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.

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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

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Getting Paid for Risk Taking

Consideration for accepting a risk needs to be at a level that will sustain the business and produce a return that is satisfactory to investors.

Investors usually want additional return for extra risk.  This is one of the most misunderstood ideas in investing.

“In an efficient market, investors realize above-average returns only by taking above-average risks.  Risky stocks have high returns, on average, and safe stocks do not.”

Baker, M. Bradley, B. Wurgler, J.  Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly

But their study found that stocks in the top quintile of trailing volatility had real return of -90% vs. a real return of 1000% for the stocks in the bottom quintile.

But the thinking is wrong.  Excess risk does not produce excess return.  The cause and effect are wrong in the conventional wisdom.  The original statement of this principle may have been

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Marshal has it right.  There are only “hopes” of great gains.  These is no invisible hand that forces higher risks to return higher gains.  Some of the higher risk investment choices are simply bad choices.

Insurers opportunity to make “great gains” out of “risks of great losses” is when they are determining what consideration, or price, that they will require to accept a risk.  Most insurers operate in competitive markets that are not completely efficient.  Individual insurers do not usually set the price in the market, but there is a range of prices at which insurance is purchased in any time period.  Certainly the process that an insurer uses to determine the price that makes a risk acceptable to accept is a primary determinant in the profits of the insurer.  If that price contains a sufficient load for the extreme risks that might threaten the existence of the insurer, then over time, the insurer has the ability to hold and maintain sufficient resources to survive some large loss situations.

One common goal conflict that leads to problems with pricing is the conflict between sales and profits.  In insurance as in many businesses, it is quite easy to increase sales by lowering prices.  In most businesses, it is very difficult to keep up that strategy for very long as the realization of lower profits or losses from inadequate prices is quickly realized.  In insurance, the the premiums are paid in advance, sometimes many years in advance of when the insurer must provide the promised insurance benefits.  If provisioning is tilted towards the point of view that supports the consideration, the pricing deficiencies will not be apparent for years.  So insurance is particularly susceptible to the tension between volume of business and margins for risk and profits,
and since sales is a more fundamental need than profits, the margins often suffer.
As just mentioned, insurers simply do not know for certain what the actual cost of providing an insurance benefit will be.  Not with the degree of certainty that businesses in other sectors can know their cost of goods sold.  The appropriateness of pricing will often be validated in the market.  Follow-the-leader pricing can lead a herd of insurers over the cliff.  The whole sector can get pricing wrong for a time.  Until, sometimes years later, the benefits are collected and their true cost is know.

“A decade of short sighted price slashing led to industry losses of nearly $3 billion last year.”  Wall Street Journal June 24, 2002

Pricing can also go wrong on an individual case level.  The “Winners Curse”  sends business to the insurer who most underimagines riskiness of a particular risk.

There are two steps to reflecting risk in pricing.  The first step is to capture the expected loss properly.  Most of the discussion above relates to this step and the major part of pricing risk comes from the possibility of missing that step as has already been discussed.  But the second step is to appropriately reflect all aspects of the risk that the actual losses will be different from expected.  There are many ways that such deviations can manifest.

The following is a partial listing of the risks that might be examined:

• Type A Risk—Short-Term Volatility of cash flows in 1 year

• Type B Risk—Short -Term Tail Risk of cash flows in 1 year
• Type C Risk—Uncertainty Risk (also known as parameter risk)
• Type D Risk—Inexperience Risk relative to full multiple market cycles
• Type E Risk—Correlation to a top 10
• Type F Risk—Market value volatility in 1 year
• Type G Risk—Execution Risk regarding difficulty of controlling operational
losses
• Type H Risk—Long-Term Volatility of cash flows over 5 or more years
• Type J Risk—Long-Term Tail Risk of cash flows over 5 years or more
• Type K Risk—Pricing Risk (cycle risk)
• Type L Risk—Market Liquidity Risk
• Type M Risk—Instability Risk regarding the degree that the risk parameters are
stable

See “Risk and Light” or “The Law of Risk and Light“

There are also many different ways that risk loads are specifically applied to insurance pricing.  Three examples are:

• Capital Allocation – Capital is allocated to a product (based upon the provisioning) and the pricing then needs to reflect the cost of holding the capital.  The cost of holding capital may be calculated as the difference between the risk free rate (after tax) and the hurdle rate for the insurer.  Some firms alternately use the difference between the investment return on the assets backing surplus (after tax) and the hurdle rate.  This process assures that the pricing will support achieving the hurdle rate on the capital that the insurer needs to hold for the risks of the business.  It does not reflect any margin for the volatility in earnings that the risks assumed might create, nor does it necessarily include any recognition of parameter risk or general uncertainty.
• Provision for Adverse Deviation – Each assumption is adjusted to provide for worse experience than the mean or median loss.  The amount of stress may be at a predetermined confidence interval (Such as 65%, 80% or 90%).  Higher confidence intervals would be used for assumptions with higher degree of parameter risk.  Similarly, some companies use a multiple (or fraction) of the standard deviation of the loss distribution as the provision.  More commonly, the degree of adversity is set based upon historical provisions or upon judgement of the person setting the price.  Provision for Adverse Deviation usually does not reflect anything specific for extra risk of insolvency.
• Risk Adjusted Profit Target – Using either or both of the above techniques, a profit target is determined and then that target is translated into a percentage of premium of assets to make for a simple risk charge when constructing a price indication.

The consequences of failing to recognize as aspect of risk in pricing will likely be that the firm will accumulate larger than expected concentrations of business with higher amounts of that risk aspect.  See “Risk and Light” or “The Law of Risk and Light“.

To get Consideration right you need to (1)regularly get a second opinion on price adequacy either from the market or from a reliable experienced person; (2) constantly update your view of your risks in the light of emerging experience and market feedback; and (3) recognize that high sales is a possible market signal of underpricing.

This is one of the seven ERM Principles for Insurers

Risk and Reward

Successful Businesses pay attention to risk.

