Archive for July 2011

Cascading Failures

July 27, 2011

Most of the risks that concern us exist in systems. In massively complex systems.

However, our approach to risk assessment is often to isolate certain risk/loss events and treat them totally marginally.  That works fine when the events are actually marginal to the system but it may put us in a worse situation if the event triggers a cascading failure.

Within a system cycles are found.  Cycles that can ebb and flow over a long time.  And cycles that are self dampening or cycles that are self reinforcing.

The classic epidemiological disease model is an example of a self dampening system.  The dampening is caused by the fact that disease spread is self limiting.  Any person will have so many contacts with other people that might be sufficient to spread a disease were they infected.  In most disease situations, the spread of the disease starts to wane when enough people have already been exposed to the disease and developed immunity so that a significant fraction of the contacts that a newly infected and contagious person might have are already immune.  This produces the “S” curve of a disease. See  The Dynamics of SARS: Plotting the Risk of Epidemic Disasters.

The behavior of a financial markets in a large loss situation is a self reinforcing cycle.  Losses cause institutional investors to lose capital and because of their gearing the loss of capital triggers the need to reduce exposures which means selling into a falling market resulting in more losses.  Often the only cure is to close the market and hope that some exogenous event changes something.

These cascading situations are why the “tail” events are so terribly large compared to the ordinary events.

Each system has its own tipping point.  Your risk appetite should reflect how much you know about the tipping point of the system that each of your risks exists in.

And if you do not know the tipping point…

Trimming Risk Positions – 10 ERM Questions from Investors – The Answer Key (6)

July 25, 2011

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

There are a number of issues relating to this question.  First of all, does the insurer ever trim a risk position?  Some insurers are pure buy and hold.  They never think to trim a position, on either side of their balance sheet.  But it is quite possible that the CEO might know that terminology, but the CFO should.  And if the insurer actually has an ERM program then they should have considered trimming positions at some point in time.  If not, then they may just have so much excess capital that they never have felt that they had too much risk.

Another issue is whether the CEO and CFO are aware of risk position trimming.  If they are not, that might indicate that their system works well and there are never situations that need to get brought to their attention about excess risks.  Again, that is not such a good sign.  It either means that their staff never takes and significant risks that might need trimming or else there is not a good communication system as a part of their ERM system.

Risks might need trimming if either by accident or on purpose, someone directly entered into a transaction, on either side of the balance sheet, that moved the company past a risk limit.  That would never happen if there were no limits, if there is no system to check on limits or if the limits are so far above the actual expected level of activity that they are not operationally effective limits.

In addition, risk positions might need trimming for several other reasons.  A risk position that was within the limit might have changed because of a changing environment or a recalibration of a risk model.  Firms that operate hedging or ALM programs could be taking trimming actions at any time.  Firms that use cat models to assess their risk might find their positions in excess of limits when the cat models get re-calibrated as they were in the first half of 2011.

And risk positions may need to be trimmed if new opportunities come along that have better returns than existing positions on the same risk.  A firm that is expecting to operate near its limits might want to trim existing positions so that the new opportunity can be fit within the limits.

SO a firm with a good ERM program might be telling any of those stories in answer to the question.

Playground Risk

July 23, 2011

Some of us are old enough to remember going to a playground without an adult trailing along to make sure that we played safely. Oh, there were always a few parents there, but they were with the pre-k aged kids. Anyone old enough to go to school was generally thought to be old enough to be able to play.

Well, thanks to the immense safety movement that has caused everything to be swathed in bubble wrap and foam padding, all of the risk is now gone from playgrounds. AND if you did go to a playground (and almost no one ever does anymore – they are no fun at all) you find that there is usually at least one and probably two adults supervising each child.


Thanks to Claire Wilkinson at the Terms and Conditions Blog of the III, we find that a new study of childhood risk taking suggests that risk taking is a necessary part of growing up to face the world as an adult. Children’s Risky Play from an Evolutionary Perspective: The Anti-Phobic Effects of Thrilling Experiences is the article.  The article says

we may observe an increased neuroticism or psychopathology in society if children are hindered from partaking in age adequate risky play

Roll the experiences of the last generation of kids forward twenty years, when they start to run the world.  They have been deprived of any chance at risk taking as kids.  Not safe enough.  They will also be living in a world dominated by the aged baby boomers.

Apply that picture to future risk appetites.  Any discussion of risk appetite talks about the amount of risk that someone is comfortable taking.

The lesson that we have taught our kids is that ZERO risk is the only level that they should be comfortable with.

I imagine that it would be a good thing to invest in a company that makes that rubber stuff that lines the floor of the playground.  That is much safer than concrete for sidewalks. It will be everywhere.

And business risk taking – forget about it.  Your business may fall and skin its knee.

