RSD Solutions - Blogs

The recent surge in the peripheral European country bond spreads has been a major source of concern to financial markets, as investors try to estimate whether it is a change in fundamentals or shifting market sentiment. It is similar to risk management where we have to understand the source of risk. Paul de Grauwe and Yuemei Ji attempt to address this issue in a Jan. 2012 VOXEU communique called Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone.

De Grauwe & Li note that markets were wrong in placing the same risk premium on Greek bonds as on German bonds from 2001-08. Since the start of the sovereign debt crisis, financial markets are making errors in the other direction – they overestimate risks... Now they are wrong in overestimating the risk that the peripheral countries will default.

The surge in peripheral country spreads since 2010 is disconnected from fundamentals such as debt-to-GDP ratios and current-account positions, and is more attributable to negative market sentiment. De Grauwe & Li note that after investors long ignored high debt-to-GDP ratios, the resulting surge in negative sentiment caused a rise in spreads. However, standalone countries with high debt ratios were immune to these liquidity crises and did not experience an increase in spreads. This was consistent with earlier research that found government bond markets in a monetary union are more fragile and susceptible to self-fulfilling liquidity crises.

The Eurozone crisis is also a story of systemic mispricing of sovereign debt, which in turn led to macroeconomic instability and multiple equilibria. The underpricing of sovereign risk in 2001-2008 in the peripheral countries led to unsustainable booms in consumption and real estate. The overpricing of sovereign risk since 2010 led to a self-fulfilling downward spiral into bad equilibria characterized by solvency crises and deep recessions.

The lesson for policymakers is that when spreads are tightly linked to underlying fundamentals such as the debt-to-GDP, the best option for spread reduction is to improve debt fundamentals. In contrast, any disconnect between spreads and fundamentals, a policy of exclusive focus on debt reduction will not be sufficient and force countries into a bad equilibrium. This can be achieved by active ECB liquidity policies that prevent a liquidity crisis in government bond markets turning to a self-fulfilling solvency crisis.

The lesson is that any policy aimed at improving fundamentals through fiscal austerity and a policy of liquidity provision from the central bank are not substitutes, but complements. In contrast, any country that is a member of a monetary union hit by a liquidity crisis that leads to a disconnect between spreads and fundamentals, will require both policies. These policies should not be seen as “either/or” options.

The systematic mispricing of sovereign risk in the Eurozone intensifies macroeconomic instability, leading to bubbles in good years and excessive austerity in bad years. The failure to address these issues has increased the duration and the cost of crisis resolution. Perhaps, we can learn some lessons for risk management.

For more on this follow the link: www.voxeu.org/index.php?q=node/7553

System D Economics

2012-02-02T08:33:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.,

Spending a yucky Saturday afternoon catching up on last month’s Wired (just got this month’s issue in the mail so I need to clear out last month’s). Wired is one of my favorite magazines and I always seem to find something useful in it.

In the January 2012 issue however I was initially ticked off by one article titled Slumdog Economist, which highlights some of the work of economist Robert Neuwirth who studies the underground economy. I reason I was ticked off is that I always wanted to study the marketing habits of street vendors. He stole my idea! How dare he!?

Kidding aside, it is a great article that looks at the underground economy of street vendors or those that work under the table. Neuwirth calls this the System D economy. Some fascinating ideas and facts in the article and I highly recommend that you take a moment to take a glance at it.

One of the surprising facts that comes up in the article is that currently 50% of workers globally are part of System D and that is projected to rise to 2/3rds by 2020. Take that you global multinationals!

Neuwirth explains many of the reasons for this surprisingly rapid rise of System D, but the most telling response to why the rapid growth is in this statement; “Because it’s based purely on unfettered entrepreneurialism. Law-abiding companies in the developing world often have to work through all sorts of red tape and corruption. The System D enterprises avoid all that.”

In my work as a consultant with many corporations what I see is a lot of red tape and corruption. True, the corruption may be slightly different than the type of corruption that Neuwirth is implying, but in my scheme of things, political interference is still corruption, and red tape is red tape.

Risk departments (all departments) should be allowed to do their work in the absence of red tape and corruption. That may be an obvious statement. What might not be so obvious is that risk departments should also work on a principle of pure unfettered entrepreneurialism. Is yours?

Global Recovery Stalls, Downside Risks Intensify

2012-01-31T08:39:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere. Financial conditions have deteriorated, growth prospects have dimmed, and downside risks have escalated. This was noted in the IMF’s latest semi-annual update World Economic Outlook (WEO) released on January 24^th.

Global output is projected to expand by 3¼ percent in 2012—a downward revision of about ¾ percentage from the September 2011 WEO. The euro area crisis entered a perilous new phase as the sovereign debt crisis has evolved into a banking crisis. As a result, the euro area economy is now expected to go into a mild recession in 2012 as a result of the rise in sovereign yields, the effects of bank deleveraging on the real economy, and the impact of additional fiscal consolidation.

Growth in other advanced economies remains mixed, the US, Canada and Australia are seeing some internal dynamics that may offset the spillover effects from Europe. While the recovery for Japan and the UK will be more modest. For major advanced economies, the key policy requirements are to address medium-term fiscal imbalances and to repair and reform financial systems, while sustaining the recovery.

Growth in emerging and developing economies is also expected to slow because of the worsening external environment and a weakening of internal demand. Despite a modest downward revision to growth (including China), these countries are still expected to see steady growth in 2012. A number of these countries are expected to benefit from firm commodity prices.

The most immediate policy challenge is to restore confidence and put an end to the crisis in the euro area by supporting growth, while sustaining adjustment, containing deleveraging, and providing more liquidity and monetary accommodation. In emerging and developing economies, near-term policy should focus on responding to moderating domestic growth and to slowing external demand from advanced economies.

For further information on this, follow the link: www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm

Jet Set

2012-01-30T08:44:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

It is a Friday morning as I write this, and to be blunt I am procrastinating big time. Probably not the best thing to be doing, but … well …, it is what it is.

As part of my productive procrastination I started reading the Wall Street Journal. (At least it looks productive if my daughter happens to walk into my home office.) In reading the Journal I rarely if ever look at the Lifestyle section, but today for some reason – perhaps in a quest to be even more thorough in my procrastination - I clicked to open up that section.

I started reading an article about private jets, and the quest by Thomas Flohr and his daughter to get their private jet business to the next level. In reality I was reading the article because of the extreme lavishness (stupidity) of the arrangements for his daughter’s 18^th birthday party. (You need to read the article yourself to understand – here is the link: http://tinyurl.com/78nvu9w)

In any case, I nearly finished the article, and just before closing I noticed the last line. "We really are detail-obsessed," he (Thomas Flohr) says. "But the joy is seeing the big picture."

Back to risk management. Are you detail obsessed, but have joy in seeing the big picture? What a great operating philosophy for a risk manager. Perhaps my time goofing off wasn’t wasted after all.

Eden

2012-01-26T10:40:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

If you were the Risk God, what would be in your Garden of Eden? What would be your ideal construction? Would your universe be without risk? Would it be without uncertainty? That would be dull, would it not? It would also be ruinous for all of us employed as risk professionals.

Twitter Risk

2012-01-25T08:37:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

With the title I suspect you thought I was going to blog today about the risks of having people within (and external to) your organization tweet about the organization. I’m not – but probably will at some time in the future.

What I thought I would spout off on today is how Twitter is slowly changing our language patterns. Expressing your thoughts in 140 characters or less is definitely having an effect on spelling and grammar. However I believe the bigger effect is on how we think in terms of small, single, thought bits, rather than in more complex and nuanced ways.

I am obviously not the only one who thinks this. For instance, the fact that there is a service called Longreads (www.Longreads.com) shows that others are realizing that our media (and our thoughts) are becoming more sound bites than biting. (BTW – I highly recommend LongReads. Great articles.)

Now back to my point about Twitter. Encapsulating your thoughts in 140 characters or less is not all bad. For one thing it forces you to be sharp and to the point. It also forces you to cut out the unnecessary. Struck and White would probably be big fans. Here is the question – could you publish your risk results using Twitter? Should you?

Virginia Two-Step Approach to Risk Management

2012-01-24T09:05:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

As the European debt soap opera continues, Europe’s leaders have expressed their willingness to “do whatever it takes” to restore financial stability and save the euro. This is very similar to the Virginia dance that moves two steps forward and then one step back. Morris Goldstein, Stop Coddling Europe’s Banks (VOXEU, Jan. 11^th), argues that policymakers’ actions too often serve the banks at the public’s expense.

Policymakers now acknowledge the wisdom of comments by IMF Head Christine Legarde at Jackson Hole (2011) about the need to recapitalize European banks. Goldstein indicates five concerns to address: incentives for deleveraging, guidelines for dividends and compensation, alternative macro scenarios for stress tests, burden sharing during restructuring and measures to address feedback loop on sovereign and bank debt.

The European Banking Authority (EBA), however, specifies a bank capitalization target (but not one made mandatory by national authorities) as a ratio to risk-weighted assets rather than converting that ratio into a target for bank capital alone. Banks may sell assets and tighten credit when new lending is needed.

The EBA advises banks to tap private-sector sources for recapitalization, but does not provide guidelines for either dividends or compensation. This is no directive for banks falling below the capital target on the payment of dividends or executive compensation.

The bank stress test scenario focused on mark-to-market losses on sovereign bonds and did not consider alternative macroeconomic scenarios (including much weaker euro area private forecasts). Bank capital positions were assessed only against a risk-weighted standard and not against an unweighted leverage target.

European Council, at the December Summit, decided to reverse its earlier position of private sector involvement; it announced that private-sector burden sharing would no-longer be required beyond the restructuring of Greek sovereign debt. This implies that the taxpayer will have to absorb any losses while the private-sector is the beneficiary of any upside potential.

Lastly, there is the problem of the adverse feedback loop between sovereign debt and bank debt. There are a number of long-term solutions, including a tougher fiscal compact, a bank capital target or a permanent financing facility. One short-term solution might involve the issuance of bonds with a risk-sharing mechanism.

While not mentioned in the paper, the slow plodding by EU policymakers, has not resolved the agency problem for European banks still subject to national regulation. As a result, these banks come under political pressure in their home countries to take additional sovereign bond exposure after any poor auctions. This has pushed a sovereign debt crisis into a banking crisis raising the risk of contagion and the cost of resolution. The temporary ECB liquidity facility provides a temporary solution and kicks the can further down the road.

If one examines the stance the official sector has taken toward banks, it looks like Euro zone leadership allows large banks to do what they please, even when they act in their own narrow interest rather than in the wider public one. It is not an optimal risk management paradigm of two-steps forward and one step back. It is time for a change.

For more information on this please follow the link: www.voxeu.org/index.php?q=node/7511

No Regrets

2012-01-23T09:15:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I am stuck in an airport with a seven hour delay as my original connecting flight home was cancelled. The exciting life of the business traveller!

To help pass the time I started to read the book “No Regrets”, by Ace Frehley, the original guitarist from the 70’s rock group KISS. It is probably not going to be the best biography of the year, but I have to admit it does help to pass the time. It also is not going to be the business book of the year, but strangely enough (and perhaps because I am late getting my blogs together for the week) I started to see a lot of business lessons coming out of the book. (Long layovers and business travel can do strange things to you – and yes I am staying away from the open bar in the airline lounge!)

One of the interesting points that Paul (Ace) Frehley brings out in his biography is the distinction between session players (musicians who earn their living by being musicians solely for the purpose of recording) and live performers. Clearly session musicians are the better musicians, but they are rarely household names. Session musicians don’t make mistakes. They are hired because they are precise, professional and can play the same piece of music exactly the same way as often as is required for a suitable track to be made. Session performers can also read music proficiently.

Live performers by contrast are generally not as good musically. Many of them (including Ace) cannot read music. Getting a reliable sound that is mistake free from a live performer is an almost impossible task. Yet live performers (such as Ace) who become successful are extremely well known and phenomenally successful economically.

In risk management are you a session performer or a live performer? Does your risk management team perform live or only in session? Which type of risk performer do you want to be?

Improving Your Tennis Game

2012-01-20T09:03:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I used to play competitive tennis – which of course is a bit unbelievable for anyone who knows me. I played junior tennis and then in college. I actually won occasionally as well.

Playing junior tennis was a lot of fun and provided those of us lucky enough to be ranked a lot of unique opportunities. One of the supposedly fun things was tennis camps. Going to the camps though was always a two edged sword. Obviously they were useful as they gave you an opportunity to work on your game. For me they were critical as I did not have a coach, and thus a tennis camp was my only opportunity to get coaching.

The problem with going to a tennis camp though was that you learned new things. Learning new things is obviously good, but when you are trying to keep a ranking it can be disastrous. In order to learn new things, you have to try new things. And to try new things and to become proficient at the new techniques, you need to “unlearn” what has already made you successful.

Unlearning is tough. We all know the old saying that “ya need to dance with the one that brought ya”, but sometimes “what brought ya” is not dancing anymore and it is time to move on.

Sometimes the only way to learn and progress is to go backwards. The same is true for risk management.

How Many Lives?

2012-01-19T09:52:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

How many lives does your company have? Is it 1, 10, 100, 1000, more? The reason I ask is because of some discussions I had lately about the applicability of Monte Carlo Simulation. I am a huge fan of Monte Carlo Simulation. I have blogged about this before, but in terms of decision making there are some very strong attributes to using Monte Carlo – not the least of which is that it forces the management team to actually think deeply and carefully about the drivers of the business (and the associated risk relationships).

The problem is that the output from a Monte Carlo is often used without realizing that the probabilities only apply IF the company has a very large number of lives. Only one outcome is going to happen in real life, while Monte Carlo assumes that there are many many lives and outcomes that will be experienced.

The next time you use Monte Carlo (which again I want to emphasize I am a fan of) you need to think carefully about Schrodinger’s Cat puzzle before you implement the decision that you created the Monte Carlo to help with.

