Archive for the ‘Systemic Risk’ category

Should we be concentrating regulatory attention on Systemic Risk?

January 1, 2013

Think of it somewhat like the town that just suffered a very bad winter season with huge snowfalls that they were unprepared for clogging up everything for weeks on end. They spend the spring fixing up and deciding what to do. Their conclusion is to have all town employees carry snowshovels at all times and to keep snow plow trucks patrolling the streets all day and all night through the entire summer. Sometime in early fall, they decide that was a waste of time and sell all the shovels and trucks by the end of the fall.

RISKVIEWS does not think that our situation will include any systemic risks that we will anticipate. We will not repeat the exact same mistakes. Systemic risk oversight will in the end be a fixed Maginot Line defense.

What we need is

  1. to figure out how to distinguish between creation of wealth by new innovation and by extraction from past innovation so that we can encourage the former and discourage the later. The former widely distributes increases in wealth while the latter concentrates it.  The former creates growth while the latter captures the benefits of future growth now – which means that we will not have them later.
  2. to understand leverage better. Look at the Minsky Financial Instability Model myself. Often, we are not honest with ourselves on the extent of debt. RISKVIEWS favors full disclosure over regulations. For example, firms should disclose the amount of debt that is implicit in derivative positions. And disclose the counterparties for that debt.
  3. to figure out how we are going to find the next big thing that will employ all of the people who are now permanently, structurally unemployed. We can keep hoping for something that increases wealth, something that merely decreases wealth less than the current situation or something that decreases wealth but employs people.
  4. to orient research into how to operate an economy in the long term with much less or no growth. Most of our economic expectations are built off of a constantly growing economy. With population about to start falling, we will necessarily experience much less growth. We don’t collectively even have any idea of what the shift to large retired populations will do to our economies.

The regulators need to focus on whatever is within their purview that gets in the way to accomplishing those things.

For the town above, that means storing the snow shovels to the winter and looking at the problems of the summer heat. They still need to keep an eye out for the next winter. But that does not mean it needs to be a primary focus NOW.

A Very Slow Emerging Systemic Risk – The Retirement Drain

August 12, 2012

This Systemic Risk is caused by the Central Banks. It is a pure and direct conflict between the “Real economy” and the “Financial System”. The Central Bankers have been taking actions to shore up the Financial System, i.e. the Banks, without any regard for this particular Systemic Risk. Perhaps they do not notice. This risk has never hit before.  But it is showing up almost daily in the press.  And it is massive.  It effects a generation of people.  And it is likely to be the most pressing worldwide financial issue of the next 30 years.

This is the Retirement Drain issue.  It is the opposite of a bubble.  It will be a constant drip, drip, drip of the assets of the retirees being liquidated to fund their living and medical expenses.  Looking backwards, it is quite possible that financial commentators will eventually decide that the two bubbles of the last decade or so are a direct consequence of the extra savings in the run up to the Retirement Drain.  Too much money that out ran the capacity of the world economy to invest productively.

But the current central bank actions are and will continue top have a very serious impact on this cycle.  The central banks have been doing all that they can to depress interest rates.  They may get what they want from that action, but they are making the Retirement Drain much worse.  The low interest rates are a transfer of wealth from the savers to the spenders in society.  From the old to the young in general.  At some point, the old will spend down their assets.  The selling of financial and real assets over the next 30 years will be putting immense pressure on prices for both over that whole time.  Just as the working lifetime of this generation of retirees has featured a general upward swing in the world economy, the retirement phase will see a massive disinvestment and the concurrent drop in world economic activity.

And the current low interest rates are making it more and more likely that the accumulated savings of the folks who did put aside money will be insufficient.  So folks will eventually sell all of their assets and then finally need to be supported by their children and grandchildren’s generations.

The problem is fundamentally demographic.  The failure of this generation to produce enough children to support them in their retirement results in the situation that the retirees will be supported by fewer and fewer working folks.  Just as a major portion of the boom of the last 50 years was actually a demographic phenomenon.

Almost all of the major economies of the world will be facing this problem sooner or later.  That is what makes it Systemic.

Let’s hope that we do not willfully deny the problem.

Systemic Risk Metrics for Insurers

July 2, 2011

The US and Global banking regulators have been tasked with regulating systemic risk.  One area where they admit that they are unprepared is with the insurance sector.  In the recent Global Financial Crisis, several insurance companies played a pivotal role, specifically AIG and the US Financial Guarantee insurers.  Most insurers do not consider their activities that helped to build up the bubble and precipitate the crisis to be insurance activities and therefore persist in saying to regulators that insurance is not a systemically important sector.  However, the political facts are that AIG and the Financial Guarantors are/were insurers and the idea of leaving insurance completely out of the efforts to prevent a future systemic crisis is simply not a possible.

