Transparency with Stakeholders Builds Trust and Enhances Risk Management

Risk Culture Belief Series

When banking regulators looked around at the financial institutions that fared less poorly during the 2008 financial crisis, one of the common themes that distinguished them was their dedication to internal transparency regarding their risks and risk management activities.  The belief that “Transparency with Stakeholders Builds Trust and Enhances Risk Management” underscores the profound impact of openness on an organization’s risk management framework and its overall relationship with stakeholders.

Strategic Significance of Transparency

The executives in central roles at those firms have constant access to the best information available. Those banks tended to react faster when their aggregate level of risk looked like it was headed above their risk tolerance. 

They also seemed to get into less trouble with risk concentration caused by people in different parts of the firm unintentionally piling onto similar and likely highly correlated risks. 

Transparency is just not expected from traditional risk management activities. Insurers that want to have an effective and disciplined ERM program must have Transparency.

In addition, Transparency in risk management fosters trust, not only with regulatory bodies but also with investors, customers, and employees. It involves clear communication about the organization’s risk exposure, risk management processes, and how risks are handled. This belief says that when stakeholders are well-informed, they are more likely to trust the organization’s management and decisions. This trust, in turn, strengthens the organization’s credibility and stability in the market.

Implementing Transparency in Practice

Generally executives are aware of the firm’s risks, but until ERM comes along and forces an actual discussion of risk, there is rarely a spontaneous agreement on priorities. For effective transparency, organizations must ensure that their risk management activities are visible and comprehensible to all stakeholders. This includes regular disclosures of risk assessments, risk management strategies, and the outcomes of such strategies. In the financial sector this might mean publishing detailed risk reports that explain the potential impacts of market changes on the institution’s portfolio and how these are being mitigated.

The RISKVIEWS blog provide examples of how financial institutions that adopted comprehensive disclosure practices not only complied with stringent regulatory requirements but also enhanced investor confidence during volatile market conditions. These institutions used transparency as a tool to manage expectations and provide a clear roadmap of their risk management strategies, which helped in mitigating panic and speculative actions by stakeholders.

Cultivating a Culture of Openness

Adopting this belief requires an organizational culture that values and practices openness at every level.

For over 20 years, some companies have practiced open-book management (OBM), sharing detailed information about their financial statements and business plans. But financial statements rarely provide actionable information about risk. Therefore, even in the OBM firms, there is generally a lack of knowledge about risk. With the transparency of risk and risk management information that comes from ERM, risk communication can become a part of the “Open Book.” 

There may be a paternalist urge to protect employees from scary information about risk, but ERM provides a language for talking not just about bad things that can happen, but also about what is being done about it. By including more employees in the risk discussion, there is also an increased chance that the firm will become aware of critical changes in the risk environment and possibilities for enhancing mitigation activities to better achieve the firm objectives with less disruption from unexpected adverse events. 

From the C-suite to the operational teams, everyone must understand the importance of transparency and its role in effective risk management. Encouraging a dialogue about risks and openly discussing failures as well as successes makes the organization more agile and responsive.

Conclusion and Forward Look

Embracing transparency is indispensable in the contemporary landscape where stakeholders demand more accountability and clarity. “Transparency with Stakeholders Builds Trust and Enhances Risk Management” is a principle that not only supports compliance but also catalyzes stronger, more trusting relationships with all parties involved in the organization’s ecosystem.

In our next post, we will explore the third Risk Culture Belief: “Cross-Functional Collaboration Optimizes Risk Response.” We’ll examine how integrating diverse functional expertise within an organization can lead to more robust risk mitigation strategies, driving home the value of collaborative approaches in contemporary risk management practices.

No Reward without Risk

Is that so? Well, only if you live in a textbook. And RISKVIEWS has not actually checked whether there really are text books that are that far divorced from reality.

