Archive for the ‘Unknown Risks’ category

Embedded Assumptions are Blind Spots

October 28, 2012

Embedded assumptions are dangerous. That is because we are usually unaware and almost always not concerned about whether those embedded assumptions are still true or not.

One embedded assumption is that looking backwards, at the last year end, will get us to a conclusion about the financial strength of a financial firm.

We have always done that.  Solvency assessments are always about the past year end.

But the last year end is over.  We already know that the firm has survived that time period.  What we really need to know is whether the firm will have the resources to withstand the next period. We assess the risks that the firm had at the last year end.  Without regard to whether the firm actually is still exposed to those risks.  When what we really need to know is whether the firm will survive the risks that it is going to be exposed to in the future.

We also apply standards for assessing solvency that are constant.  However, the ability of a firm to take on additional risk quickly varies significantly in different markets.  In 2006, financial firms were easily able to grow their risks at a high rate.  Credit and capital were readily available and standards for the amount of actual cash or capital that a counterparty would expect a financial firm to have were particularly low.

Another embedded assumption is that we can look at risk based upon the holding period of a security or an insurance contract.  What we fail to recognize is that even if every insurance contract lasts for only a short time, an insurer who regularly renews those contracts is exposed to risk over time in almost exactly the same way as someone who writes very long term contracts.  The same holds for securities.  A firm that typically holds positions for less than 30 days seems to have very limited exposure to losses that emerge over much longer periods.  But if that firm tends to trade among similar positions and maintains a similar level of risk in a particular class of risk, then they are likely to be all in for any systematic losses from that class of risks.  They are likely to find that exiting a position once those systematic losses start is costly, difficult and maybe impossible.

There are embedded assumptions all over the place.  Banks have the embedded assumptions that they have zero risk from their liabilities.  That works until some clever bank figures out how to make some risk there.

Insurers had the embedded assumption that variable products had no asset related risk.  That embedded assumption led insurers to load up with highly risky guarantees for those products.  Even after the 2001 dot com crash drove major losses and a couple of failures, companies still had the embedded assumption that there was no risk in the M&E fees.  The hedged away their guarantee risk and kept all of their fee risk because they had an embedded assumption that there was no risk there.  In fact, variable annuity writers faced massive DAC write-offs when the stock markets tanked.  There was a blind spot that kept them from seeing this risk.

Many commentators have mentioned the embedded assumption that real estate always rose in value.   In fact, the actual embedded assumption was that there would not be a nationwide drop in real estate values.  This was backed up by over 20 years of experience.  In fact, everyone started keeping detailed electronic records right after…… The last time when there was an across the board drop in home prices.

The blind spot caused it to take longer than it should have for many to notice that prices actually were falling nationally.  Each piece of evidence was fit in and around the blind spots.

So a very important job for the risk manager is to be able to identify all of the embedded assumptions / blind spots that prevail in the firm and set up processes to continually assess whether there is a danger lurking right there – hiding in a blind spot.

Solar Risk

August 20, 2011

At least 75% of the US has experienced some Solar Risk this summer. Temperatures were into triple digits.

(in Fahrenheit. Fahrenheit is a part of the ancient measuring system that only America uses. 100F is 37.7C. Not so magical stated that way.  But it is still exceptional.)

But very different solar risk is thought to be on the way.  Solar Storms are thought to entering a busy season and to have the capability of wrecking havoc on various electromagnetic broadcast and receiving systems.  GPS systems are thought to be particularly vulnerable.

The last major storm to hit earth reportedly caused the emerging telegraph systems in the US and Europe to encounter problems.  We now depend upon many, many complex electronic systems.

But see what happens if you try to get your firm to prepare for violent solar storms.  The best that may happen is that you would be laughed out of the room.

So do your own preparation.  Carry a map.

Leave Something on the Table

April 19, 2011

What was the difference between the banks and insurers with high tech risk management programs that did extremely poorly in the GFC from those with equally high tech risk management programs who did less poorly?

One major difference was the degree to which they believed in their models.  Some firms used their models to tell them exactly where the edge of the cliff was so that they could race at top speed right at the edge of the cliff.  What they did not realie was that they did not know, nor could they know the degree to which the edge of that cliff was sturdy enough to take their weight.  Their intense reliance on their models, most often models that focused like a lazer on the most important measure of risk, left other risks in the dark.  And those other risks undermined the edge of the cliff.

Others with equally sophisticated models were not quite so willing to believe that it was perfectly safe right at the edge of the cliff.  They were aware that there were things that they did not know.  Things that they were not able to measure.  Risks in the dark.  They took the information from their models about the edge of the cliff and they decided to stay a few steps away from that edge.

They left something on the table.  They did not seek to maximize their risk adjusted returns.  Maximizing risk adjusted return in the ultimate sense involved identifying the opportunity with the highest risk adjusted return and taking advantage of that opportunity to the maximum extent possible, then looking to deploy remaining resources to the second highest risk adjusted return and so on.

The firms who had less losses in the crisis did not seek to maximize their risk adjusted return.

They did not maximize their participation in the opportunity with the highest risk adjusted return.  They spread their investments around with a variety of opportunities.  Some with the highest risk adjusted return choice and other amounts with lesser but usually acceptable return opportunities.

So when it came to pass that everyone found that their models were totally in error regarding the risk in that previously top opportunity, they were not so concentrated in that possibility.

They left something on the table and therefore had something left at the end of that round of the game.

Maginot Risk Management

April 5, 2011

In the 1920’s, the French sought to protect themselves from future German invasions by building a wall across the most exposed route for such a tactic.

In the 1930’s, the Germans walked right around those fortifications and took France in short order.

Some financial firms have built Maginot Risk Management Systems. They consist of very fixed tests of risks and fixed processes for dealing with risks.

The US the Transportation Security Agency runs a Magniot Security system.   Everyone knows what the security system is going to be when they get to the airport.  So if anyone wants to get around it, it stays still or at best changes very slowly.

What is the alternative?  Something that is flexible and variable.  For security, what would happen if the airport security changed without notice, several times some days and not at all other weeks.  You never know when it will change and what they will want next.  Annoying to passengers, but probably infinitely more effective than the Maginot system now used.

And for risk management of a financial firm?  What it needed there is flexibility and variability.  The ability to look at things a number of different ways.  The ability to answer new questions quickly.  And the ability to ask new questions.

Not a system designed to prevent the last invasion.

Risk Manager Survey of Emerging Risks

March 21, 2011

“There is currently an upsurge in management’s willingness to listen to risk managers.”   But Risk Managers consistently show a disturbing tendency towards projecting the next crisis from the last.  Now in its fourth year, the Emerging Risks Survey from the Joint Risk Management Section and conducted by Max Rudolph.

Emerging risks are risks that are evolving in uncertain ways, have been forgotten in their dormancy, or are new.  Emerging risks typically do not have a known distribution, that is their frequency is unknown.

In 2007, a shock to oil prices was seen as the top “emerging risk” in the first survey of risk managers.  That year had seen a major spike in oil prices.  In 2008, a blow-up in asset prices was identified as the top “emerging risk” immediately following the melt down of the sub prime market and a major drop in stock prices.  In 2009, a fall in the value of the US dollar was identified as the top “emerging risk” at the end of a year when many major currencies had strengthened against the dollar.  The new 2010 survey, released this week, indicates again that a fall in the US dollar is the top “emerging risk”.

If in fact these risk managers are advising their employers in the same way that they answer surveys, firms will continue to be well prepared for the last crisis and unprepared for the next one.

However, when asked to identify the single top emerging risk concern, a Chinese economic hard landing was the top pick with 14% of the respondents selecting that choice.  That is certainly a scenario that has not just recently happened.  So at least 14% of the respondents are doing some forward thinking.

Download the entire survey report here.