Last week, the American Academy of Actuaries provided a letter to the US Financial Stability Council titled, “Metrics to Enable FSOC to Monitor Insurance Industry Systemic Risk”.  That letter provides a good starting point for discussion of the issues involved in bringing the insurance sector into the discussion. For example, the letter provides the following list of ways that an insurer might have systemically significant risks:

  1. Risk assumption services provided to the insurance companies through reinsurers, foreign and domestic (e.g. mortality risk in excess of a company’s risk management limit).
  2. Risk assumption services provided by the non-insurance financial services companies to the insurance industry, (e.g. hedging of financial risk, catastrophe bonds).
  3. The interconnectedness of the insurance industry when part of a financial services group.
  4. The interconnectedness of a U.S. insurance company that is owned by a foreign financial services company.
  5. The insurance industry as a lender to the US economy (e.g. through its purchase of corporate bonds).
  6. The interconnectedness of risk assumption services external to the insurance industry when part of a financial services group.

Riskviews cautions the participants in this discussion to realize that it is most likely that the next systemic crisis will take a different form than the past crises.  So setting up measures and regulatory structures that will prevent a recurrence of past crises is no guarantee of preventing a future crisis.

This letter, with its emphasis on setting down broad principles for Systemic Risk in the insurance industry is a good step in the right direction.  Much broad based discussion is needed to take this further to produce a truly dynamic, principles based monitoring and regulating structure that will be imaginative and flexible enough to actually be of future good, not just short term political cover.

Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis

April 22, 2011

A second series of essays from the actuarial profession about the financial crisis.  Download them  HERE.

A Tale of Two Density Functions
By Dick Joss

The Systemic Risk of Risk Capital (Or the "No Matter What" Premise)
By C. Frytos &I.Chatzivasiloglou

Actuaries and Assumptions
By Jonathan Jacobs

Managing Financial Crises, Today and Beyond
By Vivek Gupta

What Did We Learn from the Financial Crisis?
By Shibashish Mukherjee

Financial Reform: A Legitimate Function of Government
By John Wiesner

The Economy and Self-Organized Criticality
By Matt Wilson

Systemic Risk Arising from a Financial System that Required Growth in a World with Limited Oil Supply
By Gail Tverberg

Managing Systemic Risk in Retirement Systems
By Minaz Lalani

Worry About Your Own Systemic Risk Exposures
By Dave Ingram

Systemic Risk as Negative Externality
By Rick Gorvette

Who Dares Oppose a Boom?
By David Merkel

Risk Management and the Board of Directors–Suggestions for Reform
By Richard Leblanc

Victory at All Costs
By Tim Cardinal and Jin Li

The Financial Crisis: Why Won't We Use the F(raud) Word?
By Louise Francis

PerfectSunrise–A Warning Before the Perfect Storm
By Max Rudolph

Strengthening Systemic Risk Regulation
By Alfred Weller

It's Securitization Stupid
By Paul Conlin

I Want You to Feel Your Pain
By Krzysztof Ostaszewski

Federal Reform Bill and the Insurance Industry
By David Sherwood

The Year in Risk – 2010

January 3, 2011

It is very difficult to strike the right note looking backwards and talking about risk and risk management.  The natural tendency is to talk about the right and wrong “picks”.  The risks that you decided not to hedge or reinsure that did not develop losses and the ones that you did offload that did show losses.

But if we did that, we would be falling into exactly the same trap that makes it almost impossible to keep support for risk management over time.  Risk Management will fail if it becomes all about making the right risk “picks”.

There are other important and useful topics that we can address.  One of those is the changing risk environment over the year. In addition, we can try to assess the prevailing views of the risk environment throughout the year.


VIX is an interesting indicator of the prevailing market view of risk throughout the year.  VIX is in indicator of the price of insurance against market volatility.  The price goes up when the market believes that future volatility will be higher or alternately when the market is simply highly uncertain about the future.

Uncertain is the word used most throughout the year to represent the economic situation.  But one insight that you can glean from looking at VIX over a longer time period is that volatility in 2010 was not historically high.

If you look at the world in terms of long term averages, a single regime view of the world, then you see 2010 as an above average year for volatility.  But if instead of a single regime world, you think of a multi regime world, then 2010 is not unusual for the higher volatility regimes.

So for stocks, the VIX indicates that 2010 was a year when market opinions were for a higher volatility risk environment.  Which is about the same as the opinion in half of the past 20 years.

That is what everyone believed.

Here is what happened:

Return
December 6.0%
November -0.4%
October 3.5%
September 8.7%
August -5.3%
July 6.8%
Jun -5.2%
May -8.3%
April 1.3%
March 5.8%
February 2.8%
January -3.8%
Average 1.0%
Std Dev 5.6%

That looks pretty volatile.  And comparing to the past several years, we see below that 2010 was just a little less actually volatile than 2008 and 2009.  So we are still in a regime of high volatility.