Actually, in the world that RISKVIEWS has inhabited for many years, there are may real possibilities, for example:

• Risk without reward
• Reward without risk
• Risk with too little Reward
• Risk with too much Reward
• Risk with just the right amount of reward

The reason why it is necessary to engage nearly everyone in the risk management process is that it is very difficult to distinguish among those and other possibilities.

Risk without reward describes many operational risks.

Reward without risk is the clear objective of every capitalist business.  Modern authors call it a persistent competitive advantage, old school name was monopoly.  Reward without risk is usually called rent by economists.

Risk with too little reward is what happens to those who come late to the party or who come without sufficient knowledge of how things work.  Think of the poker saying “look around the table and if you cannot tell who is the chump, it is you.”  If you really are the chump, then you are very lucky if your reward is positive.

Risk with too much reward happens to some first comers to a new opportunity.  They are getting some monopoly effects.  Perhaps they were able to be price setters rather than price takers, so they chose a price higher than what they eventually learned was needed to allow for their ignorance.  Think of Apple in the businesses that they created themselves.  Their margins were huge at first, and eventually came down to …

Risk with just the right amount of reward happens sometimes, but only when there is a high degree of flexibility in a market – especially no penalty for entry and exit.  Sort of the opposite of the airline industry.

No Reward Without Risk

Hierarchy Principle of Risk Management

The purpose of ERM is NOT to try to elevate all risk decisions to the highest possible level, but to master discerning the best level for making each risk decision and for getting the right information to the right person in time to make a good risk decision.

This is the Hierarchy Principle as it applies to ERM.  It is one of the two or three most important principles of ERM.  Why then, might you ask, haven’t we ever heard about it before, even from RISKVIEWS.

But most insurers follow the hierarchy principle for managing their Underwriting process for risk acceptance of their most important risks.  

You could argue that many of the most spectacular losses made by banks have been in situations where they did not follow the hierarchy principle.  

• Nick Leeson at Barings Bank was taking risks at a size that should have been decided (and rejected) by the board.
• Jerome Kerviel at Soc Gen was doing the same.
• The London Whale at JP Morgan is also said to have done that.  

On the other hand, Jon Corzine was taking outsized risks that eventually sank MF Global with the full knowledge and approval of the board.  Many people suggest that the CRO should have stopped that.  But RISKVIEWS believes that the Hierarchy Principle was satisfied.  

ERM is not and cannot be held responsible for bad decisions that are made at the very top of the firm, unless the risk function was providing flawed information that supported those decisions.  If, as happened at MF Global, the board and top management were making risk decisions with their eyes fully open and informed by the risk function, then ERM worked as it should.  

ERM does not prevent mistakes or bad judgment.

What ERM does that is new is that

1. it works to systematically determine the significance of all risk decisions, 
2. it ranks the significance and uses that information, along with other information such as risk velocity and uncertainty, to determine a recommendation of the best level to make decisions about each risk,
3. it assesses the ability of the firm to absorb losses and the potential for losses within the risks that are being held by the firm at any point in time,
4. it works with management and the board to craft a risk appetite statement that links the loss absorbing capacity of the firm with the preferences of management and the board for absorbing losses.

ERM does not manage the firm.  ERM helps management to manage the risks of the firm mainly by providing information about the risks.  

So why have we not heard about this Hierarchy Principle before?  

For many years, ERM have been fighting to get any traction, to have a voice.  The Hierarchy Principle complicates the message, so was left out by many early CROs and other pioneers.  A few were pushing for the risk function to be itself elevated as high as possible and they did not want to limit the risk message, deeming everything about risk to be of highest importance. But RISKVIEWS believes that it was mostly because the Hierarchy Principle is pretty fundamental to business management and is usually not explicitly stated anywhere else, even though it is applied almost always.

ERM now receives a major push from regulators, to a large extent from the ORSA.  In writing, the regulators do not require that ERM elevate all risk decisions.  But in practice, they are seeing some insurers who have been elevating everything and the regulators are adopting those examples as their standard for best in class.  

Just one more way that the regulatory support for ERM will speed its demise.  If regulators advocate for consistent violation of the Hierarchy principle, then ERM will be seen mainly as a wasteful burden.  