– How much risk to take compared to their capacity to absorb risk via their level of average earnings and their capital position.  They have a basket.  Each basket is different.  It can easily hold so much.  Sometimes, you decide to put a little more in the basket, sometimes a little less.  They should know when they have stacked their risk far over the top of the basket.
– What kinds of risk to take.  They have a plan for how much of each major class of risk they they will pick up to use up the capacity of their basket.

– Then when the actually go to fill the basket, they need to carefully choose each and every risk that they put into the basket.

–  And as long as they have those risks in the basket, they need to pay attention and make sure that none of the risks are spoiling themselves and especially that they are not spoiling the entire basket of fruit or ruining the basket itself.

But that is not what a successful business is all about.  They are not in business to be careful with their basket of risks.  They are in business to make sure that their basket makes a profit.

+ So how much risk to take is informed by the level of profit to be had for risk in the marketplace.  Some business managers do it backwards.  If they are not being paid much for risk, they fill up the basket higher and higher.  That is what many did just prior to the financial crisis.  In insurance terms, they grew rapidly at the peak of the soft market.  Just prior to the cirsis, risk margins for most financial market risks were at cyclical lows.  What makes sense for a business that wants to get the best reward for the risk taken would be to take the most risk when the reward for risk is the highest.  Few do that.  However, the problem faced by firms whose primary business is risk taking is that taking less risk in times of low reward for risk creates even more pressure on their income because of decreased expense coverage.  This problem seems to indicate that businesses in such cyclical markets should be very careful to manage their level of fixed expenses.

+ What types of risk to take is also informed very much by the margins.  But it also needs to be informed by diversification principles.  Short term thinking suggests that risk taking shift all to the particular risk with the immediate best risk adjusted margin.  Long term thinking suggests something very different.  Long term thinking realizes that the business needs to have alternatives.  For most markets, the alternatives are only maintained if a presence in multiple risks is maintained in good times and bad.  Risk and reward needs to develop a balance between short term and long term.  To allow for exploiting particularly rich markets while maintaining discipline in other markets.

+ Which specific risks to select needs to incorporate a clear view of actual profitability.  It is very easy on a spreadsheet to take your sales projection and profit projections and multiply both numbers by two.  However, it is only through careful selection of individual risks that something even remotely like that simple minded projection can be achieved.  The profit opportunity from each risk for the additional sales may be at the same rate as the original margins, it may be higher (unlikely) and it may well be lower.  The risk reward system needs to be sensitive to all of these three possibilities and ready to react accordingly.

Do we always underprice tail risk?

What in the world might underpricing mean when referring to a true tail risk? Adequacy of pricing assumes that someone actually can know the correct price.

But imagine something that has a true likelihood of 5% in any one period.  Now imagine 100 periods of randomly generated results.

Then for each of three 100 period trials look at 20 year periods. The tables below show the frequency table for the 80 observation periods.

20 Year Observed Frequency	Out of 80
0	45
5%	24
10%	12
15%	0
20%	0
20 Year Observed Frequency	Out of 80
0	9
5%	28
10%	24
15%	8
20%	7
20 Year Observed Frequency	Our of 80
0	50
5%	11
10%	20
15%	0
20%	0

if the “tail risks” are 1/20 events and you do not have any information other than observations of experience, then this is the sort of result you will get. The observed frequency will jump around.

If that is the situation, how would anyone get the price “correct”?

But suppose that you then set a price for this tail risk. Let’s just say you picked 15% because that is what your competitor is doing.

And you have a very patient set of investors. They will judge you by 5 year results. So then we plot the 5 year results.

And you see that my profits are quite a wild ride.

Now in the insurance sector, what seems to happen is that when there are runs of good results people tend to cut rates to pick up market share. And when the profits run to losses, people tend to raise rates to make up for losses.

So again we are stymied from knowing what is the correct rate since the market goes up and down with a lag to experience.

Is the result a tendency to underprice?  You be the judge.

Rents vs. Risk and Reward

Many people talk and write as if risk and reward were the true trade-offs in a capitalist system.  It certainly makes risk management important if that were true.

But unfortunately for us risk managers, and fortunately for business managers, choosing among risky alternatives is not the best choice for business success.

In fact, the natural tendency of capitalism is directly away from risk and towards Competitive Advantage.  If a business can find a competitive advantage, their first choice forever after is to strengthen that advantage and to reduce their risk.

A business with a total competitive advantage, also called a monopoly, is crazy to then take any risk.  Economists call their income a rent.  The income from risk taking is called a risk premium.  All businesses prefer rents to risk premiums under that definition.

So the risk managers who talk all of the time about the risk and reward continuum and about the efficient frontier of risk taking are talking nonsense to any business person who knows the story of any of the most successful businesses.  The most successful businesses all made fortunes for their founders by collecting rents.

What we should be talking about is the Rent / Risk continuum.  If you want to be really successful, you need to find a way to collect rents.  If you want to get mediocre returns, then you can go out and take risks.

Many years ago, Riskviews was producing risk reports for return on risk capital for an insurer.  The insurer had some fee for service business.  This business did not fit into the risk reward framework.

Investment Banks had at one time been mostly fee for services businesses.  Then for a time, they decided that they could make more money taking risks.  It turns out that they were largely wrong.  The “profits” that they were recording on their risk taking were risk premiums for taking very large risks that were “in the dark“.  According to Taleb, they were being massively underpaid for those large but infrequent risks.

Some reinsurers that make their business taking on large amounts of catastrophe risks can be shown to be taking a significant amount of their value from the “default put” that is created because they collect premiums for all expected claims under their reinsurance contracts, but they do not intend to pay off on the largest catastrophes because they will have defaulted.

Risk taking is a questionable way to make profits.

So risk managers need to work to identify rents and properly reflect the superior place that rents should have in business goals.  Risk managers should be slow to claim that any risk taking behavior will make a profit and not just mistaken accounting of risks that are waiting in the dark and growing stronger to take back all of the so called profits from risk taking.

When is a Risk Premium Earned?

This is a difficult question.  One that challenges our accounting systems.

