Learning Risk

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Can you learn to be a good risk manager?  Can you learn to be a good golfer?  Can you learn to be a good tennis player?

 

My dad used to be the caretaker for the church tennis courts – back in the days when churches had such things as real clay tennis courts.  While I was developing as a competitive junior player he was forced to watch way more tennis than he cared to.  He also spent more time reading tennis magazines than he cared to.  The upshot of all this is that my dad knew a heck of a lot about tennis.  However he was not a tennis player.  He never bothered, nor did he have the inclination to pick up a racket and play. 

 

It is the same with golfers.  I have a lot of friends who are crazy about the game – reading all that they can and hitting the links or the driving range at every opportunity.  They know a lot about the game of golf – but they suck at it.

 

Knowing a lot about a subject does not necessarily make you an expert.  Risk is a subject where a lot of people know a lot about the subject, but like my golfer friends they are not necessarily the best at it.  Risk, like golf and tennis is a skill.  Yes – it requires knowledge, but knowledge only gets you started.  You need the practice, the passion, the wisdom, and a thirst to get better.  And that is just the list to starting to be a good risk manager – or golfer – or tennis player.

 

What are You Content With?

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I just finished Roger Ebert’s autobiography “Life Itself: A Memoir”.  It has absolutely nothing to do with risk management – or at least not the type of risk management that we discuss in this blog on a regular basis.  That by itself is a great reason to read it – explore new ideas and new areas of thought.

 

Despite it being a book about the life of a movie critic, the book closes with some interesting thoughts on life.  One in particular I thought was interesting and definitely applied to risk management.  In his conclusion to his memoir as he starts talking about the meaning of life, Roger comes up with this gem; “I am more content with questions than answers.” 

 

Sometimes as risk managers we focus way too much on the answers and are not content enough with getting some of the questions right.  Perhaps the profession would be better off with more contentment with good questions, and less disappointment at not being able to find those sometimes non-existent answers.

Basel Regulation Needs to be Rethought in the Age of Derivatives, Part

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

Paul Atkinson and Adrian Blundell-Wignall, in a second VOXEU communique (Feb 29^th) suggest that further reforms are needed to change and simplify of Basel III capital rules. 

 

Atkinson and Blundell-Wignall note that the design in the Basel framework for regulating bank capital adequacy has resulted in a “vast, poorly diversified, highly interconnected banking system” supported by a far too-small capital base.  The system is inflexible to adjust to external shocks, so local problems can become systemic.  They suggest the system can be placed on a firmer foundation by the following changes:   (1) simplification of capital requirements; (2) realistic and less complex financial supervision; and (3) more reliance on market discipline. 

 

The authors suggest that a risk-weight system for capital charges be replaced by a leverage ratio with an upper limit.  This includes reporting of gross derivative positions, according to international accounting standards, in the asset base that require equity support without the distortions using netting permitted GAAP reporting rules for calculating capital charges (not always zero risk).  Otherwise, Basel III capital rules may produce outcomes that are less stable.  Bank activities should be separated into low-risk and high-risk activities (through separate subsidiaries – legal vehicles) to limit equity base exposure to losses from any single activity (trading).  This allows each subsidiary to have its own equity base while limiting government guarantee programs to specific activities such as retail banking—but not derivative trading.  This eliminates the cross-subsidization of other activities and makes the banking system less vulnerable to shocks.  

 

Liquidity management rules serve little purpose and should be replaced with a better capital-adequacy framework and resolution structure.  There are limits to supervisor’s abilities and resources which places limits on what they can accomplish.  This might suggest simplification of the regulatory structure and strive for accident prevention rather than micro management of large, complex financial institutions.

 

Lastly, there is a need to simplify and reduce bank interconnectedness to increase the reliance on market discipline.  This would allow large creditors that provide a much larger fraction of bank funding than shareholders, to be exposed to losses for their mistakes.  This combined with the leverage limits might reduce reliance on wholesale funding and trading activity.  The simplification of the complex bank interconnections could lower counterparty vulnerability to systemic risk.   The idea is to reduce the too-big-to-fail syndrome and the implicit guarantee that is associated with it.  Large bank creditors are exposed to more losses and may help limit government exposure to those activities that require high levels of capital support.

