Archive for July 2013

Four Components of Resilience

July 13, 2013

Excerpt from The Resilience Renaissance

  1. Resilience thinking requires an acknowledgement of the fact that systems must learn to live with uncertainty and that change is inevitable. ‘“Expecting the unexpected” is an oxymoron, but it means having the tools and the codes of conduct to fall back on when an unexpected event happens’; these tools and codes can spring from memories held by societies of similar events in the past.
  2. Diversity is important to building resilience as it extends multiple options for dealing with perturbations, reducing risks by spreading them. This diversity can be nurtured ecologically through high biodiversity, both economically through livelihood diversification and through the inclusion of diverse points of view in policymaking processes.
  3. To build resilience, different types of knowledge should be appropriated in any learning process. This can be done through the appropriation of local knowledge in policy processes; ‘the creation of platforms for cross-scale dialogue, allowing each partner to bring their expertise to the table, is a particularly effective strategy for bridging scales to stimulate learning and innovation’.
  4. As renewal and reorganisation are essential parts of natural cycles, the ability of systems to reorganise is a critical determinant of their resilience. This is possible through strengthening community-based management and ‘maintaining the local capacity for social and political organization in the face of disasters. Response by the community itself, through its own institutions, is key to effective response and adaptation’. Also, building linkages across scales of governance is another component of giving communities the ability to self-organise; community organisations need to work with regional and national organisations. ‘The creation of governance systems with multilevel partnerships is a fundamental shift from the usual top-down approach to management’.

Lastly, … a dynamic learning component is crucial for providing a rapid ability to innovate in terms of the capacity to create new responses or arrangements. Such learning can be improved by adaptive co-management, defined as a process by which institutional arrangements and environmental knowledge are tested and revised in a dynamic, ongoing, selforganized process of learning-by-doing. Learning organizations allow for errors and risk-taking behaviour as part of the learning process.

Summary of Four components of resilience from Understanding Uncertainty and Reducing Vulnerability: Lessons from Resilience Thinking (Berkes 2007)

Open or Closed?

July 9, 2013

Moorad Choudry provides a good description of how banks think about ALM in a new article in The Actuary, Asset/liability management: solid as a rock?.  

But he misses one very important point that to RISKVIEWS explains the difference between banks and insurer/pension plans with regard to ALM.  That difference is the title of this piece.

The bank ALM model assumes that the bank will remain Open.  Therefore, the bank always has the option to obtain the funds that are needed to pay near term liabilities.  Unless the unfortunate occurrence of a liquidity problem.  The second part of this story is that banks do not mark their banking book of assets to market.  The banking book supports their “maturity transformation” business.  By keeping from that MTM step the bank keeps its large mismatch “off the books”.  This position has been the case, according to Choudry, since the the first banks.

Insurer and Pension ALM assumes that the company/fund becomes Closed and no longer has any access to new funds.  The new idea, that is a part of IFRS accounting that an insurer will mark everything to market is entirely consistent with the assumption that the company is assumed to be Closed.

That Closed company assumption along with the approach to ALM that insurers now use crept into insurance practice in the past 40 years with application of ideas that were no more than 75 years old.  One source speaks of these ideas as Anglo-American practices.  And in the discussions of Solvency II, one of the thorny topics goes back to this assumption since the German life insurance industry tends to favor an Open company approach.

The insurance company adoption of Closed company ALM started after some insurers suddenly went into the maturity transformation business in a big way only to learn that there was a definite limit to the amount of maturity transformation that could be done by an insurer relative to the capital and operations of the insurer.  Some insurers, notably The Equitable, experienced very large losses and had their business severely disrupted.  Almost 20 years later, as if to prove the necessity of the Closed company approach, General American also experienced massive losses when most funds were withdrawn from their maturity transformation business.

Looking at the ALM topic in this manner allows one to see the real and fundamental difference between the two approaches and in a non-pejorative manner.

In one sense, the insurers seem to be much too restrictive, too risk adverse, in their approach to ALM by adopting a full Closed.  Of course, insurers are not all planning on Closing,  on going out of business.  So preparing for this risk as if they were seems like extreme over caution.

On the other hand, banks, over the centuries have been subject to numerous runs and mass failures.  The Open company approach leaves a bank subject to a large contagion risk.  Once one bank has a problem, all banks may become subject to excessive withdrawals and all but the most secure banks that had been run with an Open company approach will experience severe trouble which could lead to a cascade of failures.  That is the reason why one of the fundamental functions of the Central Banks is to provide emergency liquidity to banks that are fundamentally sound.

