The Five Neglects of Risk Management

Here is a useful list of five "neglects" that we as risk analysts must become versed in correcting prior to disaster (Berger, Brown, Kousky, & Zeckhauser, 2009):

1. Probability neglect (consideration of probability)
2. Consequence neglect (valuation of potential benefits and losses)
3. Statistical neglect (accurate use of subjective probability and statistics)
4. Solution neglect (delineation and evaluation of all available alternatives)
5. External risk neglect (incorporation of all benefits and costs accruing to the decision maker)

Catastrophes can and should be instructive for future practice...

Source: Berger, A, Brown, C, Kousky, C, & Zeckhauser, R (2009), The Five Neglects: Risks Gone Amiss, in H Kunreuther & M Useem (Eds), Learning from Catastrophes: Strategies for Reaction and Response (pp. 83-99). Philadelphia, PA: Wharton School Publishing.

On Model Risk

I mentioned in my last posting that I am frequently asked to explain in practical terms what is meant and implied by financial modeling and risk analysis. However, the better question would be to ask about the meaning and nature of model risk in financial economics. Here is a pragmatic definition of model risk offered by Dr Riccardo Rebonato (2002):

Model risk is the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market.

Dr Rebonato's "definition" is more of an operationalization, which nevertheless offers useful guidance for analyzing model risk in practice. Financial modeling and risk analysis are legacy concepts; the front of mind practical issue of our time centers on model risk and its implications.

Source: Rebonato, R (2002), "Theory and Practice of Model Risk Management,” Unpublished manuscript.

On Financial Modeling and Risk Analysis

Here are some basic questions that I am frequently asked about financial modeling and risk analysis:

What is financial modeling...?

The process by which a firm constructs a financial representation of some, or all, aspects of the firm or a given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives.

What does financial modeling entail...?

Financial models can be constructed in many ways, either by the use of computer software, or with a pen and paper. What's most important, however, is not the kind of user interface used, but the underlying logic that encompasses the model. A model, for example, can summarize investment management returns, such as the Sortino ratio, or it may help estimate market direction, such as the Fed model.

What is risk analysis...?

The study of the underlying uncertainty of a given course of action. Risk analysis refers to the uncertainty of forecasted future cash flows streams, variance of portfolio/stock returns, statistical analysis to determine the probability of a project's success or failure, and possible future economic states. Risk analysts often work in tandem with forecasting professionals to minimize future negative unforseen effects.

What does risk analysis entail...?

Almost all large businesses require a minimum sort of risk analysis. For example, commercial banks need to properly hedge foreign exchange exposure of oversees loans while large department stores must factor in the possibility of reduced revenues due to a global recession. Risk analysis allows professionals to identify and mitigate risks, but not avoid them completely. Proper risk analysis often includes mathematical and statistical software programs.

Source: Investopedia

A Tale of Model Risk

I saw the following dialog published years ago on the Internet. The exchange remains instructive through today regarding how naïve model risk creeps into enterprise analytics:

Clueless in Chicago (7/28/00)

Dear Dr Risk – We've got a pricing model that we use on a daily basis, hundreds -- sometimes thousands -- of times. Our regulator is pressing us for details of the model. Our problem is that we don't have any documentation to give. We know the model's good, 'cause we're still in business, but we can't document the fact. Can you help us figure out which model we're using.

Dear Chicago – Your bank is certainly not the only one using an undocumented "black box" to price options with millions of dollars of notional value. Once, Dr. Risk was faced with the problem of documenting a pricing application for which the bank had no write-up. They didn't even have a name for the model, such as Black-Scholes.

"No problem," said Dr Risk. "Let me see the source code. I don't care what language."

A few days later, the liaison had some bad news: "The source code isn't on the network. They were running out of disk space one day, a few years ago, and nobody had accessed the file for a few years, so they moved it onto magnetic tape and stuck the tape into an archive. We'll have to get it out of the archive."

A week later, the liaison had some [more] bad news: "The archive was getting full, and nobody had asked for that tape after five years, so somebody chucked it."

"No problem," said Dr Risk. "Let me talk to the developer."

A few days later, the liaison had some [really] bad news: "The developer left the bank a few years ago for a new job. Then he left that job. We can't find him. A guy who worked with the developer is still with the bank. He's not answering his phone. Maybe he's on vacation. We'll ask him and get back to you."