Getting a Handle on Uncertainty

February 11, 2011

Frank Knight looked for the reason why firms are able to make a profit (in perfect competition situations that is) and he ultimately decided that firms were paid for UNCERTAINTY.  He then went on to distinguish uncertainty from risk.  Risk is the toss of the dice.  With risk, the frequency & severity distribution of possible outcomes is known.  Uncertainty differs fundamentally from risk because with uncertainty, the future likelihoods are unknown.

You are uncertain, to varying degrees, about everything in the future; much of the past is hidden from you; and there is a lot of the present about which you do not have full information. Uncertainty is everywhere and you cannot escape from it. Dennis Lindley

In risk management, we tend to treat everything as if it were a Knightian RISK and totally ignore UNCERTAINTY. We do our best job of estimating the frequency distribution of gains and losses and treat every best estimate the same.  See Sins of Risk Measurement.

But we can and should make an effort to identify the uncertainty that lurks, to vastly differing degrees within our risk measures.  A simple start to such an effort would be to develop a classification system for UNCERTAINTY.

  1. Almost Totally Certain – like a prediction of time of sunrise.  No experience contrary to predictions and good reason to believe that there will not be a regime change in the event.  Highly unlikely that any human activity will fall into this category.  Humans are just not this predictable.
  2. Highly certain – like a prediction of the Cubs not winning the World Series.  Never happened, but it is possible, but highly unlikely that there will be a regime change.  Things in this category will be things that there is a long amount of historical evidence.  The possibility of a fall in home prices were felt to fall into this category, but the historical evidence turned out to be from one single cycle.  To put something in this category, a firm should have direct experience with the activity in question so that there is insight within the firm about the reasons for the historical drivers of the seemingly highly certain event.
  3. Conditionally certain – Apple will stay successful as long as Jobs stays healthy (oops).  For these sorts of uncertain events, the firm should have a that clear idea of the drivers of a string of predictable experience and an understanding that the driver(s) are not themself highly certain events.
  4. Somewhat uncertain – “Bill says that it takes him 20 minutes to get to the airport” or “it usually takes me 20 minutes to get to the airport but sometimes it is an hour.” Here the firm either has only moderate amounts of experience to judge the actual uncertainty and the event seems to be fairly certain or else the firm has experience and knows that the event is somewhat uncertain.
  5. Unknown uncertainty – “this is the first time I am parachute jumping and I plan to land in my backyard lawn chair.”  Something new.  With only limited knowledge of other people’s experiences and not enough experience to know whether there are significant differences in the drivers.

The first time a firm does an economic capital model, they might classify the result as having Level 5 uncertainty.  Over time, some calculations might move up to Level 4 or Level 3.  In a few areas, the firm might have been doing risk calculations for a particular risk over much longer time and could move up to Level 2 uncertainty there.

But change the question from an estimation of a 1-in-200 risk to a “will this project make money or not” question and is is quite possible that many of the answers might have Level 2 or Level 3 uncertainty.

But firms should try assigning Uncertainty ratings to their efforts.  And track over time the degree to which the firm is devoting resources to projects with Level 5 Uncertainty.

Riskviews has worked for several firms that were over 100 years old at the time and those firms usually were very uncomfortable taking on any Level 5 Uncertainty.  Most often they kept those activities small until they gained experience.  When they went for long periods of time with no Level 5 Uncertainty, however, they tended to shrink relative to the rest of the industry.

On the other hand, the financial crisis was touched off by Banks and other institutions who committed to enough Level 4 and Level 5 uncertainty to send them over the edge.  Investors would certainly be interested to know how much Level 5 Uncertainty that a firm is taking at any point in time.

Using an Uncertainty scale like this and discussing the reasons for changes to the level of commitment to higher uncertainty projects will be a healthy and productive exercise for many firms.

Survival of the Firm is not Mandatory

September 1, 2010

Is that idea really understood by top management and the board?

Does the board leave every meeting certain that the firm will still be in business when the next scheduled board meeting comes around?  How did they get to that certainty?

Can management tell them the likelihood that the firm will experience a fatal loss and how much that likelihood has changed since the previous board meetings?

Can management tell them exactly what sorts of events could put the firm out of business?  Have they discussed the sorts of “highly unlikely” events that might take the firm down if they suddenly did happen?

Those are, of course, the conversations that the board might well demand to have if they really understood that Survival is not Mandatory.

Post Pandemic Period

August 31, 2010

10 August 2010 – the WHO declares that the Swine Flu Pandemic has ended.

Or rather they say that we have entered the Post Pandemic Period.

The H1N1 Pandemic is an example of what happens when you do a good job of risk management.  Because of the preparations that were made to develop and distribute vaccines as well as other measures to reduce possible transmission of the virus, and to the fact that the virus did not mutate in a way to become either lethal or resistant to the vaccine, the impact of the Pandemic was not severe.

This is what should happen with good risk management of an emerging risk like that.  Many companies created and/or tested their emergency plans and are now much better prepared for the next emergency.  The plans to prevent systemic failure did go into effect and they worked.

But one of the reactions to effective risk management is disbelief that there ever was a threat.

So it goes.  Do not be discouraged.  Keep up the good fight.

The firms that are run by the skeptics who refuse to take heed of such warnings will at some point get what they haven’t prepared for.

Meanwhile, we now get to learn what Post Pandemic Period means.

Around the Corner Risk

August 19, 2010

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.

Regime Change

July 30, 2010

If something happens more or less the same way for any extended period of time, the normal reaction of humans is consider that phenomena as constant and to largely filter it out.  We do not then even try to capture new information about changes to that phenomena because our senses tell us that that input is “pure noise” with no signal.  Hence the famous story about boiling frogs.  Which may or may not be actually true about frogs, but it definitely reveals something about the way that humans take in information about the world.

But things can and do actually change.  Even things that are more or less the same for a very long time.

In the book, “This Time It’s Different”, the authors state that

“The median inflation rates before World War I were well below those of the more recent period: 0.5% per annum for 1500 – 1799 and 0.71% for 1800 – 1913, in contrast with 5% for 1914 – 2006.”

Imagine that.  Inflation averaged below 0.75% for about 300 years.  Since there is no history of extended periods of negative inflation, to get an average that low, there must be a very low standard deviation as well.  Inflation at a level of 3 or 4% is probably a one in a million situation.  Or so intelligent financial analysts before WWI must have thought that they could make plans without any concern for inflation.

But in the years following WWI, governments found a new way to default on their debts, especially their internal debts.  Reinhart and Rogoff point out that almost all of the discussion by economists regarding sovereign default is about external debt.  But they show that internal debt is very important to the situations of sovereign defaults.  Countries with high levels of internal debt and low external debt will usually not default, but countries with high levels of both internal and external debt will often default.

So as we contemplate the future of the aging western economies, we need to be careful that we do not exclude the regime changes that could occur.  And which regime changes that we should be concerned about becomes clearer when we look at all of the entitlements to retirees as debt (is there any effective difference between debt and these obligations?).  When we do that we see that there are quite a few western nations with very, very large internal debt.  And many of those countries have indexed much of that debt, taking the inflation option off of the table.

Reinhart and Rogoff also point out the sovereign default is usually not about ability to pay, it is about willingness to make the sacrifices that repayment of debt would entail.

So Risk Managers need to think about possible drastic regime changes, in addition to the seemingly highly unlikely scenario that the future will be more or less like the past.

Stress to Failure

May 28, 2010

It is clear and obvious that BP and the US government regulators were not at all prepared for failure of a deep water oil rig in the Gulf.

What would have helped them is a procedure that I have heard Dave Sandberg describe many times that is used at his employer, Allianz.

Stress to Failure.

  1. Whenever something new is proposed, they require that a demonstration is prepared that shows the type of stress that will cause complete failure. That test provides them with several pieces of very valuable information: It helps to put a boundry around the situations under which it will NOT fail. This is the green (and yellow) zone for the new project. They can then evaluate the expected return and volatility of return in those scenarios.
  2. It allows an estimate of the likelihood of success vs. failure of the project.  This can be seen by looking at the type of situation that causes failure and the likelihood of that situation.  However, caution should be applied to not put too much weight on this likelihood estimate if the failure type of even has never before happened.  Human nature may well be biased towards underestimating adversity. 
  3. It allows for planning for the failure event.  This is where the BP folks and Transocean as well as the Minerals Management Service failed.  They clearly had no plan for the failure event.  It sounds like they were able to convince themselves that any failure event was so remote in likelihood that there was no need to plan for one. 
  4. Understanding the true weaknesses of the system.  If you do not know how to break it, then perhaps you do not understand the system. 