If insurers shifted to an Open company approach to ALM, then insurers would also be subject to the same sort of fragility as the banks.  Insurers are in a different business from banks, usually providing longer term promises that require a much higher degree of confidence in their ability to be able to fulfill those promises under extremely stressful circumstances.  If insurers were operated with the same degree of fragility as banks, it is quite possible that their business model would fail completely.

What is the definition of RISK?

July 8, 2013

The word risk is a common English word with a definition that has been well established for hundreds of years.  There is no need for risk managers to redefine the word to mean something else.  In fact, redefining a word so that its meaning would incorporate the exact opposite of the common definition is a precess that George Orwell called DOUBLETHINK.

Imagine what you would think if you hired someone to paint your house and when they showed up they told you that in their minds the word “paint” meant repaving your driveway in addition to applying a colored covering to your house?  Sounds crazy doesn’t it.  But there are many, many risk managers who will heatedly argue about this point.  For example, see The ISO 31000 group discussion here.

The Definition of risk

noun

a situation involving exposure to danger:flouting the law was too much of a risk all outdoor activities carry an element of risk

[in singular] the possibility that something unpleasant or unwelcome will happen:reduce the risk of heart disease [as modifier]:a high consumption of caffeine was suggested as a risk factor for loss of bone mass

[usually in singular with adjective] a person or thing regarded as likely to turn out well or badly, as specified, in a particular context or respect:Western banks regarded Romania as a good risk

[with adjective] a person or thing regarded as a threat or likely source of danger:she’s a security risk gloss paint can burn strongly and pose a fire risk

(usually risks) a possibility of harm or damage against which something is insured.

the possibility of financial loss: [as modifier]:project finance is essentially an exercise in risk management

verb

[with object]

expose (someone or something valued) to danger, harm, or loss:he risked his life to save his dog

act or fail to act in such a way as to bring about the possibility of (an unpleasant or unwelcome event):unless you’re dealing with pure alcohol you’re risking contamination from benzene

incur the chance of unfortunate consequences by engaging in (an action):he was far too intelligent to risk attempting to deceive her

Phrases

at risk

exposed to harm or danger:23 million people in Africa are at risk from starvation

at one’s (own) risk

used to indicate that if harm befalls a person or their possessions through their actions, it is their own responsibility:they undertook the adventure at their own risk

at the risk of doing something

although there is the possibility of something unpleasant resulting:at the risk of boring people to tears, I repeat the most important rule in painting

at risk to oneself (or something)

with the possibility of endangering oneself or something:he visited prisons at considerable risk to his health

risk one’s neck

put one’s life in danger.

run the risk (or run risks)

expose oneself to the possibility of something unpleasant occurring:she preferred not to run the risk of encountering his sister

Origin:

mid 17th century: from French risque (noun), risquer (verb), from Italian risco ‘danger’ and rischiare ‘run into danger’

from Oxford dictionary of American English

Redefining the word risk to include its opposite (i.e. gain) is a perfect example of what Orwell called DOUBLETHINK.

DOUBLETHINK:  The power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both of them… To tell deliberate lies while genuinely believing in them, to forget any fact that has become inconvenient, and then, when it becomes necessary again, to draw it back from oblivion for just as long as it is needed, to deny the existence of objective reality and all the while to take account of the reality which one denies – all this is indispensably necessary. Even in using the word doublethink it is necessary to exercise doublethink. For by using the word one admits that one is tampering with reality; by a fresh act of doublethink one erases this knowledge; and so on indefinitely, with the lie always one leap ahead of the truth.  From 1984 George Orwell (1949)

Make a seat at the table

July 5, 2013

The report of the Parliamentary Commission on Banking Standards titled “Changing banking for good” makes many bold statements about what is wrong with banking but stays very much in the area of timid when making recommendations for changes.  Most of which seem very much like the exercize of “rearranging the deck chairs on the Titanic”.  Take, for instance, the recommendation for changing from an Approved Persons Regime to a Senior Persons Regime.  You will need to read this carefully.  It seems just like the purposeless retitling that has been applied to the FSA.