A few days later, the liaison had some [really, really] bad news: "The assistant didn't answer his phone, because he's recovering from a heart attack. He's supposed to rest and may be taking early retirement. I don't think he's going to be available. Got any ideas?"

Dr Risk said, "Let's see if I can match the output with something in my library. We don't have a whole lot of right ways to go, here."

Turns out the model wasn't difficult to match. It would be nice to see the guts of the application, to make sure it doesn't contain a Trojan horse, but that's not going to happen.

In your case, if you like, Dr Risk can try to reverse engineer your application. With a little bit of luck we'll find a perfect match for your app in our extensive library of models. Let us know if you want us to pursue this as a consulting project.

You can visit Dr Risk's blog through the link below.

Source: The Derivatives 'Zine

Twelve Principles for Agile Software Development

Promulgated in 2001, the Twelve Principles for Agile Software Development continue to provide useful guidance for practice today:

Our highest priority is to satisfy the customer through early and continuous delivery of valuable software.

Welcome changing requirements, even late in development. Agile processes harness change for the customer's competitive advantage.

Deliver working software frequently, from a couple of weeks to a couple of months, with a preference to the shorter timescale.

Business people and developers must work together daily throughout the project.

Build projects around motivated individuals. Give them the environment and support they need, and trust them to get the job done.

The most efficient and effective method of conveying information to and within a development team is face-to-face conversation.

Working software is the primary measure of progress. Agile processes promote sustainable development.

The sponsors, developers, and users should be able to maintain a constant pace indefinitely.

Continuous attention to technical excellence and good design enhances agility.

Simplicity--the art of maximizing the amount of work not done--is essential.

The best architectures, requirements, and designs emerge from self-organizing teams.

At regular intervals, the team reflects on how to become more effective, then tunes and adjusts its behavior accordingly.

To learn more or to become a signatory to the "Agile Manifesto," visit their website linked below.

Source: Agile Manifesto

Value at Risk is Neither Subadditive Nor Distributive

Let's assume that a trio of financial institutions with portfolio holdings X, Y, and Z represent their respective Value at Risk (VaR) measures as

VaR (X) + VaR (Y) + VaR (Z),

and that the three portfolios are subsequently merged into one by the method

VaR (X + Y + Z).

Of course, coherence would require that

VaR (X + Y + Z) = VaR (X) + VaR (Y) + VaR (Z).

However, VaR is neither subadditive nor distributive, and depending on the composition of portfolios X, Y, and Z, the post-merger VaR can exceed the summation of VaR for the segregated portfolios, resulting in

VaR (X + Y + Z) ≥ VaR (X) + VaR (Y) + VaR (Z).

The point of this exercise is to caution that merging portfolios can increase VaR. Yet, our nation’s financial regulators and leadership continue to defend and justify such capital formations (e.g., bank mergers) as necessary and expedient within the rubric of "globalization," "too big to fail," or some other convolution of fear mongering. Given the risk calculus above, I maintain that financial institutions that become "too big to fail" are likewise too risky to keep around. Bank mergers and acquisitions that expand VaR make no sense in today's business climate.

How Far Will Interest Rates Go Up?

The Federal Reserve raised the discount rate today as part of its initial efforts to restore normalcy in the nation's lending facilities. The question that remains is just how far the Fed might eventually go with rate hikes in order to control inflation and achieve economic growth. Only time will tell, but my guess is that interest rates will increase much more than America is now anticipating. More to follow...

Alternate Currency

Reproduced with permission of XKCD.com

Related Posts

Visual Basic for Applications (VBA) 7.0

Good news for Visual Basic for Applications (VBA) programmers! I saw a report from Microsoft that Office 2010 will include VBA 7.0. Like Office 2010, this entirely new version of VBA will come in both 32-bit and 64-bit versions. Looks like VBA is here to stay, at least until Office 15.

More

Risk and Uncertainty

I propose that risk is to destiny as uncertainty is to fate...

The Nordics in the Global Crisis

by Thorvaldur Gylfason, Bengt Holmstrom, Sixten Korkman, Hans Tson Söderström, and Vesa Vihriälä © VoxEU.org

Is the Nordic model an asset or a liability? The global crisis has seen GDP in the region decline by between 4.5% and 7%. This column argues that the Nordic model, with its welfare state and high rate of investment in human capital, can, properly implemented, be part of the solution.

