Middle School

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

In Middle School (grades 7,8 and 9 where I grew up) we were allowed to read anything we wanted for 20 minutes each morning. Anything. Of course, middle school kids will be middle school kids, and so for the first few weeks students tried to see how far they could take the read “anything” rule. Yes, there were reading materials that would not be appropriate for that age group, and yes there were comic books etc. However in a short period of time something funny happened; namely kids started reading “good” stuff, namely stuff that was educational, literate or just plain interesting and useful. Students actually looked forward to reading time, and anecdotal evidence indicates that they did a lot more reading at home – despite the popularity of Mork and Mindy (obscure reference for those of a certain age). I am willing to speculate however, that once we were forced to read in High School that our willingness to read – to read anything – went down dramatically.

Left to their own choices, most reasonable people will make good choices, and they will make those good choices willingly. Forced to do something however and the task becomes harder to accomplish, and is only done grudgingly.

Dr. Heidi Grant Halvorson, in her book Success: How We Can Reach Our Goals, http://www.amazon.com/Succeed-How-Can-Reach-Goals/dp/0452297710/ref=sr_1_2?s=..., talks about this phenomenon as tasks that we perform with an intrinsic motivation - tasks that we perform to please ourselves - versus tasks that we perform with an extrinsic motivation– tasks that we perform to please others, or because others force us to. The evidence is clear from numerous studies that developing an intrinsic motivation in students leads to much better results.

At this point you may be asking what the heck this has to do with risk management. As an external consultant to several different types of institutions I see a similar effect all of the time when it comes to risk procedures. This is particularly true in financial institutions. Bankers often feel that the risk rules are needlessly rammed down their throats without them having any say. Basically this leads to resentment at best, and hostility towards the risk department and the risk rules in many cases. Bankers are forced to be extrinsically motivated, and the results are far from optimal.

In times of crisis, certain risk rules may have to be followed. However in non-crisis situations a little bit of managerial skill on the part of the risk department may go a long way. If you allow reasonable employees to make their own choices, in time you will find that they will make very reasonable choices, and will do so willingly and to much greater effect.

Perhaps risk managers should take a page from my Middle School Principal.

Outside In

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

Like most business people, I read at least accurate).  It is well accepted that it is critical to not fall too far behind in this information age.

As an avid newspaper reader, I consider myself to be relatively abreast of the major topics that concern my day to day activities.  This is particularly so when it comes to my community and my country.  Also it appears to be obvious that the best way to keep abreast of my community and my country is to read the local newspapers and the national newspapers.  The reporters for these publications live in the places they are writing about and understand the history of the issues and how they affect the community.

However, I find that it is sometimes – maybe even most times – most informative to read about my community and country by reading the views of a foreign journalist.  While they might not have the “on-the-ground” insight, they often offer insights that the local journalists miss.  Seeing your community through the eyes of an outsider can be illuminating.  Sometimes it can be a rude shock, but in those cases it is often the shock that you need to better understand the issues.

Risk departments can be like local journalists.  They understand the issues and the history well, and they appear to have their finger on the pulse of the important issues.  However, because of their “embeddedness” they may also miss issues that outsiders more readily pick up on.

Those who dismiss outside sources of information do so at their peril and at their own loss.

Two Teams

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc

Two teams went into a case competition that was based on risk management.  One team created a solution with lots of bells and whistles and fancy analysis.  It was state of the art.  Another team went basic.  The judges, who were senior line managers, did not understand the state of the art.  The team with the basic presentation won.

All sorts of lessons tied up in this.  Anyone learning?

Panic-driven austerity in the Eurozone and its implications

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Eurozone policy seems driven by market sentiment. This Paul De Grauwe and Yuemei Ji argue, in a recent VOXEU communique (Feb. 21^st), that fear and panic led to excessive, and possibly self-defeating, austerity in the south while failing to induce offsetting stimulus in the north. The resulting deflation bias produced the double-dip recession and perhaps more dire consequences. As it becomes obvious that austerity produces unnecessary suffering, millions may seek liberation from ‘euro shackles’.

There is a strong perception that countries that introduced austerity programs in the Eurozone were somehow forced to do so by the financial markets. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine.

