Archive for the ‘Growth’ category

It’s the Jobs, Stupid

March 29, 2011

Some time ago, economists noticed that people, or consumers in their terminology, are important to the economy.

What would we see if we assumed that it is not markets, or traders, or businesses, but people that was the only important factor in understanding the economy?

Here are some thoughts:

  • The Great Depression was a symptom of a problem that people had.  That problem was that there was no place in the economy for a large fraction of the population.  The introduction of the tractor and the combine harvester greatly improved the productivity of agriculture.  The flip side of productivity is a reduction in the need for laborers.  The massive unemployment of the Great Depression was not due to an irrational contraction in demand.  There was a rational contraction of jobs.
  • The efforts to stimulate economic activity during the depression failed because there was literally nothing for the vast numbers of unneeded farm workers to do.  Nothing that they had the training or the experience doing.
  • When WWII came, the war effort resulted in America becoming the factory of the Allied efforts.  Americans were trained en mass to work in the modern factories.  This changed the labor situation in the US drastically.
  • During WWII, the other large advanced economies in the world destroyed each other’s economies.  When the war was over, the American economy was able to quickly switch over to peacetime manufacturing and the global competition was busy rebuilding.  So America had a period of time to create a huge lead in its capabilities.  The manufacturing economy created great wealth and when the European and Japanese economies came back up to speed, there was more than enough for all to be wealthy.
  • Starting in the 1990’s another wave of productivity enhancement started with the internet and other electronic media.  At the same time, many of the advanced manufacturing jobs started to shift to China as it opened up to trade with the outside world.  The China wage for manufacturing was originally 10% of the American wage for manufacturing work.  India did the same for office work providing a source of office labor at 25% of the American wage.
  • In the first decade of 2000, the housing boom masked the situation.  Many people found that they had enough wealth to spend for what they wanted from the inflated values of their homes.  Many people were employed in the housing construction business, building homes that were ultimately found to be unwanted.  White collar jobs were also created by the housing boom selling houses and processing the mortgages that turned out to be so, so bad.
  • The Financial Crisis can be seen as another situation like the Great Depression.  There are no jobs for a large fraction of the population in several countries including the US.  Without jobs, because there is not enough work in those economies for their skills.
  • The unemployment problem will be not be solved by simple stimulus.  The manufacturing and construction skills of a large segment of the working age population are no longer valuable enough to support a middle class lifestyle in the advanced economies.
  • At the same time, there is a demographic issue.  Well known.  The retiring Baby Boomers may cause a major shift of spending further away from investing and into consumption.  Satisfying their needs will probably solve the short term employment issues in the economies of all of the advanced nations.  Growth of economies has been driven in part by growth of populations.  There is no model for operating a segment of the world economy with a shrinking population that is favorable to that segment.
  • The advantage that America had because of WWII has by now completely dissipated.

This related to risk and risk management because of the relationship between leverage and risk.  One of the solutions that has been a reaction to the slow growth is leverage.  And slow growth plus leverage is the recipe for disaster.  More on the relation of risk and leverage in another post.

Ponzi and Rolling Stone Risk Management

July 26, 2010

Managers of some firms just know that they do not need that risk management stuff.

They can tell because they have positive cash flow.

A firm with positive cannot possibly go out of business.  They know that.

Many young firms that are growing quickly utilize this sort of thinking to put off any development of risk management.  Because they just know that risk management would create real risk.  Risk management could put a stop to the positive cash flow.

Early in its history, insurance carriers thought that this positive risk management idea was just great.  It was so easy to keep the cashflow positive for an insurer.  Steady growth helped.  And the natural process of collecting premiums now and paying out claims later helped even more.

But then some spoilsport came along and ruined things and discovered the idea of reserves.

So the game had to shift to positive net income risk management.  As long as your net income was positive, there was no problem.  That sort of risk management created tensions between the positive net income folks and the actuary setting the reserves.  But many firms found a way around that and could set lower reserves and keep up the Ponzi Risk Management for a few more periods.

But periods of slower growth, due to economic slow downs or other issues were especially troublesome for the Ponzi Risk Management firms.  Or like its namesake, the real Ponzi scheme, Ponzi Risk Management runs into trouble as soon as the flow of new customers slows for any reason.

A variation on Ponzi RIsk Management is the Rolling Stone Risk Management.  Under Rolling Stone Risk Management, the firm keeps acquiring new smaller firms.  The chaos that exists through the transition is good to hide the waning growth and fundamental unprofitability of the Rolling Stone company.  If they can keep rolling, they gather no Loss.

