Unthinking and inflexible risk management = ineffective risk management

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

I have just returned from a few days at Wimbledon watching my daughter play in a junior tennis tournament.  It’s been a great week and a wonderful experience for the kids being able to play on the hallowed turf (but not on Centre Court unfortunately).  Although not detracting too much, it has also been an example of how unthinking and inflexibly applied risk management and bureaucracy can serve to create little more than frustration and irritation and probable do nothing to lessen risk.  

 

The organizers and security staff have their instructions and work their seemingly interminable way of enforcing all the rules to the letter, no matter how unnecessary they seem.  Clearly with a large number of kids around, they are very concerned about avoiding injuries or something going wrong and this is a laudable objective. 

 

A couple of examples follow – perhaps relatively inconsequential in themselves but intended to illustrate a point.

 

Security staff do a good job but are mainly people who probably don’t have a lot of power in other aspects of their lives.  Some of them seem happy to wield their temporary power inflexibly.  One in particular kept chasing after people to stop them taking a direct route beside Court 1 to get from the competition pavilion to the shop.  He made them exit from one gate, walk along the road and re-enter another gate, a much longer route.  This reduced the risk that people could get a free peek at Court 1 without paying for a tour of the grounds (actually futile as competitors and parents were given a free tour pass anyway).  Eliminating one perceived risk that actually did not exist created a worse one by forcing kids to walk along the road. 

 

There was a dinner one evening for all competitors.  They had to be delivered by the parents to the competition pavilion.  They were then organized into groups, counted and led along in lines to the dinner venue at the other end of the grounds where they were counted again.  Had they been delivered by parents directly to the dinner venue in the first place, only one count would have been necessary, nor would they have had to form groups and lines.

 

These things did not really lesson the overall experience or enjoyment of the week.  However, it would not take much thought and imagination to allow some flexibility and remove some of the petty irritants.  This made me wonder how many businesses are similarly losing sight of the risks in favour of process and bureaucracy.  This could be why risk management has a bad name in many organizations and does not get buy in, so is consequently ineffective. 

 

Preliminary Thoughts on Bernanke’s Speech at Jackson Hole and Fed Policy Options

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The most important event this week is tomorrow's speech by Fed Chairman Ben Bernanke at the annual Kansas City Fed Conference.  The speech is expected to focus on three elements: the downgrading of US economic prospects, a defense of past policy actions and an outline of Fed policy options.

 

Last year, Mr. Bernanke outlined details for QE II and Fed policy options: the purchase of long-term securities, communication and lowering the interest rate paid on excess reserves.  The Friday speech will most likely focus on:  the possibility of additional purchases of long-term securities and changing the composition of the balance sheet. 

 

The Fed will note the downgrading of US economic prospects, as mentioned in the recent FOMC minutes.  This view will be consistent with the lowering of US growth prospects done by a number of Wall Street (WS) analysts.  The most recent FOMC communiqué noted “a slower pace of recovery in coming quarters” and “downside risks to the economic outlook have increased”.  However, the Fed economic outlook has one key difference from WS analysts as evidenced in recent speeches by Fed officials “weakness in economic activity in the first half was due to temporary factors …” and “restraining forces have abated and thus, we should see stronger growth in the second half”.  This suggests the Fed takes the view that the slowdown was partially caused by temporary factors.  The Fed scenario is for weak growth followed by a modest recovery going into 2012.  This is slightly more optimistic than private sector forecasts.

 

The next point, to be addressed by Mr. Bernanke, is the defense of previous Fed easing efforts.  The combination of weakness in growth and downward revision to economic forecasts raise questions about effectiveness of recent policy efforts.  Previously, he argued that QE helped reduce deflation risk and raised inflation expectations.  Mr. Bernanke will most likely address these issues as follows: the first is that central banks (Fed) cannot be the sole source of stimulus in a global fiscal tightening environment; secondly, one way QE II was successful by avoiding another recession (to date) and deflation; and lastly there is evidence from economic studies that QE does have a positive impact on growth.  The jury is still out on QE II, but it has helped the economy – the question is how much?

 

As indicated earlier, the three options open to the Fed include: communication, asset purchases and balance sheet management and changing the interest rate paid on excess reserves.  The Fed has already implemented a variation of its communication policy by stating that rates will remain low for an extended period.  The Fed will not consider changing the interest rates on excess reserves due to technical aspects of implementation, potential damage to banks from already low rates and questionable impact on bank lending.

 

This leaves the last option of large-scale asset purchases and changing the composition of the balance sheet.  There are studies that suggest that selling short-dated treasuries and buying long-dated can have a significant impact on reducing real rates.  The reason why this option may be favored is that it will not change the size of the Fed balance sheet which would keep politicians happy.  The view among WS analysts is that Mr. Bernanke will present these options, but not pre-commit to any policy action except through the FOMC.  The recent rise in core inflation will keep policymakers cautious.  The use of any unconventional policy options such as a higher inflation target, price level targeting, a long-term interest rate target or option twist (used in the early 1960s) may be considered at a later date.

The uncertainty shock from the debt disaster will cause a double dip recession

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The author, Nicholas Bloom, in a short communiqué (VOXEU, August 22^nd updated from August 9th) notes the increased risk of recession and predicts a short downturn in the next 6-12 months and a recovery in 2012.  A number of Wall Street analysts place the probability of a double-dip recession around 30-35%.  The short note of Bloom’s introduces other tools to forecast recessions.

 

The potential explosive combination of Eurozone debt contagion, vulnerable banking systems, and European and American political paralysis has pushed stock-market volatility, as measured by the VIX, to levels nearly as bad as the days following the 11 September 2001 terrorist attacks and early onset of the 2007-09 crises.

