2009_EMEA_Laubsch print

8/7/2019 2009_EMEA_Laubsch print

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Risk Management 2.0Emerging Risk Management Practices

Alan Laubsch


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Agenda

1. Industry trends & risk management themes

2. Systemic risk management

3. Organizational risk management

4. Conclusions


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Industry trendsRapidly changing corporate landscape

Competition & consolidation

Governance

Regulation

Emphasis on risk managementOverhauling current practices and adopting best practices

Culture, expertise and data are the weak points in companies risk management (Economist)

Firm-wide approach, active senior management, no more silos

Integrating risk in decision making: Management is risk management

Emphasis on flexibility, timeliness, and robustness over precision

Companies seek comprehensive view of risk From broad macro to micro (specific) perspective

Focus on interrelationship of different risks


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Banking crises are generally driven by surges in international

capital flows, credit, and asset pricesBoth developed and emerging markets show similar systemic risk drivers

Financial centers have been especially vulnerable

Source: Carmen Reinhart and Kenneth Rogoff, Banking Crises: An Equal Opportunity Menace (2008)


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Financial liberalization & capital mobility tend to have a

destabilizing effectThe stylized evidence presented in Caprio and Klingebiel (1996) suggests that inadequate regulation and lack of supervision at

the time of the liberalization may play a key role in explaining why deregulation and banking crises are so closely entwined. Again, this is a theme across developed countries and emerging markets alike Reinhart & Rogoff

Source: Reinhart & Rogoff (2008), Banking Crises: An Equal Opportunity Menace


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Foreign capital inflows amplified both the U.S. Tech

Bubble and Credit BubbleKen Rogoff warned of imbalances of capital flows and risk of credit crisis

First, there has been enormous growth in the amount of foreign capital and a very significant shift in the balance of payments of many emerging markets; Second, and linked to this, nearly ten years of low long-term interest rates;

and Third, the official policy of subsidizing homeownership in the United States. - GS CEO Lloyd Blankfein commenting on underlying factors for the credit crisis (April 2009)

http://blogs.cfr.org/setser/2009/04/06/charting-financial-de-globalization-private-capital-flows-are-falling-faster-trade-flows/

Internet Bubble

CreditBubble


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Unprecedented levels of debt to GDPSustainable?

Source: IMF Global Financial Stability Report, April 2009


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Three alternatives for resolving the debt crisis1. Strong and sustainable economic grow th?

2. Credit default

3. Inflation

U.S. GDP Grow thWith And W ithout Mortgage Equity Withdrawal (MEW)

By guaranteeing everything governments have transformed a financial crisis into a debt crisis. Who guarantees the governments? Ken Rogoff (15 Sep 2009)


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Central Banks play a crucial role in managing

Systemic Risk One of the most striking features of the economic landscape over the past twenty years or

so has been a substantial decline in macroeconomic volatility. ...Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation

'the Great Moderation' (Bernanke 2004)

Unintended consequences of Feds risk managem ent paradigm Greenspan put

Asymmetric actions are inconsistent with Efficient Market Hypothesis. Implicationwould be that markets are inefficient only on the downside, and that any up-movein the market is efficient

Central Banks should act symm etrically and countercyclicallyMaxwells governance theorems (see George Coopers Origins of Financial Crises)


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Financial Instability Hypothesis (FIH)George Cooper s Origins of Financial Crises(2008) cohesively ex tendsHym an Minsk ys FIH to the current mark et environment.

Financial Instability Hypothesis (FIH)Inherent instability

Small external impacts can cause massivechange in equilibrium

Amplification loops: Leverage & Asset Prices

Credit creation and fractional reservebanking create instabilities but enable

economic growthCentral banks are essential to managinginstabilities


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Amplification mechanisms & feedback loops can lead to

great instabilities in finance and ecologyFinancial examples

Leverage & Asset Prices

Bank runs

Financial crash & real economy

Climate change examples Arctic ice reflects 80% of sunlight; as it melts theocean absorbs 80% of the heat. This feedback

loop has caused recent arctic ice melt to farexceed expected ranges as estimated by theIPCC.

As permafrost melts, heat is absorbed by theground, and methane is released. Methane is a10x more potent greenhouse gas than CO2

Many other such negative spirals, for exampleCO2 acidification of oceans hurt the marineecosystem and decreases the oceans ability toabsorb CO2.