 

The failure to identify and mitigate the risks left by Basel III could be a costly mistake.

 

For more on this, follow the link: www.voxeu.org/index.php?q=node/7678

        

Let’s take it nice and easy … but it never is! (or Thank goodness for Donald Rumsfeld!)

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

I was in Edinburgh yesterday at a presentation by Lionel Barber, Editor of the Financial Times of London.  He was more optimistic about the U.S. than Europe and very skeptical about the “managed” growth statistics coming out of China.  He thinks Greece will leave the Euro, there will not be a war with Iran and Obama, and Cameron are wrong to dismiss the possibility of the leftist Hollande becoming French President in this year’s election.  Etc., etc.  Overall, if he is correct, slightly on the optimistic side for many companies that have currency and commodity exposures, although the latter could put the cat among the pigeons in terms of what may happen to the Euro.

 

Many C-suiters take a measured view about how things will unfold.  Just like the inevitable talk of soft landings.  But human nature and psychology have a nasty habit of participating in the unfolding of events.  We don’t get soft landings – we get busts.  We never get what we expect.  Some small inconsequential thing blows up.  Do you run your enterprise depending upon a balanced and measured view of the future?  Or do you expect to have a head on collision with “unknown unknowns”?  (Thank goodness for Donald Rumsfeld!)

 

The Cost of Reducing Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The global financial system is facing a number of especially complex changes and challenges. This uncertain environment has prompted calls to reconsider or weaken financial reform and for it to take a back seat to more immediate concerns, such as sovereign risk, weak global growth and inflation risk.  In this view, financial institutions and regulators are being asked to do too much, too soon.   

 

Jaime Caruna, BIS General Manager addresses some of these issues in a recent speech Building a Resilient Financial System (Speech, Feb.7^th).  He notes with the current uncertainty and vulnerabilities makes it all the more important to strengthen global financial institutions and establish a reform agenda to avoid further unexpected strains.  As a result, authorities and banks should move faster and further to create a more robust financial system rather than taking the maximum time to achieve minimum capital strength.  A recovery is based on a stable financial system so that business and households can invest and spend with confidence. 

 

A number of broad principles guide this work.  First, financial stability is about resilience and should be prepared in advance. Second, preserving financial stability involves a wide range of policy areas.  Third, a globalized financial system requires global rules. And fourth, stay focused on the end result, namely a system characterized by less leverage, better liquidity management, sounder incentives, less moral hazard, stronger oversight, and more transparency. With this in mind, the appropriate timetables can be established, and their implementation monitored for unintended consequences.

 

The key challenges in carrying forward this agenda are: (1) implementing what has been agreed, especially with regard to bank capital; (2) designing the right transition given a still weak recovery; (3) completing the regulatory reform agenda, notably in the areas of liquidity standards, resolution regimes, OTC derivatives, and the shadow banking system; and (4) ensuring sound micro- and macro prudential oversight. 

 

Authorities have a challenge for completing the regulatory agenda, establishing macroeconomic stability at a global level, reducing debt back to sustainable levels, normalizing monetary policy and continuing to guide the recovery.  All three elements of policy – fiscal, monetary and prudential – are needed to work together to deliver a strong, sustainable global growth.

 

A question becomes what is the cost of this effort?  The Institute of International Finance, in their recent report The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework (Sept. 2011), suggests that impact of these changes will be a global loss of output of 3.2% GDP through 2020 (assumptions and results differ across countries).  This contrasts to recent BIS and IMF estimates (BIS Macroeconomic Assessment Report 2010 & 2011and IMF WP Macroeconomic Costs of Higher Bank Capital and Liquidity Requirements 2011)suggest the impact is much smaller or a loss of global output of 0.5-0.6% GDP through 2020.  Alternatively, what is the cost of doing nothing?

  

For more on this follow the link: www.bis.org/speeches/sp120208.pdf

 

 

Historical Data

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

We love historical data.  From it we develop frequency distributions, probabilities and severity curves.  With this data we develop projections and calculations of risk.  However the really important historical data is not reliable.  Conditions change.  The economy and our competitors react.  The dynamics change.  Our historical data does not reflect this until it laughs at us in our hubris.