The Nordic countries – Denmark, Finland, Iceland, Norway and Sweden – are champions of free trade and open markets. And for a good reason; they see international specialisation within a global framework as a means of raising productivity and income. Much of the Nordic socio-economic model can be interpreted as aiming at collective risk sharing with a view to fostering acceptance of open markets, new technologies and the need for change.

In a broad sense the model includes a set of labour market organisations, with an important role for negotiations, a comprehensive safety net and a high rate of publicly supported investment in human capital. Embracing globalisation and sharing risk are mutually reinforcing planks of the Nordic Model, as discussed in Andersen et al. (2007).

Is the Nordic model an asset or a liability?

The current crisis is not only a financial and economic crisis but also a crisis of the much heralded globalisation process itself. It therefore raises many key questions for small open economies, not least the Nordics. What are the lessons of the crisis for economic policies? Is the future of the global economy more unstable than the past, and does that perspective call for a fundamental review of the economic policy strategy? Is the Nordic model an asset or a liability in the light of the crisis?

As we discuss in our new report (Gylfason et al. 2010), the crisis is best seen as the outcome of a lopsided globalisation process that overwhelmed the global financial system. The global savings glut was largely absorbed by the US shadow banking system, because of its capacity to create innovative products. It seemed to offer safe investment outlets at attractive rates of return, while at the same time encouraging excessive leverage. Once the bubble burst and the world economy went down, the Nordics, with their high dependence on exports of investment goods and consumer durables, were particularly hard hit (with the exception of oil-rich Norway). Their GDP in 2009 declined at rates between 4.5% and 7%.

While the sharpness of the global downturn was a surprise, so was the early stabilisation, which started around the middle of 2009. At this point the recession has been declared over in many countries and a recovery – though weak and hesitant – seems to be underway. There is little doubt of the explanation; policies matter. Authorities have demonstrated an unprecedented activism in monetary and fiscal policy as well as inventiveness in financial crisis management. While the world escaped a repetition of the Great Depression, the crisis has nevertheless left a legacy of difficult issues and challenges.

The Nordics are vulnerable but also resilient. While Iceland is a case of its own, we believe that the Nordics have the capacity to recover and to continue combining economic efficiency with high social ambitions. Sweden and Finland experienced a severe banking crisis in the early 1990s, thereby learning a lot about the need for better financial regulation and supervision.

Lessons were learnt about the need for a solid crisis management framework, the pros and cons of a blanket government guarantee for financial institutions, the need for precautionary and other capital injections, the problems of transferring assets into “bad banks”, and the case for not shying away from the government taking over institutions in certain circumstances. Many of these lessons were useful in avoiding mistakes in this crisis and they have attracted interest in other countries. This is also why companies and banks in the region have had balance sheets strong enough to weather the crisis pretty well (we obviously leave out Iceland again).

The effect of the euro

The Nordics have all had different monetary regimes since the euro. Given their similarity in other respects, a comparison of Finland and Sweden is especially interesting. It is almost a laboratory experiment. Sweden has a floating exchange rate and an independent central bank geared to price stability, while Finland is part of the Eurozone. Who has made the better choice?

The krona was mostly stable and developments in Finland and Sweden were strikingly similar during the first decade of the euro. Once the crisis erupted, however, the krona fell significantly relative to the euro, thereby strengthening the price competitiveness of Sweden relative to Finland and the euro area. One might expect this to help Sweden come through the crisis at less cost than Finland, arguably benefitting at the expense of its neighbour by capturing market shares.

The decline in exports and output in 2009 was indeed smaller in Sweden than in Finland, and GDP growth is forecast to be somewhat faster. However, the differences do not seem large. Also, manufacturing output shows little response to the change in competitiveness, and unemployment is rising in parallel with developments in Finland.

Either the effects of the improved competitiveness are relatively modest or the lags are long, or a depreciation of a floating currency has less effect on export and output volumes than a devaluation of a pegged currency used to have. What is clear is that the floating exchange rate does not insulate an economy from external shocks, and the economic differences between the two exchange rate regimes seem smaller than often claimed in the heated debate about the Eurozone.

An effective fiscal stimulus?

