Rigid or Flexible

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I live on a relatively large wooded lot.  I love being “out in the country”.  It has a lot of advantages (and admittedly its disadvantages too).  

 

The main thing I like is the privacy and beauty offered by the trees on my lot.  They provide a home for the birds that wake me up in the morning, they provide a wonderful place for my dog to play, they provide a sense of newness and hope for every new day.  You can imagine my sadness several years ago when we had a hurricane and about 200 trees were blown over.  All was not lost however as many trees were able to withstand the onslaught and I still have a lot that is heavily treed – albeit not as heavily treed as before.

 

Surveying the damage after the storm (Hurricane Juan if anyone is interested) it became quite obvious what the secret of survival was.  It wasn’t to be the biggest or strongest tree.  The biggest, most rigid trees on my lot easily tumbled when the storm was at its height.  It also wasn’t the old, weak, feeble and sick trees that survived.  They also were blown over.  The trees that survived were the flexible ones.  They bent with the wind, but they did not break.  

 

Is your risk system rigid, old and sick or flexible?  When the winds blow – and they will – will your organization still be standing tall at the end, or will it be a victim of its thick and rigid risk management practices?  (By the way – are there any regulators out there getting this message?)

Managing Risk: The How and How Much

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

A key question for risk management is how to manage risk and by how much.  A recent short VOXEU communique  (3rd April) called The Austerity Question: ‘How’ is as Important as ‘How Much’ by Alberto Alesina & Francesco Giavazzi asked the same question when policymakers attempt to implement austerity measures.

 

Alesina & Giavazzi note that in Europe’s embrace of fiscal austerity has sparked a debate among economists.  These authors argue that the debate has gone astray – focusing exclusively on the size of the deficit reductions.  The focus of policymakers should be on the budget tightening’s composition (tax versus spending) and the accompanying policies.  The key question is not “how far” governments go but “how” they go far enough.  

 

Until the critical principle – ‘how’ as important as ‘how much’ – is embraced, the austerity debate in Europe will continue to be completely out of line with the real economic trade-offs.

 

Economists note the following evidence by the implementation of austerity: spending cuts are less recessionary than those achieved through tax increases, and the use of spending cuts with the right policy may limit the economic impact when compared to other policy measures.

 

Policymakers should stop focusing fiscal policy discussions on the size of austerity programs.  Recent IMF research suggests a relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts.  Likewise, a small spending-based adjustment could be more effective at stabilizing debt-to-GDP ratios than a larger tax-based adjustment.  

 

A number of questions need to be considered: what spending cuts are more effective, can tax reforms achieve the same revenue with minimal distortions and how should market liberalization be implemented?  In general moving taxation towards the VAT and away from income taxes is preferable.  In some countries, there is no solution without a substantial raise in retirement age and cuts in government employment.  This includes the implementation of labor-market reforms, especially in the public sector.

 

Until the critical principle “how” is as important as “how much” is embraced the austerity debate in Europe is out of whack with the real economic consequences.  Europe is in for a big disappointment on the centerpiece of Eurozone austerity – the fiscal compact.  The compact bears the seeds of its own failure: the treaty change makes no mention of the composition of fiscal packages, and encourages adjustments mostly on the tax side, suggesting that European economies will remain stagnant and debt ratios will not come down.   In the end, as was the case with the Growth and Stability Pact, the rules will be abandoned.

 

The lesson for risk management is not just the identification of potential risk, but the methodology used to manage it and its potential consequences.

 

For more on this, follow the link:  http://www.voxeu.org/index.php?q=node/7836

 

 

Small Risk Missteps Equal Good Risk

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

We spend way too much time trying to be perfect in our risk management.  Media, bosses, supervisors, shareholders, creditors, regulators et. al. want their respective organizations to not have any missteps.  However this is very poor risk management in my opinion.  Being perfect has many flaws to it.  First off it creates a sense of arrogance, overconfidence and hubris that is way more dangerous than any series of small missteps.  Secondly there is the case of risk homeostasis that I have written about before at length.  

 

The main thing though that I want to mention in this blog is that small missteps prevent the big one.  Small missteps allow the organization to learn and adapt.  Small missteps allow the internal risk of an organization to let off some steam.  They prevent risks from building to an unsustainable level of criticality that will inevitably become unstoppable.  Small missteps are good, not bad.

Forecasting Financial Risk Indicators

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Financial volatility is a crucial input for risk management, asset pricing and portfolio management and has important economic repercussions as evidenced in the recent financial crisis.  It is important to understand from a risk management standpoint the key drivers of volatility.