This is an idea our of engineering and probably we could learn much by studying how they have used the idea.

Much Worse than Anticipated

May 5, 2010

Arianna Huffington recently pointed out that time and time again, the crises that we face turn out to be Much Worse than We thought it would be.

And she has a good point there.  One that is important for risk managers to contemplate.  One that we are often asked after a major loss…

Why did your risk model get that wrong?

There is a correct answer, but it is one that we can never successfully use.

In situations where major risks are being underestimated widely in the market place, the risk managers who correctly size the worst risks can run into two responses:

  1. Their firm believes their evaluation of the risk and exits the exposure as rapidly as they can.
  2. Their firm does not believe their evaluation and will only believe a risk evaluation that gives a similar (under) estimation of the risk as the rest of the market.

It is a survival of the underestimators.

And this doesn’t just apply to risk managers and risk models.  Who do you think buys a house on a flood plain?  Someone who has a clear and realistic view of the risk or someone who vastly underestimates the risk?  The underestimator will out bid the realistic every time.

So after a flood, go around to those flooded out and ask if they expected this and most will tell you that this is “much worse that we thought it would be”.

Many “emerging risks” and “black swans” are such because most people had misunderestimated the size of the risk or the likelihood.

And one way to think of it is to go back to Knight and realize that all profits are simply rewards for the uncertainties.  So when we find ourselves getting profits where we cannot figure out the uncertainty that drives the profits, maybe we should go back and figure it out.

The solution is not to curl up in a ball, nor is it to just ignore all risks that pose these potential major threats.  The solution is to take our best shot at really evaluating the risks and make our decisions, eyes wide open, to the possibility that things might just be Much Worse than Anticipated.

Maybe we need to regularly add a column to our risk reports.  To the right of the column labeled Risk.  This one labeled “Worse Case”.

Many insurers with Cat risk exposures will report the 1/250 loss potential that is the focus of rating agencies, but along side of that show a 1/500 loss potential to remind management of just how much worse it might get.

Some people complain that risk managers are just too pessimistic.  But to me this sort of practice just seems to be acting as an adult and facing our risks honestly.  Not with the intention that we stop taking risks.  Instead hoping that we stop experiencing losses that are MUCH WORSE THAN ANTICIPATED.

Lessons for Insurers (5)

April 26, 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…

5. It is important to develop a counterparty risk management system and establish counterparty limits.

Insurers need to fully understand several things about both credit and reinsurance to get this right.

First of all, in a credit or reinsurance situation, the insurer is usually trading uncertainty in the “expected” range of probabilities for a potential loss at a very high attachment point, the failure point for the counterparty.

Second of all, the insurer needs to recognize that the failure of their counterparty usually does not in any way change their obligation.  When an insurer buys a bond, they are usually responsible to make payments to their policyholder regardless of whether the bond is good.  When an insurer buys reinsurance they are still responsible to pay claims whether or not the reinsurer is able to meet its obligations.

Recognize that in almost all cases, the standard risk management terminology is flawed.  Risk is usually not transferred.

The other consideration that is important to insurers is that they need to look for counterparty exposures everywhere in their operations.  In each of their insurance lines as well as in every part of their investment portfolio.  In firms where traditionally insurance and investments are treated as completelyt separate silos, risk managers are finding that both sides of the house are sometimes dealing with the exact same counterparties.  Aggregation and management of these concentrations is key.

And finally to scare you completely, a good way to think of counterparty risk is that you are bring a fraction of the entire balance sheet on to your balance sheet in return for a contingent payment.  So that should make you very interested in transparency.  Or maybe not.  Maybe you close your eyes when you drive around sharp curves also.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Making Better Decisions using ERM

April 21, 2010

Max Rudolph provided a lecture on ERM for the University of Waterloo and the Waterloo Research institute in Insurance, Securities and Quantitative finance (WatRISQ).

Key Points:

ERM’s Role in Strategic Planning

  • Understanding the Risk Profile
  • Solutions are Unique
  • Using Quantitative and Qualitative Tools

ERM is Not:

  • A Checklist Exercize
  • A Rating Agency Exercize
  • Just About Risk Mitigation

Have You ever heard of the Financial Crisis?

And Much more…

Max Rudolph

Volcano Risk

April 20, 2010

Remarks from Giovanni Bisignani (International Air Transport Association) at the Press Breakfast in Paris

The Volcano

There was one risk that we could not forecast. That is the volcanic eruption which has crippled the aviation sector.  First in Europe, but we saw increasing global implications.  The scale of this crisis is now greater than 9/11 when US air space was closed for three days.  In lost revenue alone, this is costing the industry at least $200 million a day.  On top of that, airlines face added costs of extra fuel for re-routing and passenger care – hotel, food and telephone calls.

For Europe’s carriers – the most seriously impacted – this could not have come at a worse time.  As just mentioned, we already expected the region to have the biggest losses this year.  For each day that planes don’t fly the losses get bigger.  We are now into our fifth day of closed skies.  Let me restate that safety is our number one priority. But it is critical that we place greater urgency and focus on how and when we can safely re-open Europe’s skies.

We are far enough into this crisis to express our dissatisfaction on how governments have managed the crisis:

  • With no risk assessment
  • No consultation
  • No coordination
  • And no leadership

In the face of a crisis that some have estimated has already cost the European economy billions of Euros, it is incredible that it has taken five days for Europe’s transport ministers to organize a conference call.

What must be done?

International guidance is weak. The International Civil Aviation Organization (ICAO) is the specialized UN agency for aviation. ICAO has guidance on information dissemination but no clear process for opening or closing airspace. Closing airspace should be the responsibility of the national regulator with the support of the air navigation service provider.  They rely on information from meteorological offices and Volcanic Ash Advisory Centers.

Europe has a unique system.  The region’s decisions are based on a theoretical model for how the ash spreads.  This means that governments have not taken their responsibility to make clear decisions based on fact.  Instead, it has been the air navigation service providers who announced that they would not provide service. These decisions have been taken without adequately consulting the operators—the airlines. This is not an acceptable system, particularly when the consequences for safety and the economy are so large.

I emphasize that safety is our top priority. But we must make decisions based on the real situation in the sky, not on theoretical models. The chaos, inconvenience and economic losses are not theoretical. They are enormous and growing. I have consulted our member airlines who normally operate in the affected airspace. They report missed opportunities to fly safely.  One of the problems with the European system is that the situation is seen as black or white. If there is the possibility of ash then the airspace is closed.  And it remains closed until the possibility disappears with no assessment of the risk.

We have seen volcanic activity in many parts of the world but rarely combined with airspace closures and never at this scale. When Mount St. Helens erupted in the US in 1980, we did not see large scale disruptions because the decisions to open or close airspace were risk managed with no compromise on safety.

Today I am calling for urgent action to safely prepare for re-opening airspace based on risk and fact.  I have personally asked ICAO President Kobeh and Secretary General Benjamin to convene an urgent extra-ordinary meeting of the ICAO Council later today. The first purpose would be to define government responsibility for the decisions to open or close airspace in a coordinated and effective way based on fact—not theory.

Airlines have run test flights to assess the situation.  The results have not shown any irregularities and the data is being passed to governments and air navigation service providers to help with their assessment. Governments must also do their own testing. European states must focus on ways to re-open the airspace based on this real data and on appropriate operational procedures to maintain safety.  Such procedures could include special climb and descent procedures, day time flying, restrictions to specific corridors, and more frequent boroscopic inspections of engines.