 

Deciding “What Should We Do?” in the Risk Business

Risk models can be used primarily to answer two very important questions for an enterprise whose primary activity is the risk business.

1. How did we do?
2. What should we do?

The “how did we do” question looks backwards on the past, usually for 90 days or a full year.  For answering that question properly for a firm in the risk business it is absolutely necessary to have information about the amount of risk that the firm is exposed to during that period.

The “what should we do” question looks forward on the future.  The proper time period for looking forward is the same as the length of the shadow into the future of the decision.  Most decisions that are important enough to be brought to the attention of top management or the board of a company in the risk business have a shadow that extends past one year.

That means that the standard capital model with its one year time frame should NOT be the basis for making WHAT SHOULD WE DO? decisions.  That is, unless you plan on selling the company at the end of the year.

Let’s think about it just a little bit.

Suppose the decision is to buy a laptop computer for the business use of one of the employees of an insurer.  You can use two streams of analysis for that decision.  You can assume that the only use of that computer is what utility that can be had from the computer during the calendar year of purchase and then you plan to sell the computer, along with the rest of the company, at the end of the calendar year.  The computer is valued at the end of the year at a fair market value.  Or you can project forward, the utility that you will get from that employee having a computer over its useful life, perhaps three years.

The first calculation is useful.  It tells us “HOW DID WE DO?” at the end of the calendar year.  But it not a sensible basis to make the decision about whether to buy the computer or not.  The reason for that is not because there is anything wrong with the calendar year calculation.  In theory, you could even run your company by deciding at the end of each calendar year, whether you wanted to continue running the company or not.  And then if you decide to continue, you then must decide whether to sell every laptop or not, and similarly to sell every part of your business or not.

Most companies will automatically make the decision to continue, will not consider selling every part of their company, even if they have gone through the trouble of doing a “for sale” valuation of everything.  That approach fits better with Herbert Simon’s “Satisficing” idea than with the theory of maximizing value of the enterprise.

But from a less theoretical point of view, putting absolutely everything on the table for a decision could be very time consuming.  So what most companies is to imagine a set of conditions for the future when a decision is made and then as the future unfolds, it it does not deviate significantly from those assumptions, decisions are not reopened.  But unfortunately, at many companies, this process is not an explicit conscious process.  It is more vague and ad hoc.

Moving away from laptops to risk.  For a risk decision, first notice that almost all risk decisions made by insurers will have an effect for multiple years.  But decision makers will often look forward one year at financial statement impact.  They look forward one year at a projection of the answer to the “How DID WE DO? question. This will only produce a full indication of the merit of a proposal if the forward looking parts of the statement are set to reflect the full future of the activity.

The idea of using fair value for liabilities is one attempt to put the liability values on a basis that can be used for both the “How did we do?” and the “What should we do?” decisions.

But it is unclear whether there is an equivalent adjustment that can be made to the risk capital.  To answer “How did we do?” the risk capital needed has been defined to be the capital needed right now.  But to determine “What should we do?”, the capital effect that is needed is the effect over the entire future.  There is a current year cost of capital effect that is easily calculated.

But there is also the effect of the future capital that will be tied up because of the actions taken today.

The argument is made that by using the right current year values, the decisions can really be looked at as a series of one year decisions.  But that fails to be accurate for at least two reasons:

