How Real Risks are Managed

The real risk that your $10 million machine that is at the heart of your production line will fail needs to be managed. There are several ways that real companies manage this sort of real risk:

1. Wait til it breaks and then fix it,
2. Replace the machine when it is old enough that there is an x% probability that it has reached the end of its useful life, based upon statistics for all users of the same machine and the passage of time.
3. Replace the machine when it has been used so much that it has reached an x% probability of failure, based upon statistics for all users of the same machine and the actual usage you make of the machine.
4. Repair the machine when one of dozens of sensors placed within the machine indicates that some part of the machine is starting to operate outside of desired specs.  Replace the machine when such repairs are not cost effective.

This list seems to have a clear analogy for financial firms and their risk management programs:

1. No risk management program – let the losses happen and mop up afterward.
2. Manage to some broad industry standard, like premium to surplus ratio or assets to surplus ratio.
3. Manage to some risk adjusted industry standard like BCAR or RBC.
4. Manage to a detailed and carefully updated comprehensive risk model.

Of course, 4 is the most expensive course, for both the “real” companies and the financial firms.  Which course you pick depends upon how devastating an event it is for your machine to break down unexpectedly.  If your business can stand a few days/weeks/months without the machine, then maybe the very low cost path 1 is fine for you.

For financial firms, the question is the cost of an unexpected and large excess loss.  How disruptive will it be to have to either curtail business activity until you are able to build back capital or to raise the capital to replace what you lost with new capital?  Can you keep doing business while you settle that question?  What is the opportunity cost of not being able to write business right after a big loss?

The analogy is a pretty good fit.  Feel free to use it when you have to argue for more risk management spend.

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What’s Next?

Buttonwood suggests that there are four paths forward from the global debt crisis:

1. Grow out of the problem
2. Inflate the debt to a more manageable level
3. Default
4. Extended Stagnation

These four paths happen to coincide exactly with the four views of risk from Plural Rationalities.

The Maximizer will be sure that we can just Grow Out of It if the government will just get out of the way and let the market work its magic.

The Managers will believe that a careful process of gradual inflation will bring the economy back into line with the debt.  This process will work if the expert government economists who really understand the problem are given their freedom to manage this. In the meantime, they will also want to increase the laws and regulations so that this sort of thing will not happen again.

The Conservators believe that since default is inevitable, then we might as well take our lumps and get it out of the way quickly.  They will not be convinced, even after the default that anything has been completely solved and will continue to worry that there is more bad news just around the corner.  So they will be preparing for the next shoe to drop. They will probably favor cutting spending to make sure that things come back into balance.

The Pragmatist will believe that there is not really a good way out and that the economy will be stuck in this stage of uncertainty for an extended period.  They may even believe that the efforts of the others to try to solve the problems might extend that uncertain period even longer.

Looking back on the 1930’s we see that in various countries at various times during that decade that all four paths were tried by various governments.

What worked then?  Well, you can find that there are four different opinions on what was the exact reason that we came out of the depression…..

Mitigating “Margin Call” risks

New movie about 24 hours in the life of a troubled bank at the height of the financial crisis, Margin Call.

Read a review from the point of view of a risk manager here.

Is Social Security a Ponzi Scheme?

The name calling involved is a distraction from the real problem – the problem of how to keep our entire economic system working with the massive shifting of people into the non-productive retirement ages. Besides the imbalances in pay as you go programs like social security and medicare, there is the problem of who is going to buy the securities that the retirees will need to sell to pay for living expenses? What usually happens when the market knows that someone MUST sell something? What percentage of the stock market’s total holdings MUST be sold over the next 30 years?

Everyone keeps pretending that this is some sort of marginal change situation.  It is definitely not.

What happens if the Boomers sell off causes the market to drop by another 25 – 30%?

Sounds crazy?  But the charts below from the San Fran FRB tells a story…

The solid line represents the ratio of middle aged people (40 – 49) to Old Agers (60 – 69).

This picture shows a 30% drop in PE.  If earnings are also challenged by the low or negative population growth during the same time period, the massive drop is stock prices is quite possible.

So even the people who did save for retirement may be woefully surprised that their money does not save them.

The stock market is but a large and often somewhated distorted mirror of the economy.  If the stock market is challenged by the low growth of the population and the shift from production to consumption of the large retiree population, then that is a reflection that the economy could be challenged in just the same manner.

That is the REALLY BIG problem that needs to be solved.

The Social Security problem is not at all difficult to solve.  According to the most recent actuarial report to the trustees, the shortfall in Social Security is 14% of projected benefits or 17% of projected revenues.  So anyone who can do arithmetic can work out some combination of increases to taxes and decreases to benefits that would bring the program into balance over the 75 year projection period.  Split it down the middle and decrease benefits by 7% and increase social security taxes by 8.5% and it is solved.  But the fact of the matter is that there is no serious consideration being given to any solution, let alone a straightforward solution like the above that anyone could understand.