For small and open economies, in particular, one may question the power of fiscal expansion as an instrument of demand management. Nevertheless, we still find that an expansionary fiscal policy is helpful in a crisis. It is a useful complement to monetary policy when the interest rate hits its lower bound or when the credit system becomes dysfunctional. Also, fiscal action may alleviate particular problems such as long-term or youth unemployment. Furthermore, automatic fiscal stabilisers allow the government to avoid hasty and unduly harmful measures. The social contract is very valuable in a crisis as it tempers the panic and gives the government more time to plan and undertake measures to reignite growth in an orderly manner.

Of course, sustainable public finances need to be restored, and it is useful to consider the merits of alternative means of fiscal consolidation. Public expenditure may be cut or its composition twisted in a growth-friendly direction, and efficiency in the provision of public services improved. The tax base may be broadened by measures to raise the employment rate, particularly by prolonging the length of working careers. There is some scope for changing the structure of taxation with a view to encouraging economic growth, notably by reducing the share of taxes that fall directly on corporate profits and wage income.

The Nordics were in a position to pursue fiscal expansion in the crisis because these countries were – in contrast to the US and almost all other EU countries –running sizeable budget surpluses in the preceding decade. The government debt level of the Nordics is only half of what it is in the OECD on average and they continue to borrow at very favourable terms. Given their track record, there is reason to believe that the Nordics will continue to be countries with relatively sound public finances, retaining the scope for fiscal policy to be used when needed.

Safety in numbers

Most importantly, the Nordic model itself contributes to resilience. The comprehensive safety net, one of the attributes of the Nordic model, has proved to be robust also in times of crisis. The entitlements are not tied to the fate of individual companies or particular markets, and risks are widely shared in the society. While forest plants are shutting down in Finland and car manufacturing is sharply contracting in Sweden, the governments are firmly rejecting requests for support of ailing industries. Still, there are no crowds protesting in the streets, largely because flexible work arrangements, based both on general and company-specific agreements between businesses and labour, alleviate a rise in unemployment. Structural change is enhanced by the employment protection legislation, which is more liberal than in most other EU countries. A well-educated labour force, another of the attributes of the Nordic model, facilitates adjustment by making it easier to upgrade skills through additional training.

Provided that governments continue to be able to take the decisions needed to safeguard competitiveness and the sustainability of public finances, the Nordic model can be both robust and resilient. The Nordic model with its welfare state, labour market institutions and high rate of investment in human capital, is not the source of the current problems. On the contrary, the Nordic model, properly implemented, can be part of the solution.

References

Andersen, T, Holmström, B, Honkapohja, S, Korkman, S, Söderström, H T, and Vartiainen, J (2007), ”The Nordic Model – Embracing Globalisation and Sharing Risks,” The Economic Research Institute of the Finnish Economy, Helsinki: ETLA.

Gylfason, T, Holmström, B, Korkman, S, Söderström, H T, and Vihriälä, V (2010), "Nordics in Global Crisis – Vulnerability and Resilience,” Helsinki: ETLA.

Republished with permission of VoxEU.org

Eleven Lessons from Iceland

by Thorvaldur Gylfason © VoxEU.org

How to stop a repeat of Iceland’s crisis – both in the country and elsewhere? This column provides eleven lessons covering asymmetric information, moral hazard, better warning systems and improved regulation, preventing banks becoming “too big to fail” and restricting asset bubbles, holding creators of externalities to account, and providing safeguards on political interference.

Iceland’s economic crisis has destroyed wealth equivalent to about seven times its GDP. The damage inflicted on foreign creditors, investors, and depositors amounts to about five times its GDP, while the asset losses thrust upon Icelandic residents account for the rest. These figures do not include the cost of Iceland’s increased indebtedness. Iceland’s gross public debt, domestic and foreign, is estimated to increase by more than 100% of GDP as a result of the collapse of the banks, or from 29% of GDP at the end of 2007 to 136% by the end of 2010. In 2009, the government spent almost as much on interest payments as on healthcare and social insurance, the single largest public expenditure item. The damage due to Iceland’s tarnished reputation is harder to assess.

A number of economists have discussed the consequences of Iceland’s troubles and suggested solutions (Buiter & Sibert, 2008; Danielsson, 2010), but a key question remains: How could this happen?