Systemic Risks in the Shadow Banking System

2012-01-18T09:03:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The role of alternative investments in the financial intermediation process has moved into the background as Basel III, Dodd-Frank and other proposed reforms are thought to solve all problems. However, these reforms do not address all the issues, in particular the role of asset managers in the intermediation process and the role of derivatives. Zoltan Pozsar & Manmohan Singh, two IMF economists, in The Nonbank-Bank Nexus and the Shadow Banking System (IMF Working Paper WP/11/289, December 2011) look at the role of asset managers.

The current view of financial regulation does not incorporate the rise of asset managers as a source of funding through the shadow banking system. Asset managers are sources of demand for non-M2 types of money and serve as source collateral “mines” for the shadow banking system. Banks receive funding through the re-use of pledged collateral “mined” from asset managers. This has allowed asset managers to replace traditional creditors, primarily household retail deposits, as a key funding source to the banking system.

In this process, asset managers, normally long-term investors, transform the maturity of the long-term assets into short-term liabilities (similar to bank retail deposits). This follows the tendency to use these short-term liabilities to boost returns. Asset managers receive cash collateral in return for the securities they loan. It’s a gain for both parties since the cash they receive helps them to manage their funds liquidity needs (however they act like wholesale funds).

Using this methodology, the US shadow banking system reached $25 trillion in 2007 and declined to $18 trillion in 2010, higher than earlier estimates. The authors suggest regulators incorporate the re-use of pledged collateral when defining prudent bank liquidity and leverage position ratios.

The lack of sufficient disclosure will become apparent during a period of a collateral crunch to the financial system (lack of acceptable collateral). This will lead to greater funding stresses during a credit squeeze. According to the authors, there was approximately US$ 5.8 trillion in off-balance sheet items of banks used for collateral mining and collateral re-use. This is down from nearly US$ 10 trillion at the end of 2007. The size of the number should be of concern, especially with events in Europe.

Monitoring the shadow banking system will warrant closer attention beyond current regulatory parameters. Regulatory reform is focused on fortifying the equity base of the banking system and limit leverage through caps and capital adequacy requirements. Pozsar and Singh note that the present framework of financial intermediation and data collection does not fully incorporate asset managers as funding sources for banks through the shadow banking system. Non-bank sources of funding are thought to be sticky like retail deposits. They note a number of weaknesses in current data availability: a broader definition of bank leverage, a breakdown of non-bank funding sources and a closer look at dealer’s ability to borrow and re-pledge collateral from various sources.

They suggest an improvement in the current regulatory framework by increasing incentives for banks to move away from wholesale short-term funds into retail deposits and term funds. Otherwise, the shadow banking system will fill the role, especially for riskier activities. Other changes they suggest incorporating the unregulated shadow banking system more into Basel III and Dodd-Frank. Lastly, making changes in the flow of funds data to incorporate derivatives, off-balance sheet transactions and breaking down short-term funding sources for better monitoring. The use of off-balance sheet sources of funding should be included in risk management monitoring.

For more on this follow the link: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf

Computerless

2012-01-17T09:02:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.,

How would risk management change if your company had to run without computers for more than a month? I bet your risk management would actually improve. At least it would force people to focus on priorities and communicate more directly. That can’t be a bad thing.

Ben Bernbach

2012-01-16T09:58:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.,

I had a meeting earlier this week in the New York offices of advertising giant DDB. I think all risk managers should take time to hang out with some creative types such as those that work at the iconic firm that many believe is part of the inspiration for the popular Mad Men TV show.

While waiting for my appointment to join the meeting, I had a chance to examine some of the original writings of Ben Bernbach, one of the founders of DDB. A giant of the advertising industry he was a person who had a keen mind. Reading his original writing, actually better described as random musings (from a page from one of his notebooks) was a walk back into the history of modern advertising as we know it.

While I was enjoying reading the page of Bernbach’s writings (in a framed display on the wall of the waiting room) there was one note he wrote that jumped out at me. The note was; “research keeps you from thinking”.

What an applicable statement for risk management I thought. Then I thought that the statement that “calculation keeps you from thinking” was also equally appropriate. Are we as risk managers so busy researching and calculating that we forget to think?

Foreign Exchange Risk for 2012

2012-01-13T12:13:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

As we enter 2012, the euro has emerged as the weakest currency against the US dollar among the major currencies. Investors still continue to short the euro on expectations the currency move lower is not finished. This view is based on the ECB facility is a stop-gap measure and does not resolve the solvency issues. Investors note the following: the Greece refinancing led by the IMF is still not functioning as expected, the cost of Italian and Spanish debt still remains around 7%, European banks are having a difficult time raising new capital and real investors lack additional appetite for further euro risk exposure.

Global economic indicators have started to improve, especially in the US. However, the demand for European risk assets remains weak as the focus remains on a potential recession and contagion impact to the global economy. Previously in 2011, anytime the euro came under pressure it was often followed by a countertrend rally. However, 2012 could be different as real non-European investors continue reducing their euro sovereign bond exposures. The supply surge of sovereign debt, euro $1 - 1.2 trillion, coming to the market in 2012 and the rollover, euro 700-800 billion, of bank paper/new capital could cause digestion problems as global investors to reduce European exposure.

In 2011, the US dollar was used as the funding currency for risky assets. Given the prospect of a European recession, will cause the ECB to further cut rates and keep them low for an extended period. The poor reception of capital market issues of European banks suggests that further balance sheet contraction is needed to meet the higher capital ratios. Banks continue to place funds with the ECB and not employing the central bank liquidity in the real economy. Real yields have moved into negative territory as the ECB tries to promote an investor shift into riskier assets. The problem is that the time lag between liquidity creation and a move into risky assets has a time lag. However, the uncertain outlook suggests this delay may take an extended period of time.

The use of the euro as a funding currency rather than an asset currency, a prolonged period of low ECB rates, the prospect of a European recession and uncertainty from the overhang of sovereign/bank debt will push the euro lower. There will be limited countercyclical euro rallies compared to 2011. The euro downtrend should continue through the summer until either political gridlock in Washington grabs investor attention as the November election approaches and/or policymakers can provide a resolution for the sovereign debt/banking crisis in Europe.

Watching Football

2012-01-12T09:06:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

As I write this blog I am also watching one of the bowl games on the internet. As I would be too distracted by watching the actual game (and not getting this blog done), I am watching the box score. It is actually a very unique way to watch a football game. You get lots of stats updated in real time that you would not get if you were at the game. You also get to participate in chat rooms and read and send zingers about how the game is going to literally thousands of other fans who also have their computer at hand while the game is on. It is a data junkie’s dream.

It also sucks compared to actually being at the game.

But wait – before you sign off thinking this is another crappy blog by yours truly, ask yourself if there is a parallel in risk management? Namely, are we running risk management by being so absorbed in the numbers that we actually have forgotten about the much more enriching and valuable experience of actually being at the game? Are we a slave to the stats, or by what is actually happening on the field?

Francis Bacon

2012-01-10T11:14:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Francis Bacon was one of the pre-eminent philosophers of the Renaissance. (I hope that one of my University philosophy profs is smiling that I remembered that.) Gifted in many fields, he epitomized the concept of “renaissance man”. He likely would have failed as a risk manager – but that is another story.

The thing I am writing this blog about is to introduce you (reintroduce you to those who remember more of their university philosophy class than I do) to a quote of Sir Bacon. That quote is “He that will not apply new remedies must expect new evils”.

Risk management has lots of both new and old remedies. Extrapolating Francis Bacon, does that mean that we must also expect lots of new evils?

Reality TV

2012-01-09T09:06:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I have a confession. During the holidays I watched way too many reality TV marathons. For some strange reason I got hooked on Repo Wars, King of Cars, and Storage Wars. Pure unmitigated brain dead TV. Awesome!

Based on this experience I am thinking of pitching a reality TV series “Risk Management”. I think it would be a hit. Each week we would see our risk management team of characters deal with yet another issue that has an element of suspense that keeps us watching for all 8 minutes of actual footage in the 30 minute time slot.

Think about having a camera follow you around at work while you do your risk management stuff all day. It is not as silly as it sounds if you think about it for a minute. Oopps, gotta go – the episode where Darrell gets into it with Brandi is about to start.

Happy 2012 – The Failure of Risk Management in Europe

2012-01-06T09:21:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Rene Stulz in a 2008 paper, Risk Management Failures: What Are they and When Do They Happen, looked at risk management failures and how various types occur. Stulz noted there are six types: mismeasurement of known risks, failure to take risks into account, failure to communicate the risks to top management, failure to monitor risks, failure in managing risks and failure to use appropriate risk metrics. Can we apply these failures to the management of the Eurozone?

Charles Wyplosz in a communique, Happy 2012, (VOXEU, 3^rd January) looks at the problems of the Eurozone and proposes what issues can be addressed without the pain of a new EU treaty. The crisis continues to linger on despite the ECB liquidity facility. Wyplosz asks why the crisis continues, discusses what can be done and offers a proposed solution.

The persistence of the crisis is due to policy mistakes, the lack of fiscal discipline, ongoing imbalances and focus on moral hazard without specific solutions. Political leaders do not understand the complexity of the financial crisis and propose only partial solutions without technical staff involved in the decision process. Politicians cater to their national electorate and will any avoid unpopular decisions.

The crisis is complicated because it combines financial turmoil with governance issues under challenging macroeconomic conditions. As result, the economics profession has not converged on a shared diagnosis contributing to policymaker confusion. Government and bank bailouts raise a moral hazard issue not addressed in the current EU structure.

Wyplosz outlines four conditions to be addressed for crisis resolution: governments that lose market access must be bailed out effectively (restructuring) and there are limits to moral hazard (investors may be exposed to a haircut), the ECB should lead the bailout since the amount maybe large and unknown, banks need to be recapitalized before a sovereign default and limiting moral hazard will require fiscal discipline. The current proposal for a new treaty and suspension of sovereignty to manage fiscal discipline is intrusive, takes too long and could cause economic stagnation.

According to Wyplosz, the best alternative is work through the ECB, an independent entity. The ECB can manage the amounts involved; they can determine their own collateral requirements and work with an independent board to monitor fiscal developments (details to be determined). The cost continues to increase as it moves from a sovereign to a banking crisis.

If we look back at the six types of risk management failures, they are all present in the management of the Eurozone. A few of the lessons we learned: sovereign debt is not a riskless asset, how do we monitor and control these risks, the lack of effective communication can increase crisis severity, the lack of an effective control system comes at a price, the interests of policymakers must be aligned with investors/electorate and professional management is required. We can conclude that the events in the Eurozone reflect all six failures of risk management.

For more on this follow the links:

For Rene Stulz http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1278073

And for Charles Wyplosz http://www.voxeu.org/index.php?q=node/7487

Victory

2012-01-05T09:16:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

info@RSDSolutions.com

The key to success we are often told is to have a clear goal. To be able to clearly and unambiguously define what success is. What is success – or victory – for your risk department? Can you explain it to your mother, your boss, your Board?

How will you know when the battle for risk is won? Is it when downside risk has been eliminated? (I hope not.) Is it when all upside risk has been exploited? (I hope not.)

Is victory when the risk department gets a huge bonus pool? (I hope so.) However how can this happen if you can’t define what victory is?

Absence of Worry

2012-01-04T09:15:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

info@RSDSolutions.com

This time of year everyone talks and thinks about stress. We hear reports of how suicides are up and the theories that in part they are caused by the stress of the holidays. We meet people who are rushing too and fro, stressed out about getting the right gifts, the coming credit card bill, about getting a good deal on the Boxing Day sales.

As a risk manager your job is to think about the stresses, both present and real, perceived but false, as well as future and potential, that affect the operations of a company or institution. To be sure, corporate stress is different from the stresses experienced by an individual, but the concept is certainly the same.

As individuals we talk a lot of how great it would be to have a stress free life. However is this an appropriate dream for a corporation? Is it an appropriate dream for the risk manager of a corporation?

What worries me in the corporate world is the absence of worry or equivalently (depending on your semantics) the absence of stress. Is it really good to have the absence of worry on a corporation? I propose that when the corporation stops worrying, that is when it is about to be blinded-sided in a catastrophic way.

Santa Claus

2012-01-03T09:12:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

info@RSDSolutions.com

I play Santa Claus at our Faculty Christmas party (shhhh! – don’t let the secret out). Yes Santa is about to become a faint memory for another year. Boys and girls of all ages are now spending the week after Christmas either enjoying the gifts they received, rushing to buy the gifts they really wanted at a Boxing Day sale, or hoping for a better haul from Santa next year. What did your risk department get this year that was great, needs to be achieved, or is a lamentable “wait for next year”?

European Banking System – Systemic Risk Accident?

2011-12-30T11:14:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Basic research is like shooting an arrow into the air and,

Where it lands, painting a target (Homer Adkins)

The euro is heading toward an abyss. The sovereign debt crisis is evolving into a full-fledged banking crisis with global consequences. Nicholas Veron, of the Peterson Institute, has written a short-article on issues facing European banks “Europe Must Change Course on Banks” (Dec. 19^th).

The crisis is evolving along multiple dimensions. On the sovereign debt, Greece’s debt restructuring remains unresolved, and Italy and Spain face major refinancing needs in early 2012. Eurozone countries may have to refinance between euro 1.2-1.5 trillion in 2012. The Eurozone summit on December 9^th, fell short of delivering a true fiscal union, and raised tensions within the euro area and with the United Kingdom. On the growth front, a possible deep and prolonged recession looms, especially as countries place emphasis on fiscal austerity.

The banking system is a crucial piece of the puzzle and epitomizes the contradictions of Europe’s experiment with monetary union. Since 2007, the system has exhibited gaps in risk management, and massive supervisory failures in some countries. The banks are exposed to an agency problem – they are under national control, but pose risks for the euro. To keep on favorable terms with local authorities, they are often buyers of last resort after failed auctions. In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility, especially since they depend on wholesale money markets for funding. CDS premiums remain elevated for European sovereign debt

Political affirmation of the integrity of the euro area banking system does not require new treaties, but major resistance comes from, among others, individual banks fearing the loss of national privileges or protections. However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities. A euro-area-level banking policy framework that will transcend interdependences between banking and political structures at the national and local level is a necessary condition for the survival of the monetary union.