Time to Ban RISK FREE!

Perhaps the very act of declaring something a RISK FREE ASSET guarantees that it will not be such. 

Underneath that declaration of RISK FREE is a presumption that the RISK FREE entity can absorb an unlimited amount of debt.  When in fact, the thing that we are seeing over and over again is that it is the debt itself that causes the risk!

In insurance, if insurers allowed someone to insure a building that they own for five times its value in the event of a fire, we all understand that a fire becomes highly likely.

In banking, it is also a basic tenet of lending that if you lend someone much, much more than they could ever possibly repay, that they will not repay.  But in banking, we have let the concept of RISK FREE creep into our heads and let that overcome the basic tenet about lending and repayment.  Banks are actually encouraged to put more of their money into RISK FREE securities to make them more secure.  But in the case of both the sub prime and the sovereign crises, the problem comes from assets that were improperly designated RISK FREE.

But what if it is the designation of RISK FREE itself that leads to the problems?

In the US Life insurance sector, the regulators provide a Risk Based Capital (RBC) regime.  It assigns a level of capital based upon the regulators understanding of the risk of various activities.  Most life insurance products at the time of the creation of the RBC regime in the early 1990’s involved a guarantee from the general account of the insurer to the beneficiaries of the insureds.  Life insurers traditionally took large amounts of credit risk to support those guarantees.  The RBC originally was focused first on the largest risk of the life insurers, credit.

Variable Annuities did not involve a guarantee from the general account and were therefore considered RISK FREE.  Many insurers wrote that business and did not attribute any capital because the products were RISK FREE.  From the start, insurers paid a fixed commission to brokers who wrote the business.  Insurers did not directly charge the customers for those commissions, but instead recovered those payments from the accounts over time.  Later, life insurers started to also add guarantees from the general account of the benefits from the variable annuities.  The variable annuities were still considered to be RISK FREE so there was still no RBC charge.

It was not a surprise that valuable risk protection that was highly underpriced was attractive to buyers and these products became very heavy sellers for a dozen or more companies.  So much so that attempts to later change the RBC to require proper capital amounts for the product were potentially critically damaging to some of those firms. Eventually, when the financial crisis hit, some of those dozen insurers that wrote large amounts of these products were looking for help from the TARP program

So perhaps we should be rethinking this concept of RISK FREE.   When the activity deemed as RISK FREE starts to become risky, it starts (or in the case of the sub prime backed CDOs always) pays a higher return than the lowest risk activities.  When the denominator for RISK FREE is zero or very near zero, very tiny amounts of excess returns from growing risk of the activity which is now designated RISK FREE in error will look to be fantastically profitable.  A firm that is trying to optimize its return on capital will shift as much activity as possible into the improperly designated assets class.

As long as there is a RISK FREE class, there will be an incentive to shift as much activity as possible into any security in that class that is misclassified. 

And because the capital requirements for risk free are zero, there is no limit to how much banks can move into that class.  They actually look good if they leverage up to increase activity in RISK FREE.

We need to stop even saying that any class of investments is RISK FREE.  As we see where that idea has led us, we need to leave it in the universities where it belongs and keep it out of the business world.  They can keep it on a shelf right next to their bottles of perfect vacuum and along side their frictionless surfaces.  That is where it belongs.

In the real world, there are no RISK FREE assets.  The capital requirements need to be floored with a positive number and graded up with the level of returns.  The market really is telling us something about risk when returns are higher, not about the brilliance of the companies that are able to find the misclassified RISK FREE investments.

 

Winners and Losers

European leaders are in conference as this is being written. Their sole concern is to determine the shares of the Losers from the lending boom.  Candidates for Loser shares include:

1. The Greek citizens  –  this has been the first place that they wanted to go.  But so far the Greeks have shrugged off attempts to get them to even stop running up additional debt, let alone repaying any old debt.  Realists are now struggling with trying to determine who else they can find to take the Loser shares.  The efforts of the Greek government have all been to slow the rate of new borrowing, and those have fallen short of goals.
2. The non-Greek Europeans  –  this approach is accomplished through a government to government or government to ECB to government transfer of money.  This has been the central approach to date.  This approach is limited because of the reluctance of the German people (and therefore their politicians) to take a larger Loser share.  Their concern is that the Greek citizens have been the winners (through excessive government spending and salaries) so the Germans who have been frugal and prudent should not be providing a larger share than the Winners.
3. The banks  –  who all somehow managed to own greater or lesser amounts of Greek debt.  Unfortunately, these banks are mostly European.  And if forced to bare the bulk of the losses might find themselves in need of government bailouts.  Back to the non-Greek Europeans.   But it is worthwhile to think for a minute what making the banks taking a large Loser share would involve.  If the banks take a large Loser share, they have to decide who among six parties will they then spread the share to.  Those parties are:  bondholders, stockholders, management, employees, customers and other counterparties.
4. Non- Europeans  –  enter the IMF which has made smaller contributions to this situation than the Europenas, but not insignificant contributions.  The involvement of the IMF creates interesting precedents for future situations.  The Greeks are proving that there is no reason whatsoever to ever comply with international financial covenants.  The IMF was famous for imposing draconian requirements on those to whom it lends.  But that story is being rewritten by the Europeans.  To some it appears that there are two sets of rules when it comes to loans from the IMF.  And where you live determines which set of rules apply.