 

A recent working paper (March 2012) at the BIS, "A Comprehensive Look at Financial Volatility Prediction by Economic Variables", by Charlotte Christiansen, Malik Schmeling & Andreas Schrimpf looks at the use economic and financial variables as a predictor of volatility. Christiansen et al investigate if asset return volatility is predictable by macroeconomic and financial variables. The main goal of the study is to shed light on the economic sources of financial volatility. 

 

Their approach is distinct due to its comprehensiveness and extends recent research in several directions: First, they employ a long-term sample period and use forecast methodology to handle a large set of potential predictors, Second, they include multiple asset classes (equities, foreign exchange, bonds, and commodities), Third, they employ a comprehensive set of predictive variables which goes beyond existing studies in the literature on the economic drivers of volatility, and Fourth, the authors use comprehensive model selection and forecast combination procedures to assess whether economic variables are useful and robust predictors of financial volatility.  

 

The authors find that there is significant information contained in economic variables that helps in predicting future volatility for all four asset classes under study. Importantly, this predictive content by economic variables goes beyond the information contained in the history of the time series of realized volatility. 

 

The results are also supportive of financial volatility predictability by macroeconomic and financial variables in a realistic out-of-sample setting. The variables that are the most robust predictors of volatility are those that have sensible economic interpretations. In particular, variables that proxy for credit risk and funding liquidity (illiquidity) consistently show up significant forecast variable of volatility across several asset classes. Variables capturing time-varying risk premia (such as valuation ratios for equities, or interest rate differentials in foreign exchange) also perform well as significant indicators of volatility. 

 

In contrast to these financial predictors, variables that proxy for macroeconomic conditions, are much less informative about future volatility. Thus, the results suggest that channels that emphasize the effects of leverage, credit risk and funding illiquidity as well as time-variation of risk premia are the most promising candidates for understanding the economic drivers of financial volatility.

 

A key requirement for risk management is the understanding of volatility, but it also provides other information.  This may include uncovering linkages between price movements in financial markets and underlying risk factors or business cycle variables.  There is growing evidence showing that risks associated with volatility are priced into most asset and derivative markets. 

 

For more on this, follow the link:  www.bis.org/index.htm?ht=Research

 

 

Complexity to the power of n

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I used to like watching horror movies (among other genres).  It seems that each new horror movie has to be just a bit more horrific that the previous one.  If not, it would seem lame and disappointing. It’s great to watch the old original Frankenstein and Drakula movies, but they don’t seem particularly horrific nowadays.  I’m sure that when they were first released the audiences were gripped with terror.  I do remember that when movies like the Exorcist and Jaws came out, they were on the cutting edge of the genre and had audiences hiding their eyes.  In fact, to my embarrassment, the female companion who watched The Exorcist with me in the movie theatre managed a few blood curdling screams.  Nowadays, there are many more scary movies than those.

 

What is the relevance of this?  Well producers of financial products are no different from movie producers.  They need to constantly “improve upon” and outdo the last product that someone came out with.  Over time, complexity increases to such an extent that it becomes impossible for more and more people to tell if the products are useful or dangerous.  Unfortunately, too many people have been too successful at selling such things and too many buyers have been too keen to jump on the bandwagon.  The good news is that many companies have become much more cautious about using anything that is not plain vanilla.  However, bandwagons do have a habit of rolling on and human nature has not changed.  

Ecology for Bankers

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

As some of you may know, I am currently working on a book about the science of complexity and the lessons it has for us in business in general, and more specifically in risk management.  The book is loosely based on my RMA Journal article (available at the link on our website www.RSDsolutions.com) that was titled “It’s Not Complicated!”

 

One of the articles that I reference in the book is “Ecology for Bankers”, which was published in the February 21, 2008 issue of Nature by Robert May, Simon Levin, and George Sugihara.  This is a wonderful article that shows some of the similarities between financial systems and ecosystems, and points out how an understanding of ecosystems can help in risk management.  It is a wonderful article, and one that each and every risk manager, CEO, banker and perhaps most particularly, regulator should read.

 

Here is the issue.  This article is in a science magazine.  It is not in a business magazine (or a business research journal).  Thus, given the relatively narrow focus of most in the business community it will probably be totally ignored.  What a shame.  The biggest systemic risk of all is that we are all so focused on having the state of the art risk management system, that we lose sight of the forest as we all examine the same piece of bark from the same tree.