As the euro crisis continues to unfold, there is increasing risk that the crisis could move across the Atlantic. The near-term conduit from the banking system through money markets, derivatives or some other under radar surprise. A longer-term mechanism is through a severe credit contraction that could induce a global recession.

The problem for global banks, especially for European banks, is that Basel I and II encouraged banks to hold sovereign debt as risk-free. Basel III imposes more capital requirements and it will require additional euro hundred billions of capital over that suggested by recent stress tests. The question is how European banks can meet the new capital shortfalls without causing growth stagnation?

The immediate goal for European authorities is provide standardization of regulation across the Eurozone such as national interests do not subvert the euro. Long-term European banks have to be recapitalized without causing a severe credit contraction. It will require prudent central bank policy and cooperation between national regulators. The failure to implement prudent reforms could result in a near-term freeze in bank funding or a global recession. Neither outcome is provides a favorable target for a sustainable US recovery.

For more on this follow the link: http://www.piie.com/realtime/?p=2581

Four Hard Truths for 2011 – Risks for 2012

2011-12-29T09:08:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

History is the science of things which are never repeated (P. Valery)

The year 2011 was supposed to be the year that broke the back of the global crisis. However, the crisis is still with us as the North Atlantic banking part of the crisis morphed into the Eurozone crisis. The persistence of the European sovereign debt crisis risks moving toward a full-blown banking crisis. The impact of slower growth in the advanced countries now threatens emerging economies. Olivier Blanchard, the chief IMF Economist, looks at some of these issues in a VOXEU communique called “Blanchard on 2011’s four hard truths” dated December 23^rd.

The global economy entered 2011 in a recovery mode, although weak and unbalanced. However the issues appeared tractable: dealing with excessive US housing debt, adjustment of countries on the periphery of Europe, how to handle volatile capital flows to emerging markets and to improve financial sector regulation. It was a long agenda, but appeared within reach. As the year draws to a close, a number is issues remain unresolved: the recovery in many advanced countries is at a standstill, the implications of a potential breakup of the Eurozone and the possibilities that conditions could deteriorate.

The four main lessons that Blanchard sees: the global economy is in a state of self-fulfilling outcomes of pessimism or optimism with major macroeconomic implications. The self-fulfilling attacks can lead to bank runs which reduce the distance between a sovereign debt crisis and a full-fledged banking crisis. Government entities have provided liquidity to ensure market interest rates remain reasonable. The main risks remain for banks in Europe and the rollover of sovereign debt.

Secondly, incomplete or partial policy measures can make things worse. We have seen how perception got worse after high-level meetings in Europe promised a solution, but delivered only half without details. The announcement was made with great fanfare, but turned out insufficient with potential obstacles.

Thirdly, financial investors are schizophrenic about fiscal consolidation and growth. Investors react favorably to positive news on fiscal consolidation, but tend to ignore lower growth which can lead to increase, not a decrease, on risk spreads on government bonds. Fiscal consolidation is required to reduce debt to prudent levels, but not to produce stagnation “slow and steady wins the race”.

Lastly, perception molds reality. This was the case of conditions in Europe. Once Italy was considered as a risk, the perception did not go away. The concern about the viability of the European economy led to concerns about the possible breakup for the Eurozone.

If you put the four factors together, you can explain why entering into 2012 why macroeconomic risks have increased. It will be harder for officials to put the recovery back on track than it was a year ago. Fiscal consolidation is required without causing growth stagnation. Central banks and governments will be required to provide liquidity as a backstop to prevent a bank runs and avoid multiple equilibria. It will require plans not only announced, but implemented with full disclosure and effective collaboration among all involved.

We have to learn from our mistakes in 2011, otherwise 2012 is going to be a period of higher risks. The alternative is just too unattractive.

For more on this follow the link: www.voxeu.org/index.php?q=node/7475

Step by Step Approach to Crisis Resolution

2011-12-28T09:00:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

info@RSdsolutions.com

Politics is not the art of the possible.

It consists of choosing between

The disastrous and the unpalatable

(JKGalbraith)

Eurozone officials and politicians have adopted a mini step-by-step approach to crisis resolution. This approach has back-fired as cost of crisis resolution has increased dramatically as the sovereign debt crisis is turning into a full blown banking crisis. The European Central Bank (ECB) finally took a big step last week when they made nearly euro 500 billion in three-year low rate loans available to 500 banks across the region. This comes ahead of a crucial time for policymakers as a large volume of sovereign and bank debt has to be refinanced in the first quarter of 2012. The ECB has provided a near-term fix for the Eurozone crisis, but what has to be addressed longer-term?

Charles Goodhart & Dirk Schoenmaker in “The Political Endgame for the Euro Crisis” (VOXEU, Dec. 14^th) discuss some of these issues. The euro crisis is deepening, as European leaders continue with their “too little too late” policy reforms. Solving Eurozone problems requires a strong direction for fiscal and banking policy. This in turn needs greater political integration through an elected president of the European Commission and a two-chamber parliament representing EU citizens and EU member states.

The euro has a supranational monetary policy framework, while the fiscal side is still national or inter-governmental. With political legitimacy, the President of the European Commission could: first, enforce budget discipline on participating members and restrict the impact of fiscal spending, and second oversee Eurozone banking supervision and resolution to foster banking system stability.

One step is the establishment of a Eurozone Minister of Finance with power to enforce provisions of the Stability and Growth Pact on fiscal deficits. A second step is a reform of the parliamentary side of the political union by establishing one chamber to address issues of the electorate and a second chamber to represent interests of the separate member countries. This would allow a gradual transition of banking supervision and resolution from the national level toward a wider European scale. The new Eurozone Finance Minister would need specific authority from the European Parliament to establish budgetary and banking powers and the European equivalent of the FDIC, SEC, etc.

The resolution of the euro crisis needs both political reforms as well as a technocratic solution. There are major issues that need to be addressed, but the min-step approach to financial crisis resolution or risk management has a cost – often a higher cost.

For more on this follow the link:

www.voxeu.com/index.php?q=node/7420

Fast Company Creativity Issue

2011-12-27T09:05:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I just finished the latest Fast Company issue, which was centered on creativity. Creativity is not a word that you hear a lot about in risk management. Neither is the term “Fast Company” for that matter. Why is this? Is this a good thing?

Exceptions

2011-12-23T09:09:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

We have all heard the saying, “the exception that proves the rule”. I have to admit that I have never really grasped the meaning of this statement, although I realize it is always said when there is a clear exception to a rule.

In risk we always have to deal with exceptions. In fact I would argue that exceptions are the rule of risk management. Without exceptions there would not be a field or an industry of risk management. Without exceptions we would not have schools or degrees in risk management. Without exceptions I would have to find something else to blog about.

The tough question of risk management however is how do we deal with exceptions. How do our risk models incorporate exceptions? The toughest question of all perhaps is deciding when to abandon the risk protocol for an exception – in essence deciding when an exception is exceptional (assuming that is not an oxymoron).

Backtesting

2011-12-22T09:04:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Coming from a background in investments (and nuclear physics), we always talk about back-testing a new idea. In other words, how would have the world unfolded (differently, better, worse) if we implemented (did not implement) a given strategy. Back-testing however seems to be a rarity in the world of risk management (with the possible exception of financial risk management). Perhaps this is a major oversight of the profession.

I realize that back-testing operational or strategic risk is tricky. A lot of assumptions need to be made, and models of outcomes need to be constructed. Perhaps however it is the exercise of working through the necessary assumptions and constructing the models that would make it such a useful and valuable exercise.

ERM Course – I Need Your Help

2011-12-21T09:05:00.001-05:00

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I am putting together a new Enterprise Risk management Course for my MBA students. I would love to hear suggestions from my readers as to what I should include. Any suggestions you have for readings, papers, topic suggestions would be most welcomed.

I have put together now four major ERM courses and this will be my 5^th version where I have started from scratch. The one interesting thing about teaching ERM is that the field is still so young and still rapidly evolving that each new version allows for a fresh look at things. I look forward to hearing your suggestions.

Steve Jobs as Risk Manager

2011-12-20T09:22:00.001-05:00

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc

Just finished the Steve Jobs biography. Interesting book about an interesting person. Not sure if it is a biography on how to be a manager (rip people apart, be ruthless, demand nothing but perfection, be a rebel, think differently, be obsessed with design, be obsessed) or how not to be a manager (see previous set of parentheses). Interesting to think though about what Steve Jobs would be like as a risk manager. Would his qualities be an asset, or a liability?

Tebow Stats

2011-12-19T09:17:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Like many of you I sat and watched with a sense of expectation as Tim Tebow played awful for three quarters against the Chicago Bears last weekend. I kept watching the game in part because Tebow (and the Broncos in general) were playing in such a mediocre fashion. We all know the script – Tebow sucks statistically for three quarters and then in the fourth quarter comes to life to impossibly pull the game out of the hat for a win for the Broncos.

I suspect that the dismal performance of the Broncos for three quarters, only to pull out the game after coming from behind is making Rolaids addicts out of the Broncos coaching staff and management. The fans however seem to love it. The only stat that fans know about in the final analysis is who won. The vast majority of fans are not at all concerned with how the win occurs. A win is a win. Stats are simply things to debate in the off-season when there is nothing else to talk about. Broadcasters, coaches and managers seem to be the only ones concerned about performance statistics.

Now shifting back to risk management, which they tell me is supposed to be the purpose of my rambling – but thankfully short – blogs. Are risk managers more concerned about stats (i.e. VAR, risk weightings, volatility levels etc.) or are we more concerned with outcomes? The answer should be obvious, but I am not sure that it is. In my working with risk managers, they often seem more concerned that their numbers look good, and less concerned about the actual outcome (assuming of course that the numbers looked good beforehand). Perhaps risk managers should be more like the fans and more concerned about outcomes.

Sometimes the numbers suck, but the desired result occurs. Sometimes the numbers are great but the outcome sucks. Sometimes uncertainty occurs. (Did I say “sometimes” in the previous sentence – I meant “always”.) Stats are stats, and wins are wins. Sometimes (always) it really is that simple.

Risk Genius

2011-12-16T09:17:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc

Genius has many definitions. Genius is often thought of at performing at a superb level of intelligence. However genius was once described to me in this fashion; someone who thinks superbly has a superb intelligence, a genius however thinks differently. A genius is not more and faster intelligence. Genius is a different kind of intelligence.

It is my opinion that the risk industry (and in particular in the financial sector) has a lot of extremely intelligent people. However there are few, if any geniuses at work. A group of really intelligent people are like a group of lemmings – except they are really efficient and quick lemmings – they get to a higher cliff, much quicker than more ordinary mortals.

Risk (and in particular, financial risk) needs some geniuses.

Trouble in Paradise

2011-12-15T09:03:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

There’s trouble in paradise

And Heaven’s not the same,

These are lyrics from a doo-wop song by the Crests that can be applied to risk management and stop-gap measures proposed by Eurozone officials to stabilize financial markets. This can describe the Brussels deal last week that attempts to reformulate the underlying rules for the euro zone. The problem is that the full details were not disclosed and already it is falling short of market expectations.

There are a number of unresolved issues from the meeting: there are no details on how much money will be needed to protect the market from further speculative attacks and prevent contagion, how will the banks be recapitalized to cover losses on their sovereign debt holdings, there is limited information on what measures will be implemented to reduce the borrowing costs and does the cure proposed in Brussels actually work?

The amount of European debt that needs to rollover in the next 12-24 months is staggering compared to the amounts discussed for a temporary financing facility. The outstanding sovereign debt of Italy is nearly $3 trillion that would dwarf any temporary financing facility being considered. A rating down-grade could spark another speculative attack.

The recent stress tests for the European banks suggest a further need for $150 - $200 billion in new capital. This does not take into account any further write-offs of existing debt. In addition, the banks are often under intense pressure in their country of domicile to take on additional sovereign debt after poor auctions. If the sovereign debt crisis moves into a full blown banking crisis, the speed of contagion will increase rapidly.

The borrowing costs of a number of countries have increased to near-record levels in recent auctions. The issue of borrowings costs has not been adequately addressed and may not be reduced until financial markets are stabilized. Details of how this is being implemented are lacking.

There have been a number of measures proposed to promote fiscal discipline, central oversight by Eurozone authorities and rules to discipline countries that break the debt limits. The idea is that once these rules are in place, the ECB and Eurozone officials could do more to resolve the underlying problems. However, this is rehashing old issues that were in the earlier treaty and raise issues about national sovereignty. There is some doubt that all countries will accept the proposed changes.

There is another issue not addressed by authorities and that is the persistence of imbalances and the lack of economic growth. A number of countries are experiencing problems from lack of growth and not budget management. There is concern that fiscal austerity will blunt growth and actually worsen the debt problem. Eurozone officials need to consider lessons from the 1930s and not just the 1990s.

The ECB needs to take a more active role in ring-fencing the crisis and act as a lender of last-resort (such as debt purchases in the secondary market). Officials need to provide a larger financing facility to deal with the crisis. Otherwise, there will be further trouble in paradise.

The Cost of ECB Inaction as Lender of Last Resort

2011-12-09T13:32:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The recent newspaper headlines have included such items as “S&P Warns on 15 Euro-Zone Nations”. Other topics include the size of a temporary bailout fund may rise to $1.0-2.0 trillion to stabilize financial markets and the European banks may eventually need $150-200 billion of new capital to offset potential losses on their holdings of sovereign debt. The point is that the cost of stabilizing financial markets has risen dramatically – it might help to understand why policymakers delay decisions and provide some lessons for risk management. A recent communique “Why the ECB refuses to be a Lender of Last Resort” (VOXEU, Paul de Grauwe, Nov. 28^th) looks at some of these issues.