So what sort of change could make a difference?  How about this:

Banks have been found guilty of taking advantage of a one sided option.  This option grants huge gains to shareholders and employees if risky behavior pays off and has limited downside in the case of a blow up of the risks undertaken.  Much energy has gone into seeking to make sure that there is going to be ANY downside in the future, since in the recent past, governments around the globe tended to rescue the investors and many of the employees of the banks that lost the worst.

One of the reasons that banks have become so very risky can be summed up in one word, LEVERAGE.  So a simple step that would cause the whole culture at the bank to immediately swing around towards the caution that seems desired would be to give the providers of debt capital a seat (or several) in the board of directors.  Then number of seats going to bondholders would be proportionate to the proportion of capital provided by the bondholders.  The bondholder seats on the board could be capped at 1 less than a majority for a bank that was leveraged at a higher level.  Or they might be set according to the percentage of net income before the cost of debt servicing that is theirs.  That perhaps makes the most sense, since the riskiest firms are pledging the highest percentage of their income to their debt servicing.

The risk committee of the board could be chaired by one of these bondholder directors.  For firms above a certain percentage of debt financing (perhaps half way to the 49% position described above) the Risk Committee chair could have the power of the Veto as wielded by the Tribune of the Plebs in ancient Rome.

The bondholders would not want to harm the company, but they would have a very strong interest to keep the bank from making any of those highly risky decisions that would wipe out the debtholders stake in the firm.  It only makes sense that if the majority of the earnings of the firm are going to service debt, that the debtholders should be calling the shots.

The idea that a company exists only to enrich the shareholders is a fiction created by university writers in the last 50 years, and has no basis in law or custom.  It was created because it simplified the mathematical models that the financial economists wanted to build.  The model caught on because company management found it to be a convenient way to justify increasing their compensation.

Because, for the large part, bondholders were protected by government bailouts, they have largely continued to fund banks.  But the only way to rationally justify the continual funding of the opaque, highly risky banking enterprises via debt with almost no upside and plenty of possible downside is with a belief that bailouts will continue and will continue to protect bondholders.

If however, bondholders ever became convinced that their money really was at risk, and with the current structure, they would never learn how much at risk (see London Whale and MF Global stories and see if you can find any material disclosures of these risks), then they would either require a much higher spread that actually represented a risk premium for the uncertainty involved in bank risk or a seat at the table.

Summer ERM Readings

July 3, 2013

Beach Choroni in Venezuela

This Summer – Sun and Fun and ERM can all go together. Eight short ERM stories for the beach.

What to Do About Emerging Risks…

Managing emerging risks requires more than just blue sky sessions to identify the black swans and unknown unknowns in the imagination.   Actions must be taken to evaluate the potential impact of these risk and plan for their emergence and track their approach. 

http://blog.willis.com/2013/04/what-to-do-about-emerging-risks/

ERM in the Hierarchy of Corporate Needs

Businesses have a hierarchy of needs just like individuals.  ERM helps to provide for one of those needs, but not the highest need. This puts the importance of risk management into the perspective that boards and executives may have. 

http://www.soa.org/Library/Newsletters/The-Actuary-Magazine/2013/june/act-2013-vol10-iss3-ingram.pdf

Creating a Risk Management Culture

Often risk culture is talked about as the tone at the top. To make that tone permeate the entire corporate culture, executives and managers need to talk the risk talk constantly.

http://www.soa.org/Library/Newsletters/The-Actuary-Magazine/2013/april/act-2013-vol10-iss2-ingram.pdf

Discovering empirical risk appetite

More than half of all insurance companies lack a fully formed risk appetite statement.  But in the course of normal operations, many decisions and actions are taken that if examined properly will reveal an empirical risk appetite. 

http://wp.me/aevO4-15W

Get Ready for ORSA

US insurers need to learn a new word – ORSA.  It stands for Own Risk and Solvency Assessment.  By 2015, all insurers with more than $500M of premiums need to prepare an ORSA report to be filed with their state regulator.  A few are ready for this but most will need to do significant preparation.  

http://blog.willis.com/2013/02/u-s-insurers-need-to-get-ready-for-orsa/

Help Wanted: Risk Tolerance

Only the experienced need apply.  Insurers with a history of risk measurement have a much easier time with forming their initial risk appetite statement.  Firms without that experience will have a hard time coming to a final conclusion. 

http://www.soa.org/Library/Newsletters/The-Actuary-Magazine/2013/february/act-2013-vol10-iss1-toc.aspx