Think of two insurance contracts.  One lasts for one minute, the other for an hour.  They are both sold for residents of Antartica.  They cover the risk of being hit with a snowball.  On the average, residents of Antarctica are hit with a snowball 3 times per day.  The contracts pay out $10 every time the insured is hit with a snowball.  Premiums are $5 for the one hour policy and $0.10 for the one minute policy. The policies are renewable.

On Antarctica it is the custom of insurers to publish quarterly financials, that is every quarter hour.

Right now, there are 4 people on Antarctica and two of them have policies.  One bought the one minute policy and the other bought the one hour policy.

After the first quarter hour, there have been no claims.  What are the profits from the two policies?

The answers are completely different depending upon whether you decide to look at earning risk premium over the maximum holding period for the policies or the minimum holding period.

Our accounting systems tend to take the minimum holding period approach.  However, the maximum holding period approach might give a more useful answer.

The maximum holding period approach would be to think of the risk over the effectively infinite maximum holding period.  To determine profits, look forward and consider the amount needed for future losses.  You expect to have lumpy losses that average to a certain level.  The maximum holding period approach would then tend to reflect the excess over the expected losses as the profits in a period as profits and allow a build up of reserves to take care of the lumpy losses.

The minimum holding period approach suggests that at the end of the minimum holding period, you are done and reflect any revenue not needed to pay losses as profits.

So if no snowballs were thrown that quarter hour, all premiums (less expenses, which are very high for insurers operating in Antarctica) as profits.  If during any quarter hour there are snowballs, then there will be losses.  Very lumpy results.

This is not just an insurance consideration, it applied to any risks, such as credit or any far out of the money derivatives where losses are not expected in every period.

The minimum holding period approach will tend to encourage risk taking.  The maximum holding period approach would tend to make risk takers realize that they do expect losses sometimes.

Then if someone wants to recognize all of their profits from exposure to an infrequent risk during no loss periods, they would need to totally exit that position.

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The following chart is referenced in the comment from Robert Arvanitis…

Eggs and Baskets

Andrew Carnegie once famously said

“put all your eggs in one basket. and then watch that basket”

It seems impossible on first thought to think of that as a view consistent with risk management.  But Carnegie was phenomenally successful.  Is it possible that he did that flaunting risk management?

Garry Kasparov – World Chess Champ (22 years) put it this way…

“You have to rely on your intuition.  My intuition was wrong very few times.”

George Soros has said that he actually gets an ache in his back when the market is about to turn, indicating that he needs to abruptly change his strategy.

Soros, Kasparov, Carnegie are not your run of the mill punters.  They each had successful runs for many years.

My theory of their success is that the intuition of Kasparov actually does take into account much more than the long hard careful consideration of a middling chess master.  Carnegie and Soros also knew much more about their markets than any other person alive in their time.

While they may not have consciously been following the rules, they were actually incorporating all of the drivers of those rules into their decisions.  Most of those rules are actually “heuristics” or shortcuts that work as long as things are what they have been but are not of much use when things are changing.  In fact, those rules may be what is getting one into trouble during shifts in the world.

Risk models embody an implicit set of rules about how the market work.  Those models fail when the market fails to conform to the rules embedded in the model.  That is when things change, when your thinking needs to transcend the heuristics.

So where does that leave the risk manager?

The insights of the ultra successful types that are cited above can be seen to refute the risk management approach, OR they can be seen as a goal for risk managers.

The basket that Carnegie was putting all of his eggs into was steel.  His insight about steel was correct, but his statement about eggs and baskets is not particularly applicable to situations less transformational than steel.  It is the logic that many applied during the dot com boom, much to their regret in 2001/2002.

The risk manager should look at statements and positions like those above as levels of understanding to strive for.  If the risk managers work starts and remains a gigantic mass of data and risk positions without ever reaching any insights about the underlying nature of the risks that are at play, then something is missing.

Perhaps the business that the risk manager works for is one that by choice and risk tolerance insists on plodding about the middle of the pack in risk.

But the way that the risk manager can add the most value is when they are able to provide the insights about the baskets that can handle more eggs.  And can start to have intuitions about risks that are reliable and perhaps are accompanied by unmistakable physical side effects.

Hierarchy of Corporate Needs and ERM

In psychology 101 class you heard about Maslow’s hierarchy of needs, They are:

1. Physiological Needs
2. Safety Needs
3. Belonging
4. Eswteem
5. Self-Actualization

Corporations have needs as well.  The needs of firms is similar to the needs of the people in the firms.

Hierarchy of Corporate Needs

• Sales

• Profits

• Security

• Growth of Value

The ERM process can help companies to satisfy these needs.  In ways that no other business management process will. This is true for all businesses, but it is particularly true for financial services businesses like insurance and banking where every transaction can have a significant element of risk for the firm.

Sales

• For a business to exist, it must have something that it can sell to some market.
• ERM is usually thought of as “the Sales Prevention Department”.  But ERM can be instrumental in planning the sales process.  But let’s come back to that after discussing the other corporate needs.

Profits

• Once a firm has mastered the ability to produce or otherwise provide something that some market will buy, they need to figure out how to deliver that product or service at a cost lower than the price that the market will pay.  This is a combination of managing costs and convincing the market of the price that the product/service is worth.
• In businesses like insurance or banking, the fundamental transactions of the business involve risk taking in a way that is different from most other businesses.  Making a profit ultimately means getting the price right for risk and properly managing the risk so that it rarely gets out of hand.
• That is the prime territory for ERM – evaluating and managing risks.  So to satisfy this second need of corporations, at least for the corporations in the risk business,  ERM is needed.
• Without ERM, profits are hit or miss for firms in the risk business.

Security

• Once a business has a product that they can reliably sell to a market and has figured out a way to reliably deliver that product at a profit, then that business has value.  And the third need becomes important; Security.
• This is the case not just for companies in the risk business,  but for all types of firms.  Once they get used to making money, there is a strong need to keep that happening.
• But there are many, many things that can go wrong and put an end to that profitable business.  As a general class, we call those things RISKS.
• So risk management is applied by firms to deal with those things that might go wrong and end the stream of profits – separately, risk by risk as management becomes aware of those risks.
• Enterprise Risk Management provides a different approach, and one that should appeal to those who are fundamentally interested in the security of the firm.  While risk management seeks to prevent outsized losses from one cause or another, ERM seeks to manage outsized losses from ANY and ALL sources.