The euro is under intense pressure, as it has a number of weeks to save itself, as a number of institutions prepare for a potential restructuring or its actual demise. Analysts are calling for the ECB to act as lender of last resort for the Eurozone bond market. Why does the ECB hesitate to act as a lender of last resort? If a central bank is to do so, it must evaluate the costs and benefits of its inaction of not providing last resort buying service.

The cost of inaction arises from the risk that inaction will lead to a collapse of the banking system. The benefit of inaction is the avoidance of future moral hazard risk which is beneficial to long-run the banking system stability. When evaluating the cost and benefit, the time horizon which these costs and benefits materialize matters a great deal. The cost of not providing lender-of-last-resort is almost instantaneous, since bank liabilities are short-term. The results of inaction are likely to be realized quickly while the benefits will be realized sometime in the future, possibly far in the future.

The asymmetry of the timing costs and benefits helps explain central bank behavior. Viewing the government bond markets, the sovereign debt crises occur at a much slower pace than banking crises. When facing a sovereign debt crisis, the conservative central bank view will weigh the long-term importance of reducing moral hazard unless the banking system is in immediate danger of collapse.

The implication is ECB inaction unless the cost is immediate and clear and the sovereign debt crisis leads to an immediate banking crisis. The implication of ECB caution suggests two results: this means the amount of the liquidity/aid the ECB eventually may have to inject into the banking system is likely to be far higher than the amount required to stabilize government bond markets and a banking crisis will also trigger a deep and long-lasting Eurozone recession.

The ECB may well be behaving rationally, but it is both foolish and dangerous. The lessons for risk management – address potential risks or pay the consequences.

For more on this follow the link: http://www.voxeu.org/index.php?q=node/7352

Tailors

2011-12-08T09:05:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I was conducting a class last week when we starting discussing a quote attributed to Einstein that “Elegance is for tailors”. The meaning that I take from this is that as scientists (and as risk managers I consider us to be scientists – although what science(s) we should be is a great topic for a future blog) should be most concerned with the functional and what works, rather than what is mathematically elegant.

There is a lot of finance and risk management that is elegant. The problem is that a lot of it is wrong. It assumes conditions that are only approximately correct (I blogged before on quasi-arbitrage), and thus when scaled up to industrial size the mistakes become huge, rendering the original elegant result not only wrong but misleadingly wrong.

An old saying that I first saw attributed to Riskmetrics rephrases Einstein’s saying as; “It is better to be approximately right, than precisely wrong”. Let’s leave the tailoring to the tailors. (Unfortunately great tailors are a dying breed.)

Old Favourites

2011-12-06T09:08:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I am writing this blog late on a Sunday night as I wait for a connecting flight to get home from an international trip. I am tired, exasperated with the hassles of travel, and hungry yet not wanting to face another airport meal. Those of you that travel a lot know the drill all too well. (The flip side is that I have a really cool job as a consultant, and I get to meet a lot on interesting people who give me great ideas and inspire me.)

While I sit in the airport lounge and think of all the things I have to do, I am reminded for some strange reason of my university days. It must be the Sunday night fatigue, and combined with the time of year of the semester end with all of its stresses with exams and term projects coming due. In any case, I am tired, but have a long layover, and thus I need to get myself to some level of reasonable work efficiency.

Thinking of my university days, I thought I would pick out an old album that I used to listen to while I did my university work. In my university days I always had energy (youth is an amazing thing) and somehow I always got things done. Perhaps instead of the youth it was the music?! At this stage it can’t hurt I thought. I cued up an old university album on my iPad and you know what – the music did revive me, and I am now starting to have a productive evening again.

Listening to an old album inspires old feelings – most of which were good feelings. Indeed the music is inspiring me and I am being quite productive. However it got me wondering if as risk managers we too go back to the old tried and true when creativity and energy for new solutions is lacking. Old favorites are great for a short spurt, but do we want to constantly and consistently live in the past? Or is the old music and the old way of doing things invigorating because it was great and continues to be great? An interesting double sided coin.

Why

2011-12-05T09:21:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

As a kid I was a royal pain (some – maybe most – of the people who know me now might say that not a lot has changed). I was always asking my parents why this and why that. Everything was one big question to me. Fortunately my parents were patient and answered my questions and then when fatigue set in they would send me to the bookstore. My addiction with questions is probably what led me into studying science at school.

Kids in general tend to be very curious. They ask lots of questions, and they ask lots of layers of questions. Kids think their parents are smart, as their parents (and teachers) have answers. It is fun being a kid – ask a question and get an answer. Now as a parent I realize that sometimes the answers were not quite as accurate and true as I originally thought.

Do we as risk mangers ask lots of questions – or do we try to play the role of grownups in always having an answer (no matter how flimsy or inaccurate)? Count how many times today you ask why, and how many times you give an answer to someone else’s question (implied or explicit). What is your question to answer ratio? Are you a parent or a kid? Which should you be as a risk manager?

“Bad Recipe” for Risk Management – The Agency Problem

2011-12-01T09:39:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.voxeu.org/index.php?q=node/7137

The Wall Street Journal of November 23, 2011, focusing on the demise of MF Financial, noted flaws in their risk management – the lack of accountability for decisions. The article noted that decisions made by MF Financial CEO Jon Corzine, on his European sovereign debt trades of $6.3 billion, lacked proper supervision. The typical trader would have position limits and require approvals from the head trader, the risk manager, chief risk officer, the CEO and eventual approval by the Board of Directors. In the case of Mr. Corzine, it was only the Board of Directors, and most likely, reviewed well after the positions were established or sometimes called the agency problem (conflict on incentives). The failure to implement an effective risk management system resulted in the demise of MF Financial.

The US bi-partisan Super Committee on deficit reduction failed to reach an agreement by the November 23, 2011 deadline imposed by Congress. The lack of a clear outcome and responsibility by politicians pose a special problem for risk management – the agency problem. The agency problem, or sometimes referred to the agency dilemma, attempts to address difficulties that may occur under periods of incomplete or asymmetric information when a principal (voter) hires an agent (congressmen), to address a problem of moral hazard (weak economy) with a potential conflict of interest. The problem is when the agent (congressmen) acts for their own self-interest rather than that of the principal’s interest (restoring economic growth). A recent example is the no-tax pledge made by Congressmen to Grover Norquist, of the lobbying group “Taxpayer Protection Pledge”. Mr. Norquist does not have any accountability to voters on the economy.

As a result, a number of automatic spending cuts are supposed to kick-in 2013. The nastiness of the cuts and their potential implications were expected to encourage lawmakers to strike a deal. It now appears that Congressional leaders will be unable to reach a compromise as special interest groups try to limit/offset the impact of mandatory spending cuts implemented in 2013. The question becomes how long will this impasse persist? It could last until the election looming in November of 2012.

Under the current incentive system, US Congressmen have little incentive to reach a compromise to tackle the debt problem and adopt policies to restore economic growth. It was noted in an earlier column in VOXEU on November 23, 2011 that the surge in political uncertainty comes at a cost. A recent note Policy uncertainty and the stalled recovery (Scott Baker, Nicholas Bloom & Steve Davis, VOXEU, October 22nd) address these issues. The authors distinguish between economic uncertainty and economic policy uncertainty, constructing an index to measure policy-related uncertainty and argue that reducing policy uncertainty would raise output and add dramatically to job creation. The authors noted that if their index for policy uncertainty was restored to 2006 levels, it could result in a rise of industrial production by 4% and the creation of 2.5 million jobs over 18 months. This may not be enough to create a booming economy, but it is a step in the right direction.

The lack of clear accountability of Congress (agent) to the voter (principal) will likely result in a stagnant economy through 2012. The failure to implement an effective risk management system for politicians has a cost for the US economy. Politicians need to learn the lessons on risk management from MF Financial.

A reference for the Baker, Bloom & Davis paper.

How do you recognise the best risk manager?

2011-11-25T09:12:00.001-05:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

Is the best risk manager the one who has the best solutions? Is it the one with the most experience, the best grasp of technical fundamentals, the one with the best solutions? Is the best risk manager the one who understands the optimum risk appetite for his or her organization? I would contend that it’s none of these. The best risk manager is the one who asks the best questions.

Quantitative Inflation

2011-11-24T11:48:00.001-05:00

By Stephen McPhie, CA

RSD Solutions Inc.,

The American and British cure for many of our current ills has been printing money. Quantitative easing as those who practice it are concerned. Germans, especially the head of the Bundesbank are dead set against it. They view it as a way to let some countries off the hook. They also believe it will lead sooner or late rot inflation – a logical view.

Perhaps like many, for or against it, you just desperately hope for the best and that it will work somehow and lead to strong growth. However, if you are a financial executive in the US or UK, do you also countenance the inflation possibility? A medium term view is important and the consequences of inflation should be considered in risk management. In spite of a benign rate environment, caused partly by flight to quality), consequences include higher interest rates.

The Cost of Political Gridlock and Uncertainty

2011-11-23T11:35:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The waning confidence in US political leadership threatens global financial markets as the super committee has failed to reach a plan for deficit reduction. This failure is leading investors to wonder how long the debt overhang will impact the struggling economy. There is concern that an impasse could last until the November 2012 election as politicians haggle over mandatory spending cuts.

The political gridlock in Washington has a cost and that is the focus of this communique. There are two lessons for risk management: decision paralysis has a cost and an adverse incentive system can lead to gridlock. This outcome would not be tolerated in the private sector.

In a recent column, we reviewed the cost of policy uncertainty. Policy uncertainty and the stalled recovery (Scott Baker, Nicholas Bloom & Steve Davis, VOXEU, October 22nd). The authors distinguish between economic uncertainty and economic policy uncertainty, constructing an index to measure policy-related uncertainty and argue that reducing policy uncertainty would raise output and add dramatically to job creation.

Prior to the financial crisis of 2008, stock markets moved in response to economic numbers such as GDP or employment and corporate earnings. But today, it is politicians and government regulators making comments about bailouts, budgets and regulatory reforms that are driving the markets. As a result of diverse comments from politicians and government officials, have generated massive economic uncertainty. This policy uncertainty is a key factor in stalling the recovery and contributing to the risk of a double dip.

Baker et al constructed a new index of US policy uncertainty by combining three types of information: frequency of articles that reference economic uncertainty and policy, references to expiration of various federal tax code provisions and disparity among forecasts about inflation and government purchases of goods and services. In addition, the authors are able to separate an indicator of economic uncertainty from that of policy uncertainty. They note the key drivers of policy uncertainty are dominated by monetary and tax issues. When businesses and investors are uncertain about taxes, health care costs, budget prospects and regulatory initiatives, they adopt a cautious stance. They find it costly to make a hiring or investment mistake, waiting for calmer times to expand or consider riskier investments.

As a result, the recovery never takes off as business remains cautious on making investments in capital goods, research and worker training – key determinants for long-run sustainable growth. Investors remain on the sidelines in “safe” investments avoiding risk. The authors noted that if their index for policy uncertainty was restored to 2006 levels, it could result in a rise of industrial production by 4% and the creation of 2.5 million jobs over 18 months. This may not be enough to create a booming economy, but it is a step in the right direction.

The lesson for the continued political fiasco is that it comes at a cost. The lesson for risk management is that inaction on risk mitigation also has a cost.

For more on this follow the link: www.voxeu.org/index.php?q=node/7137

BRIC … BTIC

2011-11-22T12:10:00.001-05:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.,

Something does not feel quite right with BRIC. The "R" in fact. This represents a country that has shunned the opportunity for reform that could have been afforded while high oil and gas revenues have been flowing in. One where corruption is rife, the rule of law inadequate at best, the demographics are unfavourable and floods of people are getting out or getting their money out or both. One where an increasingly oppressive regime seems destined to continue for many years to come. Why is it part of BRIC?

Perhaps the "R" should be removed and replaced with "T". Of course, many countries in the developing world have great promise and improving conditions for growth so BRIC represents the large powerhouses among them. T is for Turkey, which looks in a very good position to grow and prosper over the coming decades and which has good looking demographics. Only problem is that BTIC does not flow so easily off the tongue.

What does this mean at the company level for risk managers? Perhaps little but perhaps a lot, depending on sales, supply and investment flows and potential currency movements. Such things should at least be considered in an ERM context.

It would be interesting to hear any comments about my "R" for "T" substitution, especially among any ex-pat Turks!

Regulation and Risk Reduction in the Shadow Banking Sector

2011-11-21T09:05:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The shadow banking system is vast and plays an important role in financial intermediation. Analysts suggest that it played a small role in the early 1990s and now accounts for over 60% of US financial intermediation. A question is why did it arise and become so important? Some view it as regulatory arbitrage and others suggest it as the market fulfilling investors demand for “riskless” assets. A recent communique by Zoltan Pozsar; Can Shadow Banking Be Addressed Without the Balance Sheet of the Sovereign (Voxeu, Nov. 16^th) explains some of the issues and potential policy options.

Shadow banking system is the name given to the financial infrastructure that exists outside the regulator’s remit. There are two ways to understand shadow banking: one a supply-side approach where banks use securitization-based credit intermediation process through various vehicles, funds and subsidiaries that are globally interlinked and two, the demand side which focuses on cash investors that provide banks with wholesale market funding rather than via traditional deposits. The volume of institutional cash pools increased from $100 billion in the early 1990s to over $3.5 trillion today.

The intersection of the two approaches indicates that shadow banking is a significant part of the risk-intermediation process, and for that reason the Financial Stability Board (FSB) has issued a set of recommendations to monitor its activities. Investors manage large cash pools, which replaced institutional deposits, in the form of repos and asset-backed commercial paper. These instruments are considered safer since they have layers of protection compared to unsecured deposits.

The privately guaranteed money involves risk stripping into credit, maturity and liquidity transformation components and came about due to the shortage of government-guaranteed instruments. The sovereign balance sheet plays into the emergence of shadow banking and the money claims against it. The first priority is safety as mortgage pools are securitized and placed into tranches. The tranches are put into a levered maturity transformation and funded with short-term instruments and quasi-liquidity guarantees. Short-term money market instruments are put into vehicles such as money market funds vulnerable to changing market conditions.

