2 plans immediately if both they and the board are prepared by advance discussion. While it is unlikely that the exact plan that was developed would be used, the conversation about what will be done can focus more around the variations to the developed plan that are demanded by the actual situation.

This part of risk management can also be a job saver for the risk manager. Many risk managers may be one of the scapegoats in the event of major losses to an organization. By providing the leadership needed to prepare in advance and forcefully recommending the needed steps in the loss event, the risk manager can make sure that they are seen as part of the solution, rather than the cause of the problem.

Maginot Risk Management

April 5, 2011

In the 1920’s, the French sought to protect themselves from future German invasions by building a wall across the most exposed route for such a tactic.

In the 1930’s, the Germans walked right around those fortifications and took France in short order.

Some financial firms have built Maginot Risk Management Systems. They consist of very fixed tests of risks and fixed processes for dealing with risks.

The US the Transportation Security Agency runs a Magniot Security system.   Everyone knows what the security system is going to be when they get to the airport.  So if anyone wants to get around it, it stays still or at best changes very slowly.

What is the alternative?  Something that is flexible and variable.  For security, what would happen if the airport security changed without notice, several times some days and not at all other weeks.  You never know when it will change and what they will want next.  Annoying to passengers, but probably infinitely more effective than the Maginot system now used.

And for risk management of a financial firm?  What it needed there is flexibility and variability.  The ability to look at things a number of different ways.  The ability to answer new questions quickly.  And the ability to ask new questions.

Not a system designed to prevent the last invasion.

Countercyclical Capital Regime

April 4, 2011

There has been much talk about the procyclicality of the Basel II and Solvency II type capital regimes.

There is a very simple alternative that was used for many years in Canada that would work most of the time.

The system was very simple.  It applied to common stocks as well as real estate.  In the following discussion, the common stock application will be the focus. It was not thought of as a risk capital system.  But it can be used for such, and can be quite effective to create a capital regime that accumulated more capital during booms and that can require less capital after a bust.  That is what is wanted for a Countercyclical Capital Regime.

For common stocks, the process was to add all capital gains and losses to the requires capital balance and then to release a steady percentage of the required capital balance into earnings each year.

To illustrate, lets look at a firm that in 1991 acquires $100M of equities in a S&P500 index fund that beats the index by exactly its expenses each year.  They use those assets to fund $65 M of fixed liabilities that for this illustration never change in amount.

Each year, they intend to dividend out 90% of the funds that they are not required to hold to support the $65 Million of liabilities or the required capital.   Their returns are as follows:

Now if the regulatory regime says that they need to hold 34% of their position as capital each year.  That regime is PRO CYCLICAL because when they have losses, they will also need to find funds somewhere to add to their capital in the years when they have large losses.  This sort of system usually means that they will need to liquidate some risky assets somewhere to release capital to fund this or some other shortfall.  They might just choose to stop funding this liability with equities therefore meaning that they sell their entire position into a down market thereby adding to the sales that drive down prices.

The table below shows what happens in that situation.

Now with the counter cyclical system that is described above, that situation does not happen.  For this illustration, the rule is set that the initial capital requirement is the same 34% as the previous example.  But after that, the capital requirement moves up and down with the gains and losses and releases from the capital.   The same rule of paying dividends with 90% of excess assets.

With this COUNTERCYCLICAL CAPITAL REGIME, you can see two things.  (1) What sort of countercyclical rule might have worked and (2) Why there will never ever be anywhere near enough will for an adequate countercyclical regime to actually be put into place.

  • The sort of regime that is needed is one that will build up capital in good times and allow lower capital in bad times.  In this illustration, the capital build up went as high as 72.3% of assets in 1999.  The bursting of the dot com bubble losses were all absorbed by the enormous capital cushion.  Then the Global Financial Crisis bubble burst in 2008 was also absorbed by the capital, driving the capital level down below 20%.
  • And that is why it will never happen.  Regulators will never be able to withstand the pressure to allow release more of the capital when it gets as high as 70%.  And they will never be able to agree that less than 20% capital is sufficient right after the market has shown that it can lose 37% in a calendar year (almost 50% for the 365 day maximum peak to trough.)

So here is a simple, practical countercyclical capital regime that was actually part of the Canadian system for many years.  It can work.

But if you try to propose something along these lines to one of the regulators who claim to be seeking an answer to this problem, they will say that they do not want something this formulaic.  They want there to be some discretion.

Does that mean that they think that they will be able to do better than this simple tested process?

Or are they simply being realistic and admitting that they have no political chance of staying the course with such a system so there is no reason to adopt.


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