How many significant digits on your car’s speedometer?

Mine only shows the numbers every 20 and has markers for gradations of 5. So the people who make cars think that it is sufficient accuracy to drive a car that the driver know the speed of the car within 5.
And for the sorts of things that one usually needs to do while driving, that seems fine to me. I do not recall ever even wondering what my speed is to the nearest .0001.

That is because I never need to make any decisions that require the more precise value.
What about your economic capital model? Do you make decisions that require an answer to the nearest million? Or nearest thousand, or nearest 1?  How much time and effort goes into getting the accuracy that you do not use?

What causes the answer to vary from one time you run your model to another?  Riskviews tries to think of the drivers of changes as volume variances and rate variances.

The volume variances are the changes you experience because the volume of risk changes.  You wrote more or less business.  Your asset base grew or shrunk.

Rate variances are the changes that you experience because the amount of risk per unit of activity has changed.  Riskviews likes to call this the QUALITY of the risk.  For many firms, one of the primary objectives of the risk management system is to control the QUANTITY of risk.

QUANTITY of risk = QUALITY of risk times VOLUME of risk.

Some of those firms seek to control quantity of risk solely by managing VOLUME.  They only look at QUALITY of risk after the fact.  Some firms only look at QUALITY of risk when they do their economic capital calculation.  They try to manage QUALITY of risk from the modeling group.  That approach to managing QUALITY of risk is doomed to failure.

That is because QUALITY of risk is a micro phenomena and needs to be managed operationally at the stage of risk acceptance.  Trying to manage it as a macro phenomena results in the development of a process to counter the risks taken at the risk acceptance area with a macro risk offsetting activity.  This adds a layer of unnecessary cost and also adds a considerable amount of operational risk.

Some firms have processes for managing both QUANTITY and QUALITY of risk at the micro level.  At the risk acceptance stage.  The firm might have tight QUALITY criteria for risk acceptance or if the firm has a broad range of acceptable risk QUALITY it might have QUANTITY of risk criteria that have been articulated as the accumulation of quantity and quality.  (In fact, if they do their homework, the firms with the broad QUALITY acceptance will find that some ranges of QUALITY are much preferable to others and they can improve their return for risk taking by narrowing their QUALITY acceptance criteria.)

Once the firm has undertaken one or the other of these methods for controlling quality, then the need for detailed and complex modeling of their risks decreases drastically.  They have controlled their accumulation of risks and they already know what their risk is before they do their model.

Explore posts in the same categories: Economic Capital, Enterprise Risk Management, Risk Management System


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2 Comments on “How many significant digits on your car’s speedometer?”

  1. riskviews Says:

    Reblogged this on Riskviews and commented:

    Regulatory regimes require companies to waste huge amounts of money on useless precision of risk evaluation.

  2. Robert Arvanitis Says:

    First the metaphor: Drivers know intuitively how fast to go. That is a subjective decision based upon experience and road conditions. It is vain, grasping and just stupid for government to attempt to micro-manage. The right approach is to license or bar based on skill and emotional suitability, and to manage by way of tools such as the Air Force uses — OODA. If a meteor hits your car, that is an accident; everything else is driver error, and that includes drinking, drugs, texting, and rage.

    Next the implications. Model precision is useless beyond the quanta of the feedback mechanisms. In other words, if you can only change credited interest quarterly, then daily marks are mere frustration. Besides, it is the gross mis-alignments that kill firms, not mere blips in profitability. Macro, not micro, is fatal.

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