The FSB reform idea is to adopt measures that shorten the financial intermediation process, allowing governments to issue short-dated instruments to absorb the cash pools. Recently, the US Treasury Borrowing Advisory Committee produced the issuance of floating- rate notes to serve a similar as the issuance of t-bills as money for institutional cash pools. Regulatory approaches to design a smaller and less run-prone banking system are a key step. A more hands-on approach is required to engineer a migration of cash pools away from wholesale funding markets and toward short-term sovereign claims.

For more on this click on the link to the Voxeu article: http://www.voxeu.org/index.php?q=node/7278

Do I think the Euro will still be around in 5 years?

2011-11-17T09:07:00.001-05:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

The short answer is yes. And this is due to self-interest, particularly for Germany. The Euro has certainly been a weaker currency for Germany than a stand-alone Deutschemark would have been. At the same time it has been a stronger currency for many other Eurozone countries than stand-alone currencies would have been. This might have been expected to force the latter countries to become more productive and remove some compulsion for Germany to become so. In fact, Germany has improved productivity substantially over the life of the Euro and produced very strong export performance helped by a weaker Euro. At the same time, other countries, notably Italy have not restructured, or notably improved productivity, and fallen behind. However, their borrowing costs, until recently, have been low. Germany has in effect been benefiting from a weak currency policy (like China has) relative to its economic strength, under cover of the common currency.

If weak Eurozone countries left the Euro, their currencies would likely plunge dramatically making it even more difficult to repay debts that would still be denominated in Euros. This would apply not only to sovereign debt, but also to corporate debt. Large bankruptcies and default s would follow resulting in massive losses for German banks that are hugely exposed to these countries. As import costs for these weak countries would soar, German companies would also lose significant export markets. Also German goods internationally would be more expensive with a stronger Deutschemark

Conversely, if Germany left the Euro, a new Deutschemark, would soar compared to the new weaker Euro and other currencies hitting German exports globally. German banks would incur large losses as their Euro exposures lost value against the Mark.

In short, there is certainly going to be large cost for Germany arising out of all this one way or the other. They have benefitted from the Euro for over 10 years and now will have been shown to have squandered part of the surplus generated by providing liquidity to unreformed weak economies. Ensuring survival of the Euro is probably the least bad course, which is why I think the Euro will still be around in something like its present form in 5 years.

Do you think the Euro will still be around in 5 years?

2011-11-16T10:52:00.001-05:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

Perhaps “in its current form” should be added to that. For any corporate treasurer, this is an important question and should encourage them to re-examine their currency exposures and hedging practices. (Exposures may include hidden exposures like imported components in goods bought from domestic suppliers for example.) The effects of a Euro break up, or of a change in its form may well be felt much more and further afield than most people might realize. An independent analysis and view might be appropriate for many businesses. Whatever your view, this should be on the radar as high risk.

Too little too late has characterized all or most actions during the current crisis. Denial, prevarication and changing positions have also been in plentiful evidence. Of course, it is politicians of various different stripes and different nationalities and cultures that are trying to find a common solution to the problem. Not necessarily the recipe for a timely, practical and effective solution. The main player, Angela Merkel, has been trying to keep domestic political balls in the air during all this and that appears to have precluded swift and decisive action.

Of course it could be argued that without going to the brink, countries like Italy will not institute any truly effective reforms. On the other hand, the longer it takes to come to a satisfactory solution, the higher the cost is likely to be and the higher the risk that the house of cards will come crashing down.

There seems to be an intent to maintain the Eurozone in its current form. However, when going close to the brink, events can get out of control and unintended consequences come about. (Look back in history to how the First World War started.)

Next: Do I think the Euro will still be around in 5 years?

Confronting and Managing Risk

2011-11-15T12:54:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The recent confrontation between Greece and EU officials provide a good lesson for risk managers. EU officials continue to minimize potential risks, fail to take realize their magnitude and communicate the problems, and take the necessary steps to remedy the situation. These are all symptoms of a failure of risk management.

Greek Prime Minister Papandreou made a stand, against the proposed Greek debt restructuring, and even though he was forced to backpedal, Wyplosz argues that he did the Eurozone a favor by providing it an opportunity to change course. The Greek government has largely been following the dictates of EU officials to not restructure their debt, but this might have been the least costly remedy if done in a timely manner.

The Greek revolt, even if short lived, is good news on the European crisis front – it might provoke the long-awaited policy turnaround that is necessary to end the Eurozone crisis. It may finally awaken Eurozone leaders to the futility of the path they’ve chosen. One way or another, a disorderly Greek default is in the cards with its attendant contagion for all of the rest of the PIIGS (Portugal, Ireland, Italy, and Spain) and maybe even France. The cost of a default could be much larger than delaying the inevitable Greek restructuring.

Dazed and Confused? Eurozone officials took the wrong path in early 2010, because they did not fundamentally understand the nature and depth of the problem. Perhaps, they did not want to deal with it and brazenly assumed things would revert back to normal. However, the seriousness of the surging debt and slow growth revealed all the flaws hidden in the euro’s first ten years. There is a cost for their negligence.

At that point a real solution is inevitable – one that requires Eurozone leaders and the ECB to play on the same side with credible rules for all. An ECB backstop for Eurozone bonds will be required, but this does not mean underwriting banks and sovereigns. The ECB guarantee should be set to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates.

Banks will have to be bailed out, possibly with EFSF resources, but in a way that minimizes moral hazard and maximizes taxpayer protection. That means wiping out shareholders and, if need be, unsecured bondholders. The cost of the bailout could reach into the hundreds of billions and does not include recapitalizing financial institutions. A long-term cost is the sustained period of sub-trend growth resulting from the overhang.

Can we learn anything for risk management?

For more on this follow the link: http://www.voxeu.org/index.php?q=node/7222

Eurozone Risk Identification & Mitigation

2011-11-14T09:15:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Eurozone policymakers and politicians continue to ignore the growing risks to the euro and the failure to take appropriate action to address these risks. They continue to view recent developments as a temporary liquidity crisis instead of a solvency issue. They commit all the classic failures of risk management outlined by Rene Stulz in a recent article in the Journal of Corporate Finance (2008). A proposed outline on VOXEU identifies some of the methods how the Euro crisis can be addressed.

The Eurozone crisis has taken a turn for the worst. A group of German economists from the “German Council of Economic Experts” have proposed a temporary program to stabilize financial markets by creating two temporary entities: the European Redemption Pact and the European Redemption Fund.

This involves the creation of a joint debt vehicle with a finite maturity date. The objective is to ease temporary market dislocations and mandate the implementation of credible fiscal reforms for all Eurozone members. This program would combine two elements: accounting and solidarity. Accounting requires member countries to consolidate public debt and eventually reduce debt levels toward more sustainable levels. Solidarity requires assistance from stronger members to weaker partners, but encourages fiscal discipline.

The European Redemption Pact is based on a revised Growth & Stability Pact that combines joint and several liabilities and a strong commitment to push countries toward a 60% debt-to-GDP ratio. The point is to separate the accumulated debt of member countries into a part that is compatible with a 60% debt threshold and a part that exceeds this limit. Participants can refinance themselves through a joint European Redemption Fund (ERF) until the debt refinanced reaches the 60% debt threshold. Participants in the program would be jointly liable, but each country is required to service its own debt financed through the ERF.

The advantage of the program is its limited duration and the strong strings attached for participation (tax provisions, collateral & redemption guidance). Another advantage of the program is a market rate for weaker members and for stronger member’s avoidance of a potential messy default.

The classic failures of risk management include using the appropriate metrics, measuring known risks, accounting for all risks, failure to communicate and failure to monitor and manage. Can we learn something from events in Europe?

For more on the article A European Redemption Pact, please follow the link: http://www.voxeu.org/index.php?q=node/7253

Who is Risk’s Steve Jobs

2011-11-09T09:50:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

We all already miss Steve Jobs. In fact it may be argued we miss him too much as media articles are asking if we are making him a saint. That is another issue for another time as far as I am concerned.

My question is “Who is Risk’s Steve Jobs?” Who is the individual who has had the force of character to change the risk industry? Who has created a paradigm shift in risk products and services? Most interestingly, what risk manager has been a massive failure and let go rather unceremoniously from their own company, to only come back and have an even greater triumph?

Risk Sim

2011-11-08T09:03:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Everyone who has been to business school is familiar with business simulations. These computer models simulate economic conditions and the competitive environment of one industry or another. You spend the weekend, or time during an offsite competing against either the computer, or your peers to see who can run the most successful company according to the simulation.

Business simulations are fun, and students and training participants enjoy them up to a point. Simulations attempt to get participants to learn how to juggle the multitude of factors that affect the outcomes of business decisions.

Business simulations function by taking a set of rules, and correlations between rules and create outcomes based on the participant’s decisions. They are based on a set of assumed cause and effect relationships. If a simulation is played for too long of a period of time (or too many rounds), then it has been my experience that participants start to focus on reverse engineering the simulation, rather than thinking about making good decisions.

This raises an interesting question; “Can we create a risk management simulation?” In other words, can we create a realistic simulation that allows a risk manager to develop their skill at making risk based decisions? Are there a set of well known rules and correlations – cause and effect mechanisms, that will allow the construction of such a simulation?

Italy – Credibility or Fundamentals

2011-11-07T09:04:00.001-05:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Credit default swaps for Italy have surged over the last few weeks as the Italian government of Silvio Berlusconi seems to be occupied elsewhere.

In the Voxeu article Credibility is not everything, Paolo Manasse notes that many analysts have argued that the Eurozone emergency meetings could restore creditability if they came out with an all encompassing program. However, this may not work in Italy where the problem is not credibility, but continued deterioration of the fundamentals.

For Italy, self-fulfilling prophecies may generate opposite and unpredictable outcomes for the same level of fundamentals. This can result multiple equilibria such as a favorable debt/GDP and primary balance depending on market expectations which may suggest solvency or insolvency depending on prevailing market view.

The favorable prospects of Italy joining the euro and reducing currency risk allowed the average cost of debt to drop from 10% to 4% in 1996 and the interest bill declined from 12% to 4% of GDP. This allowed for a significant improvement of the budget and a strong reduction of the debt ratio. However, this progress was squandered due to a deterioration of fundamentals since 2004. The debt to GDP level is now back to 1996 levels and the primary balance is near negative territory. It is only a matter of time before market rates move higher on worsening fundamentals.

The market gave too little consideration to fundamentals such as the debt/GDP ratio and primary surplus, assuming that Italy’s default and possible exit from the euro was inconceivable. If you look at history, bond yields could return to levels last seen in 1996. The prospect of Mr. Berlusconi resignation is necessary at this point, however, it is hardly a substitute for taking decisive action for fiscal adjustment.

Italy provides a good lesson for risk management. Risks can return when we least expect them and the risk manager cannot get distracted from their primary job –managing risk.

For more on this story follow the link: http://www.voxeu.org/index.php?q=node/7187

1952

2011-11-06T08:37:00.001-05:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

One of my guilty pleasures is going through old magazines – particularly old business magazines from the 50’s and 60’s. It is a very useful exercise in that you frequently observe that the factors and practices that made companies successful 50 and 60 years ago are the same factors or practices that make them successful today. In essence there are a set of best business practices that are timeless.

This raises an interesting, and perhaps troubling point. What risk practices are timeless? What risk practices that we currently utilize would have also been considered to be best risk practice in the 1950’s? What risk practices from the 1950’s are still considered to be best risk practices? What risk practices from today will be considered best risk practice in 2060?

Eurozone Rescue Package Euro Implications: Fundamentals vs. Sentiment

2011-11-04T09:03:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Financial markets loved the rescue package as equity markets rallied and the euro surged. However, this short-term good news for markets did not last as Greek politicians feuded among themselves and Eurozone officials. As Eurozone policymakers threaten to with hold Greek aid, it raises the question of whether Greece may exit the euro. The fallout for financial markets could be costly.

Near-term, the package avoided sovereign default and a banking crisis. .The rescue package accomplished three objectives: it provided a temporary fix for Greece, backstopped banks writing down Greek sovereign debt and provided a temporary backstop for sovereign debt.

Long-term, the rescue package is bad news for banks, financial markets and the euro. Banks will experience a credit crunch as they struggle to meet capital adequacy ratios, the resulting austerity could create a fiscal contraction and provide a negative feedback loop for banks and sovereigns. It failed to address three specific long-term issues: the package is too small to cover fallout from Italy or Spain, the lack of ECB involvement is a mistake and failed to address treaty reform and long-term monitoring of budget deficits by Eurozone authorities. Eurozone policymakers may need to consider another rescue package by next summer.

The Euro rallied, after the package was announced, from the positive sentiment. However, this rally does not appear related to yield differentials. Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar. Economic fundamentals and market sentiment are clearly out of line and pose potential downside currency risks once the market digests long-term implications of the package.

Bond investments tend to be one of the largest cross border flows. Any divergence between currency values and rate differentials suggests that decision to buy and sell currencies may be related to other factors. It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets. The rising losses on Greek sovereign debt and bank shares trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.

When banks start a deleveraging process, the first adjustment is made to overseas business that is considered non-essential. A second adjustment may occur when banks attempt to reduce their short-term funding requirements, especially in non-core currency markets away from the euro. In particular, this could impact trade finance and commodity finance where European banks are major players.

The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro. This has allowed the euro to withstand selling pressure against the dollar. This may allow the euro to be well supported against the dollar as long as repatriation flows continue. As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices. These policies will serve to weaken the fiscal positions of Eurozone governments, add additional pressure to bank balance sheet and increase the potential default pressure on Greece. The only long-term answer is ECB involvement and implementation of euro-wide reforms in Brussels. Otherwise, there is growing sentiment that Greece may exit the euro

Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation are negative for financial markets and could spell euro weakness as economic fundamentals reassert themselves or Greece decides to exit the euro. What is your hedging strategy?