But Rolling Stone risk management requires larger and larger acquisitions to be big enough to hid all of the prior sins because the backlog of problems keeps getting larger and larger.  And the compulsion to acquire means that the Rolling Stone company pays more and more for the acquisitions because those purchases are really a life and death matter for them.  They desperately need more Good Will to amortize.

But to be slightly clearer, Ponzi Risk Management is not real risk management.

The difference between Ponzi Risk Management and real Risk Management is that real Risk Management provides protection to firms that are growing and to firms that are not growing.  Real risk management means that the risk manager has taken into account the risks of the firm in both a going concern basis to help to maximize value of the firm as well as the potential risks of a stoppage of growth.  Real risk management means that the firm has made provision, not just for the profitability of most parts of the business on a stand alone, more or less static basis, they have also made sufficient provision for the risks of that business both in terms of margin to compensate the firm for the risks and to provide a cushion against the fluctuations of profitability and even the extreme loss potential of that business.

Lessons for Insurers (6)

May 25, 2010

In late 2008, the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis. This report featured nine key Lessons for Insurers. Riskviews will comment on those lessons individually…

6. Insurers must pay special attention to high growth/profit areas in their companies, as these are often the areas from which the greatest risks emanate.

All high growth areas are not risk problems, but almost all risk problems come from areas of high growth.

And high growth areas present several special problems for effective risk management.

  1. High growth in the financial services field usually results when a firm has a new product or service or territory.  There is almost always a deficit of experience and data about the riskiness of the new area.  Uncertainty rules.
  2. In new high growth areas, pricing can be far off the mark at the outset.  If the initial experience is benign, then the level of pricing can become firmly set in the minds of the distributors, the market and the management.  When adverse experience starts to undermine the pricing, it may be initially dismissed as an anomaly, a temporary loss.  It may be very difficult to determine the real situation.
  3. If risk resources were included in the plan for the high growth activity, they were probably not increased when the growth started to exceed expectations.  As growth occurs, the risk resources are most often held at the level called for in the initial plan.  Any additional resources that are applied to the growing area are needed to support the higher level of activity.  Often this is simply a natural caution about increasing expenses in what may well be a temporary situation.  This caution is often justified as growth ebbs.  But in the situations where growth does not wane, a major mismatch between risk resources and business activity develops.
  4. There is usually a political problem within the firm.  The management of the highest growth area are most likely the current corporate heroes.  It is very highly unlikely that the CRO will have as much clout within the organization as the heroes.  The only solution to this issue is support from the CEO for the importance of risk.
  5. Risk efforts need to be seen not as “business prevention” but as a partner with the business in getting it right.  This is difficult to accomplish unless risk is involved from the outset.  If the business gets going and growing with procedures that are questionable from a risk perspective, then it is quite possible that changing those procedures might well hurt the growth of the area.  Risk needs to be involved form the outset so that appropriate procedures and execution of those procedures does not become a growth issue later on.

This is the most difficult and important area for the risk management of the firm.  The business needs to be able to take chances in new areas where good growth is possible.  The Risk function needs to be able to help these new activities to have the chance to succeed.

At the same time, the organization needs to be protected from the sort of corner cutting that leads to growth through drastically under-priced risks.

It is a delicate balancing act that requires a high degree of political skill as well as good business judgment about when to dig in the heels and when to let go.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Risk and Strategy

May 17, 2010

Understanding the relationship between RISK and STRATEGY is an extremely important step in incorporating ERM into strategic decision making.

Management and the Board need to decide which of three fundamental relationships that the firm expects to persue over the near term (next several years):

  1. The Firm can GROW the business and the risks taken by the business significantly faster than the growth of capital.
  2. The Firm can MAINTAIN the relationship between the capital of the firm and the risks of the firm at the current level.
  3. The Firm can STRENGTHEN the firm by growing capital faster than the business grows.

If management and the board do not understand these three fundamental choices AND have a clear idea of which choice that the Firm is persuing, it is highly unlikely that conversations about risk and risk management will go anywhere.  In fact, what will happen is that they will spin in whirlpools of changing topics and inconsistencies.

The choice among these three ideas is not permanent.  But it should be a choice that is set down for a multi year period of time.  It should reflect management and the board’s understanding of both the level of resources of the firm as well as the opportuinities in the marketplace.

GROW –  This choice represents the understanding that there are very good opportunities in the marketplace and that the firm has excess capacity to take risks.  That excess capacity might have arisen because of some non-repeatable gains.  The underlying profitability of the business of the firm is not high enough to fund the growth of the firm for some period of time.  The firm either cannot obtain additional outside funding for the growth or else the available funding is too expensive or restrictive.  This strategy cannot be the long term strategy of the firm because the firm will grow ever more risky over time and will eventually experience a loss that will impair the firm.