Asset Prices

Leverage

Actual Arctic Melt vs I PCC M odels

Real Economy

Financial Markets

Source: Dan Miller, A Really Inconvenient Truth, climateplace.org


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Market Cycles & Social Epidemics

Source: Wikipedia; see Geoffrey Moores Crossing the Chasm (1999)

Diffusion of ideas and innovation follow a predictable courseDiffusion of ideas and innovation follow a predictable course

Malcolm GladwellMalcolm Gladwell ss Tipping PointTipping Point describes process of social epidemicsdescribes process of social epidemicsLaw of the few (Pow er Law )

1. Connectors (who bring people together)

2. Mavens (information specialists )

3. Salespeople (persuaders)

Financial fashion today?


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PIMCO - Momentum strategies prevail once phase transitiontipping point reached, mean reversion fails

Tipping points mark dramaticphase transitions, abrupt S-shaped transitions betweenstates with radically differentproperties.

Climate scientists are obsessed with finding tipping points, the levels at w hich the momentum for change becomes unstoppable. - Time, A

Green Tipping Point (2007)


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Systems Theory: Emergence & Power Law

Financial markets as Complex Adaptive Systems (CAS), featuring A dynamic network of agents

Feed back loops

Self similarity (fractal patters)

Emergence

Evolution

Power laws govern network dynamicsLaw of the few (e.g, 80-20 rule, Zipf Law)

Fat tailed distributions (e.g., Pareto, Student t)

Seen all over the world, from wealth distribution to city sizes


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McKinsey: Financial crises and earthquakes both fitpower curves

Power curves: What natural and economic disasters have in common - The McKinsey Quarterly (2009)

Source: The McKinsey Quarterly, (June 2009)


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Extreme outcomes: Dragon Kings vs Black Swans

Nassim Talebs Black Sw an claims that crises arise fromunknow able events that cannot quantified or predicted

Historical examples: Eisenhower heart attack; Lincoln & Kennedy assassinations;asteroid impact or flood basalt eruptions resulting in mass extinctions; 911;

Didier Sornettes Dragon King thesis holds that most financialcrises are endogenous in natu re and can be diagnosed in advance,

can be quantified, and have som e predictabilityExam ples of endogenous crises in history: rise of Fascism; rise of dictators(Hitler, Mao); rise of tech moguls (see Gladwells Outliers), mega-bestsellers (HarryPotter), current ecological crisis; 29 Great Depression, 87 Black Monday, 89 JapanBubble; 01 Tech Bubble; current Global Financial Crisis (credit, equities, oil)

Endogenous structural risk combined with exogenous precipitating event is common(e.g., forest fire)


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Foreshocks and aftershocks

Big shocks can originate from amplifying feedback of small shocks

Super-exponential instability and change characterizes phase transitions

See: http://www.er.ethz.ch/presentations/Endo_Exo_Oxford_17Jan08.pdf Source: Sornette et al., Endogenous versus Exogenous Origins of Crises (2008)


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Hang Seng exhibits textbook super-exponential rate of change6 months to 1 year before peak or bottom

Hang Seng Index returns (log scale)

Source: Sornette et al., Shocks, Crises and Crashes in Nature and the Economy (2006)


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Chinese equities 2007 and 2009 forecasts

Prediction disclosed on Oct 18, 2007 Stockholm Hedge Fund Conference:

See http://arxiv.org/PS_cache/arxiv/pdf/0909/0909.1007v1.pdf

Participants responded that the predicted change of regime was impossible because,in their opinion, the Chinese government would prevent any turmoil on the Chinese stock market until at least the end of the Olympic Games in Beijing (August 2008).

After the communication of October 18,2007, the Hang Seng China Enterprises Index (HSCEI) reached the historical high 20609.10 on 2 November 2007.

Afterwards, the first valley HSCEI=15460.72 (-25% from historical high) was reached on 22 Nov 2007 and the bottom HSCEI=4792.37 (-77% from historical high) was on 29 Oct 2008

Didier Sornette et al. Source: Sornette et al., Bubble Diagnosis andPrediction of the 2005-2007 and 2008-2009 Chinesestock market bubbles (2009)


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2007 S&P 500 peak forecast

July 15 07 peak forecast: 80/20 range = Aug 6 to Dec 20, Nov 5 median;actual peak Oct 9


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Super exponential rise in U.S. real estate

Didier Sornette accurately predicted 2006 peak in U.S. real estate bubble, and implywhich states would be most affected by the bust


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Outliers as early warning signs

We learn more from extreme circumstances than anything else -Malcolm Gladwell

Ozone Hole discovery by Joe Farman (19 80-198 5 publication)Missed by NASA satellite, which was programmed to ignore outliers

Outliers can signal important changesSpurious data or has the distribution changed?