Growth of Value

• Once a business has Sales, Profits and Security the focus shifts.  And it shifts to growing the value of the firm.
• Some firms focus on growing their value by making more of the sales that they mastered at the outset of their existence.  Others seek to grow value by increasing their efficiency and increasing the profitability of their business.  A few are able to focus on both at the same time.
• However, the value of the firm, by some reckonings is the present value of future earnings.  Those future earnings can be higher because sales grow or because profits per unit grow.  But that future will be discounted by the market.  Discounted for both risk and for time.
• Since Risk is a major component to value, growing value means managing risk.  SO we are again back to ERM.  ERM helps management to see the trade-offs, the risk reward trade-offs, that will influence value.

Sales

• And so, back to sales.  What you find when you look to manage value with ERM is that it helps you to see the value of sales.  And what you see will be that different sales have a different impact on the value of the firm.
• So ERM can halp to guide the sales planning process, shedding light on which sales to plan to grow the most and which to limit.

So ERM can play a major role in the achievement of all four of the main Corporate Needs.

Around the Corner Risk

That is where the risk manager really earns their money.

The risks that are coming straight down the road, well that is important to pay attention to them.  But those are the obvious risks.  I would not pay very much for help in avoiding serious accidents from those risks.

But those round the corner risks, that would be very valuable, to have someone who can help to make sure that those out of sight risks do not ruin things.

However, what any risk manager who has tried to focus attention on the Around the Corner Risks has learned is that attending to such risks is often seen as spoiling the game.

In the Black Swan, Nassim Taleb talks about the degree to which businesses are in effect selling out of the money puts and pocketing the risk premium as if it is pure profits.

And that is often the case.  Risk managers should extend their view to include analysis of the actual source of profits of the various endeavors of their firms.  Any place where the profits are larger than can be explained is a place where the firm might well be getting paid for selling those puts.

The risk manager needs to be able to take that analysis of sources of profits back to top management to have a frank discussion of those unexplained sources of profits.

In most cases, those situations are risks to the firm, either because they represent risk premium for out of the money puts or because they represent temporary inefficiencies.  The risk from the temporary inefficiencies is that if management mistakenly assumes that those inefficiencies are permanent, then the firm may over-invest in that activity.  That over-investment may then eventually lead to the creation of those our of the money puts as a way to sustain profits when the inefficiencies are extinguished by the market.

An example of this situation is the Variable Annuity market in the US.  In the early 1990’s firms were able to achieve good profits from this business largely because there were too few companies in the market.  Every market participant could show good profits and growth in this new market without resorting to price competition.  This situation attracted many additional insurers into the market, flattening the profitability.  The next phase in the market was to offer additional benefits to customers at prices below market cost.  These additional benefits were in the form of out of the money puts – guarantees against adverse experience of the investments underlying the product.  And the risk premium charged for these benefits was often booked as a profit.

One of the reasons for the confusion between risk premium and profit is the way in which we recognize profits on risks where the period of the risk occurrence is much longer than the period for financial reporting.

The analysis of source of profits can be a powerful tool to help risk managers to both see those around the corner risks and to communicate the possible around the corner risks before them become immanent.

Risk Adjusted Performance Measures

By Jean-Pierre Berliet

Design weaknesses are an important source of resistance to ERM implementation. Some are subtle and thus often remain unrecognized. Seasoned business executives recognize readily, however, that decision signals from ERM can be misleading in particular situations in which these design weaknesses can have a significant impact. This generates much organizational heat and can create a highly dysfunctional decision environment.

Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM frameworks were shown to produce credible and useful risk adjusted performance measures

Risk adjusted performance measures (RAPM) such as RAROC (Risk Adjusted Return On Capital), first developed in banking institutions, or Risk Adjusted Economic Value Added (RAEVA) have been heralded as significant breakthroughs in performance measurement for insurance companies. They were seen as offering a way for risk bearing enterprises to relate financial performance to capital consumption in relation to risks assumed and thus to value creation.

Many insurance companies have attempted to establish RAROC/RAEVA performance measurement frameworks to assess their economic performance and develop value enhancing business and risk management strategies. A number of leading companies, mostly in Europe where regulators are demanding it, have continued to invest in refining and using these frameworks. Even those that have persevered, however, understand that framework weaknesses create management challenges that cannot be ignored.

Experienced executives recognize that the attribution of capital to business units or lines provides a necessary foundation for aligning the perspectives of policyholders and shareholders.

Many company executives recognize, however, that i) risk adjusted performance measures can be highly sensitive to methodologies that determine the attribution of income and capital and ii) earnings reported for a period do not adequately represent changes in the value of insurance businesses. As a result, these senior executives believe that decision signals provided by risk adjusted performance measures need to be evaluated with great caution, lest they might mislead. Except for Return on Embedded Value measures that are comparatively more challenging to develop and validate than RAROC/RAEVA measures, risk adjusted performance measures are not typically capable of relating financial performance to return on value considerations that are of critical importance to shareholders.

To provide information that is credible and useful to management and shareholders, insurance companies need to establish risk adjusted performance measures based on:

• A ( paid up or economic) capital attribution method, with explicit allowance for deviations in special situations, that is approved by Directors
• Period income measures aligned with pricing and expense decisions, with explicit separation of in-force/run-off, renewals, and new business
• Supplemental statements relating period or projected economic performance/ changes in value to the value of the underlying business.
• Reconciliation of risk adjusted performance metrics to reported financial results under accounting principles used in their jurisdictions (GAAP, IFRS, etc.)
• Establishment and maintenance of appropriate controls, formally certified by management, reviewed and approved by the Audit Committee of the Board of Directors.

In many instances, limitations and weaknesses in performance measures create serious differences of view between a company’s central ERM staff and business executives.

Capital attribution

The Most Successful Financial System the World has Ever Known

Chris Whalen in his June 1 Commentary for RiskCenter reproduces an excerpt from a piece by Peter Wallison.  In that, Peter makes the statement that

“the United States is well on its way to taking down the most innovative and successful financial system the world has ever known.”