The Six Million Dollar Man

2011-11-03T09:42:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

The Six Million Dollar Man will likely go down as one of the corniest TV shows of all time. Bad acting, bad scripts, bad everything. With the exception of one of its opening lines; “We have the technology, we can rebuild him …” the show has been almost totally forgotten. It is likely that anyone under the age of 40 will have no idea that such a TV show even existed.

The premise of the show – rebuilding a super person with the best of technology for various body parts, creates an interesting thought experiment for risk managers though. If we were to rebuild the most technologically advanced risk manager, what parts (skills) would they have?

Your Great Grandmother

2011-11-02T09:15:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

We all grew up getting wisdom passed down from our great-grandmother (or great aunt, etc.) Timeless quips such as “An apple a day keeps the doctor away.” As kids, and young adults we often shrugged off these bromides as old-fashioned and quaintly simplistic. As more mature adults however we likely began to see that there was some value in these simplistic directives that often proved to be more useful than our more modern and sophisticated methods of doing things. Thus I ask, would your great-grandmother, with her simplistic and folksy wisdom, be a better risk manager than you are with all of your degrees and sophistication?

Euro Outlook: Fundamentals versus Market Sentiment

2011-11-01T09:30:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The euro has rallied against the US dollar last week ending the week just below 1.39. This rally does not appear related to yield differentials. Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar. Economic fundamentals and market sentiment are clearly out of line and pose potential currency risks.

Bond investments tend to be one of the largest cross border flows. Any divergence between currency values and rate differentials suggests that decisions to buy and sell currencies may be related to other factors. It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets. The rising losses on Greek sovereign debt and bank share trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.

The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro. This has allowed the euro to withstand selling pressure against the dollar. This may allow the euro to be well supported against the dollar as long as repatriation flows continue. As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices. The impact of European bank deleveraging and potential credit rationing could have a strong impact on European growth prospects.

Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation could spell weakness for the euro as economic fundamentals start to reassert themselves. What is your hedging strategy?

Wordless PowerPoint

2011-10-31T09:03:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

We all dislike (hate) the conference PowerPoint presentation. Slide after slide dulling your senses and killing grey cells – forever to be forgotten 7 nanoseconds after the conclusion of the presentation.

To combat death by PowerPoint various new styles and formats are being promoted – and indeed I try to integrate some of the new styles into my professional and academic presentations. One of the more common types of “enlightened” presentation is to construct a PowerPoint that has no words – only pictures. The thinking behind this is that pictures evoke emotions (which are better remembered and understood by audience members) and pictures also force listeners to focus on the speaker (and who, as speaker, does not want the focus to be on them?) Wordless PowerPoints are rapidly catching on, and I suspect you have been the victim (or perhaps the perpetrator) of them yourself.

As a consultant I have an idea and a challenge for you. The next time you have to give a risk presentation, can you make it mathless? Can you give a risk presentation that has no math, no numbers, and no graphs? Can you create a risk based presentation that evokes emotions, understanding, and keeps the focus on you – the speaker and professional?

Eurozone Leaders still don’t get it

2011-10-28T09:15:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Eurozone policymakers have put together another plan to save the euro. Will it work – only time will tell? Charles Wyplosz, in a communiqué They still don’t get it (VOXEU, 25^th Oct.) reviews recent progress. He is not optimistic they will take the necessary steps. He notes that by rejecting an ECB role, leaders have guaranteed that any package will fail as too little too late. They are addressing two of the three needed steps: putting Greece on a sustainable path and backstopping banks. The last stop still needed is to backstop all European sovereign debt to avoid contagion.

The author identified three issues in an earlier VOXEU column (22^nd Aug 2011) for policymakers: a clear misunderstanding of the situation, understanding the danger ahead, and unwilling to take the necessary steps to resolve the situation. The real danger is contagion has spread to Italy and Spain pass the point of no return and the risk of spreading to core countries.

The European Financial Stability Facility (EFSF) is too small to deal with the amounts involved, even under the new proposal. The authorities must move ahead of the curve and put together policies to contain the crisis and avoid further contagion – the new proposal may not be enough. This can be accomplished by placing a floor under public debt valuation. This can be accomplished two ways: the ECB can act as a guarantor of public debt as maturing debt is rolled over and the second approach is to replace maturing Eurozone debt with Eurobonds.

The ECB is the only institution that can deal with the amounts involved and provide breathing space to address bank recapitalization. The continued rescue packages for banks and government are creating moral hazard problems. Long-term, authorities must address the weakness of the Stability and Growth Pact and enact restrictive fiscal policies with monitoring. Wyplosz notes that recapitalizing Greek banks is a temporary solution, but could undermine its purpose by increasing debt levels. The only solution is to tap the EFSF short-term and involve the ECB to provide a backstop for public debt.

The worst outcome is to reject a role for the ECB. The lack of a backstop for public debt prices will allow the crisis to fester and deepen pushing up the cost of resolution.

For more on this follow the link: http://www.voxeu.org/index.php?q=node/6845

Stupid Interview Question

2011-10-27T10:36:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Working with MBA students is always busy this time of year. Students are in the final round of interviews and they are always anxious and looking for any advice they can get that will give them an edge. To that end, I often see a fairly large number of students in my university office looking for interview tips.

Interviews have changed a bit since I was in the middle of looking for a job after graduation. In my day an interview was assessing your skills and trying to ascertain if you were a likable person or not. When I was interviewing, it was always a line manager that did the initial interviews, and they were often inconsistent in how they went about things. Now it is human resource professionals who supposedly have much more systematic and objective interviewing techniques. The goal now is to assess behavioural traits. Competence and the ability to do a good job are on the list – but quite far down the list.

In my day interview questions were along the lines of what do you know, and what have you done. Now that ask questions like “If you were a tree, what type of tree would you be?” I understand why they ask that type of question, but ultimately it has become such a common question (or style of question), that in my opinion it is just plain stupid. I am not a tree, I have no immediate plans to become a tree, and if I was a tree I am quite confident that no one would want to pay me a salary.

That may be considered cynical however. So just to show that I can be open minded, I will ask the question of risk professionals; “If risk management were a tree, what type of a tree would it be?” That’s just stupid, but a hell of a lot of fun to discuss at the water-cooler!

Rick Nason project described in recent Canadian Business article

2011-10-25T09:02:00.001-04:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

In a recent Canadian Business article on October 20, 2011, "What's your thesis?" by Michael McCullough, RSD Solutions Partner Rick Nason had his thesis: "Financial regulation isn’t rocket science" described in the article. Rick's thesis is one of five quoted in an article that looks at the latest academic thinking being applied to the business world. Rick's background of physics allows him to bring a unique perspective to business solutions and in particular the area of risk.

To read the article follow the link: http://tinyurl.com/3clb8m2

Lessons for European and US politicians – How not to create jobs

2011-10-24T09:10:00.001-04:00

by Don Alexander, MBA

RSD Solutions Inc.

A striking feature of recent equity market volatility is that politicians and government bureaucrats are making the news. It seems that statements about bailouts, restructuring, budgets and regulatory reforms are driving stock market volatility. Policymakers’ and bureaucrats choices are dominating headlines in the global crisis.

Policy uncertainty and the stalled recovery (Scott Baker, Nicholas Bloom & Steve Davis, VOXEU, October 22^nd). The authors distinguish between economic uncertainty and economic policy uncertainty, constructing an index to measure policy-related uncertainty and argue that reducing policy uncertainty would add dramatically to job creation. Prior to the financial crisis of 2008, stock markets moved in response to economic numbers such as GDP or employment and corporate earnings. But today, it is politicians and government bureaucrats. They cannot agree, generating massive economic uncertainty. This policy uncertainty is a key factor in stalling the recovery and contributing to the risk of a double dip.

When businesses and investors are uncertain about taxes, health care costs, budget prospects and regulatory initiatives, they adopt a cautious stance. They find it costly to make a hiring or investment mistake, waiting for calmer times to expand or consider riskier investments. As a result, the recovery never takes off as business remains cautious on making investments in capital goods, research and worker training – key determinants for long-run sustainable growth.

Investors remain on the sidelines in “safe” investments avoiding risk.

The lessons for European and US policymakers are clear. They need to take action that will reduce policy uncertainty for business and investors.

For more on this follow the link: www.voxeu.org/index.php?q=node/7137

Issues that need to be addressed to reduce European sovereign risk

2011-10-20T11:36:00.001-04:00

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by Don Alexander, MBA

Associate, RSD Solutions Inc.

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European leaders face a deadline this Sunday to implement policies to help resolve the sovereign debt crisis. A review of these issues is summarized in a recent commentary.

A deadline for solving a deadly Eurozone sovereign debt crisis (Guillermo de la Dehasa, VOXEU October 20^th) Time is running out for EU leaders to put an end to the Eurozone crisis. European leaders face the following issues: 1. find a definitive solution to Greek insolvency, 2. isolate solvent countries from possible Greek contagion, 3. improve EU governance by creating a true European Parliament and 4. refocus on a pro-growth policy mix.

Eurozone leaders must reach a clear and definitive solution to Greece’s insolvency without triggering a credit event. Private sector involvement is not the best solution since “voluntary haircuts” can be an oxymoron and impede decisions. Haircuts can be imposed on banks and a Brady-like swap program can be implemented for Greek bonds into European Financial Stability Facility (EFSF) bonds of longer maturities. A challenge for policymakers is to isolate solvent members from contagion. The can be implemented through a backstop for Eurozone member debt, such as a leveraged EFSF. The guarantee is implemented in return for debt consolidation and structural reforms.

Long-term, the present structure of European governance and crisis management needs to be addressed. This issue can be resolved by amending the treaties and moving away from the current system where council decisions need unanimous approval within national governments. Long-term, the EU needs to move to a federal system of governance by a true European parliament. It should set up an independent European treasury to monitor states compliance to debt limits and structural reforms. Lastly, policymakers need to implement a policy where Eurozone growth rate can exceed the real interest rate on its debt.

European banks will need to be recapitalized. However, this will only be a stop gap measure without addressing the other issues. Otherwise the concept of the euro will be at risk.

The Cost of a Capital Cushion for Global Systemically Important Banks

2011-10-17T09:29:00.000-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Recently, a number of financial institutions along with the International Institute of Finance (IIF), an industry association owned by financial institutions, have raised concerns about the economic costs for a capital cushion for global systemically important banks (GSIB). The BIS has answered some of these questions in a recent report Assessment of the Macroeconomic Impact of Higher Loss Absorbency for Global Systemically Important Banks (BIS Macroeconomic Assessment Group, October 10^th).

Weakness in large financial institutions has often played a central role in the triggering and propagation of systemic financial crises. The Financial Stability Board (FSB) and the Basel Committee on Banking have made a number of proposals for improving the loss absorbency of the GSIB and put together a Macroeconomic Assessment Group (MAG) to investigate the macroeconomic costs and benefits of these proposals.

The GSIB proposal costs stem from the adverse impact on economic activity, bank policies to increase rate spreads and reduced lending to build up their capital buffers. The 30 potential GSIBS, for the study, were based on their domestic market lending share and share of financial assets in their domestic economy.

The initial result showed a 1% increase in the capital requirement reduced GDP by 0.06% over 8 years, or a little less than 0.01% per year. The primary driver of this macroeconomic impact was the increase in lending spreads by 5-6 basis points. The overall results conceal differences across countries related to role of the domestic financial system, existing capital buffers and international spillover effects. It was found that by varying key assumptions: such as asset size, a larger bank list, a shorter implementation period or authorities altering only had a limited impact of growth.

The MAG group looked at the full impact of implementation of all the Basel proposals and increased the capital buffer by an additional 2% for the GSIBs implemented over 8 years. The actual results of the two components indicate reduced GDP growth by 0.04% per year while lending spreads rise by 31 basis points. As noted earlier, different assumptions lead to different effects, while faster implementation or a weaker monetary response increasing the impact on GDP.

The benefits for the GSIB framework relate primarily to the reduction in the exposure of the financial system to systemic crises that can have long-lasting effects on the economy and financial markets.

For more on this follow the link to the BIS: http://www.bis.org/publ/bcbs202.htm

Wanted: An Inuit Risk Manager

2011-10-14T09:15:00.001-04:00

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

Recently while driving home from my teaching engineering students about entrepreneurship I was listening to the CBC radio program “Ideas” which had at that time a woman who studied the Inuit (the indigenous people of the Canadian arctic) language and by default its culture. One of her more interesting discoveries is that one of the Inuit dialects has a term which best translates to X-ray eyes – in this case it is used to describe the situation a lone hunter may find themselves in when on the ice floes. The idea is that the hunter is alone and with no form of contact with anyone and thus by necessity is forced by themselves to see through all the options that lay before them and “see” their consequences before acting.

This powerful cultural characteristic would be a very desirable trait for a risk manager (and the rest of us). Effectively what the hunter has done is eliminating the “noise”, list the options and play them out to see which has the greatest net benefit or chance of success – be that pure survival or food. This would be a highly desirable trait for a risk manager and the metaphor of survival (no bankruptcy) or food (profitability) is rather fitting.

Taxation rant - Part 2

2011-10-13T10:19:00.001-04:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

Politicians are jumping up and down about tax evasion and blurring the lines between tax evasion and tax avoidance. Some are saying that, although legal, tax avoidance is immoral. Presumably this is a prelude to calls to grab more tax. I find this tendency to be objectionable at the very least. After all, IRA and charitable deductions in the U.S. and RRSP contribution deductions in Canada can be seen as a form of tax avoidance but are considered desirable from a personal and societal perspective.

What is immoral about quite properly avoid paying tax that you don’t have to? Should people and companies voluntarily pay extra tax and if so, how much? If there are loopholes, these can be dealt with by legislation, but many so called loopholes encourage investment and wealth creation, which might go elsewhere if plugged. Politicians often know this but carry on spouting nonsense in any event rather than try to educate people.