Kids and adults and businesses and current and future business leaders need to experience risks and get comfortable with the losses that sometimes come from risk taking.  They need to learn that it is not the end of the world if they skin their knee.  Or even break a leg.  Maybe when that happens, we learn something new about ourselves and our ability to take risks in the world. 

Because if someone believes that they are not taking any risks then the only risks that they have are risks that they are not aware of.

High Risk Adjusted Returns and Risk Management – 10 Key ERM Questions from an Investor – The Answer Key (5)

July 20, 2011

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

5.  In the sub prime market prior to the crisis, investors were buying AAA securities but getting a little more yield.  Since they were AAA rated, the capital required was minimal.  So the return on equity could be attractive.  Unless you held that story up to the light and freely admitted that your bank profits were bolstered by exploiting the fact that the market and the regulators had different opinions of the creditworthiness of the sub prime securities.

So, if the banks had answered honestly, they would have been saying that their profits were coming from regulatory arbitrage.  There are only three possible outcomes from this situation.  First, the market could wise up and the excess profits would disappear.  Second, the regulators could wise up and suddenly the banks would find themselves needing lots more capital, and third, the market persists in its opinion of higher risk and it turns out the market is correct.  But since under this third option, the bank is playing the regulators for the fools, as the risks stay the same or grow ever larger, the banks take more and more advantage of the stupid regulators.  They pretend to their board that the bank is safe because they are holding the capital that the regulators require.  The banks takes more and more risk – the compulsion to grow and grow earnings in the face of the shrinking spreads for everything with “normal” risk is an immutable imperative that requires banks to multiply their risk.

So one of the possible reasons that Risk Adjusted Return is high is that the risk adjustment is based upon regulatory requirements – not on an actual assessment of risk.  And there are three possible outcomes of playing the regulatory arb game that are unfavorable.

Another reason for higher risk adjusted returns is a competitive advantage.  Investors should be happy to hear about a competitive advantage.  They should also do their own assessment about how permanent that advantage might be.

From the point of view of assessing an ERM system, the answer to this question should reveal how seriously that management takes the idea of risk management.  High and unexpected returns are as good a signal as any of higher risk.  In fact, in the financial markets, high returns are almost always a symptom of higher risk.

Prop Trading – Do Not Try This at Home

July 19, 2011

The GAO last week released a report on Proprietary Trading of banks. The headlines feature a conclusion from the report that the six largest US banks did not make any money our of Prop Trading over the 4.5 years of the study period.

The analysis looks pretty straightforward.  But it is difficult to see if the conclusions are quite so obvious.

First and most important for a risk manager to notice is that this is a post facto analysis of a risky decision.  Risk Managers should all know that such analysis is really tricky.  Results should be compared to expectations.  And expectations need to be robust enough to allow proper post facto analysis.  That means that expectations need to be of a probability distribution of possible results from the decision.

Most investments had performance that was vaguely similar to the pattern shown above during that time.  Is the conclusion really anything more than a 20-20 hindsight that they should have stayed in cash?  That is true everytime that there is a downturn.   Above is a graph of a steady long position in the S&P.

On the other hand, traders in such situations seem to generally get paid a significant portion of the upside and share in very little, if any of the downside.  In this case, the downside cancelled out all of the upside.  The good years had gains of over $15.6 B.  If the traders were getting the usual hedge fund 20% of the gains, then they were paid 3.9 B for their good work.  In the bad years, banks lost $15.8 B.  That means that the gains before bonus were $3.7B.  Incentives were over 100% of profits.

The one other question is why investors need banks aas intermediaries to do prop trading?  Why can’t investors do their own prop trading?  Why can’t investors go directly to the hedge funds or mutual funds or private equity funds?

Ultimately, the report says that prop trading was not really significant to bank earnings and not a real diversifier of bank volatility.  So in the end, is there any reason for banks to be doing prop trading?

It seems that the banks are reaching that conclusion and exiting the activity.

Tranching Expectations

July 18, 2011

Stochastic Monte Carlo simulations (SMCS) of insurer activities have been used to create nearly continuous distribution curves of expected gains and losses.  Economic Capital models are often aggregations of these separate SMCS models to create a similar distribution of total group gains and losses.  There are several primary characteristics of the results of these models:

  • They produce a nearly infinite number of numerical results giving an incredibly rich vision of the possibilities for the results of the activities of the firm.
  • That tidal wave of numeric results is very difficult to digest and make sense of.
  • While the modelers may have developed methods for validating the models, it is extremely difficult for general management who are supposed to be the primary users to “validate” the models and therefore, very difficult for them to trust the models

What would validation mean for the general managers?  It would mean that they would have confidence that the experiences that they have of the company’s risks and their expectations of future experience would be consistent with the model.