So we can conclude that 2010 was a year of both high expected and high actual volatility.

If an exercize like this is repeated each year for each important risk, eventually insights of the possibilities for both expectations and actual risk levels can be formed and strategies and tactics developed for different combinations.

The other thing that we should do when we look back at a year is to note how the year looked in the artificial universe of our risk model.

For example, when many folks looked back at 2008 stock market results in early 2009, many risk manager had to admit that their models told them that 2008 was a 1 in 250 to 1 in 500 year.  That did not quite seem right, especially since losses of that size had occurred two or three times in the past 125 years.

What many risk managers decided to do was to change the (usually unstated) assumption that things had permanently changed and that the long term experience with those large losses was not relevant. Once they did that, the risk models were recalibrated and 2008 became something like a 1 in 75 to 1 in 100 year event.

For the stock market, the 15.1% total return was not unusual and causes no concern for recalibration.

But there are many other risks, particularly when you look at general insurance risks, that had higher than expected claims.  Some were frequency driven and some were severity driven.  Here is a partial list:

  • Queensland flood
  • December snowstorms (Europe & US)
  • Earthquakes (Haiti, Chile, China, New Zealand)
  • Iceland Volcano

Munich Re estimates that 2010 will go down as the sixth worst year for amount of general insurance claims paid for disasters.

Each insurer and reinsurer can look at their losses and see, in the aggregate and for each peril separately, what their models would assign as likelihood for 2010.

The final topic for the year in risk is Systemic Risk.  2010 will go down as the year that we started to worry about Systemic Risk.  Regulators, both in the US and globally are working on their methods for inoculating the financial markets against systemic risk.  Firms around the globe are honing their arguments for why they do not pose a systemic threat so that they can avoid the extra regulation that will doubtless befall the firms that do.

Riskviews fervently hopes that those who do work on this are very open minded.  As Mark Twain once said,

History does not repeat itself, but it does rhyme.”

And for Systemic Risk, my hope is that the resources and necessary drag from additional regulation are applied, not to prevent an exact repeat of the recent events, while recognizing the possibility of rhyming as well as what I would think would be the most likely systemic issue – that financial innovation will bring us an entirely new way to bollocks up the system next time.

Happy New Year!

What is Too Big to Fail?

November 20, 2010

There seems to be various discussions going around about who needs to be considered Systemically important to qualify for “Special Attention” from regulators. Very large money managers are saying that they are not systemically important.

But it seems to me that there are quite a number of considerations. And everyone seems to be arguing solely from the part of that list that exempts them.

When thinking about money managers, I would think of the following:

  1. How is their liquidity managed? Can they really raise funds fast enough to satisfy a run on the bank?
  2. If they were to try to liquidate their funds, what would that do to the financial markets?
  3. How interconnected are they to other financial firms? Do regulators now have information about that?
  4. What about the future? (Isn’t that our concern, not the past or even the current situation?)
  • Could they shift their liquidity practices to become much more illiquid?
  • Their argument revolves around leverage, how much could they change their leverage under their current regulations? They can quickly leverage through derivatives as well as borrowing.
  • Could they become the center of new risky financial behavior that would endanger the financial sector?

That last point is a major concern of regulators regarding the Insurance industry. And they have history on their side. The insurance industry helped the financial sector to blow the mortgage business up to 4 or 5 times the underlying.

All you need to do that is a big balance sheet and a willingness to take one side of a trade without balancing it with the other side. And the money managers as well as the insurance companies both have exactly those characteristics.

Watch your Own Wallet

November 14, 2010

Polling the people who work at the New York banks that were at the center of the financial crisis, people were asked which of the following statements that they agreed with the most:

  1. We did it and we need to do something differently.
  2. They did it and they need to do something differently.
  3. Space Aliens did it and we hope that they do not do it again.

The poll results are in and the findings are:

  • No one answered that they agreed with 1.
  • The innocent all were able to answer that they agreed with 2.
  • Those who were directly involved in the problems that led to the crisis all answered 3.

So the conclusion that you should reach from this survey is that nothing will be different in the future.  The financial system will be run mostly the same as it had been run.

Your only protection is to WATCH YOUR OWN WALLET.  That is, pay attention yourselves to things that might turn into the next set of systemic risks.  Those things will all tend to be very large systematic risks.

So you need to use the emerging risks type process on the largest systematic risks.  You need to assess periodically whether your firm’s exposures to these risks might in a crash result in firm ending losses.  (Or you can prepare your application for a bailout – good luck on that).

Then you need to have a heart to heart discussion with your board.  Stories of the firms that did the worst in the crisis tell that their boards urged them to take more and more risk.

Risk managers need to know whether it is their board’s wishes to be dancing up until the band sinks below the water or to stop perhaps a few songs before and leave the ship ahead of the crash.


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