And I want to react to the conclusion that he starts with that the financial system is “the most successful”. 

There are two issues that I have with that conclusion. 

1. The main evidence of success of the financial system is that it has been successful in collecting a major share of the US economy’s profits.  In 1980, the share of the financial sector of total US corporate profits was under 10%.  In the 30 years before that time, the sector had averaged about 12% of profits.  From 1980 to 2006, the financial sector was extremely succesful.  Its share of total US profits grew to over 40%.  A more than four fold leap in share. 
2. The destruction of value in 2008 in both the financial sector and in the “real economy” was enormous.  In the financial sector, that destruction amounted to over 10 years of profits. 

So first I would question whether the “success” of the financial sector is first of all real?  Shouldn’t we take into account both the losses and the gains when determining success? 

And second, I would question whether even just looking at the “up side” experiences prior to the financial crisis, whether the financial sector success was of any benefit to the economy as a whole, or just to the bankers.  (and many have commented that the bankers did much better than the owners of banks, since the owners had both upside and downside exposures, while the bankers had mostly upside exposures.)

When we decide what sort of regulations that should be applied to the banks, we have concentrated upon the second item above.  The bankers have been concentrating on the first item.  They want to make sure that a system is maintained where their ability to take profits is not constrained by our attempts to limit the possibilities of the second situation reoccurring. 

But I would suggest that in the regulatory discussion, we ought to be thinking about the first situation as well.  Is it possible to run a healthy economy while the bankers are taking over 40% of the profits?  Unless we know the answer to that, we do not know whether we ought to be encouraging the bankers to shoot for 60% of profits or limiting them somehow to under 20% (the pre-1990 maximum level). 

This question is the elephant in the room that is motivating the bankers and that is funding their enormous contributions to politicians.  And the recent Supreme Court decision that allows unlimited political contributions from corporations makes that a much more important question to the politicians than ever before.

Risk/Reward NOT Linked

At least they are not automatically linked.

Here is a description of the “Law of Risk and Reward” from somewhere on the web. . .

The risk versus reward curve is a fundamental principle in business. The simple explanation is that, as risk in a given transaction increases so does the reward.

This is the fallacy that most of us have heard many, many times.  We hear it so often, it actually seems to be true. 

But it definitely is not now, nor was it ever true that increasing risk increases reward.  

Alfred Marshal is the originator of the supply and demand curves that we were all taught in microeconomics. 

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Somehow, as his idea above about “hopes” for gains was repeated over the years, the word “hopes” was left off. 

And in fact, it takes much more than “hopes” to get great gains out of great risks.  In fact, there are two paths to great gains…

• Great Luck
• Great Risk Management

The “Law of Risk and Reward” above seems to follow a fairness sort of reasoning.  It would only be fair if increased risk resulted in increased reward.  But the world is not fair. 

It is quite possible to:

1. Get a large gain after taking a small risk
2. Get a large loss after taking a small risk
3. Get a small gain after taking a large risk
4. Get a small gain after taking a small risk
5. Get a large gain after taking a large risk
6. Get a large loss after taking a large risk

There are several reasons for this.  First of all, the size of the risk is always an estimate made in advance with incomplete information.  Clearly the situations like number 2 above are cases where the risk may have been underestimated.  Also, the economists will emphasize that situations like 1 do not usually last for long.  (See the old joke about the economist and the $20 bill.)  A second reason is that the risk management performed by the risk taker can be effective both in terms of risk selection and in terms of loss severity mitigation.  However, the risk management tasks that result in good risk selection and effective loss severity mitigation require skill and execution. 

Risk takers who believe in the “Law of Risk and Reward” will tend to think that the time, effort and expense of doing good risk management is wasted effort since more risk results in more reward by law.

Skating Away on the Thin Ice of the New Day

The title of an old Jethro Tull song.  It sounds like the theme song for the economy today!

Now we all know.  The correlations that we used for our risk models were not reliable in the one instance where we really wanted an answer.

In times of stress, correlations go to one.

That is finally, after only four or five examples with the exact same result, become accepted wisdom.

But does that mean that Diversification is dead as a strategy?

I would argue that it certainly puts a hurt to diversification as a strategy for finding risk free returns.  Which is how it was being (mis) used in the Sub Prime markets.

But Diversification should still reign as the king of risk management strategies.  But it needs to be real diversification.  Not tiny diversification that is observable only under a mathematical microscope.  Real Diversification is where risks have completely different drivers.  Not slightly different statistical histories.

So in Uncertain Times, and these days must be labeled Uncertain Times (or the thin ice age), diversification is the best risk management strategy.  Along with its mirror image twin, avoidance of concentrations.

The banks had given up on diversification as a risk strategy.  Instead they believed that they were making risk free returns by taking lots and lots of concentrated risk that they were either fully hedging or moving the risk off their balance sheets very quickly.

Both ideas failed.  Hedging failed when the counter party was Lehman Brothers.  It succeeded when the counter party was any of the other institutions that were bailed out, but there was an extended period of severe uncertainty about that before the bailouts were finally put into place.  Moving the risks off the balance sheet failed in two ways.  First it failed because they were really playing hot potato without admitting it.  When the music stopped, someone was holding the potato.  And some banks were holding many potatoes.  It also failed because some banks had been offloading the risks to hedge funds and other investors who they were lending funds to finance the purchase.  When the CDOs soured, the loans secured by the CDOs were underwated and the CDOs came back onto the bank balance sheets.

The banks that were hurt the least were the banks who were not so very concentrated in just one major risk.

The cost of the simple diversification strategy is that those banks with real diversification showed lower returns during the build up of the bubble.

So that is the risk reward trade off of real diversification – it will often produce lower returns than the mathematical diversification but it will also show lower losses in proportion to total revenue than a strategy that concentrates in the most profitable risk choices according to a model that is tuned to the accounting or performance bonus system.

Diversification is the risk management strategy for the Thin Ice Age.