The next question that arises is whether the judgment of the market (measured by the spreads) about how much austerity each country should apply was the correct one. There are essentially two theories that can be invoked to answer this question. According to the first theory, the surging spreads observed from 2010 to the middle of 2012 were the result of deteriorating fundamentals.

Another theory, while accepting that fundamentals matter, recognizes that collective movements of fear and panic can have dramatic effects on spreads. These movements can drive the spreads away from underlying fundamentals, very much like in the stock markets prices can be gripped by a bubble pushing them far away from underlying fundamentals.

The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries.

This decision of the ECB provides us with an interesting experiment to test these two theories about how spreads are formed.   Thus it appears that the only variable that matters to explain the size of the decline in the spreads since the ECB announced its determination to be the lender of last resort is the initial level of the spread. Countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads – a remarkable feature. 

A large component of the movements of the spreads since 2010 was driven by market sentiments. These market sentiments of fear and panic first drove the spreads away from their fundamentals. Later as the market sentiments improved thanks to the ECB, these spreads declined.

Three conclusions can be drawn:  the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushing spreads artificially high and forced cash-strapped nations into intense austerity; Panic and fear are not good guides for economic policies as the quick and intense austerity  led to deep recessions, but did not help to restore sustainability of public finances; and financial markets did not signal northern countries to stimulate their economies, thus introducing a deflationary bias that lead to the double-dip recession.

The intense austerity programs that have been dictated by financial markets create new risks for the Eurozone. While the ECB 2012 decision to be a lender of last resort in the government bond markets eliminated the existential fears about the future of the Eurozone, the new risks for the future of the Eurozone now have shifted into the social and political sphere. As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the people who have been thrown into unemployment and poverty, resistance against these programs associated with the euro is likely to increase.

www.voxeu.org/article/panic-driven-austerity-eurozone

Sports and Risk Management

by Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

It seems as if there is no end of sports talk shows.  There are many reasons for this – in part because sports fans like to talk about, and hear about, and discuss their favorite teams.  Another reason is that there is no end of sports experts / pundits.  A third reason is the sheer quantity of data to analyze and discuss.  Particularly for the major team sports like baseball, football and basketball, it seems like there is an endless stream of statistics that allow one to analyze every angle of the game.  With all of this analysis, and all of these experts, you would think that the outcome of virtually every game ought to be completely predictable.  However, we still tune in to watch the "big game".

Sports are complex, and thus despite all of the analysis, there is great variability in the outcome.  This is despite the volume of data and analysis that is available to coaches.  (Has anyone read Moneyball by Michael Lewis?)  Players perform in unpredictable ways to pressure referees make unexpected calls, the ball bounces in strange ways, the wind blows etc. etc. (the Bud Light Fans do not align their bottles correctly http://adsoftheworld.com/media/tv/bud_light_very_superstitious ….)

Risk management is also complex.  Despite all of the analysis, we still have to watch the game unfold, and just as a coach is limited in what they can do to affect the results of a game, as risk managers we are also limited in how we can affect outcomes.  Data, analysis, talk, debating, etc. etc. all help, but they do not make outcomes predictable.  Gotta go – game is starting.

Overfitting

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

In academic finance we tend to research questions where there is data, rather than where there are important questions that need some answers.  One of the problems this raises (there are many) is that of the problem of “overfitting”.  In other words, with enough data you can make almost any hypothesis have statistical significance.  In turn we tend to think of statistical significance (and correlation) as the same as causation.  Overfitting means that you can explain almost anything with enough data.  It is not knowledge.  Important difference.

Culture

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

In biology class you may have grown a culture of some organism in a petri dish.  With the right ingredients and conditions, the culture could be reliably formed.  There is a “recipe” if you will, of growing a bacterial culture in a biology lab.

In risk management we also talk about culture, and the need to form a specific risk culture in order to achieve the risk management objectives of the organization.  Growing a risk culture is not the same as growing a bacterial culture.  There is not a “recipe” for growing a risk culture.  There are not a set of conditions or nutrients that will guarantee success.  Stop thinking that there is.