• Friction in selling or closing out of a long term position.  The values posted, even though they are called fair value rarely reflect the true value less transaction costs that could be received or would need to be paid to close out of a position.  It is another one of those theoretical fictions like a frictionless surface.  Such values might be a good starting point for negotiating a sale, but anyone who has ever been involved in an actual transaction knows that the actual closing price is usually different.  Even the values recorded for liquid assets like common equity are not really the amounts that can be achieved at sale tomorrow for anyone’s actual holdings.  If the risk that you want to shed is traded like stocks AND your position is not material to the amounts normally traded, then you might get more or less than the recorded fair value.  However, most risk positions that are of concern are not traded in a liquid market and in fact are usually totally one of a kind risks that are expensive to evaluate.  A potential counterparty will seek through a hearty negotiation process to find your walk away price and try to get just a litle bit more than that.
• Capital Availability – the series of one year decisions idea also depends on the assumption that capital will always be available in the future at the same cost as it is currently.  That is not always the case.  In late 2008 and 2009, capital was scarce or not available.  Companies who made commitments that required future capital funding were really scrambling.  Many ended up needing to change their commitments and others who could not had to enter into unfavorable deals to raise the capital that they needed, sometimes needing to take on new partners on terms that were tilted against their existing owners.  In other time, cheap capital suddenly becomes dear.  That happened when letters of credit that had been used to fulfill offshore reinsurer collateral requirements suddenly counted when determining bank capital which resulted in a 300% increase in cost.

RISKVIEWS says that the one year decision model is also just a bad idea because it makes no sense for a business that does only multi year transactions to pretend that they are in a one year business.  It is a part of the general thrust in financial reporting and risk management to try to treat everything like a bank trading desk.  And also part of a movement led by CFOs of the largest international insurers to seek to only have one set of numbers used for all financial decision-making.  The trading desk approach gave a theoretical basis for a one set of numbers financial statement.  However, like much of financial economics, the theory ignores a number of major practicalities.  That is, it doesn’t work in the real world at all times.

So RISKVIEWS proposes  that the solution is to acknowledge that the two decisions require different information.

Free Download of Valuation and Common Sense Book

RISKVIEWS recently got the material below in an email.  This material seems quite educational and also somewhat amusing.  The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.  

For example, the table following shows a plot of Required Equity Premium by publication date of book. 

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice. 

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic.  See post Friedman Model.

===========================================

Book “Valuation and Common Sense” (3rd edition).  May be downloaded for free

The book has been improved in its 3rd edition. Main changes are:

1. Tables (with all calculations) and figures are available in excel format in: http://web.iese.edu/PabloFernandez/Book_VaCS/valuation%20CaCS.html
2. We have added questions at the end of each chapter.
3. 5 new chapters:

Chapters	Downloadable at:
32 Shareholder Value Creation: A Definition	http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010	http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation	http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return	http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance	http://ssrn.com/abstract=2357432

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:

Chapters	Downloadable at:
Table of contents, acknowledgments, glossary	http://ssrn.com/abstract=2209089
1  Company Valuation Methods	http://ssrn.com/abstract=274973
2  Cash Flow is a Fact. Net Income is Just an Opinion	http://ssrn.com/abstract=330540
3  Ten Badly Explained Topics in Most Corporate Finance Books	http://ssrn.com/abstract=2044576
4  Cash Flow Valuation Methods: Perpetuities, Constant Growth and General Case	http://ssrn.com/abstract=743229
5   Valuation Using Multiples: How Do Analysts Reach Their Conclusions?	http://ssrn.com/abstract=274972
6   Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories	http://ssrn.com/abstract=256987
7   Three Residual Income Valuation Methods and Discounted Cash Flow Valuation	http://ssrn.com/abstract=296945
8   WACC: Definition, Misconceptions and Errors	http://ssrn.com/abstract=1620871
9  Cash Flow Discounting: Fundamental Relationships and Unnecessary Complications	http://ssrn.com/abstract=2117765
10 How to Value a Seasonal Company Discounting Cash Flows	http://ssrn.com/abstract=406220
11 Optimal Capital Structure: Problems with the Harvard and Damodaran Approaches	http://ssrn.com/abstract=270833
12 Equity Premium: Historical, Expected, Required and Implied	http://ssrn.com/abstract=933070
13 The Equity Premium in 150 Textbooks	http://ssrn.com/abstract=1473225
14 Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers	http://ssrn.com/abstract=2084213
15 Are Calculated Betas Good for Anything?	http://ssrn.com/abstract=504565
16 Beta = 1 Does a Better Job than Calculated Betas	http://ssrn.com/abstract=1406923
17 Betas Used by Professors: A Survey with 2,500 Answers	http://ssrn.com/abstract=1407464
18 On the Instability of Betas: The Case of Spain	http://ssrn.com/abstract=510146
19 Valuation of the Shares after an Expropriation: The Case of ElectraBul	http://ssrn.com/abstract=2191044
20 A solution to Valuation of the Shares after an Expropriation: The Case of ElectraBul	http://ssrn.com/abstract=2217604
21 Valuation of an Expropriated Company: The Case of YPF and Repsol in Argentina	http://ssrn.com/abstract=2176728
22 1,959 valuations of the YPF shares expropriated to Repsol	http://ssrn.com/abstract=2226321
23 Internet Valuations: The Case of Terra-Lycos	http://ssrn.com/abstract=265608
24 Valuation of Internet-related companies	http://ssrn.com/abstract=265609
25 Valuation of Brands and Intellectual Capital	http://ssrn.com/abstract=270688
26 Interest rates and company valuation	http://ssrn.com/abstract=2215926
27 Price to Earnings ratio, Value to Book ratio and Growth	http://ssrn.com/abstract=2212373
28 Dividends and Share Repurchases	http://ssrn.com/abstract=2215739
29 How Inflation destroys Value	http://ssrn.com/abstract=2215796
30 Valuing Real Options: Frequently Made Errors	http://ssrn.com/abstract=274855
31 119 Common Errors in Company Valuations	http://ssrn.com/abstract=1025424
32 Shareholder Value Creation: A Definition	http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010	http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation	http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return	http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance	http://ssrn.com/abstract=2357432