To make a long story short (for the longer story, see Gylfason et al., 2010), the absence of checks and balances that had led to an unbalanced division of power between the strong executive branch and the much weaker legislative and judicial branches came to haunt the country when unscrupulous politicians put the new banks in the hands of reckless owners who then found themselves in a position to expand their balance sheets as if there were no tomorrow – and no supervision. Politicians who privatise banks by delivering them on a silver plate to their friends are not very likely to subject the banks to stringent supervision or other such inconveniences.

Collective guilt and responsibility

Iceland’s predicament raises old questions about collective guilt and responsibility. Many wonder how taxpayers can be held responsible for the failures of private bankers. But taxpayers are also voters – many of them voted for the politicians who sided with the bankers, having abstained or voted for the opposition is clearly not a valid excuse. Guilty or not, many feel responsible as taxpayers, but not all.

Opinion polls suggest that a majority of the electorate did not want parliament to approve the IceSave deal between Iceland, the UK, and the Netherlands by which Iceland agrees to repay the British and the Dutch about a half of the amount that the latter unilaterally decided to pay out in compensation to depositors in the IceSave accounts of Landsbanki.*

The stakes are high because Iceland’s agreement with the IMF appears to hinge on the parliament’s approval of the deal with the British and the Dutch. As it turned out, even this is not enough, because the President of Iceland chose to intervene by referring the IceSave law to a national referendum. It is a matter of record that the stipulation concerning the deal on the IceSave accounts is part of the IMF-supported programme at the behest of the Nordic countries, or at least some of them (Gylfason 2009). Without their support, the programme – with less financing available – would require stricter adjustment of public expenditures and taxes. In other words, without a settlement of the IceSave dispute, Iceland’s short-run crisis would deepen – an almost certain outcome of a “no” vote in the referendum scheduled for 6 March.

Parting company

In 2009, while the unemployment rate shot up to 9% of the labour force, a very high rate by Icelandic – if not by European – standards, GDP fell by 7%, and is not expected to be restored to its 2008 level until 2014 in local currency at constant prices. In dollars or euros, however, per capita GDP will take longer to recover enough to regain parity with the Nordic countries because the króna is not expected to rise in value for a number of years to come. As a result of the collapse of Iceland’s banks and of the króna, Iceland’s GNI per person sank in 2008 to a level one-third below that of Denmark, Finland, and Sweden (see Figure 1; Norway’s oil puts it in a class of its own). Due to emigration, Iceland’s population fell slightly in 2009 for the first time since 1889. Significant emigration over the next few years would weaken the tax base and depress the living standards of those who stay.

Figure 1. Nordic countries: Gross National Income per capita 1980-2008 (at purchasing power parity, current international $)

Source: World Bank (2009), World Development Indicators.

And the lessons?

What can be done to reduce the likelihood of a repeat performance – in Iceland and elsewhere? Here are eleven main lessons from the Iceland story, lessons that are likely to be relevant in other less extreme cases as well.

Lesson 1. We need effective legal protection against predatory lending just as we have long had laws against quack doctors. The problem is asymmetric information. Doctors and bankers typically know more about complicated medical procedures and complex financial instruments than their patients and clients. The asymmetry creates a need for legal protection through judicious licensing and other means against financial (as well as medical) malpractice to protect the weak against the strong.

Lesson 2. We should not allow rating agencies to be paid by the banks they have been set up to assess. The present arrangement creates an obvious and fundamental conflict of interest, and needs to be revised. Likewise, banks should not be allowed to hire employees of regulatory agencies, thereby signalling that by looking the other way, remaining regulators may also expect to receive lucrative job offers from banks.

Lesson 3. We need more effective regulation of banks and other financial institutions; presently, this is work in progress in Europe and the US (see Volcker, 2010).

Lesson 4. We need to read the warning signals. We need to know how to count the cranes to appreciate the danger of a construction and real estate bubble (Aliber’s rule). We need to make sure that we do not allow gross foreign reserves held by the Central Bank to fall below the short-term foreign liabilities of the banking system (the Giudotti-Greenspan rule). We need to be on guard against the scourge of persistent overvaluation sustained by capital inflows because, sooner or later, an overvalued currency will fall. Also, income distribution matters. A rapid increase in inequality – as in Iceland 1993-2007 and in the US in the 1920s as well as more recently – should alert financial regulators to danger ahead.