We must move away from blanket closures and find ways to flexibly open airspace. Risk assessments should be able to help us to re-open certain corridors if not entire airspaces.  I have also urged Eurocontrol to also take this up. I urge them to establish a volcano contingency center capable of making coordinated decisions.  There is a meeting scheduled for this afternoon that I hope will result in a concrete action plan.

Longer-term, I have also asked the ICAO Council to expedite procedures to certify at what levels of ash concentration aircraft can operate safely.  Today there are no standards for ash concentration or particle size that aircraft can safely fly through. The result is zero tolerance. Any forecast ash concentration results in airspace closure. We are calling on aircraft and engine manufacturers to certify levels of ash that are safe.

Summary

1. Safety is our number one priority
2. Governments must reopen airspace based on data that tell us it is safe. If not all airspace, at least some corridors
3. Governments must improve the decision-making process with facts—not theory
4. Governments must communicate better, consulting with airlines and coordinating among stakeholders
5. And longer-term, we must find a way to certify the tolerance of aircraft for flying in these conditions

You might wonder about your own Volcano Risk.  Check out an explanation of what is covered by State Farm.

Finally, I got a question from the press about companies that I knew that had prepared specifically for this event.  One more example of how the press misses the point.  ERM is not about guessing the future correctly.

For something that is as unique as this event, the best any company could have expected to do would have been to anticipated the broad class of events that would cause extended disruptions of flights, tested the impact of such a disruption on their business operations and made decisions about contingency plans that they might have put in place to prepare for such disruptions.

Lessons for Insurers (4)

February 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…

4. Insurers should establish a robust liquidity management system to ensure that they have ample liquidity under stress scenarios.

The only trouble with this advice it that it is totally unneeded.  That is because almost all cases of insurer problems with liquidity, those problems were preceded by a loss that significantly exceeded management expectations for a worst loss.

So it would not have made a difference whether those insurers planned more for liquidity, those plans would have been inadequate.

Insurers are generally cash flow positive.  Liquidity is only ever a problem if that changes drastically.  Even the “runs on the bank” that have occured on insurers have followed large losses.

So this advice sounds nice, but is actually unnecessary.  If insurers properly anticipate extreme losses, then they will be prepared to pay those losses without triggering problems.

That is because they will:

  1. Price for the losses so that they have sufficient income to pay the losses.

  2. Only accept as much of the risks that might trigger extreme losses as they can afford and spread effectively.

Those are fundamental risk management tasks.  If they are done properly, liquidity management is relatively trivial.  It consists of remembering not to invest the funds you have on hand to pay those extreme claims in instruments that are illiquid or or widely fluctuating value.

Seems like a good rule in general.  One that many insurers forget after many years of positive cashflows.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Take CARE in evaluating your Risks

February 12, 2010

Risk management is sometimes summarized as a short set of simply stated steps:

  1. Identify Risks
  2. Evaluate Risks
  3. Treat Risks

There are much more complicated expositions of risk management.  For example, the AS/NZ Risk Management Standard makes 8 steps out of that. 

But I would contend that those three steps are the really key steps. 

The middle step “Evaluate Risks” sounds easy.  However, there can be many pitfalls.  A new report [CARE] from a working party of the Enterprise and Financial Risks Committee of the International Actuarial Association gives an extensive discussion of the conceptual pitfalls that might arise from an overly narrow approach to Risk Evaluation.

The heart of that report is a discussion of eight different either or choices that are often made in evaluating risks:

  1. MARKET CONSISTENT VALUE VS. FUNDAMENTAL VALUE 
  2. ACCOUNTING BASIS VS. ECONOMIC BASIS         
  3. REGULATORY MEASURE OF RISK    
  4. SHORT TERM VS. LONG TERM RISKS          
  5. KNOWN RISK AND EMERGING RISKS        
  6. EARNINGS VOLATILITY VS. RUIN    
  7. VIEWED STAND-ALONE VS. FULL RISK PORTFOLIO       
  8. CASH VS. ACCRUAL 

The main point of the report is that for a comprehensive evaluation of risk, these are not choices.  Both paths must be explored.

Crisis Pre-Nuptial

January 21, 2010

What is the reaction of your firm going to be in the event of a large loss or other crisis? 

If you are responsible for risk management, it is very much in your interest to enter into a Crisis Pre-Nuptial

The Crisis Pre-Nuptial has two important components. 

  1. A protocol for management actions in the event of the crisis.  There is likely a need for there to be a number of these protocols.   These protocols can be extremely valuable, their value will most likely far exceed the entire cost of a risk management function.  Their value comes because they eliminate two major problems that firms face in the event of a crisis or large loss.  First is the deer in the headlights problem – the delay when no one is sure what to do and who is to do it.  That delay can mean that corrective actions are much less effective or much more expensive or both.  Second is the opposite, that too many people take actions, but that the actions are conflicting.  This again increasses costs and decreases effectiveness.  Just as with severe medical emergencies, prompt corrective actions are almost always more likely to have the most favorable results. 
  2. Setting up an expectation that the crises and losses either are or are not an expected part of the risks that the firm is taking.  If the firm is taking high risks, but does not expect to ever experience losses, then there is a major disconnect between the two.  Just as a marital pre-nuptial agreement is a conscious acknowledgement that marriages sometimes end in divorce, a Crisis Pre-Nuptial is an acknowledgement that normal business activity sometimes involves losses and crises. 

Risk managers who have a Crisis Pre-Nuptial in place might, just might, have a better chance to survive with their job in tact after a crisis or large loss. 

And if someday, investors and/or boards come to the realization that firms that plan for rainy days are, in the long run, going to be more valuable, the information that is in the Crisis pre-nuptial could be very important information for them.

Best Risk Management Quotes

January 12, 2010

The Risk Management Quotes page of Riskviews has consistently been the most popular part of the site.  Since its inception, the page has received almost 2300 hits, more than twice the next most popular part of the site.

The quotes are sometimes actually about risk management, but more often they are statements or questions that risk managers should keep in mind.

They have been gathered from a wide range of sources, and most of the authors of the quotes were not talking about risk management, at least they were not intending to talk about risk management.

The list of quotes has recently hit its 100th posting (with something more than 100 quotes, since a number of the posts have multiple quotes.)  So on that auspicous occasion, here are my favotites:

  1. Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.  Douglas Adams
  2. “when the map and the territory don’t agree, always believe the territory” Gause and Weinberg – describing Swedish Army Training
  3. When you find yourself in a hole, stop digging.-Will Rogers
  4. “The major difference between a thing that might go wrong and a thing that cannot possibly go wrong is that when a thing that cannot possibly go wrong goes wrong it usually turns out to be impossible to get at or repair” Douglas Adams
  5. “A foreign policy aimed at the achievement of total security is the one thing I can think of that is entirely capable of bringing this country to a point where it will have no security at all.”– George F. Kennan, (1954)
  6. “THERE ARE IDIOTS. Look around.” Larry Summers
  7. the only virtue of being an aging risk manager is that you have a large collection of your own mistakes that you know not to repeat  Donald Van Deventer
  8. Philip K. Dick “Reality is that which, when you stop believing in it, doesn’t go away.”
  9. Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.  Albert Einstein
  10. “Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”  Sherlock Holmes (A. Conan Doyle)
  11. The fact that people are full of greed, fear, or folly is predictable. The sequence is not predictable. Warren Buffett
  12. “A good rule of thumb is to assume that “everything matters.” Richard Thaler
  13. “The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.”  Avinash Persaud
  14. There are more things in heaven and earth, Horatio,
    Than are dreamt of in your philosophy.
    W Shakespeare Hamlet, scene v
  15. When Models turn on, Brains turn off  Til Schuermann

You might have other favorites.  Please let us know about them.

Black Swan Free World (10)

November 17, 2009

This is the final post in a 10 part series.

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…

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Of the ten suggestions, this one has the most value by far.  Unfortunately, this one may be the suggestion that has the least chance of being taken up.  No one is talking about any part of this.  We seem to be moving to try to set the world back into the place that is was, or very close to it.