MAINTAIN – This choice comes from a conclusion that the firm can fund its desired growth level by the profits of the business of the firm.  It might also mean that some of the growth will be funded from outside and that with the funding and the growth and the retained profits, the firm will be able to maintain the level of security that it has had over the recent past.  This strategy is sustainable over a long time period.

STRENGTHEN – This choice is often made after a loss event weakens the firm.  It can be accomplished by increasing profit margins or by limiting growth.  Often, increasing profit margins will limit growth.  This can also be a necessary choice after growth that has far exceeded the level that can be sustained by the earnings of the business.  It can also be a choice that is made during a period when the markets are particularly soft and the choices for profitable growth are poor.  Firms may choose to “keep their powder dry” and to increase their capacity for future growth once market opportunities improve.

The choice among these three strategies is made by every firm, either consciously or unconsciously resulting from their other choices.

A good starting point for bringing Risk into the Strategy discussions is to have a direct discussion of this choice and to find out whether it is possible to get management to clearly understand the choice that is needed at the time for the firm.

Burn out, Fade Away …or Adapt

February 27, 2010

When I was a kid in the 1960’s, I was sick and tired of how much time on TV and movies was taken up with stories of WWII.  Didn’t my parent’s generation get it?  WWII was ancient history.  It was done.  Move on.  Join the real world that was happening now.

From that statement, you can tell that I am a Boomer.  But I am already sick and tired of how much ink and TV and movies and Web time is devoted to the passing of the world as the Boomers remember the golden age of our youth.  Gag me.  Am I going to have to hear this the entire rest of my life?  Get over it.  Move on.  Live in the current world.

Risk managers need to carefully convey that message to the folks who run their companies as well.  What ever way the world was in the “Glory Days” of the CEO or Business Unit manager’s career, things are different.  Business is different.  Risks are different.  Strategies and companies must adapt.  Adapt, Burn Out or Fade Away are the choices.  Better to Adapt.

I saw this happen once before in my career.  Interest rates steadily rose from the late 1940’s through the early 1980’s.  A business strategy that emphasized amassing cash, locking in a return promise and investing it in interest bearing instruments could show a steady growth in profits almost every single year without too much difficulty.  Then suddenly in the mid-1980’s that didn’t work anymore.  Interest rates went down more than up for a decade and have since stayed low.  Firms either adapted, burned out or faded away.

We have just concluded a (thankfully) brief period of massive financial destruction and are in an uncertain period.  When we come out of this uncertainty, some of the long held strategies of firms will not work.  Risks will be different.

The risk manager needs to be one of the voices that helps to make sure that this is recognized.

In addition, the risk manager needs to recognize that one or many of the risk models that were used to assess risk in past periods will no longer work well.  The risk manager needs to stand ready to adapt or fade away.

And the models need to be calibrated to the new world, not the old.  Calibrating to include the worst of the recent past might seem like prudent risk management, but it may well not be realistic.  If the world reverts to a reasonable growth pattern, the next such event may well not happen for 75 years.  Does your firm really need to avoid exposures to the sorts of things that lost money in 2008 for 75 years?  Or would that mean forgoing most of the business opportunities of that period?

Getting the correct answers to those questions will mean the different between Growth, burn out or fading away for your firm.

You may not be able to Grow out if it

December 21, 2009

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

Growth has a way of masking problems.  Things are changing and it is often very difficult to understand whether the changes are just a lag in reporting the good things that come from healthy growth or if they are leading indicators of major problems.

The firm needs to grow risk management analysis and attention along with highest growth activities.  That needs to be demanded from the top.  No middle or even high level risk officer will ever have the authority to slow down the part of the company that is growing the best.  Firms need to have CEO commitment to extra risk analysis of the fastest growing business.

The firm needs to establish its operational capacity for handling growth.  The most common reaction to unexpected growth is to delay hiring additional staff (along with delaying adding additional risk staff as mentioned above).  After more delay and more growth, the business might seem much more profitable than expected.  Some of that excess profitability is coming from the understaffing.  Some of the profitability might be coming from mistakes in recordkeeping due to the understaffing.  A sudden delayed effort to fix the under staffing will most often hurt more than it helps in the short run.

And what is most likely to be shortchanged in an understaffed growing situation  Why it is quality control and recordkeeping.  So if there is a growing problem it is very hard to notice it.