I would very much appreciate any of your suggestions for improving the book.

Best regards,
Pablo Fernandez

The Risk of Paying too much Attention to your Experience

The Drift into Failure idea from the Safety Engineers is quite valuable.

One way that DIF occurs is when an organization listens too well to the feedback that they get from their safety system.

That is right, too much attention.  In the case of a remote risk, the feedback that you will get most days, most weeks, most months is NOTHING HAPPENS.

That is the feedback you are likely to get if you have a good loss prevention system or if you have none.

This ties to the DIF idea because organizations are always under pressure to do more with less.  To streamline and reduce costs.

So what happens?  In Safety and Risk Management, someone studies the risks of a situations and designs a risk mitigation system that reduces the frequency or severity of problem situations to an acceptable level.

Then, at some future time, the company management looks to reduce costs and/or staff.  This particular risk mitigation system looks like a prime candidate.  The company is spending time and money and there has never been a problem.  Doubtless, the same “nothing” could be achieved with less.  So the budget is cut, a position is elimated and they get by with less mitigation.

Then time pass and they collect the feedback, the experience with the reduced risk mitigation process.  And the experience tells them that they still have no problems.  The budget cutters are vindicated.  Things seem to be just fine with a less costly program.

If the risk here is highly remote, then this process might happen several times.

Which may eventually result in a very bad situation if the remote adverse event finally happens.  The company will be inadequately unprepared.  And no one made a clear decision to dilute the defense to an ineffective level.  They just kept making small decisions and eventually they drifted into failure.

And each step was validated by their experience.

On Thin Ice

Most people who know that they are walking on thin ice will proceed very slowly and carefully.

That is also the effect that we get when we fail to recognize losses. Everyone HOPES that things will turn out ok and either the losses will eventually emerge at a lower value (i.e. less loss) than expected or that while we defer recognition, other earnings will make up for the losses.

Loss recognition is an important step in getting off of the thin ice.  Firms need to have a disciplined loss recognition process so that they can avoid getting into the thin ice situation. 

One important concept in risk management was stated by Nassim Taleb in his “Black Swan Free World” piece – that failures should be frequent and small.  That principles applies to losses as well.  A good risk management program should encourage small and frequent losses. 

A firm that rarely recognizes losses is either (a) not taking any real amount of risk or (b) failing to recognize the losses that it has.