We should be asking “What should be the place of banking in our economy?”  This is not a question of allowing the free market to choose.  The free market has nothing to do with this.  The role of the banking sector is entirely determined by the government.  The banking sector had grown to eat up a huge percentage of all of the profits of the entire economy.  Does that make any sense to anyone?  Banking can be a symbiont with the economy or it can be a parasite or it can be a cancer.  Before the crisis, banking had definitely moved beyond the level of parasite to becoming a harmful cancer.  Too much of all of the profits of all of business activity in the entire economy were being diverted to the banks and with the pay structure of the banks, into the pockets of a very small number of bankers.  Did that make any sense whatsoever?  Is there any way that anyone can show that situation makes for a healthy economy?  The bubbles that happened twice could be seen as the way that bankers justified their huge take from the economy.  If values were growing rapidly, no one seemed to mind that bankers took so much out of the deals.

Finance Share of GDP PhilipponSource:Evolution of the US Financial Sector Thomas Philippon

However, if the economy and the values of businesses and assets in the economy grow at only a sane pace, and bankers try to go back to the level of take from the economy that they have grown accustomed to, then the amount of total profits left for the rest of the economy are bound to be negative.  So unless we re-think things and figure out how to muzzle the banks, then we are headed for more bubbles that will justify their stratospheric incomes.

The financial sector, once it exceeds a certain share of the economy, should be viewed as a tax on the economy.  Many protest the taxes that the government imposes because the money is not well spent.  Well, the money from this tax goes to personal expenditures of the bankers themselves.  There is not even any pretense that this tax will be spent for the common good.

One question that really needs to be answered is how much of this financial “innovation” that is touted as the result is really beneficial to the economy and how much of it is just unnecessary complexity that hides that take of the bankers and hedge funds.  The excuse that is always given is that all of this financial innovation helps to provide lubrication for businesses.  But that is more like an excuse than a reason.  Mostly the financial innovation has fueled bubbles.  It has led to the excessive leverage that feeds into one sided deals for hedge fund managers.

More often than not, financial innovation has helped to fuel the extreme fixation on short term gains in the economy.  Financial innovation has featured hollowing out companies to maximize short term values.  Quite often the companies “helped” by this process turn into worthless shells somewhere along the process.  This destroys that productive capacity of the economy to allow for the extraction of the maximum amount of short term profits.

Financial innovation helps to turn corporate assets into profits and to take those profits out of the firm through leverage.

So Taleb’s suggestion that we think through Capitalism 2.0 is a good and timely one.  But we need to start asking the right questions to figure out what Capitalism 2.0 will be.

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)

2040 – America Becomes the Land of the Very Poor Old Baby Boomers

November 12, 2009

By 2040, the oldest of the infamous Baby Boom generation will turn 95.  The youngest, born almost 20 years later will be 75.  Unless there is a drastic change in course for the way that we generally prepare for retirement living, amost all of the Baby Boomers who survive until then, and many of us will, will be living entirely off of Social Security.

For more than half of the retirees, that will mean a big drop in the standard of living that we have grown accustomed to.  Five factors will feed into that trend:

  • Unless there is a sub prime like boom in lending, the part of Baby Boomers standard of living that is supported by debt, will lose that support.  Lenders are quite likely to develop a lack of ability to understand that people with low fixed income and declining assets are not good credit risks, but I would not plan the future of the generation on that presumption.
  • Real estate will NOT be the unbeatable asset that is has been most of the lives of the Baby Boomers.  There will just not be enough demand from the smaller generations coming after the Baby Boomers to keep real estate appreciation at levels comparable to inflation.
  • Inflation will be higher into the future.  That is because there are two ways that future generations can afford to pay off the promises that have been made to Baby Boomers for retirement:  Inflation and a Miracle.  With inflation, wages can grow enough to fund the retirement and medical benefits if there are small differences in the ways that the inflation impacts on Social Security and Medical expenses and how inflation impacts wages and taxes.  The Clinton administration started this trend by changing the definition of inflation, lowering it by 1%.   Future changes will be needed to allow for balance without large tax increases.  Medical costs inflation must be controlled to something lower than wage inflation, or health care will simply bankrupt the economy.
  • It is well known that Baby Boomers are not saving enough for retirement.  And the Boomers who started late were all putting much of their savings into stocks to roll the dice to hope that they picked up 30% per year returns to make up for 30 years of zero savings.
  • Very few Boomers will have a significant part of their retirement income in lifetime guaranteed annuities.  The most common approach to dealing with longevity risk is for retirees to plan to spend their retirement income over their life expectancy.  That thinking is the same as planning to run across the street knowing that you have a 50% chance of being struck by a car.  Half of all people live beyond the life expectancy.  Life expectancy is another one of those very bad terms that totally misleads people, in this case will help for them to plan for a very poor old age.

This could be thought of as a Black Swan scenario, except that it is highly likely.  It is probably much too late for anything different to happen.  There are just not enough future working years for the Boomers to make a major change in their own future and there is doubtless little will for the rest of the world to sacrifice to focus yet one more period in history on our generation.

But this scenario needs to be seriously understood by both the individuals who will be a part of this and by the firms who are in the businesses that will be most impacted.

How to Fail

November 5, 2009

Reasons Civilizations Fail

from Jared Diamond
Author of “Guns, Germs & Steel”
1. Failure to anticipate a problem before it arrives
2. Failure to see a problem once it arrives
3. Failure to even try to solve a problem once they have perceived it
4. Failure to solve a problem that they are trying to solve.
http://www.edge.org/3rd_culture/diamond03/diamond_index.html

Diamond presents a simple taxonomy of failure.  Much of what risk management attempts to do is to prevent failures.

So a risk manager can use this list as a control list for risk management practices.

Failure to anticipate a problem before it arrives – this appplies to both emerging risks as well as identified risks. Anticipating a problem means more than just fretting about it; it means preparing for it as well.

Failure to see a problem once it arrives. Knowing of a risk, but not knowing when that risk becomes risky is almost as bad as not knowing about the risk at all.  The risk manager needs to assist the business manager in identifying when risk is risky.  In addition, there needs to be a process for identifying emerging risks, especially those that are just about emerged. 

Failure to even try to solve a problem once they have perceived it As Diamond points in his books, sometimes people fail to act because they know that the first action would be to stop or reduce something that is really important to them.  This part of the risk management role falls on the CEO.  The CEO needs to be able to take the reins out of the hand of the frozen manager.  And if it is the CEO that is frozen, then the board needs to act.

Failure to solve a problem that they are trying to solve. In the risk management context, this occurs when the standard rules and tools just do not work.  The risk manager needs to reframe the problem along with a scramble for alternate tools while throwing out the rules.

Black Swan Free World (7)

October 17, 2009

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…

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

Hyman Minsky’s Financial Instability Hypothesis talks about the financial markets working in three regimes, Hedge, Speculative and Ponzi.   Under Hedge financing, investments generally have sufficient cashflow to pay both principle and interest.  Under Speculative financing, investments generally have cashflows sufficient to pay interest, but depend upon rolling over financing to continue.  Ponzi financing does not have sufficient cashflows to pay either interest or principle.  Ponzi financing requires that values will increase enough to pay both principle and interest to repay financing.

Speculative financing requires a belief that the value of the collateral will be stable to justify future refinancing or rolling over of the financing.  That belief could be called confidence.

Ponzi financing requires a belief that the value of collateral will grow faster than the interest rate charged.  That belief requires a significantly higher amount of confidence.

There are several other levels that a financial business could operate.  For example, the value of the collateral could be viewed in terms, not of its current value, but of its value in an adverse scenario.  A very conservative lender could then make sure that each investment used that adverse value as the actual amount of collateral granted.  In that situation, the investor does not want to rely upon the belief that the asset value will be stable.  A significantly more aggressive investor will want to make sure that their portfolio in total adjusts the value of collateral for the possible loss in an adverse situation, allowing for the effects of diversification in the portfolio.