So what to do?

Every great mistake has a halfway

moment, a split second when it can be

recalled and perhaps remedied.

Pearl Buck

Part of the process of planning for each new thing that might grow, if it is as successful as is hoped, needs to be to determine where that halfway moment might be.

No Thanks, I have enough “New”

September 24, 2009

It seems sad when 75 year old businesses go bust.  They had something that worked for several generations of managers, employees and investors.  And now they are gone.  How could that be?

There are two ways that old businesses can come to their demise.  They can do it because they stick to what they know and their product or service  (usually) slowly goes out of fashion.  Usually slowly, because all but the most ossified large successful companies can adapt enough to keep going for quite some time, even when faced by competition with a better business model/product or service.  Think of the US auto industry slowly declining for 40 years.

The second way is a quick demise. This usually happens after the old company chooses to completely embrace something completely new.  If their historic business is in decline, many large old firms are on the look out for that new transformational thing.  The mistake that they sometimes make is to be in much too much of a hurry. They want to apply their size advantage to the new thing and start getting economies of scale in addition to early adopter advantages.

The failure rate of new business is very, very high.  A big business that jumps to putting a large amount of its resources into the new business will be transforming a solid longstanding business effectively into a start-up.  But rarely do the big businesses in restart mode deliver anything like start-up returns.  So investors bare the risks of of the start-up with the returns only slightly higher than long term averages.

This is a clear example of when the CEO needs to be the risk manager.  The established firm needs to have a limit for “New” businesses.  The plan for the new business should reflect an orderly transition between the franchise business and what MAY become the new franchise.  This requires the CEO to have a time frame in mind that is appropriate for a business that may have existed before he/she was born and that, if the risks are managed well, should exist long after they are gone.

There are good underlying reasons why the “New” needs to be limited for a company with long term survival plans.  “New” involves several risks that a well established firm may have mastered a generation ago and have relegated to the corporate unconscious.

The first is execution risk.  The established firm will doubtless be excellent at execution of its franchise business.  But the “New” will doubtless require different execution.  An example of this from the insurance industry, when US Life Insurers started into the equity linked products, man of them experienced severe execution problems.  Their traditional products involved collecting cash and putting it into their general fund.  They only provided annual information to their customers if any.  Their administrative systems and procedures were set up within an environment that was not particularly time sensitive.  The money was in the right place, their accounting could catch up “whenever”.   With the new equity linked products, exacting execution was important.  Money was not left in the general fund of the insurer but needed to be transferred to the investment manager within three days of receipt.  So insurers adapted to this new world by getting to the accounting and cash transfers “whenever” but crediting the customer with the performance of their chosen equity fund within the legal 3 day limit.  This worked out fine with small timing delays creating some small gains and some small losses for the insurers.  But the extended bull market of the late 1990’s made for a repeated loss because the delay of processing and cash transfer meant that the insurer was commonly backdating to a lower purchase price for the shares than what they paid.  Some large old insurers who had jumped into this new world with both feet were losing millions to this simple execution risk.  In addition, for those who were slow to fix things, they got hit on the way down as well.  When the Internet bubble popped, there were many, many calls for customer funds to be taken out of the equity funds.  Slow processing meant that they paid out at a higher rate than what they received from their delayed transactions with the investment funds.

The insurers had a well established set of operational procedures that actually put them at a disadvantage compared to start-ups in the same business.

The second is the “unknown” risk.  A firm that has been operating for many years is often very familiar with the risks of its franchise business.  In fact, their approach to risk management for that business may well be so ingrained, that it is no longer considered a high priority.  It just happens.  And the risk management systems that have been in place may work well with little active top management attention.  These organizations are usually not very well positioned to be able to notice and prepare for the new unknown risks that the new business will have.

The third is the “Unknowable”.  For a new activity, product or business, you just cannot tell what the periodicity of loss events or the severity of those events.  That was one of the mistakes in the sub prime market  The mortgage market has about a 15 year periodicity.  Since a large percentage of people operating in the sub prime space were not in that market the last time there was a downturn, they had no personal experience with the normal cycle of losses in the mortgage market.  Then there was the unknowable impact of the new mortgage products and the drastic expansion into sub prime.  It was just unknowable what would be the periodicity and severity of losses in the “new” mortgage market.

So the point is that these things that are observed about the prior “new” things can be learned and extrapolated to future “new” things.

But the solution is not to never do anything “new”, it is to keep the “new” reasonable in proportion to the rest of the organization, to put limits on “new” just like there are limits on any other major aspect of risk.


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