Understanding the Paradigm for Risk Management: Lessons from the Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

A key question for risk management: do you have the correct framework to analyze risks.  This is a question that Claudio Borio & Piti Disyatat (Bank for International Settlements) ask in a recent VOXEU communiqué “Did Global Imbalances Cause the Financial Crisis?” about international policymakers?  The authors note the emphasis on current-account imbalances diverts attention away from monetary and fiscal factors that sowed the seeds of destruction leading to the underestimation and mispricing of risk.   

 

A key part in G20 and IMF discussions was the role of financial imbalances in causing the recent financial crisis.  The focus on savings-investment balances, current accounts and net capital flows may be flawed.  The authors suggest that other factors should be considered as causal factors and could provide a better understanding of the process and linkages. 

 

The authors object to two key policymaker assumptions: (1) net capital flows from current-account surplus to deficit countries helped finance credit booms; and (2) a rise in savings relative to investment in surplus countries depressed global rates.  The authors argue that global imbalances, which measure net flows, provide little evidence about global financing patterns based on the surge in gross capital flows that was largely between advanced countries.  These flows increased from 10% of world GDP in 1998 to 30% in 2007 and were driven by flows between advanced countries.  The surge in US gross capital flows involved developed areas not running a current account surplus and was private in nature.  Net capital flows do not capture the disruptions created by 2008’s collapse in cross-border lending.  Excess savings or the unwinding of global imbalances did not trigger the crisis; disruptions in the chain of global intermediation did. 

 

Their second critique is that the excess-savings view provides an incomplete explanation of low global rates.  Market interest rates reflect both monetary and financial factors: central bank policy rates, risk premia, market expectations, and supply and demand for assets.  These factors interacting with artificially low policy rates contributed to the turmoil. 

 

The authors conclude that global imbalances offered little explanation about the global intermediation process behind the credit boom or how contagion is transmitted.  The international monetary and financial system lacks a strong policy framework to prevent future credit bubbles and asset booms.  The authors suggest that without a better understanding of the analytical framework, policymakers could be prone to policy errors, faulty assumptions and flawed risk estimation.

 

Do you have the correct framework in place to understand potential risks?

 

The first author, Claudio Borio, was one of the first to note a rise in systemic risk at a presentation at Jackson Hole in 2003.

http://www.voxeu.org/index.php?q=node/6795 

 

Models - Part 2

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Sunny Marche is a colleague of mine at Dalhousie, as well as one of the Associates at RSD Solutions.  Dr. Marche is an incredibly thoughtful person, and combined with his interest in knowledge development and his breath of academic interests, it makes for a powerful intellect.

 

Sunny was explaining some of his work on models in database management, when he said something that embarrassingly I had not considered before.  Namely, he said that models are devices for “hiding things”.  In other words, models leave out details that are not believed to be germane to the problem at hand.  In reading this here, it of course seems obvious, but does the implication?

 

It is generally acknowledged that we live in a complex world.  (I will avoid the easy reference to my upcoming book on complexity theory).  A complex world by definition (and by fact) means that you cannot separate the parts from the whole.  In a complex world you need “systems thinking”.  Studying the parts does not help you find solutions, and indeed is probably counterproductive.

 

In that context, thinking about models as devices “that leave parts out” seems to be a stupid thing to do.  The implications of leaving things out are that you are ignoring the systems characteristic of all aspects of business.

 

What do the models that you use leave out?  Is risk management immune from systems thinking, and thus it is ok to leave stuff out?  I think not.

US Economic Developments & Conventional Fed Policy Options

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions,com 

 

Recent US Economic Developments

 

S & P has downgraded the US long-term sovereign debt rating from AAA to AA+ and kept the rating outlook as negative.  They noted a further improvement in the fiscal situation will be required to avoid further downgrades (reducing the deficit by $4tr not $2tr).  Moody’s & Fitch have not altered their AAA rating at the current time.  The US short-term rating remains intact at A1+, with no impact expected on money market funds.

 

US non-farm payrolls showed gains of a little over 115,000 with unemployment rate at 9.1%.  The gains in the private sector were partially offset by a decline in government employment.  The US economic growth was revised lower to 0.8% in the first half of the year.  Overall, a number of investment firms have lowered growth estimates through 2012 year-end to a little over 2%.

 

Conventional Fed Policy Options

 

Fed officials enter August with weaker than expected economic growth and projections of extended period of below trend growth increasing the pressure for further monetary easing.  This has a similar parallel to last year and if further downside risks persist, the Fed may implement QE III.  Currently, the Fed’s three conventional policy options: communication to investors & the public, asset purchases & sales and interest rate policy.

 

The first option the Fed might consider is “forward guidance” given the size of the Fed’s balance sheet.  This might have a minimal economic impact, but could be combined with a link to a specified period of low policy rates or an economic event.  Asset purchases or sales are a second policy option, but are limited by the size of the Fed’s balance sheet.  One application is to keep the balance sheet size the same, but to increase the duration risk by buying longer-term securities.  This could be combined with a reinvestment of maturing mortgage holdings.  Any proposed increase in the aggregate duration risk would be considered as policy easing.   The last option is to cut the interest paid on excess reserves left at the Fed.  This would have minimal impact since effective fed funds are already 0.08% and a zero rate on excess reserves could damage market institutions.  

 

Fed action would only be driven by increased downside risk.  Any change in communication or composition of the balance sheet would have at best a symbolic impact on the economy.  The US economy stands on the risk of falling into a double-dip recession; the Fed clearly lacks conventional policy tools to do much about it unless combined with other policy alternatives.

 

Models - Part 1

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

On a warm summer afternoon of a long weekend, models for some strange reason popped into my head.  I am in the midst of doing researching for my book on complexity, and thus it may be natural that models, and “concepts of models” are swimming around that thing that is on my shoulders.  A lot has been written about models (in fact I have written a lot about models – both in their praise and in their condemnation), but I think it is always healthy to resurface a few ideas that have not been thought about in a while.  Thus this four part blog series on models.  Unfortunately I understand a very high proportion of the science jokes on “The Big Bang Theory” and thus I am of course talking about mathematical models and not runway models – which of course would be a much more interesting topic, but not all that germane to risk management.

 

Richard Levins, the mathematical ecologist (according to Wikipedia) is claimed to have said “ models tend to be so general that they cannot make predictions about particular systems, or so detailed that they merely rephrase what is already known about a system.”  (This quote is from Ants at Work: How an Insect Society us Organized, by Deborah Gordon, Free Press, 1999)

 

I believe that the same could be said about our risk models, and finance models in general.  They are so vague to be useless, or so detailed that they simply replicate the past (and are subsequently useless for the current or future contexts).

 

Models should be a balancing act, and one dimension of that balancing should be between the general and the specific.  Where do the models that you use lie on this spectrum?  Or were they models that were handed down from a regulator or a textbook, or even worse, a committee?

Aliens

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

If Aliens came down from outer space and studied your organization, would they find a system that was running in a clear cut and coherent fashion, or would they find something more closely resembling chaos?  Would they quickly be able to appreciate the rationality that was being the core element of each and every decision?  Would they see an efficient flow of critical information between all parts of the organization?  Would the logic of the strategy be immediately apparent?

 

Looked at objectively, organizations are pretty messy, stupid, chaotic, and a whole bunch of other terms that implies inefficiency.  I guess that is why business and risk management is so much fun.