Credit practices in the US have drifted against the path of having the borrower put up cash for that difference between adverse value and current value.  Instead, practice has changed so that the lender will hold capital against that adverse scenario and charge the borrowed the cost of holding that capital.

What has changed with that drift, is who will bare the losses in the adverse scenario.  That has shifted from the borrower to the lender.  So the loan transaction has changed from a simple credit transaction to a combined credit and asset value insurance transaction.  (Which makes me wonder if the geniuses who thought of this thought to charge appropriately for the insurance or if they just believed that if the market bought it when they securitized it, then the price must be right.)

This will look different from the former loan business where the borrowed bore the asset value risk because the lender will have fluctuations in their balance sheet when the adverse scenarios hit and the collateral value falls below the loan value.  And that is exactly what we are seeing right now.

In addition, as we are seeing now, when there is a extremely severe drop in the value of collateral, having the banks hold the risk of the decline in collateral value, then a drop in the collateral will have a significant impact on bank capital.  The impact on bank capital may have a major impact on the bank’s ability to lend which will impact on all of the rest of the economy that had no connection to the impaired asset class.

So to Taleb’s point about confidence,  it seems that he is stating that lending practices should revert to their prior level where collateral was valued under an adverse scenario.  Then there will be little if any confidence involved in the lending business.  And less chance that a steep drop in any one asset class will spill over to the rest of the economy.

So the dividing line would be that the financial firms that could be subject to future government bailouts would need to value collateral pessimistically and to avoid loans that are not fully collateralized.

Sounds SAFE.

But here is the problem with that proposal…

If any other firms, outside of that restriction are permitted to lend in the same markets, business will ultimately shift to those institutions.  They will be able to offer better loan terms and larger loans for the same collateral AND in most years, they will show much higher profits.

Bad risk management will drive out good.  The institutions that take the most optimistic view of risk, those who have the most confidence, will drive the firms with the more pessimistic view (whether that is their own view or the view imposed by the regulators) out of the market.

And then when the next crisis hits, regulators will find that the business has shifted to the non-regulated firms and they they will instead need to bail them out, unless they make it illegal for non-regulated firms to do any of the kinds of finance that is related to a government’s need to bailout.

Then the bank would almost always have real collateral and any drop in confidence could be resolved by assigning that collateral over to someone with cash and settling any needs for cash that the lack of confidence creates.

Taleb is not clear however whether he is referring to banks or the financial system in general or to the government with his statement.  The discussion above is about banks.

Trying to think about this idea in the context of the entire financial system, I wonder if he was suggesting a return to the gold standard.  When there was a gold standard, there was no need for confidence in the currency.  If you stay with the current currency regime, then the confidence idea, I suppose, relates to the question of inflating the currency.  If the government does seem to consistently hold the money supply at a reasonable level in proportion to the economy, then there will not be a problem.  However, I cannot think of any way of looking at the floating currency system that does not REQUIRE confidence that the government will hold inflation in check.

Applying the idea to the government, I would also say that confidence is required there as well.  A government that could be counted on to fund fully for spending programs would instill confidence, but there could be no surity, especially under the US system where the next congress could immediately trample on the good record of a all preceding governments.

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)

Emerging Risk Scenario (1)

October 14, 2009

The British dominance of the world scene was largely seen to have ended with WWI.  However, that decline was not really an absolute decline in wealth, it was really mostly just a relative decline.  Other countries, especially the US rose in wealth faster than the UK.

That story begins to hint at the ELEPHANT in the room.  That elephant is the relative per capita wealth of the people in China, India, and the other emerging economies.

We have entered a period of equalization of personal wealth between the have-nots and the haves.  That will be a very disruptive process in the Have countries.  It may go gradually with small slow changes or it may go rapidly through a series of big jumps.

But what we will see will be a series of shocks like the dot com bubble and the current financial crisis.  At the end of each shock, the PPP per capita wealth of the rising economies will be the same as at the start or more likely higher and the PPP per capital wealth of the Have economies will be lower.

This will happen largely via shocks because there is extreme amounts of resistance to the process on the part of the Have economies.  This resistance took the form of excessive leverage in recent times.  People were unwilling to accept the fact that their PPP income was dropping, so that they borrowed to keep their lifestyle at the level that they felt that they are entitled to.

So discussions about deficits are really about how the US will handle the coming change in distribution of the wealth of the world.  If we simply choose to resist the change and try to bring things back to “normal” by government or personal deficit spending, then eventually we will have to pay through devaluation of our currency and if we persist, those funding our debt will cut us off.

It is hard to imagine our political process coming to the conclusion that we need to rethink our financial strategies in the light of the changing world financial order. That thinking has to come from outside the political process and eventually find its way in.

So the Emerging Risks scenario is for the long term decline of the income of the Have economies accomplished through a long series of financial system shocks accompanies by growing government deficits and declining credit quality for the government debt of the developed nations.  At the same time, the successful “emerging market” economies become the dominant economic players and their people gradually risk in PPP income to match up with the PPP income of the “developed” nations for people who still do the same or comparable work.  That income equalization will include some significant increase in overall wealth, but not enough to maintain the incomes of the developed countries during this process.

So if this is the emerging risk scenario. the questions are:

1.  How would your firm fare in this scenario if no specific advance planning or anticipation is done?

2.  Are there any things that your firm might do differently if you thought that this scenario was somewhat likely?

3.  Assuming that this scenario occurs, what is the cost benefit of those actions?  i.e. do they make sense in that scenario?

4.  Are there any ways to track secondary signs that this scenario might be coming to be?

From time to time, different Emerging Risk scenarios will be posted here and in the INARM LinkedIn Emerging Risks group for discussion.

Readers can post scenarios also – directly on LinkedIn or as a comment here (that I will “promote” to a posting.)

Black Swan Free World (6)

October 13, 2009

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…

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

It is my opinion that many bubbles come about after a completely incorrect valuation model or approach becomes widely adopted.  Today, we have the advantage over observers from prior decades.  In this decade we have experienced two bubbles.  In the case of the internet bubble, the valuation model was attributing value to clicks or eyeballs.  It had drifted away from there being any connection between free cashflow and value.  As valuations soared, people who had internet investments had more to invest in the next sensation driving that part of the bubble. The internet stocks became more and more like Ponzi schemes.  In fact, Hyman Minsky described bubbles as Ponzi finance.

In the home real estate bubble, valuation again drifted away from traditional metrics, the archaic and boring loan to value and coverage ratio pair.  It was much more sophisticated and modern to use copulas and instead of evaluating the quality of the credit to use credit ratings of a structured securities of loans.

Goerge Soros has said that the current financial crisis might just be the final end of a fifty year mega credit bubble.  If he is right, then we will have quite a long slow ride out of the crisis.

There are two aspects of derivatives that I think were ignored in the run up to the crisis.  The first is the leverage aspect of derivatives.  A CDS is equivalent to a long position in a corporate bond and a short position in a risk free bond.  But few observers and even fewer principals considered CDS as containing additional leverage equal to the full notional amount of the bond covered.  And leverage magnifies risk.  Worse than that.

Leverage takes the cashflows and divides them between reliable cashflows and unreliably cashflows and sells the reliable cashflows to someone else so that more unreliable cashflows can be obtained.

The second misunderstood aspect of the derivatives is the amount of money that can be lost and the speed at which it can be lost.  This misunderstanding has caused many including most market participants to believe that posting collateral is a sufficient risk provision.  In fact, 999 days out of 1000 the collateral will be sufficient.  However, that other day, the collateral is only a small fraction of the money needed.  For the institutions that hold large derivative positions, there needs to be a large reserve against that odd really bad day.

So when you look at the two really big, really bad things about derivatives that were ignored by the users, Taleb’s description of children with dynamite seems apt.

But how should we be dealing with the dynamite?  Taleb suggests keeping the public away from derivatives.  I am not sure I understand how or where the public was exposed directly to derivatives, even in the current crisis.