A framework for validating your Economic Capital Model

In the last several years, economic capital models have become ubiquitous for larger, complex insurers and now a broader swath of the industry is beginning to examine the potential benefits.  The users of model outputs need assurance that the economic capital model adheres to its guiding conceptual principles, aligns with prior editions of the same model, and conforms to standards imposed by the regulator.   Model validation is the process of confirming these qualities.

http://wp.me/aevO4-15V

Trifurcation:Divide to Conquer Risk

Risk analytics often portray risk as a single quantity.  But risk has many aspects.  By splitting the projected future possibilities into three tranches, some new insights into the impact of different risk mitigation alternatives can be found. 

http://www.soa.org/library/newsletters/risk-management-newsletter/2012/december/jrm-2012-iss26-ingram.aspx

A Fatal Flaw in Reasoning

July 2, 2013

Financial economics has a basic fundamental fatal flaw. That flaw is that:

Financial Economics assumes that no one pays any attention to Financial Economics.

So if we stopped reading and listening and thinking about the insights of financial economics, they are at least somewhat more likely to actually be true.  At least for longer than they are now. 

But in the recent past, say the last 40 years, more and more people are trying to use the insights of financial economics to guide their actions in the financial markets. 

The problem is that once they do that, they are no longer acting like the rational actors that financial economics assumes that they are.  Those rational actors would have used their own insights about the way that markets work to make their decisions.  That is the way that decisions were made during the past time periods that financial economists studied to prove that their theories were reasonable.  Perhaps many people in those historical periods were being informed by earlier, now discredited, financial theories. 

But now, most people who now move money in the financial markets are informed by the exact same financial theories.  That is different from the past because now we have better communications and better education systems so that these best ideas are much more ubiquitous.  So there are large groups of folks who are all using the exact methods of analysis and decision making.  Those methods often are based upon a freeze tag assumption. 

Freeze tag is the children’s game where one person is it and as he or she tags the other palyers, they all freeze. 

The Freeze tag assumption that is built into the models that everyone uses is the assumption that we are all marginal to the market.  We are assuming that while we are doing our analysis and making our choise that the entire market is frozen AND that no one else is doing the analysis or making the decisions that we are making. 

“The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.”  Avinash Persaud

Financial economics is like magic that gets less and less powerful as more and more people learn it.  Once everyone can pull a coin from behind an ear, no one is very impressed by that trick. 

So the very success and power of financial economics ability to explain and predict financial markets resulted in more and more people adopting it which led to more and more herding of financial behaviors. 

That has led to a secondary issue.  Smart traders know this.  So just as financial economics provided the point of view and formulas and tools to look at how markets should act that applied to the world without financial economics, the smartest traders are looking at the world with financial economics to make their choices of trades to make their profits.  That takes the economic markets not one but two or more steps away from the pre financial economics markets. 

Game theorists have a game that they like where a group of folks are asked to guess the value of 2/3 of the average of their guesses.  If the range of possible guesses is 1 to 100, then all guesses above 66 are impossible, so the “right” answer is 44. But if only numbers below 66 are rational guesses, then you can rationally eliminate guesses above 2/3 of that value and so on until the only logical guess is 0. 

It is the problem that Keynes talked about with beauty contests (and stock markets):

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

Every financial economics theory has a tail like that.  Think about risk free rates.  Once you tell someone that a particluar interest rate is risk free, then those who can borrow at that rate will borrow more and more and more until the borrower is no longer  riskless.  An observation that a praticular rate was a good proxy for a risk free rate can only be correct in retrospect. In any forward sense, it is highly likely to be untrue. 

Businesses are hedging based upon measures of sensitivity of certain instruments to underlying financial information, “the greeks”.  But in October 1987, we found that those sensitivities were, in fact, totally variable based upon the number of people who were relying upon those relationships. 

This is all true because of the flaw in financial economics.  It would never have happened if financial economics papers were not published but were instead only read aloud at economics conferences. 

So what can risk managers learn from this story?  (This blog is for discussing matters of interest to risk managers, so that question is applied to each and every post.)

Risk managers can learn two things:  First, we need to have models that are not  based upon freeze tag type assumptions where “no one but us” knows of the theory.  And second, we need to be careful to try to not ourselves fall into this sort of cycle by getting into a process of trying to guess what everyone else’s risk models will be telling them.


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