So back to the negotiating table.  History of the past 10 years has shown that the Greek government will agree to any terms, but will have trouble delivering on anything.  Countries have not recently tried living without banks.  But most assume that would be fairly difficult.  So in the end, the European people will pick up the tab.  It seems makes sense to settle this sooner rather than later so that it will be possible to put a stop to further Greek overspending.  But that sensible concern does not seem to be moving the leaders to doing the difficult work of assigning the Loser shares.

Clearly, there was not any realistic discussion of this possible situation BEFORE the crisis.  The Greeks promised repeatedly not to ever get close to this sort of mess.  The banks have rules against lending to entities who are not likely to repay and they have regulators whose job it is to make sure that they do not get in over their head.   Governments presumed, perhaps without any basis in reality, to believe that those three lines of defense would be more than enough.

The response ultimately needs to be something other than adding two more nevers to the promise to never, never, never, never let this happen again. 

An actuary from one insurer often tells the story that his firm will always want to understand how a new product might fail before they agree to start selling that product.

Perhaps that is what is needed for countries and their banking systems.  They need to think through how things might break and say in advance who will bare the Loser shares.  In really having that discussion, perhaps it will become clear that it is much easier to distribute losses when they are smaller and that their main task needs to be to identify and deal with Loser shares when they are smaller rather than the recent strategy of hoping that they would go away.

Some might suggest that there are a set of rules in place for that.  But the evidence is clear that those rules are insufficient.  We all need to get realistic about these situations and develop a new set of rules that might carry us for another 50+ years.  Rather than solutions that work for a few months.

Does Your Firm Know What To Do At a Yellow Light?

An Audi advertizement says:

The Yellow light was invented in 1920.  Almost 100 years later. 85% of drivers have no idea what to do when they see one.

A risk management system needs yellow lights.  Signals that automatically tell people to “Proceed with Caution”.  These signals need to be sensitive to both outside changes in the risk environment and to inside decisions about risk.

In the outside world, the level of risk is changing all of the time.  Everyone anywhere a hurricane zone knows the annual season for those storms.  They make sure that they are prepared during that season and don’t worry so much in the off season.  Most risks do not have clear regular seasons, like hurricanes.  (And in fact hurricanes are not really completely bound by those rules either.)

A good risk management program needs to have a system that looks for the conditions that mean that it is hurricane season for each of the major risks.  And it needs to have plans for what needs to to done in each part of the firm so that they “Proceed with Caution”.  And the managers of the affected areas need to know those plans and their own roles.  And there needs to be a Yellow (or Amber) light that flashes somewhere. And then the managers need to act, they need to execute the plans to Proceed with Caution.

The same thing applies to the other reason that might trigger a yellow light.  That would be company actions.  Most firms have risk limits.  Some of those risk limits are “soft” limits.  That means that the limit itself is a Yellow Light. Hitting the limit in these firms means that you must “Proceed with Caution”.

More commonly, the limits are HARD; either Red Lights, Cement Barriers or Brick Walls.  A red Light risk limit, means that when you get to the limit, you must stop and wait for someone to tell you that you can proceed.  A cement barrier risk limit means that you are prohibited from proceeding when you hit a limit.  A brick wall risk limits means that if you hit the limit, you are likely to be terminated.  In these three sorts of control systems, there are often informal Yellow Lights and occasionally formal caution signals.  RISKVIEWS suggests that all firms that use HARD limits should create a formal Yellow Light system with a process that identifies an official Caution point along with suggestions or rules or plans of how to proceed when the Yellow Light goes on.

On the highway, Yellow Lights cause problems because there are really three different understandings.  One group believes that it means “Speed Up to avoid the Red Light”, while another group thinks it means “Stop now and Avoid having to make an Emergency Stop when the Red Light comes on”.

The third group knows that what the Yellow Light really means is

“watch out for the other two groups“.

The Importance of Managing Risk Quality

One possible reason that insurers might need to regularly perform the difficult and expensive process of calculating Economic Capital is that they lack any significant Risk Quality control process.  They do not know the quality of the risks that they write and they have no existing process for monitoring changes in risk quality and acting upon those changes to bring risk quality back into line.