Lessons for Insurers (1)

In late 2009,  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…

1. The success of ERM hinges on a strong risk management culture which starts at the top of
a company.

This seems like a very simple statement that is made over and over again by most observers.  But why is it important and why is it very often lacking?

First, what does it mean that there is a “strong risk management culture”?

A strong risk management culture is one where risk considerations make a difference when important decisions are made PERIOD

When a firm first adopts a strong risk management culture, managers will find that there will be clearly identifiable decisions that are being made differently than previously.  After some time, it will become more and more difficult for management to notice such distinctions because as risk management becomes more and more embedded, the specific impact of risk considerations will become a natural inseparable part of corporate life.

Next, why is it important for this to come from the top?  Well, we are tying effective risk management culture to actual changes in DECISIONS and the most important decisions are made by top management.  So if risk management culture is not there at the top, then the most important decisions will not change.  If the risk management culture had started to grow in the firm,

when middle managers see that top management does not let risk considerations get in their way, then fewer and fewer decisions will be made with real consideration risk.

Finally, why is this so difficult?  The answer to that is straight forward, though not simple.  The cost of risk management is usually a real and tangible reduction of income.  The benefit of risk management is probabilistic and intangible.  Firms are compared each quarter to their peers.

If peer firms are not doing risk management, then their earnings will appear higher in most periods.

Banks that suffered in the current financial crisis gave up 10 years of earnings!  But the banks that in fact correctly shied away from the risks that led to the worst losses were seen as poor performers in the years leading up to the crisis.

So what will change this?  Only investors will ultimately change this.  Investors who recognize that in many situations, they have been paying un-risk adjusted multiples for earnings that have a large component of risk premiums for low frequency, high severity risks.

They are paying multiples, in many cases where they should be taking discounts!

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Commentary on Timeline of the Global Financial Crisis

Link to Detailed Timeline

The events of the past three years are unprecedented in almost all of our lifetimes.  One needs to go back and look at how much was happening in such a short time to get an appreciation of how difficult it must have been to be in the hot seats of government, central banks and regulators, especially during the fall of 2008.

On the other hand, it is pretty easy, with 20-20 hindsight, to point to events that should have made it clear that something bad was on its way.

The timeline that is posted here on Riskviews is an amalgam from 5 or 6 different sources, including the BBC, Federal Reserve and Wikipedia.  None of them seemed to be very complete.  Not that this one is.  My personal biases left out some items from all of the sources.

Let us know what was left out that is important.  This timeline was created over a one year period and there was little effort to go back and pick up items that did not seem important at the time, but that later were found to be early signals of later big problems.

The reaction that I have had when I used this timeline to make a presentation about the Financial Crisis is that it is pretty unfair to go pointing fingers about actions taken during the fall of 2008.  When you look at the daily earth shaking events that were happening, it is really totally overwhelming, even a year later.  If the events that occured daily were spread out one per month, then perhaps a case could be made that “they” should ahve done better.

Going back much further, I am not willing to be quite so kind.  This crisis was manufactured by collision of two deliberate government policies – home-ownership for all and deregulation of financial markets.  That collision was preventable.  Neither policy had to be taken to the extreme that it was taken – to what looks now like an absurd extreme in both cases.

And in addition, the financial firms themselves are far from blameless.  Greenspan’s belief that the bankers were capable of looking out for their shareholder’s best interest was correct.  They were capable.

Read the history.  See what happened.  Decide for yourself.  Let me know what I missed.

Link to Detailed Timeline

Whose Loss is it?

As we look at the financial system and contemplate what makes sense going forward, it should be important to think through what we plan to do with losses going forward.

There are at least seven possibilities.  As a matter of public policy, we should be discussing where the attachment should be for each layer of losses.  Basel 2 tries to set the attachment for the fourth layer from the bottom, without directly addressing the three layers below.

So for major loss scenarios, we should have a broad idea of how we expect the losses to be distributed.  Recent practices have focused on just a few of these layers, especially the counterparty layer.  The “skin in the game” idea suggests that the counterparties, when they are intermediaries, should have some portion of the losses. Other counterparties are the folks who are taking the risks via securitizations and hedging transactions.

However, we do not seem to be discussing a public policy about the degree to which the first layer, the borrowers, needs to absorb some of the losses.  In all cases, absorbing some of the losses means that that layer really needs to have the capacity to absorb those losses.  Assigning losses to a layer with no resources is not an useful game.  Having resources means having valuable collateral or dependable income that can be used to absorb the loss.  It could also mean having access to credit to pay the loss, though hopefully we have learned that access to credit today is not the same as access to credit when the loss comes due.

+    +    +   +

This picture might be a useful one for risk managers to use as well to clarify things about how losses will be borne that are being taken on by their firm.  The bottom layer does not have to be a borrower, it can also be an insured.

This might be a good way to talk about losses with a board.  Let them know for different frequency/severity pairs who pays what.  This discussion could be a good part of a discussion on Risk Appetite and Risk Limits as well as a discussion of the significance of each different layer to the risk management program of the firm.

The “skin in the game” applies at the corporate level as well.  If you are the reinsurer or another counterparty, you might want to look at this diagram for each of your customers to make sure that they each have enough “skin” where it counts.

Black Swan Free World (5)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

Complexity gets away from us very, very quickly.  And at the same time, we may spend so much time worrying about the complexity, building very complex models to deal with the complexity, that we lose sight of the basics.  So Complexity can hurt us both coming and going.

So why do we insist on Complexity?  That at least is simple.  Most complexity exists to provide differentiation between financial products that otherwise would be pure commodities.  The excuse is that the Complex products are needed to match up with the risks of a complex world.  Another, even less admirable reason for the complexity is to create something that sounds like a simple risk relief product but that costs the seller much less to provide, by carving out the parts of the risk relief that are more expensive but less desirable or less well understood by the customer.

Generally, customers who are buying risk relief products like insurance or hedges have a simple objective.  If they have a loss they want something that will make a payment that will offset the loss.  Complexity comes in when the risk relief products are customized to potentially better meet customer needs. (according to the sales literature).