Indirectly the exposure was through the banks.  And I strongly believe that we should be making drastic changes in what different banks are allowed to do and what different capital must be held against derivatives.  The capital should reflect the real leverage as well as the real risk.  The myth that has been built up that the notional amount of a derivative is not an important statistic and that the market value and movements in market value is the dangerous story that must be eliminated.  Derivatives that can be replicated by very large positions in securities must carry the exact same capital as the direct security holdings.  Risks that can change overnight to large losses must carry reserves against those losses that are a function of the loss potential, not just a function of benign changes in market values and collateral.

In insurance regulatory accounting, there is a concept called a non-admitted asset.  That is something that accountants might call an asset but that is not permitted to be counted by the regulators.  Dealings that banks have with unregulated financial operations should be considered non-admitted assets.  Transferring something off to the books to an unregulated entity just will not count.

So i would make it extremely expensive for banks to get anywhere near the dynamite.  Or to deal with anyone who has any dynamite.

Black Swan Free World (5)

Black Swan Free World (4)

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Black Swan Free World (2)

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Black Swan Free World (5)

October 9, 2009

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.

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Black Swan Free World (4)

October 3, 2009

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…

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

For many years, money managers were paid out of the revenue from a small management fee charged on assets.  The good performing funds attracted more funds and therefore had more gross revenue.  Retail mutual funds usually charged a flat rate.  Institutional funds charged a sliding scale that went down as a percentage of assets as the amount of assets went up.  Since mutual fund expenses were relatively flat, that meant that the larger funds could generate quite substantial profits.

Then hedge funds came along fifty years ago and established the pattern of incentive compensation of 20% of profits fairly early.  In addition, the idea of the fund using leverage was an early innovation of hedge funds.

Another innovation was the custom that the hedge fund manager’s gains would stay in the fund so that the incentives were aligned.  But think about how that works.  The investor puts up $1 million.  The fund gains 20%, the manager gets $400k and the investor gets $160k.  Then the fund drops 50%, the investor’s account is now worth $580k – he is down $420k.  The manager is down to $80k, but still up by that $80k.  The investor is creamed but the manager is well ahead.  Seems like that incentives need realignment.

Taleb may be thinking of a major issue with hedge funds – valuation of illiquid investments.  Hedge funds often make purchases of totally illiquid investments.  Each quarter, the manager makes an estimate of what they are worth.  The manager gets paid based upon those estimates.  However, with the recent downturn, even in funds that have not shown significant losses have had significant redemptions.  When these funds have redemptions, the liquid assets are sold to pay off the departing investors.  Their shares are determined using the estimated values of the illiquid assets and the remaining fund becomes more and more concentrated in illiquid assets.

If the fund manager had been optimistic about the value of the illiquid assets or simply did not anticipate the shift in demand that has ocurred with the financial crisis, there may well be a major problem brewing for the last investors out the door.  The double whammy of depressed prices for the illiquid assets as well as the distribution based upon values for those assets that are now known to be optimistic.

And over payment of the one sided performance bonuses to the manager were supported by the optimistic valuations.

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Custard Cream Risk – Compared to What???

September 26, 2009

It was recently revealed that the custard Cream is the most dangerous biscuit.

custard-cream-192b_684194e

But his illustrates the issue with stand alone risk analysis.  Compared to what?  Last spring, there was quite a bit of concern raised when it was reported that 18 people had died from Swine Flu.  That sounds VERY BAD.  But Compared to What?  Later stories revealed that seasonal flu is on the average responsible for 30,000 deaths in the US.  That breaks down to an average of 82 per day annually, or more during the flu season if you reflect the fact that there is little flu in the summer months.  No one was ever willing to say whether the 18 deaths were in addition to the 82 expected or if they were just a part of that total.

The chart below suggests that Swine flu is significantly less deadly than the seasonal flu.  However, what it fails to reveal is that Swine Flu is highly transmissable because there is very little immunity in the population.  So even with a very low fatality rate per infection, with a very high infection rate, expectations now are for more than twice as many deaths from the Swine Flu than from the seasonal flu.

disease_fatalities_550

For many years, being aware of the issue I tried to make a comparison whenever I presented a risk assessment.  Most commonly, I used a comparison to the risk in a common stock portfolio.  Was the risk I was assessing more or less risky than the stocks.  I would compare both the average return, the standard deviation of returns as well as the tail risk.  If appropriate, I would make that comparison for one year as well as for many years.

But I now realize that was not the best choice.  Experience in the past year reveals that many people did not really have a good idea of how risky the stock market is.  Many risk models would have pegged the 2008 37% drop in the S&P as a 1/250 year event or worse, even though there have now been similar levels of loss three times in the last 105 years on a calendar year basis and more if you look within calendar years.

spx-1825-2008-return

The chart above was made before the end of the year.  By the end of the year, 2008 fell back into the 30% to 40% return column.  But if your hypothesis had been that a loss that large was a 1/200 event, the likelihood of one occurrence in a 105 year period is only about 31%.  Much more likely to see none (60%).  Two occurrences only about 8% of the time.  Three or more, only about 1% of the time.  So it seems that a 1/200 return period hypothesis has about a 99% likelihood of being incorrect.  If you assume a return period of 1/50 years, that would make the three observations a 75th percentile event.

So that is a fundamental issue in communicating risk.  Is there really some risk that we really know – so that we can use it as a standard of comparison?

The article on Custard Creams was brought to my attention by Johann Meeke.  He says that he will continue to live dangerously with his biscuits.

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.

UNRISK (Part 1)

September 16, 2009

Post from Jawwad Farid

I have now been doing this “risk” business for more than a decade. Eleven years ago, right about this time, I was rudely introduced to my first risk application. Fresh from my actuarial exams, I was stumped on an interview question dealing with moments of a distribution. I have read the material, struggled with it, taken an exam on it and passed it. But in the room overlooking Fleet Street in London, in the month Russia defaulted on its domestic debt, I couldn’t explain it.

A question dealing with the moment generating function has an exact and mathematical answer. These days, across three continents, clients ask more difficult questions. “Does risk really works? Or is it smoke and mirrors” and/or “what is the one thing I can do to better manage my exposures?” While risk managers are generally stereotyped as the quite sort with short snappy answers (or little to say as some uncharitable critics suggest), it has been difficult to come up with a catchy symbolic one word answer to the above two questions.

Sometime last year while reviewing a list of competitors I came across an interesting name “Unrisk”. Same concept as insured, uninsured. Risk, unrisk. Just the word I had been looking for. Catchy, symbolic and with far more cool/mystique factor than just plain simple risk management. A bright new term for an age old profession. When I saw it for the first time, I instantly knew that Unrisk would represent a state of institutional nirvana that we would achieve when we have done all that we could possibly do to manage risk on our platforms.

Next time a client would ask for a guide to a risk based paradise; you would simply give him the road map to the Unrisk state. The real question would be what you would put on that road map? And would it really protect you from all that an evil generating function could throw at you.

Second question first. No the unrisk state won’t really guarantee immunity from the evil eye. Neither will we stop booking risk. We will keep on carrying exposures on our balance sheet and will load as much risk as we can carry, sometimes even more.

And yes it won’t stop us from falling, stumbling or faltering.

Just that the frequency and severity of our nightmares would reduce a bit; we would still degrade but we would do it far more gracefully.

My personal recipe for the state is a short one. It only has one item on it.

  1. Understanding the distribution

To be continued

DISLOCATION

September 10, 2009

Guest post from Mike Cohen

http://www.cohenstrategicconsulting.com/index.php

Dislocation: dis-lo-ca-tion (\,dis-(,)lō-’ka-shən): a disruption of an established order

The financial world has undergone a dislocation of epic proportions, one that is rivaled by only two such situations in our lifetimes: the Great Depression and to a lesser magnitude the interest spike and related chain of events of the early 1980’s. Financial institutions, and even more profoundly the world financial order, have been found to be standing on foundations of sand, and dynamics/financial behaviors/paradigms/systems that we took for granted are not effective, or at the very least stumbling along in a state of disarray and confusion.