Lesson 5. We should not allow commercial banks to outgrow the government and Central Bank’s ability to stand behind them as lender – or borrower – of last resort. In principle, this can be done through judicious regulation, including capital and reserve requirements, taxes and fees, stress tests, and restrictions on cross-ownership and other forms of collusion.

Lesson 6. Central banks should not accept rapid credit growth subject to keeping inflation low – as did the Federal Reserve under Alan Greenspan and the Central Bank of Iceland. They must take a range of actions to restrain other manifestations of latent inflation, especially asset bubbles and large deficits in the current account of the balance of payments. Put differently, they must distinguish between “good” (well-based, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth.

Lesson 7. Commercial banks should not be authorised to operate branches abroad rather than subsidiaries if this entails the exposure of domestic deposit insurance schemes to foreign obligations. This is what happened in Iceland. Without warning, Iceland’s taxpayers suddenly found themselves held responsible for the moneys kept in the IceSave accounts of Landsbanki by 400,000 British and Dutch depositors. Had these accounts been hosted by subsidiaries of Landsbanki rather than by branches, they would have been covered by local deposit insurance in Britain and the Netherlands.

Lesson 8. We need strong firewalls separating politics from banking because politics and banking are not a good mix. The experience of Iceland’s dysfunctional state banks before the privatisation bears witness. This is why their belated privatisation was necessary. Corrupt privatisation does not condemn privatisation, it condemns corruption.

Lesson 9. When things go wrong, there is a need to hold those responsible accountable by law, or at least try to uncover the truth and thus foster reconciliation and rebuild trust. There is a case for viewing finance the same way as civil aviation: there needs to be a credible mechanism in place to secure full disclosure after every crash. If history is not correctly recorded without prevarication, it is likely to repeat itself.

Lesson 10. When banks collapse and assets are wiped out, the government has a responsibility to protect jobs and incomes, sometimes by a massive monetary or fiscal stimulus. This may require policymakers to think outside the box and put conventional ideas about monetary restraint and fiscal prudence temporarily on ice. A financial crisis typically wipes out only a small fraction of national wealth. Physical capital (typically three or four times GDP) and human capital (typically five or six times physical capital) dwarf financial capital (typically less than GDP). So, the financial capital wiped out in a crisis typically constitutes only one fifteenth or one twenty-fifth of total national wealth, or less. The economic system can withstand the removal of the top layer unless the financial ruin seriously weakens the fundamentals.

Lesson 11. Let us not throw out the baby with the bathwater. Since the collapse of communism, a mixed market economy has been the only game in town. To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks – and even General Motors – having to be propped up temporarily by governments, even nationalised. Even so, it remains true that banking and politics are not a good mix. But private banks clearly need proper regulation because of their ability to inflict severe damage on innocent bystanders.

Footnotes

* According to the IceSave agreement, Iceland must during 2016-23 pay the UK 2.350 million pounds and the Netherlands about 1.330 million euros. The sum of the two figures is equivalent to about a half of Iceland’s GDP in 2009, and seems, with reasonable asset recovery, likely to overstate the ultimate cost involved. The interest rate on the loans is 5.5% per year.

References

Buiter, W, and Sibert, A (2008), “The Icelandic Banking Crisis and What To Do About It,” CEPR Policy Insight, 26.

Danielsson, J (2010), “The Saga of Icesave,” CEPR Policy Insight, 44.

Gylfason, T (2009), “Governance, Iceland, and the IMF,” VoxEU.org, 26 September.

Gylfason, T , Holmström, B, Korkman, S, Söderström H T, and Vihriala, V (2010), “Nordics in Global Crisis,” Helsinki: ETLA.

Volcker, P (2010), “How to Reform Our Financial System,” New York Times, 31 January.

Republished with permission of VoxEU.org

Valentine's Day Math

I am having trouble with the math for Valentine's Day...

Reproduced with permission of XKCD.com

Related Posts

What is Risk?

If one accepts that probability theory is objectively valid and reliable, then drawing a distinction between what is knowable (probabilistically) and unknowable in matters of chance becomes instructive for informed decision-making in general. Prof Frank H Knight (1921) was speaking objectively when he proposed his infamous distinction between "risk" and "uncertainty." According to Knight (p. 233):

To preserve the distinction... between the measureable uncertainty and an unmeasurable one we may use the term "risk" to designate the former and the term "uncertainty' for the latter.