Taleb suggests that complexity also hides leverage.  That is ver definitely the case.  For example, a CDS can be replicated by a long position in a credit and a short position in a treasury.  A short position in a treasury is finance speak for a loan at a better rate than you can actually get.  And a loan is leverage.  THe amount of the leverage is the full notional amount of the CDS.  Fans of derivatives will scoff at the idea that the notional amount if of any interest to anyone, but in this case at least, anyone who wants to know how much leverage the buyer of a CDS has, needs to add in the full notional amount of all of the CDS.

Debt bubbles are vicious because of the feedback loop in debt.  If one borrows money to purchase an asset and the asset increases in value, then you can use that increased value as collateral to increase the debt and purchase more of the asset.  The increase in demand for the asset causes prices to rise and so it goes.

But ultimately the reason that may economists have a hard time identifying bubbles (other than they do not believe that bubbles really ever exist) is that they do not know the capacity of any asset market to absorb additional investment.  Clearly in the example above, if there is a fixed amount of the asset that becomes subject to a debt bubble, it will very, very quickly run into a bubble situation.  But if the asset is a business or more likely a sector, it is not so easy to know exactly when the capacity of that sector to efficiently use additional capital is reached.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Unrisk – Part 3

From Jawwad Farid

Transition Matrix

Here is another way of looking at it. It is called a transition matrix. All it does is track how something rated/scored in a given class moves across classes over time

How do you link to profitability?

This is how profitability is calculated generally. Take the amount you have lent, multiply it by your expected adjusted return and voila, you have expected earnings. But that is not the true picture.

What you are missing is the impact of two more elements. Your cost of funds (the money you have lent is actually not yours. You have borrowed it at a cost and that cost needs to be repaid) and your best and worst case provisions. So true profitability would look something like this.

That is a pretty picture if I ever saw one. Especially when you compare the swing from the original projected number. Back to the question clients ask. Where do projected provisions come from? From transition matrices. And where do transition matrices come from. From applying your understanding of your distribution to your portfolio.

Remember these are not my ideas. They are hardly even original. The Goldman trader who first asked me about moment generating functions wanted to understand how well I understood the distributions that were going to rule my life on Fleet street?

Full credit for posing the distribution problem goes to our friend NNT (Nicholas Nassim Taleb) who first posed this as getting comfortable with the generating function problem. He wrote all of three books on the subject and then some. Rumor has it that he also made an obscene amount of money in the process (not with book writing, but with understanding the distribution). All he suggested was that before you took a punt, try and understand how much trouble could you possibly land in based on how what you are punting on is likely to behave in the future. Don’t just look at the past and the present, look the range, likely, unlikely, expected, unexpected.

UNRISK Part 1

UNRISK Part 2

UNRISK (2)

From Jawwad Farid

UNRISK Part 2 – Understanding the distribution

(Part One)

Before you completely write this post off as statistical gibberish, and for those of you were fortunate enough to not get exposure to the subject, let’s just see what the distribution looks like.

Not too bad! What you see above is a simple slotting of credit scores across a typical credit portfolio. For the month of June, the scores rate from 1 to 12, with 1 good and 12 evul. The axis on the left hand side shows how much have we bet per score / grade category. We collect the scores, then sort them, then bunch them in clusters and then simply plot the results in a graph (in statistical terms, we call it a histogram). Drawn the histogram for a data set enough number of times and the shape of the distribution will begin to speak with you. In this specific case you can see that the scoring function is reasonably effective since it’s doing a good job of classifying and recording relationships at least as far as scores represent reasonable credit behavior.

So how do you understand the distribution? Within the risk function there are multiple dimensions that this understanding may take.

The first is effectiveness. For instance the first snapshot of a distribution that we saw was effective. This one isn’t?

Why? Let’s treat that as your homework assignment. (Hint: the first one is skewed in the direction it should be skewed in, this one isn’t).

The second is behavior over time. So far you have only seen the distribution at a given instance, a snapshot. Here is how it changes over time.

Notice anything? Homework assignment number two. (Hint: 10, 11 and 12 are NPL, Classified, Non performing, delinquent loans. Do you see a trend?)

The third is dissection across products and customer segments. Heading into an economic cycle where profitability and liquidity is going to be under pressure, which exposure would you cut? Which one is going to keep you awake at night? How did you get here in the first place? Assignment number three.

Can you stop here? Is this enough? Well no.

This is where my old nemesis, the moment generating function makes an evul comeback. Volatility (or vol) is the second moment. That is a fancy risqué (pun intended) way of saying it is the standard deviation of your data set. You can treat volatility of the distribution as a static parameter or treat it with more respect and dive a little deeper and see how it trends over time. What you see above is a simple tracking series that is plotting 60 day volatility over a period of time for 8 commodity groups together.

See vol. See vol run… (My apologies to my old friend Spot and the HBS EGS Case)

If you are really passionate about the distribution and half as crazy as I am, you could also delve into relationships across parameters as well as try and assess lagged effects across dimensions.

The graph above shows how volatility for different interest rates moves together and the one below shows the same phenomenon for a selection of currency pair. When you look at the volatility of commodities, interest rates and currencies do you see what I see? Can you hear the distribution? Is it speaking to you now?

Nope. I think you need to snort some more unrisk! Home work assignment number four. (Hint: Is there a relationship, a delayed and lagged effect between the volatility of the three groups? If yes, where and who does it start with?)

So far so good! This is what most of us do for a living. Where we fail is in the next step.

You can understand the distribution as much as you want, but it will only make sense to the business side when you translate it into profitability. If you can’t communicate your understanding or put it to work by explaining it to the business side in the language they understand, all of your hard work is irrelevant. A distribution is a wonderful thing only if you understand it. If you don’t, you might as well be praising the beauty of Jupiter’s moon under Saturn’s light in Greek to someone who has only seen Persian landscapes and speaks Pushto.

To bring profitability in, you need to integrate all the above dimensions into profitability. Where do you start? Taking the same example of the credit portfolio above you start with what we call the transition matrix. Remember the distribution plot across time from above.

THis has appeared previously in Jawwad’s excellent blog.