As our ‘rose-colored glasses’ (spawned by over-optimism, greed, laziness, ignorance and unjustified trust) have been taken away and replaced with optical devices fitted with Coke-bottle lenses with Vaseline smeared on them, we are confronted with the critical endeavor of recreating nothing less than our way of life and arguably the most important underpinning of it, our financial system.

Our World Has Changed: This dislocation is different and more troubling than any other in history, in large part because it almost triggered the collapse of the world’s financial system.  The crisis we are faced with today was caused by widespread business practices where society’s hard learned lessons were ignored:

–       The financial system is based on trust (in people, in the system itself), and the resulting belief that it works; there has been a considerable amount of activity that almost any observer would describe as untrustworthy

–       Accurate, objective analysis is critical

–       Greed kills, sooner or later

Joseph Schumpeter, the famous Czechoslovakian economist, observed in the 1920’s:

Capitalism moves forward following a process of creative destruction. Inevitable cycles of expansion and retraction are not only survivable but are in fact the secret of capitalism’s extraordinary power to inspire innovation and progress.”

It would be completely inaccurate to describe the financial crisis that has occurred as the result of ‘creative destruction’. The root causes of this crisis are much darker.

How did we get to where we are?

–       Unjustifiably easy credit was offered to homebuyers who very logically couldn’t have been expected to be able to service their mortgage loans.  A substantial price bubble was created and inevitably burst, as many have before it, but this time the entire American society was hurt badly as opposed to individual investors in past bubbles.

–       Asset managers making ambitious claims about investment returns they said they couldn’t possibly achieve, and others committing outright fraud

–       Rating analysts not adequately analyzing securities, causing them to be overrated and underpriced

–       Investment bankers and others facilitating transactions built on elements that had not been properly vetted, and which have turned out to have crushing levels of risk and unforeseen financial liabilities

Macro Issues Abounded:

– The banking system almost collapsed, and may have had it not been for considerable government intervention, which has raised a host of other profound issues. An enormous amount of bad loans were made as the result of capricious underwriting, leading to huge amounts of bad assets on banks’ books and causing a paralyzing level of fear for making further loans.

– The financial markets ‘froze’. The flow of capital slowed to a trickle because lenders did not believe that borrowers were credit-worthy; ironically, the thought process evolved from lending money to anybody to lending money to no one. The markets are just beginning to thaw, a year later.

– Complicated financial instruments confused and overwhelmed the system, creating enormous risk. Counterparties, partners in transactions, did not understand these vehicles they were buying and selling (and in many cases how their counterparts were managing their own enterprises) … and the risks they were taking on. A certain notorious business operation has long held the notion that “Be close to your friends, and closer to your enemies”.

– The real estate market plunged into its worst cycle in decades, and possibly ever. This collapse was caused by a number of dynamics:

* Selling housing/making loans to individuals or companies whose financial positions were not strong enough to service their financial obligations

– The rating agencies have been called to task over their role in the current situation, and a number of vexing questions have been raised:

* How are they analyzing companies and investment vehicles?

* How are they to be paid for their rating services? Are there conflicts of interest imbedded in their client relationships?

* How will they be operating going forward?

* How will they be regulated?

– Consumer attitudes have been more negative than ever since they began being monitored in the 1960’s, although recently they have improved marginally as economic and financial stabilization is beginning to occur.  The widespread view is that the current situation is beyond a cyclical downturn and is perceived as a failure of the system. Uncertainty about the financial system, rising unemployment, restricted credit, and a depressed housing market have all contributed to plummeting consumer sentiment.

– Government responses in the form of rescue programs of various types are beginning to fix the problems within the financial system (banks and insurers) and key industries (automotive), and are gradually beginning to calm fears. Substantial efforts to revise the nation’s financial services regulatory infrastructure are underway, conceived to both address current issues and create a more shock-free system in the future. A number of vexing problems have arisen, however, that will be very difficult to solve:

* Well intentioned programs to interject capital to troubled sectors of the economy have been slow to take effect

* Massive budget deficits are building, which will lead to substantial debt servicing obligations in the future and consequentially depressed economic growth

* The government owns stakes in huge corporations (with the implication of socialistic-type government in the United States, for crying out loud!), and is being perceived as making broad decisions on which corporations will survive or fail.

* Understanding that things that can go wrong (either known or unknown), and making sure the adverse affects do not cause crippling and irreversible harm

* A fundamental question begging to be asked is “how did so many elements of this financial disaster occur that had aspects and implications of risk that no one either understood or quantified anywhere close to properly, or didn’t bother to look at?”

Zombie, Elephant and Monkey Risk

September 8, 2009

This is a guest post from Trevor Levine at riskczar.com

Is it too soon to add Zombie Risk to our heat maps?

According to researchers at two Ottawa universities who modeled a zombie attack using biological assumptions based on popular zombie movies, “classic” slow-moving zombies could take over our cities in under a week. (The “nimble, intelligent creatures” would take a few days less I imagine.)

And while we can all laugh this one off and conclude that at best Zombie Risk would be in the upper corner or our heat map (Extremely Unlikely and Catastrophic), a zombie “plague” in fact resembles any sort of lethal, rapidly spreading infection.

Where are those H1N1 sort of risks on your heat maps?

You can read more about this at http://news.bbc.co.uk/2/hi/science/nature/8206280.stm

Elephant Risk

A few weeks ago, I wrote about the threat of zombies and whether it was too soon to ad zombie risk to your risk register or heat map. Well what about Elephant Risk?

The Scientific Leader Blog writes about the increasing danger of elephants in India and Sri Lanka entering cities and causing trouble. For those of us sitting in Toronto, New York or Chicago, elephants are not risk we need to add to our heat maps but it does make you think about unknown unknows.

What’s out there that we have not thought about before?

Monkey Risk

Earlier today I wrote about the threat of elephants in some parts of India or Sri Lanka; risks we would never consider including in a heat map in major North American cities but are threats in other parts of the world.

Well, if you were tasked with identifying and assessing risk to the municipal government of Delhi, India in 2007, would you have included Monkey Risk?

A BBC article from October 2007 reads:

The deputy mayor of the Indian capital Delhi has died a day after being attacked by a horde of wild monkeys. SS Bajwa suffered serious head injuries when he fell from the first-floor terrace of his home on Saturday morning trying to fight off the monkeys. The city has long struggled to counter its plague of monkeys, which invade government complexes and temples, snatch food and scare passers-by.

I am not advocating adding Monkey Risk to your risk maps, just open your minds to identify and assess all sorts of risks while searching for similarities in seemingly dissimilar things. Maybe we don’t have to worry about monkeys but what about rats, birds, insect infestations, etc.

Just think about it and how something so far fetched could affect your business plan.

http://news.bbc.co.uk/2/hi/south_asia/7055625.stm

The Black Swan Test

August 31, 2009

Many commentators have suggested that firms need to do stress tests to examine their vulnerability to adverse situations that are not within the data set used to parameterize their risk models. In the article linked below, I suggest the adoption of a terminology to describe stress tests and also a methodology that can be adopted by any risk model user to test and
communicate a test of the stability of model results. This method can be called a Black Swan test. The terminology would be to set one Black Swan equal to the most adverse data point. A one Black Swan stress test would be a test of a repeat of the worst event in the data set. A two Black Swan stress test would
be a test of experience twice as adverse as the worst data point.

So for credit losses for a certain class of bonds, if the historical period worst loss was 2 percent, then a 1BLS stress test would be a 2 percent loss, a 4 percent loss a 2BLS stress test, etc.

Article

Further, the company could state their resiliency in terms of Black Swans. For example:

Tests show that the company can withstand a 3.5BLS stress test for credit and a 4.2BLS for equity risk and a simultaneous 1.7BLS credit and equity stress.

Similar terminology could be used to describe a test of model stability. A 1BLS model stability test would be performed by adding a single additional point to the data used to parameterize the model. So a 1BLS model stability test would involve adding a single data point equal to the worst point in the data set. A 2BLS test would be adding a data point that is twice as bad as the worst point.


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