What is this mysterious Risk Quality, you ask?

Risk Quality if the amount of risk per unit of business activity.

The bottom up risk management process would then be to define the acceptable levels of Risk Quality for a business and then to establish a risk underwriting process to determine the Risk Quality at time of consideration for acceptance, processes for modifying the inherent Risk Quality to achieve an acceptable Risk Quality at time of acceptance.  Then during the exposure period, the Risk Quality would be monitored to determine whether it had changed and if there was a change that caused the residual risk to now be unacceptable, the risk manager would undertake to again take steps to bring the risk back into the acceptable range.

With the Risk Quality bottom up type risk management system, the responsibility of to central staff is to verify whether the risk quality pieces add up to an acceptable amount of risk.  If they do, then the business unit managers have a clear process to manage.  They have a risk budget in the aggregate.  They know that their expected mix of business among the different classes of risk quality will fit with that budget, so their management process then can focus on the trade-offs between the different classes.

The quantum of risk can be calculated by a simple formula then:

Total Risk = Sum over all risk classes of (Risk per unit of business activity X amount of business activity) – diversification adjustment. 

400 Posts – 70,000 Hits and Still Blogging

In April 2009, someone said to RISKVIEWS, why don’t you try blogging.

From April to August, the RISKVIEWS website consistently drew at least 600 hits per month to the Risk Management Quotes.  Then the blogging started.

Someone recently asked “How does this fit into your career plan?”  Interesting question.

Posting is now just a habit.  It happens in bursts.  Some weeks there are no good ideas, others there are many.  At least many ideas.  Over time there are even a few really good posts.

Here are a few that you may not have noticed:

You may not be able to Grow out if it

Growth does not always mean excessive risk, but excessive risk is almost always associated with high growth.

Who wins with leverage?

Leverage increases apparent returns in best of times but Increases risk considerably in worst of times.

How about a Risk Diet?

Why do you need an aggregate risk limit?  For the same reason that a dieter needs a calorie limit.

Adaptability is the Key Survival Trait

To survive such situations, it seems that the ability to quickly assess new situations, especially ones that look like old tried and true but that are seriously more dangerous, and to change what the organization is doing in response to these risks is key.

Your Mother Should Know

Something as massive as the current financial crisis is much too large to have one or two or even three simple drivers.  There were many, many mistakes made by many different people.  My mother, who was never employed in the financial world,  would have cautioned against many of those mistakes.

According to the site stats that I get, these posts have been read a total of less than 30 times.

So on a day like today, check one of them out.  Chances are you did not see it already.

Back in The Playroom

As the UBS story unfolds, we clearly see that banks still believe the story that they have been telling over the years.

The story of the recent “rogue trader” loss is that he made large trades and faked the offsetting position.

That makes sense only if you believe the story that the traders have been telling for years that it is not the gross positions, but the net positions that count.

RISKVIEWS wonders at what ultimate cost they will hold onto that idea?

The other similar idea is that the notional amount of a derivative is not important, just the price and the recent price volatility.

You see, the gigantic gross position with another gigantic gross position offsetting is just like a derivative contract.

So the two ideas are really the same.  And both totally wrong.  They are only correct if things stay nice and tame.

But the flaw in the two arguments is that things are not really guaranteed to stay tame.  Haven’t the banks noticed that yet?

When things are not tame, the recent price volatility is not any indication of future volatility.  The amount of the notional becomes a giant level that can catapult the bank sitting with lots and lots of notional right out of the playroom.

It is starting to seem like the banks are making decisions on what ideas that they will believe based upon a a Peter Pan system.  If they close their eyes and really, really believe then things will go back to when the playroom was really, really fun and they made lots and lots of money.

When things are not tame, those two gigantic offsetting positions are not guaranteed to move in opposite directions.  Doesn’t anyone remember why LTCM went bust?  For heavens sake, some of the offsetting positions that they lost hundreds of millions on were treasuries with only slightly different maturities.  THERE ARE NO RELIABLE OFFSETS.

Banks may want to consider a simple rule that is used by insurers.  For large transactions, have a limited number of responsible individuals who must personally authorize.  (Note to bank HR departments – need to hire some.)  For extremely large transactions require that the CEO personally authorize.  For multi Billion transactions, require board approval.

Why would any rational person who is running a bank give a trader on a desk authority to make a two billion transaction, even if there is supposed to be an offset somewhere?  What sort of playroom is a bank trading desk?

But the most important question, in RISKVIEWS mind, is why would anyone give these folks their hard owned money to go out and gamble like that, offsetting positions or not??????????

The insanity WILL continue until investors get some sanity and insist on only giving money to banks that have sensible and transparent risk management rules that they actually follow.  

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