Black Swan Free World (1)

On April 7 2009, the Financial Times published an article written by Nasim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

It does seem safer to that fragile things break when they are small.  Unfortunately, what seems to have happened was that big things were permitted to become fragile.  So large things need to be encouraged to avoid becoming fragile.  It is hard to imagine why such encouragement might be needed.  For something to be large, it is usually very valuable. (Unless it is a US auto manufacturer)  And most sane people work very hard to protect their valuable possessions.  And most of the people who are engaged to run large firms are sane people who would be expected to avoid fragility as well.

So one explanation that fits the facts is that almost everyone did not know that the large firms were fragile.

Which leads to the third sentence.  The easy conclusion is that the risks of the big banks were hidden.  Some they hid themselves – such as all of the off balance sheet risks.  Other risks was hidden even from them.

And fortune favors those with hidden risks because they will hold capital based upon the visible risks and report profits from the actual risks.

So how do we solve the riddle? How do we make sure that large organizations do not become fragile?

The only sensible answer seems to be that there needs to be better risk assessment, probably independent reliable risk assessment.

And because of the extreme complexity of the larger firms, the resources applied to this independent assessment need to be quite substantial.

Time will be required for a thorough risk assessment.  It is unlikely that a good job could be done in time for a financial statement, unless the independent assessors are working inside the institutions with full knowledge of positions at all times.

The second sentence suggests that the risk assessments should have a negative size bias- the larger the firm the more risk would be assumed.  There seems to be some talk in that direction from the regulators.  But the thing that will put that to an abrupt end will be if one or more of the countries with major international banks fails to adopt the same sort of anti-size bias, tilting competition in the favor of their banks.

What can a risk manager take from this?  For assessing investment risk, it may make sense for risk models to take a sector, rather than an index or ratings approach to looking at investment risk.  The financial sector tends to lead the real economy in timing and severity of downturns.  More robust modeling may reveal better strategies for investing that reflect the real risks in financial firms.

And finally, the risk manager should really question whether it ever makes sense to invest in financials unless their risk disclosures become much, much better.  There was really no hint to investors that the large banks had built up so much risk.  Why, from a risk management point of view, does it make any sense to make an investment that you cannot find out the nature or extent of the underlying risks or any usable information about when that risk materially changes.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Who wins with leverage?

Leverage increases apparent returns in best of times but Increases risk considerably in worst of times. Investors do not benefit from leverage over time. Managers benefit greatly from leverage. Derivatives are highly levered. Traders think that it is silly to spend any time thinking about notional amounts of derivatives. Insurers should learn that they need to pay attention to the notional amount of their insurance contracts. Owners of now highly diluted shares of banks (and AIG) now know that the leverage of those organizations did not in the end create value. Insurers, like banks, are by their fundamental nature highly leveraged with capital a tiny fraction of gross obligations. Insurers should take extreme caution when considering activity that increases leverage. And they should make an analysis of the true amount of leverage in their activities an important activity before entering a new activity and periodically as the world turns.

For example, if one investor puts his money in a 2/20 hedge fund that is 10 for 1 levered and that pays 10% interest on its funds. If the returns for the first four years are 20% per year, After 4 years, the investor is up over 400%! The hedge fund manager has been paid over 150% of the original investment and the debtholder has been paid 400%. But then in year 5, the investment loses 20%, giving back just one of those four years of outsized gains. All of a sudden, the investor is down to an 8% cumulative gain!!! while the manager and lender have slightly higher gains than after the four fat years.

The sister of this investor had the same amount of money to invest, but put it into an unlevered fund with the same types of investments and without the 20% profit share for the manager. After four fat years of 10% gains, the sister is up over 35% and the manager has been paid only 7% of the original fund value. Now the market drop hits sis’ fund with a 10% loss and she ends the five years up a respectable 19%. The fund manager gets about 9% of the original fund for his five years of work.

Leverage Illustration

Of course, the illustration can be manipulated to make anyone the supreme winner. But this scenario seems pretty telling. Leverage primarily benefits the fund manager, not the investor in this scenario. In many scenarios they both benefit, but there are no scenarios where the manager does poorly on a leveraged investment fund.

So when you die, pray to come back as a leveraged hedge fund manager.

ERM only has value to those who know that the future is uncertain.

Businesses have three key needs.

First they need to have a product or service that people will buy. They need revenues.

Second they need to have the ability to provide that product or service at a cost less than what their customers will pay. They need profits.

Once they have revenues and profits, their business is a valuable asset. So third, they need to have a system to avoid losing that asset because of unforeseen adverse experience. They need risk management.

So Risk Management is the third most important need of a firm.

And there is often a conflict between risk management and the other two goals. Risk management will sometimes say that a business activity that produces revenue is too risky and must be curtailed or modified in such a way that it produces less revenues. Risk Management often costs money or otherwise depresses profits. For example, an insurance policy covering fire of a building owned by the firm will cost money and depress profits.

So Risk Management needs to defend its value to the firm. Many risk management proponents have been asked to tell the value added of their activities. This is difficult to explain. Not because risk management does not have a value, but because the cost of risk management in terms of reduced revenues or increased costs are usually tangible and definite, while the benefits are probabilistic. Often the person asking the question is looking for a traditional spreadsheet answer that shows two columns adding up and perhaps the difference between the two is the benefit of risk management.

It does not work that way. For Risk Management to have value, one must understand that the future is uncertain. The value of risk management comes from the way that it shapes that uncertainty.

The next time you are asked about the value of risk management, ask the questioner what value they would put on the airbags and seat belts in their car. If they have no uncertainty about their ability to avoid accidents, then they will put a zero value on the safety devices – the personal risk management systems. If they resist answering, ask them if they will agree to have them removed for $20? Or for $2000? What value do they place on that risk management?

Most people will agree that the demise of a company is less serious than the demise of a person, but it is not difficult to see that there is some value to activities that increase the chance that a company will not expire in the next business cycle or windstorm.

So risk management decreases the uncertainty about the survival of the firm. There is a way to quantitatively value that reduction in uncertainty and compare it to the reduced revenues or increased costs of the risk management activities.