 

Bloom starts with looking at the VIX as a traditional measure of market uncertainty or what he calls a fear factor.   The author introduces alternative measures of potential volatility, such as the frequency of news headlines or the use of the word “uncertainty”, and finds these measures elevated.  The role of news, headlines or specific words are additional information now being incorporated into credit models.

 

Nobody knows what happens next?  How long will the current stock-market panic last? This column reviews research by the author on 16 previous episodes of uncertainty shocks (going back to the 1950s) and concludes that today’s uncertainty shock will create a short, sharp contraction.  He notes that uncertainty shocks have a 1.9 month life (it takes about two months for volatility to decline by 50% from the peak).  Hence, the current panic has another six weeks to run based on historical data.

 

During a period of uncertainty, hiring and new investment grind to a halt with the durable goods sector being the most severely impacted.  Bloom is negative in the short-term, but positive over a long-term horizon.  He notes that the current uncertainty may force the necessary structural reforms in Europe and the US, while growth in China and India may offset some of the adjustment costs.

 

The author provides specific metrics from his research of a 1% contraction in late 2011 and a rebound in late 2012. This research looks at the average impact of the previous 16 uncertainty shocks to predict the impact of future shocks. Typically these leads to reductions of growth of about 2% immediately after the shock, with a recovery about six months later once uncertainty subsides.

 

The author notes that early work in this area was done by the current Fed chairman (Bernanke 1983).

 

What risks do you face in a double-dip recession?

For more on this click on the link:  www.voxeu.org/index.php?q=node/6846

 

Humor

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

How much humor is there in your risk group?  Is the risk gang a fun bunch of people who are always pulling gags and taping Dilbert cartoons to their cubicle walls?  No?!  I thought not.

 

I recently read this quote by the Canadian author Robertson Davies.

 

The people who fear humor, and they are many, are suspicious of its power to present things in unexpected lights, to question received opinions, and to suggest unforeseen possibilities.

 

At the risk of pointing fingers (and poking fun at), I suggest that the above quote sums up the stereotypical risk manager.  It is not that risk managers are boring – it is just that the profession has forgotten to occasionally laugh at itself.  It may also be that, as Mr. Davies suggests, that the profession has become “… suspicious of its power to present things in unexpected lights, to question received opinions, and to suggest unforeseen possibilities”.

 

Perhaps we all need to lighten up.

 

The Euro Crisis Reaches the Core – What is your Risk?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The author, Daniel Gros, noted in a recent communique (VOXEU, August 11^th) that the current euro crisis has reached the core.  Investors and treasurers need to ask themselves what is their exposure in a worst case scenario?

 

Investors anticipate the unraveling of the 21 July 2011 “solution” and a potential Lehman type breakdown of the interbank-market and put the European economy into an “immediate recession” like the one experienced after the Lehman bankruptcy. The European Financial Stability Fund (EFSF) was designed to provide liquidity financing and not solve solvency issues.  Gros argues that without quick and bold action such as giving it access to unlimited ECB re-financing there will be a generalized breakdown of confidence.    

 

Greece is not interpreted as a special case, but viewed as the manifestation of a general problem: (1) as a sign that the Global Crisis was spreading to public debt; and (2) as a sign that capital markets would no longer refinance excessive levels of public debt, especially in the Eurozone members who could no longer rely on central bank support.   The EFSF was sized to provide the financing promised to Greece, Ireland, and Portugal and provide lower rates for their long-term financing.  However, if the borrowing costs of Italy and Spain stay at crisis levels, how can they be expected to provide billions in euro in aid to peripheral countries at 3.5% when they pay a much higher rate?  Any decline in the core Eurozone members that remain to back the EFSF and the debt burden would become unbearable. Italian government debt alone is equivalent to the entire German GDP. 

 

The situation is critical due to a domino effect. At this point the Eurozone needs a massive infusion of liquidity.  Given that the cascade structure of the EFSF is part of the problem, the solution cannot be a massive increase in its size.   

 

Banks are the weakest link due to European debt exposure.  This increases the cost of capital for banks exposing them to a breakdown in the interbank market and credit circuit.  If the EFSF was registered as a bank and given access to unlimited re-financing by the ECB, it is the only institution to provide liquidity quickly and in convincing quantity.  This solution has the advantage that it leaves the management of public debt problems in the hands of the finance ministries, but provides governments with the liquidity backstop that is needed when there is a generalized breakdown of confidence and liquidity as a lender of last resort.  A massive increase in the ECB’s balance sheet (which if the US experience is any guide will not lead to inflation) constitutes a lesser evil compared to a breakdown of the Eurozone financial system.

 

What is your exposure to European sovereigns and banks?

http://www.voxeu.org/index.php?q=node/6853 

 

Disorganized

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Steven Johnson, in his book “Where Good Ideas Come From”[1], outlines the academic work of Robert Thatcher a brain scientist at the University of South Florida.  In essence, Dr. Thatcher’s work shows that “the more disorganized your brain is, the smarter you are.”

 

This somewhat counterintuitive result actually makes a lot of sense if you consider the world to be a complex place (complex again in the scientific sense of the world).  In a world with connected systems, feedback loops, non-linear effects, and unknown unknowns, having a highly rational and organized brain can be a handicap.  A highly rational and organized brain is ideal for a complicated world (again using complicated in the scientific sense of the world), but as my recent RMA article[2] argued, the world is not complicated but instead it is complex.  In a complex world, a disorganized brain is free to wonder and wander, which in turn is much better at making new and novel connections that turn out to be “smart”.

 

In risk, we all too often try to be highly organized and rational.  Highly organized and rational however do not jive with the complex world we find ourselves in.

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[1] For more on this check out the link:  http://tinyurl.com/3orxum3

[2] To see this RMA article check out the link:  http://tinyurl.com/4abuawb