Ultimately, managers should have the same sort of reliance on the model that they have on the speedometer in their car or the clock on their wall.  The same sort of confidence that a cook might have on the thermometer on the oven.  They get that confidence not by having an expert show them a report, they get that confidence by experience.  The speedometer tells them that they are driving within the speed limit and they go past a police speed trap and they are not stopped for speeding.  They leave for work with enough time to get there and they arrive on time.  The cook puts the cake in the oven and it does not burn and it does cook appropriately in the time expected.  Not just once, but over and over again.

The problem is trickier for the SMCS model.  The output is really a set of likelihoods.  But when that output is presented as the infinite stream of numbers, there is no intuitive way to validate it naturally against experience.  And also, when the output is presented as a single remote number, like a 1 in 200 loss, it is also nearly impossible to validate naturally, by experience.

Tranching a security means splitting up the cashflows in some particular, predetermined way.  The idea of tranching can be used to help with promoting the natural validation process for a SMCS model.  The future possibilities can be tranched into 6 or 8 natural stories.  Then the model results can be sorted into the scenarios that match up with the stories.  The model output can be characterized as predictions of likelihood for the stories.  Here are some possible stories:

  • Highly favorable results – Bonuses are maximized
  • Favorable results – Bonuses are above expected/average
  • Somewhat unfavorable results – Bonuses are paid but below average/expected
  • Unfavorable results – no bonuses are paid
  • Highly unfavorable results – Layoffs and/or executive firings
  • Critical Loss – Company has to drastically change activity – may go into runoff
  • Disaster – company insolvent – seised by regulator

Management can participate in defining the range of results that frame each story there.  Then the model can provide its prediction of likelihood of each tranche.  Management can also provide their prediction of the likelihood of each tranche.  The stories do not have to be compensation related.  Riskviews has found that if the bonus program of a company was thoughtfully constructed, there are likely to be other stories that can be told of company experience to define the same ranges of results.

A seriously valuable and interesting discussion might result.

Riskviews was once an executive manager for a business unit within an insurer.  The insurer’s risk model was used to produce a projection of what might happen to that business in an adverse market.  Riskviews response was to ask on which day of that crisis the modeler was predicting that Riskviews was going into a coma, because the business decisions that are predicted would never happen if Riskviews was conscious.

These stories can be used to promote the validation process by the managers.  At the conclusion of each period, the modelers and the managers can review the actual experience in terms of the stories.  Then they can all decide if the experience validated the model or if it provided experience that suggests recalibrating the model.

Now if this process happens once per year, then it will take a very long time for that natural validation to take place.  Probably longer than the tenure of any single management team.  And as the management team turns over, the validation process is likely going to need more time.  Therefore, it is highly recommended that this process be repeated quarterly.  And perhaps repeated for each of the sub models of the economic capital model.

The way that the cook or the driver or the commuter got to rely on their tools was by repeated experiences.  The same sort of repeated experience is needed to validate the SMCS model in the minds of the management users.

How Not to Handle a Crisis

July 17, 2011

News International has been the news for several days now.  ABC News says that they are an example of How not to Handle a Phone Hacking Crisis.  It seems that nearly every year hands us another example of how a company should NOT handle a crisis.  The ideas of how TO handle one are pretty simple:

  1. Get all the news out.  Don’t withhold.  The constant drip, drip of additional revelations makes many people skeptical about whether they ever hear the whole story.
  2. Don’t just take advice from your lawyer.  It is quite possible to be totally safe in a legal sense and totally ruined in the court of public opinion.
  3. Have a plan and practice.  Most company CEO’s that are faced with a crisis do not give the impression that they have ever given a minute of thought to what they might say in a crisis up until the very minute that they open their mouths.  They also seem to be totally surprised by the questions that they get.  There is no upside to knowing how to handle a crisis, but the downside to not knowing is a large fraction of the total net worth of the company.  If the CEO cannot be bothered to prepare, then they must assign a very senior person to be prepared to be the spokesperson in a crisis.  And also be prepared to hand over the top job to that person if there is a crisis and they handle things well.
  4. Speed of response is Key.  And once you have a crisis, every new item needs a response.  In normal times, most items will blow over.  Ignoring them is the best policy.  In a crisis, the opposite is true.  Everything, no matter how trivial or inaccurate, needs a response.  You need to target getting as much airplay as your detractors.
  5. Crisis management is not just talking.  The actions that you take need to be as clear and decisive as your words.  In many problem situations, early mitigation can be much more effective than a late mitigation, and less costly, and less troublesome to talk about.  Imagine someone trying to make a big deal of a problem that you have already solved.  Being ready to fix lots of things is not cheap, however.  But imagine how much money BP would have saved if ANYONE would have had the equipment right there in the Gulf that was needed to fix that leak.

What in the end it takes is to focus some time and attention and money to being prepared for your worst nightmare.


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