Taxation rant – Part 1

2011-10-11T12:07:00.001-04:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

Most western countries are massively fiscally challenged. In plain English of course that means running large and unsustainable deficits adding to already excessive debt. And yes, I include Canada as a country that is not the worst but is far too indebted, especially when the Provinces are brought into the equation. So governments are now under huge pressure to reduce those deficits. Cost cutting is of necessity a major component of this effort.

Taxes are close to the limit of what people will tolerate, especially here in the UK where years of Gordon Brown saw massive overall tax increases, but governments are still squeezing out extra cash from fees and stealth taxes.

Another part of the effort to squeeze out every possible dollar is beefing up enforcement. Not only will there be more audits and challenges for businesses, but there will be less (or no) leniency about imposing penalties for the most minor of infractions. There are many existing filing requirements with new ones springing up all the time. Many of those requirements are nothing really to do with the amount of tax to be paid but are to provide information, most of which is likely to be of no use and often people are totally unaware of the requirements. However, they do create traps – and financial penalties for those who get caught that grab yet more of our money.

I have 3 examples of areas where tax departments will impose penalties

· Example 1 – UK - a recent quarterly filing requirement in the form of a “Value Added Tax EC Sales List” whereby UK companies must list sales to customers in other EU countries by customer along with VAT registration numbers for each customer. Presently total sales to EU customers have to be reported on VAT returns (Value Added Tax, which is equivalent to Canada’s GST). Now businesses have to file this separate form quarterly. Some companies could have thousands of names to report. This is hugely onerous and for no apparent useful purpose. Furthermore, the form has to be filed by calendar quarter and that might not coincide with quarterly VAT reporting periods. Of course, there are penalties for not filing the form or for filing it late.

· Example 2 – Canada – Regulation 105 (which this author has written about before and would be happy to forward information to anyone who requests it) imposes a requirement for Canadian businesses to withhold 15% of amounts paid to foreign service providers, even if no withholding tax is applicable under a tax treaty. The foreign service provider must file Canadian tax returns to recover these amounts. There appear to be few Canadian businesses that are aware of this. However, the penalties for non-compliance can be significant. I am told that CRA enforcement of Regulation 105 is being stepped up.

· Example 3 – U.S.A. – many U.S, citizens have lived much of their lives outside the U.S. but still have to file U.S. tax returns, even though many of them have little connection with the U.S, and owe no tax under tax treaties. Unfortunately, the U.S. tax system is a constantly changing minefield. One requirement is to file a Form 90-22.1 detailing accounts with foreign financial institutions if the total balance in all accounts is $10,000 or more at any time in a year. This includes all accounts over which the person has signing authority. This form is filed separately from tax returns. The penalty for non-willful failure to file is $10,000 for each account. (Fines for willful failure to file start at $100,000 and can go up to $500,000 plus 5 years in prison.) Recently, such fines have been imposed on U.S. citizens living abroad who in good faith thought they were in compliance with all their filing requirements. The fines were so onerous that the Canadian finance minister has even complained to the U.S. about it. There are obviously reasons for the U.S. wanting to know about foreign bank accounts but applying such fines to honest citizens acting in good faith is not going to convince people that the tax system is fair.

It seems that tax departments are aggressively seeking out little known and apparently innocuous filing requirements to grab more of our hard earned cash. Creating what many may view as absurd filing requirements that only dedicated tax practitioners can hope to keep up with, and imposing stiff penalties for non-compliance may be viewed as confiscation by some, but there is not much we can do but be aware and beware. The taxman is sharpening his fangs.

Central banking post-crisis: What compass for uncharted waters?

2011-10-09T09:19:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The global financial crisis has shaken the foundations of the deceptively comfortable pre-crisis banking world. Central banks face a threefold challenge: economic, intellectual and institutional. Claudio Borio in a paper for the Bank of International Settlements, notes the changing environment that central bankers face going forward; operating in a more hostile economic environment, the current economic benchmarks paradigms and models have failed and central banks will need to adjust their policy framework to maintain their independence.

Policymakers will look for a new compass that should have the following characteristics: (1) tight interdependence between monetary and financial stability; (2) a greater awareness of the global, as opposed to purely domestic, dimensions of those tasks; and (3) the autonomy of central banks will need to be protected and strengthened.

Borio notes three lessons that central banks learned from the crisis. The first is that low and stable inflation does not guarantee financial and macroeconomic stability: monetary policy may have contributed to the crisis’s severity. This is especially true during a period of prolonged easing. The use of monetary policy to clean the post-crisis debris can be costly. Interest-rate policy may not the right policy tool for the nature of the crisis: it is not optimal during a balance sheet recession. There are times when a disagreement on policy may be as good as consensus.

Borio proposes the compass include adjustment to policy regimes, including the tighter integration of monetary policy and financial stability, adjustment for financial imbalances, consideration of monetary policy response to financial busts, the operational independence of central banks and a keener awareness of the global dimensions of these tasks.

The key challenges for the implementation of the compass: the operational independence of central banks is likely to come under growing pressure and the need for greater international policy coordination. A compass for central banks is needed as they sail into uncharted waters.

Please see the attached link for more details. http://www.bis.org/publ/work353.htm

IMF Fiscal Monitor – Progress on Deficit Reduction

2011-10-07T13:24:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

According to a recent IMF report, governments are making progress in addressing fiscal policy issues, but downside risks remain elevated as 2011 growth prospects are reduced. The rising public debt levels in advanced countries are projected to top 100 percent of GDP in 2011. A large portion of the increase came since 2007 from a drop in GDP, lower revenues and elevated spending damaging government balance sheets.

Overall, fiscal adjustment in advanced countries has declined by over 2% of GDP since 2010. The improvement in most cases was at or better than expectations. Progress in fiscal adjustment is better than expected.

For Europe, the challenge is to sustain fiscal consolidation while minimizing the growth fallout. Europe needs to focus on crisis resolution mechanisms to help resolve the solvency issues and limit contagion. Overall, the deficits in the euro area are expected to decline by 2% of GDP this year and 1% next year. The speed and severity of the spread of financial pressures in the euro should serve as a lesson for the United States and Japan.

In the United States, a focus is needed on entitlement and tax reforms as well as measures needed to raise revenues and broaden the tax base. The U.S. deficit is projected to decline by 1% of GDP to 9.6% for 2011. For Japan, disaster relief and reconstruction are short-term objectives, but more detailed medium-term planning is needed to focus on reducing the debt and budget deficit ratio and raising tax revenues through reforms.

Emerging markets emerged from the crisis in relatively good shape, with continued progress expected on deficit reduction. A few countries could be vulnerable to shift in capital inflows. Low-income countries survived based on buffers built-up in good times, but need to address social spending and their vulnerability to rising food and commodity prices.

However, despite the IMF’s relative slightly optimistic view markets remain concerned about growth prospects. The IMF noted two risks in the outlook: that public sector insolvency and/or that excessive fiscal tightening are not sources of instability. The optimal policy is to reduce the deficit in a timely manner without severely impacting growth.

For more on this click on the link to the IMF site: www.imf.org/external/pubs/ft/fm/2011/02/fmindex.htm

QE2 sets sail in the UK. The emerging markets say “Thank you”.

2011-10-06T15:47:00.001-04:00

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

The Bank of England decided today that because of the Euro-crisis and a sluggish home economy the financial system in the UK needed more quantitative easing: a flood of cash to build some forward economic momentum. Over the near future the Bank will purchase £75 billion (about 115 billion USD) of bonds with freshly printed money in the hope (?) that the financial crisis hitting Europe will, at worse, only have a minor impact on the UK economy. Will this new flood of cash help the UK avoid the effects of the contagion now pulsing through Europe? That is the question that has economist offering as many answers as there are economist plus one. Regardless of the effect on the UK, there is a more generally accepted feeling that the more powerful benefits will be to the emerging markets. To quote Sir Terry Leahy (ex boss of Tesco): “QE created an awful lot of liquidity intended for the real economy but found a home in markets and speculators looking for quick returns."

We witnessed from the Great Recession the power of quantitative easing’s effects on the economies of the emerging markets. The positive effects included creating new wealth and a near unprecedented increase in their middle classes. This benefit came back to haunt the easing nations in the form of a high commodity prices which have arguably contributed to a sluggish economic recovery and increased talks of a second dip recession.

What does this mean for risk departments? Keep an eye on the horizon and watch for signs of other countries joining the QE parade. It may be time to revisit those hedging strategies you put off due to the current pullback in commodity prices – it’s days may be short lived.

Cash everywhere, but what to do with it!

2011-10-05T13:00:00.001-04:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

Many companies are hoarding cash at present. Apple is a prime example with over $80 billion of cash. This indicates that businesses are reluctant to go on buying sprees of targets that might seem cheap at the moment but might become cheaper in coming months. It also indicates that they are keeping reserves in place in case the global economic situation continues to deteriorate. These factors also make them more reluctant to return cash to shareholders in the form of dividends or share buy backs. Normally it is considered inefficient for companies to hold large cash balances as they reduce returns to shareholders. However, the foregoing illustrates that there are good reasons at present for companies to hoard at least a certain prudent amount of cash.

Of course, U.S. companies also have the problem of “stranded cash” (or “trapped cash”); that is cash held in foreign subsidiaries, which is very tax-inefficient to repatriate.

High cash balances in a company should beg certain questions, especially in the current climate. In what is it invested? What currencies is it invested in? How liquid is it? Is it earning the best return possible? Even investments that were recently considered very low risk need to be focused on right now. Is your company investing enough additional time and expertise in managing cash? Does your Board of Directors take an interest?

The risks are huge and we have certainly seen companies with growing and substantial cash balances that are not beefing up their investment strategies, risk management, controls and oversight accordingly. Some can manage to these issues internally. Others could use outside help for a very modest expenditure in relation to the risks and possible downsides they face. Doing nothing more than has been done before seems particularly unwise.

We seek it here, we seek it there. Is risk everywhere?

2011-10-03T09:04:00.001-04:00

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

Seeking risk in everything can sometimes be as debilitating as not seeking or understand risk at all. One of my favourite blog discussion points is those dealing with individuals and organizations that spend great human and financial capital to minimize downside risk. It can be argued that everything entails some degree of risk (which should not be equated with opportunity costs) but at times, the likelihood of occurrence of the actual cost when the risk is realized is rather trivial.

The word of advice here is understand the risks you or your organization face and identify those with true cost (financial and in human capital) to the firm for addressing the others may set your firm back on innumerable levels.

Note: A thank you to "funny times" (http://www.funnytimes.com/cartoons_tag_result.php?tag=risk) for today's risk cartoon.

Create a currency and hope for the best!

2011-09-30T09:15:00.001-04:00

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

So the markets heaved a big sigh of relief as Germany’s parliament today (Sept. 29) approved increased powers for the European bail out fund. Armageddon postponed. But perhaps not for long. This is the last proposal that has now been approved by most of the 17 Eurozone members. However, it has been recognized that it is grossly inadequate and more and greater contributions are proposed. The trouble is that the Euro was born as a political animal and was, as we now know (if we did not realize it before), flawed. In its early days, France and Germany flouted the stability pact rules with impunity. After all, was Luxemburg going to insist on those two countries being fined? Since then, Italy, Greece and others have not, to put it mildly, observed anything like prudent fiscal policies.

For some time now, markets have been way ahead of the politicians who are floundering around, partly in denial and partly trying to protect their own jobs and partly wondering how to recognize which is the front end of a cow.

Meanwhile options are becoming more and more limited. The politicians will muddle through to a solution in the end but the real question is how long will it take to get there and how much damage will be done before they get there.

Danger Will Robinson! Think before adopting best practices.

2011-09-29T09:15:00.001-04:00

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

In the mid-1960’s an eager young teen space traveller named Will Robinson would rush into activities he believed were for the greater good only to be warned by the Robot of the coming danger. While the show “Lost in Space” lasted a brief 3 seasons, its lesson of think before you leap is something the business and investment world should still consider especially when the idea of “benchmarking” is discussed as a cure for department/company ills.

Recently the good people at the Harvard Business Review pointed out three questions one should ask before following industry or department best practices. These being:

What are the downsides of following the leader?
Is a competitor’s success really linked to a particular management aspect of the corporation?
Are the (market and economic) conditions face by the market leader similar to yours?

Of particular note is the first point which is similar to the dreaded idea of “group think”. The financial markets most recently witnessed this when a number of Wall Street and City firms decided to follow the best practice of bundling mortgages and utilizing the same algorithm to price the package. Yes it was profitable,… originally.

So before your risk department decides to follow the leader, heed the word of the Robot and take a closer look at their best practices and pick them apart to see if it really is a best practice and one that will survive the test of time.

Note: A thank you to the good people at Harvard University and the HBR’s Management Tip of the Day for the idea.

IMF World Economic Outlook September 2011

2011-09-28T22:15:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The global economy has entered a dangerous new phase as the signs of an emerging recovery on 2010 have given way to a decline in confidence and the emergence of downside risk. A number of shocks have hit the international economy from which it has not fully recovered: including the earthquake in Japan, political unrest in Arab countries, the fallout from political gridlock in Washington over deficit reduction and the unresolved sovereign debt crisis in Europe. The structural problems facing crisis-hit advanced countries have proven more intractable than expected, but emerging markets have been the bright spot despite concerns about vulnerability to shocks.

The IMF World Economic Outlook (WEO) projections indicate that global growth will fall to 4% in 2011 from 5% in 2010. In the advanced countries, growth is expected to be an anemic 1 ½% in 2011 from 2% last year. This assumes that European policymakers can contain the sovereign debt crisis and US policymakers can reach a compromise on fiscal consolidation. Emerging market should be able to maintain a solid pace of 6%. The advanced countries will be paced by the US at 1.8%, Europe at 1.1% and Japan at 2.3% for 2012. While China and India will pace emerging market countries at 9% and 7.5%, respectively.