Knight's proposition contrasts with the earlier subjective views of David Hume (1748) who argued that chance is non-existent, therefore implying that the distinction between knowable and unknowable risks is a tautology. According to Hume (p. 469):

Though there be no such thing as Chance in the world; our ignorance of the real cause of any event has the same influence on the understanding, and begets a like species of belief or opinion.

The debate between the objectivist and subjectivist conceptions of risk continues to this day. However, the philosophical debate is more intense than ever given the reliance that modern finance makes of the objectivist approach to risk management and control (if that is even possible). I will not seek to resolve the two here. However, it behooves those intent on entering the field of finance to prepare themselves for this discussion. The future of financial economics may depend on your conclusions.

References:

Hume, D (1748/1952), An Enquiry Concerning Human Understanding, in R M Hutchins & M Adler (Eds), Great Books of the Western World (Vol 35, pp. 451-509). Chicago, IL: Encyclopedia Britannica.

Knight, F (1921/2002), Risk, Uncertainty, and Profit, Washington, DC: Beard.

Why Management Consultancies Fail?

The biggest problem confronted by many small management consulting firms is lack of specialization. The second problem is lack of world-class expertise in their stated specialization. The last problem for small consultancies is simply the inability to recognize or deal with the two problems above.

The Risk Paradox

Risk management is too often perceived to be a perfunctory activity assigned to the lower echelons of the firm. As described by Douglas W Hubbard (2009, p. 174):

The paradox of risk management... is that the most sophisticated risk analysis methods used in an organization are often applied to low-level operational risks, whereas the biggest risks use softer methods or none at all.

How do we elevate the stature of risk management (and analysis in general) in the executive suite?

Reference: Hubbard, D W (2009), The Failure of Risk Management: Why It's Broken and How to Fix It, Hoboken, NJ: John Wiley.

Subjectivism is a Fact of Life

Many scientists, and especially classically trained statisticians believe that science should be objective and tend to reject methodologies that are based on subjectivism. However, effective risk analysis requires that risk analysts make subjective judgments throughout the analytical process. As observed by David Vose (2008, p. 215):

For the risk analyst, subjectivism is a fact of life. Each model one builds is only an approximation of the real world. Decisions about the structure and acceptable accuracy of the risk analyst's model are very subjective. Added to all this, the risk analyst must very often rely on subjective estimates for many model inputs, frequently without any data to back them up.

Bottomline, subjective judgments matter, even in quantitative risk analysis.

Reference: Vose, D (2008), Risk Analysis: A Quantitative Guide (3rd ed), Hoboken, NJ: John Wiley.

The Future of Risk Management and Financial Ratings

I recently came across a thought-provoking table purporting to compare the present and future of risk management and financial ratings (2009, Ontonix). Most of the predictions are illuminating. However, I doubt that financial risk analysts will migrate away from statistics and Monte Carlo simulation (MCS) models toward "model-free" methodologies (whatever that means). In fact, I predict that the use of statistics and MCS methods in financial risk analysis will expand in the coming years. Nevertheless, I find the juxtapostion of the conventional and future to be parallactically interesting and intriguing.

Reference: "The Present and Future of Risk Management and Rating," (2009), Ontonix Complexity Management.

Practical Steps for Corporate Risk Management

The Economic Intelligence Unit (2009, "Managing Risk in Perilous Times: Practical Steps to Accelerate Recovery," London) recently published a white paper admonishing corporations regarding the practical steps necessary to accelerate recovery during these perilous times. The lessons and steps outlined in the report are instructive for corporations of all industries:

1. Risk management must be given greater authority.

2. Senior executives must lead risk management from the top.

3. Institutions need to review the level of risk expertise in their organization, particularly at the highest levels.

4. Institutions should pay more attention to the data that populates risk models, and must combine this output with human judgment.

5. Stress testing and scenario planning can arm executives with an appropriate response to events.

6. Incentive systems must be constructed so that they reward long-term stability, not short-term profit.

7. Risk factors should be consolidated across all the institution’s operations.

8. Institutions should ensure that they do not rely too heavily on data from external providers.

9. A careful balance must be struck between the centralization and decentralization of risk.

10. Risk management systems should be adaptive rather than static.

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