Not a moment too soon

“At first glance, Homo sapiens is an unlikely contestant for taking over the world.”  Gerd Gigerenzer

Evolutionary biologists have identified that one of H. sapiens original competitive strengths was the ability to run for very long periods of time, chasing their prey to exhaustion.  Not a particularly powerful weapon.  For my money, in the primitive world, I would have choosen large teeth and blinding speed any day.

But that was not mankind’s only advantage.  Humans eventually found that we could use tools.  And best of all, man was one of the best on the planet (among larger life forms at least) in adapting.  In “Rationality for Mortals”, Gigerenzer calls the approach that humans used the “fast and frugal heuristic”.  With that approach, humans developed ways to best use both man’s limited natural and constantly growing artificial toolset adapting to the environment.  A heuristic is an approach to problem solving with partial information.

Gigenzer gives an example of a heuristic used by a baseball outfielder catching a fly ball.  You will see that in most cases that outfielder will catch the ball on the run.  That is because the natural heuristic is for the outfielder to keep moving and to make small adjustments to their position until they and the ball are in the same location.  Binocular vision does not necessarily give enough information soon enough to position properly.  But successive observations provided by moving approximates a much wider set of eyes.  The heuristic uses a skill that the human brain already has – the ability to process multiple images of the same object to develop a three dimensional view of the world.

Flash forward 10,000 years.  Zoom down into the world of insurance and pensions and you will find a conflict for the role of key decision maker.  On the one hand is the management (or in general insurance the underwriter), who is the product of tens of thousands of years of advances in the “fast and frugal heuristic” regarding the financial risks that insurers and pension plans have been running more or less profitably for a few hundred years.  Their ability to make judgments in this arena is honed by decades of experience avoiding the necessity to run down their prey for days until it dies of exhaustion.  Some of these heuristics can be readily explained to colleagues in the business decision making process, but some can not be put into words any better than a baseball player can explain exactly how they are able to hit a 95 mile per hour fastball.  Those heuristics are called “Gut instinct”.

In the other corner of this conflict are the actuaries.  Actuaries represent one of the most highly evolved specimens of scientific man.  Actuaries are trained to build sometimes excruciatingly complex models of small bits of the world to inform their decision making.  These actuarial models are fundamentally statistical in nature.  They rely upon a number of statistical laws for their power, such as the lay of large numbers and Bayes law.

There is a constant push and pull between the actuarial model builders and the heuristic weilders for the major decisions of the firm.  And since actuaries do not always win, there is a feeling of oppression.  There are jokes about the actuarial approach by the followers of the heuristic approach.

But in fact, the two approaches are closer than one might think from first (or even repeated) exposure to the issue.  Both approaches have at their core a Baysean view of how to get to the right decision.  That approach is to constantly update your decision making engine with new experiences.

The heuristic decision makers may cast a wider net for the information that they bring into their heuristic.  The modelers are usually limited to specifically quantifiable information that can be put into the model.  Since the heuristic group does not have a quantitative model, they do not have that constraint.  However, they have the disadvantage that they do not necessarily have a systematic way to incorporate new information.  The heruistic forming process is not necessarily a fully conscious process.  In fact, explanations of heuristics are usually post hoc, not really a part of the development process.

That flaw does not make heuristics something to sneer at.  Humans came to take over the world primarily because of this ability to create and update powerful heuristics.

The actuarial, statistical, quant approach to risk management and decision making is a development out of the scientific revolution.

Part of the scientific revolution was an effort to drive heuristics out of the position that they held in the area of major human decision making.  They did such a good job that it is often difficult for us modern people to even understand the pre-scientific revolution thinking processes and discussions.

We now favor evidence based logical reasoning.  Heuristics are often formed without any clear reasoning.  They just work.  But that heuristic thinking is also what we now call “judgment” that we are now trying to leven our quant approach to models with.   We say that without even noticing that this is a movement against the grain of several hundred years of scientific progress.

And not a moment too soon.

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…..

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“.