The report noted two lingering risks that could have severe negative consequences for global growth. The first is the debt crisis in Europe spirals out of policymakers control and spills over into the global economy. The US might be vulnerable if political gridlock remains over fiscal consolidation and the housing market remains in the doldrums from underwater mortgages.

The report noted that further progress was needed structural reforms for the global economy could return to a more stable growth trajectory. First, private demand must take over from public demand. On this issue, many countries have made progress, but the advanced countries have been the laggards. Second, economies with large external surpluses must shift to reliance on domestic demand, while those with large deficits must do the opposite. All countries must do more to advance rebalancing and to hedge against potential downside risks.

The optimism that greeted a rebound in the global economy in 2010 has given way to caution in 2011 as downside risks emerged. The lack of prompt action by policymakers to address key issues could lead to another year of anemic economic prospects.

For more on the IMF’s views follow the link: www.imf.org/external/pubs/ft/survey/so/2011/RES092011A.htm

Extreme Financial Risks & The Eurozone

2011-09-27T11:04:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

http://www.voxeu.org/index.php?q=node/6628

“An error does not become truth by reason of multiplied propagation, nor does truth become error because nobody sees it.” (Gandhi)

The point is that the emphasis of Eurozone policymakers focus on a stop gap liquidity facility rather than solvency can have long-term consequences. This is illustrated in the following communiqué (The Future of the Eurozone (VOXEU, Konrad & Zschapitz, June 10^th)) on the outlook for the Eurozone.

A year has passed since the initial bailout of Greece. The Eurozone is still on life support, the authors argue, including the view that Europe’s policymakers have got their strategy desperately wrong. The failure to modify the Stability and Growth Pact to account for macroeconomic imbalances is a move in the wrong direction. They treat the bailout as a temporary liquidity problem and not a solvency issue, which will ultimately increase the costs of the policy error.

The authors note two options, which while considered, are not deemed viable. The first would be the reversal of the socialization of private sector debt and funding from other ECB members to finance budget deficits – a return to national fiscal responsibility. The economic cost of restructuring would have a large economic cost to all countries. A second alternative is the use of “financial repression.” This is when governments adopt measures to channel funds to themselves that may go elsewhere in unregulated markets. This method is particularly effective at liquidating excessive government debt. However, from an economic efficiency standpoint, it makes little sense for banks to use their funds to invest in government bonds unless it is part of their shareholder mandate.

Reinhart and Sbrancia (2011) characterize financial repression as consisting of the following key elements:

Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market.
Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
Government restrictions on the transfer of assets abroad through the imposition of capital controls.

The authors consider following the current option of intergovernmental transfers as a means to avoid debt default or restructuring. However, the sums required to make this viable would not be considered acceptable to taxpayers. The most likely outcome is a breakdown of the Eurozone prior to reaching an endpoint as policymakers focus on stop gap liquidity facility rather than deal with the solvency issue. One possible reason for this breakdown is a rise in political tensions among member countries. A second, more likely outcome is a breakdown in the Eurozone as political tensions increase and investors lose confidence in the sustainability of the Eurozone as a whole.

For more information on this subject, click on the link:

Note: Because of it's relevance today, this is a re-posting of a blog that originally appeared in June

“Let’s do it”: 3 Common (hidden) decision traps

2011-09-26T10:35:00.001-04:00

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

Making decisions, be it on which movie to see, what new product to launch or what risk strategy to follow can be difficult. However we tend to reduce this difficulty by unknowingly slipping into three common decision traps, these being:

Anchoring – Giving disproportionate weight to the first information we receive

Status quo – Favoring alternatives that basically keep things the same

Confirming evidence – Finding and following new evidence that validates your point

To avoid these traps, which is difficult as they appear to use common sense, the best approach is to increase the diversity of minds around the table and perhaps even go to the extent of “appointing” a contrarian. For smaller organizations or those with large established departments, you may wish to seek the help of consultants or third parties – as paying for a second opinion sometimes has the benefit of heightening your attention to it.

IMF Global Financial Stability Report – Grappling with Crisis Legacies

2011-09-25T10:01:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The latest Global Financial Stability Report (GFSR) from the IMF noted financial stability risks have increased for the first time since early 2008. The weaker growth prospects have had an adverse impact on private and public balance sheets that are coping with heavy debt burdens. The financial system has been buffeted by market turbulence emanating from peripheral Europe, a U.S. credit downgrade with political gridlock and an adverse feedback loop between the banking system and the real economy. The IMF estimates that the need to recapitalize European banks and insurance could eventually be as high as euro 350 billion (US$400-500 billion). The continued political gridlock in Washington is already damaging financial market prospects.

Low policy rates are required under current conditions, but carry long-term threats to financial stability. Some sectors of the advanced economies remain in repair-and-recovery phase of the credit cycle as balance sheet repair remains incomplete, while the search for yield is pushing some segments to become more leveraged and vulnerable. Low rates are pushing credit creation into non-traditional sources such as the shadow banking system.

Emerging markets provide a better story as they are in a more advanced phase of the credit cycle, but could be vulnerable to contagion, especially from advanced countries. The combination of low rates and capital inflows leave emerging markets vulnerable to a gradual buildup of financial imbalances and potential fallout from a sharp reversal of financial flows.

The GFSR notes that risks are elevated and time is running out to tackle vulnerabilities that could affect the financial system and fragile recovery. The IMF offered four areas for policy action: (1) reduce sovereign risk in advanced countries and prevent contagion; (2) strengthen the resilience of financial system and contain against excesses; (3) in emerging market policymakers need to guard against overheating and a buildup of financial imbalances through the use of prudent macroeconomic and financial policies; and (4) the completion of financial reform agenda implemented internationally in a consistent manner.

For more on the IMF’s views click on the link: http://tinyurl.com/62hwbgn

Rugby World Cup

2011-09-23T02:07:00.001-04:00

by Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.
www.RSDsolutions.com
info@RSDsolutions.com

I just finished watching the Rugby World Cup match between Canada and France. A bit early for me to get up, but I wanted to get ahead start on writing my blogs for the week.

Watching the match, it was immediately clear that the Canada team had a far superior advantage when it came to the volume of facial hair. For instance, France had no one at all in the same league as Canada’s Kleeberger.

There is one tiny problem for the Canadians though – and that is facial hair does nothing to affect the outcome of a rugby match. Therefore, although the Canadians had a decided advantage in facial hair, it was ultimately not worth much, and Canada lost the match despite a valiant effort – and despite their huge advantage in facial hair.

Now the question is – is your risk department more concerned about winning matches, or more concerned about irrelevant factors such as politics, avoidance of blame, great looking risk reports, great press reviews, state of the art metrics – or even quantity and quality of facial hair?

Go Canada Go!

Size Matters

2011-09-22T09:20:00.001-04:00

by Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.
www.RSDSolutions.com
info@RSDsolutions.com

There is a different feel to working in a small entrepreneurial “shop”. In an organization where there are a relatively small number of employees, everyone has a sense of ownership and responsibility. There is more energy and more collaboration – since that is the only way that an organization with few resources can survive.

It is because of this size issues that many companies – particularly in manufacturing - have adopted the strategy of once a unit gets beyond a certain size, they intentionally break themselves into smaller autonomous units. It keeps the overall company fresh, and inspires the entrepreneurial feeling and sense of ownership that is so hard to maintain in a larger unit.

In the quest for risk perfection, there is an argument to be made that firms have developed risk groups that are simply too large for the professionals within the unit to feel the same sense of ownership and responsibility than they might in a smaller less centralized (and less bureaucratic) grouping. Perhaps it is time for risk units to take a tactic from the manufacturing world and split themselves into smaller autonomous units, so risk professionals can once again feel that they have responsibility and accountability for their actions and decisions.

Understanding Risk: IMF Treating the Symptoms and not the Cause

2011-09-21T09:02:00.001-04:00

by Don Alexander, MBA

Associate, RSD Solutions Inc.

A recent paper “The Eurozone debt crisis: Is this a banking problem? (VOXEU, Jordi Gual, September 13^th”) provides a valuable lesson for risk management. In this case, it is the focus on the consequences and not the cause of risk.

The IMF recently suggested that recapitalization of Europe’s banks as the most prudent way out of the continent’s economic crisis. Gual argues that such thinking is based on a flawed analysis and at best it serves as a distraction to policymakers. The primary problem facing Europe is a sovereign debt crisis.

The call for a recapitalization of the banking system is a distraction and if the sovereign debt crisis was resolved, the banks would not be in trouble. According to the Institute of International Finance (IIF), European banks raised $414 billion in new capital since 2008 compared to their American counterparts which raised $314 billion in the same period. The perception problem is that European banks hold more of their assets in public debt than their American counterparts.

One by product of the euro is the pricing of most private and public sector debt at eurozone reference rates. This has resulted in a mispricing of eurozone risk, poor investment choices and a misallocation of capital. The current proposal of bank recapitalization arises from the potential losses from mark-to-market of government debt. The idea is that investors should suffer from the poor investment decisions made by the banks despite having a potential economic cost (credit availability).

The real problem is that Europe has built a monetary union with an inherent flaw – the absence of a sovereign safety net, since the debts are accumulated by member states have been incurred in a currency that none control. This is the issue, and not bank recapitalization.

Have you correctly identified your source of risk?

For more on this follow the link: http://www.voxeu.org/index.php?q=node/6970

Engagement

2011-09-20T11:28:00.001-04:00

by Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.
www.RSDsolutions.com
info@RSDsolutions.com

At RSD we do a lot of training. It is something that we are good at, and something that we enjoy doing. I believe that being good at something has much less to do with skill and much more to do with passion – or even the more pedestrian “enjoying what you do”.

When we are first contacted by companies about training, they always present us with a wish list of topics that they want their people “trained” on. In this age of efficiency, the list of topics is always much longer than the time allotted to the training. This quest for efficiency in training is quite understandable. However the real efficiency comes not from cramming a lot of training into a short period of time, but from cramming a lot of engagement into a short period of time.

No one likes cramming – admit it, did you really like cramming for an exam when you were in school? No – it was a drag, a bore, and totally ineffective as you probably lost 90% of the information you crammed within three days after the exam.

What is effective in training is getting engagement of the participants. At RSD we focus on engagement and getting people who “do things” rather than people who “know things”. With engagement, training is fun, effective and efficient. You learn so much better when you want to rather than when you have to. Cramming sucks. Engagement is a joy.

Risk Energy

2011-09-19T16:54:00.001-04:00

Normal 0 false false false EN-CA X-NONE X-NONE

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Oswald Gruebel, CEO of embattled UBS is quoted in the paper saying that the recent loss at the firm could not have been prevented because, “If someone acts with criminal energy, then you can’t do anything. That will always be the case in our business.”

I understand that preventing criminal activity is extremely difficult, but criminal activity to the tune of $2.3 billion is something else. Where was the risk energy?

Foxes vs. Hedgehogs

2011-09-18T09:09:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

A fox knows many things. A hedgehog knows only one thing, but knows it well. Is your risk management unit a fox or a hedgehog? There are arguments for both strategies (for example the well known book Good to Great argues that hedgehog firms perform best, while most will agree that having a portfolio of ideas is preferable). What is not acceptable however is not knowing which category the firm falls into.

A firm that thinks it is a fox, when it is in reality a hedgehog is as stupid, weak and exposed as a firm that thinks it is a hedgehog when in reality it is a fox. So what is it? Is your risk management unit a fox or a hedgehog?

“…, This century is different”: A quote right on cue

2011-09-16T09:03:00.001-04:00

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

Predicting the future is fun for you are never wrong until it happens: one of my past times is looking back at future predictions and comparing them to the current reality. Great insight can be gained from this – usually it is that trends don’t continue indefinitely because some other reality appears like higher energy prices or some form of political (in) stability. My favourite forecaster of the social and economic reality of the 21^st century is William Draves (left in above photo) and his book “Nine Shift” which looks at the nine shifts in human behavior that will come about this century. His book is interesting for it not only makes the predictions but also provides the time line for them to occur. Published in 2004 this little read book is spot on on innumerable levels.

The above quote is from a recent Bloomberg article on US employment - the realization about this century being different is right on cue with Mr. Draves's forecast. In his book, Draves believed it would be around 2012 that the world would begin to realize that we are living in a very different economic and social environment – and this for a trend that started at the birth of World Wide Web.

Does this story sound familiar to your business – are you in a state of denial that we are now living within a new paradigm and that 20^th century business practices and risk management techniques will get you through the new (?) century? Definitely food for thought and I would recommend to you to have a read of Mr. Draves’s book to perhaps learn about the “Shifts” that are taking place or check out his website for current confirmations.

(A special thank you to Jeff Roach (http://jeffroach.ca) (of Sociallogical (http://sociallogical.com) for introducing me to Nine Shift)

For more on William Draves, follow the link: http://www.nineshift.com/

For more on what is different, click on the link to the Vivien Lou Chen’s article in Bloomberg: http://tinyurl.com/3dbyp2k

Experience Precedes

2011-09-15T09:06:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

What do the books “The Inner Game of Tennis” (by Timothy Gallway) and “Managers Not MBAs” (by Henry Mintzberg) have in common? The answer is that both argue in their own way that “Experience precedes technical knowledge”.

“Experience precedes technical knowledge” is a direct quote from the Inner Game – the best selling tennis book that was originally published in the 1970’s. The argument is basically that you do not know much about playing tennis until you have picked up a racquet and hit some tennis balls. Technical expertise is meaningless unless you have experience. Mintzberg argues much the same thing when he essentially argues that MBA programs have limited effectiveness due to the limited experience of the students in business school.

This brings us to risk management. The demands of quantitative regulation (regulation by means of quantitative measures) and the prominence of quantitative techniques for best practice in risk management has led to an emphasis on technical knowledge over experience. In my opinion this puts the cart before the horse, and is as useful as hiring a PhD in tennis as your tennis coach, even though the person has never picked up a tennis racquet.

Watches

2011-09-14T09:07:00.001-04:00

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.