Outliers were flashing w arning signs throughout the global financial crisis

Subprime Crisis: the bubble bursts, starting a process of amplifying market moves1. Dec 12-21, 2006: 300% spike in Jan AAA ABX spread volatility, GS exits subprime after

repeated subprime P&L outliers relative to VaR2. 20 Feb 2007 Financial stocks reach an all time high (XLF at 37.99)3. 22 Feb 2007 HSBC announces $10.5bn subprime loss4. 23 Feb 2007 - 12 sd residual / 350% increase in vol (largest outlier in subprime)5. 27-Feb-2007 7.8 sd residual / 3.3% loss in DJIA, 6 th largest residual since 1900


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Responsive volatility forecast revealed major relative spreadchanges and outliers 7 & 4 months before the meltdown

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300%+ increase in vol fromDec 12 to 21 '06

357% vol spike onFeb 23 '07

RM 2006 99% VaR bands vs 2006-1 AAA spread changes

One major outlier, a 12 sd move on Feb 23 '07, the day

after the $10.5bn HSBC loss announcement

Backtesting summary:2.4% upside excessions

0.81% downside excessions

Major ratings agencies initiate reviews and/ordowngrades week of July 9 '07


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The Dec 06 and Feb 07 spikes in volatility can be seen as tremors(foreshocks) that cascaded into a major earthquake

'2006-1 AAA'

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The first tremor(vol up 300% Dec 12-21)

Feb 23 '07, first majoroutlier, 350% vol increase

in 1 day, 12sd move

June 20 '07, ML triesto liquidate BearSub rime CDO's

Absolute Spread Levels

Major ratings agenciesinitiate reviews and/ordowngrades week ofJuly 9 '07

bp's

Absolute spread moves were small, but rate of change was super-exponential. Parallels to failure andrupture process in material science (pressure to break point)


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Top ten DJIA outliers (1900 to 2008)

Program trading losses due to options/futures expiry9.6-3.9-6.615-Nov-1991

Austrias ultimatum to Serbia, war looming8.5-3.5-6.728-Jul-1914

NYSE about to close, WW116.9-6.9-6.730-Jul-1914

?11.4-4.9-7.020-Jan-1913

Beginning of subprime, China worries6.8-3.3-7.827-Feb-2007

Start of Korean War9.3-4.7-8.126-Jun-1950

Collapse of junk bond market11.4-6.9-10.013-Oct-1989

? [May 13 German economy collapsed; rise of Hitler]8.3-5.2-10.129-Jul-1927

Black Monday32.4-22.6-12.619-Oct-1987

Eisenhower heart attack8.1-6.5-13.326-Sep-1955

Comment Volatility

(%)Return

(%)ResidualDate

Source: Finger. Doomed to Repeat It? RiskMetrics Research Monthly (NOV 2008)

6th biggest outlier inhistory of DJIA 4 days

after largest spike in AAA subprime a tipping point

in contagion


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Feb 27 DJIA outlier marks a regime shift from low to highvolatility where 3.3% daily moves would not be exceptional

Increasing amplitude of volatility is a telltale sign of endogenous crises

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DJIA daily returns vs 99% VaR bands (.94 decay, t dist)

Feb 27, 6th biggest outlier in DJIA history 4 days after largest spike in

subprime spreads


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Feb 27 2007 also marks the beginning of contagion fromsubprime to equities, especially financials (XLF)

4. Feb 27,6th biggestoutlier inDJIA history

1. Feb 20 th Financials peak at an all time high of 37.99.

2. Feb 22 HSBC announces $10.5bn U.S. Subprime loss

3. Feb 23 12sd subprime spread move in subprime Global equities peak in Oct 2007,

with high levels of institutionaland individual investor confidence

NEWDefaults

inMarch(CFRA

warningsince

Nov 06)

BearHFs bust

May & MLsfailedasset

sale onJune 20

Ratingsagenciesinitiate

subprimedowngradeon July 9

07

Sep 15 08LEH

default

March16

Beartakenover

by JPM


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Market volatilities clearly show the contagion effectof the subprime crisis

Correlation vs causality

here we see a domino effect,

a tectonic shift in one assetclass triggers cascades inother assets in a series of amplifying loops that buildmomentum.

Pay attention to red lights,

but also to many yellowlights



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Implied volatility jumps provided early warning to majorcredit events

Credit, equity & implied volatilities proved useful as early warning signs to impending companyfailures.

Observing changes in volatility and outliers is more important than the absolute level of volatility



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Evolutionary Perspective: The Great Dying (Ferguson)

Evolution spawns biodiversity, punctuated by periods of mass extinctionThe big question for our time is: are we on the brink of a great dyingone of those mass extinctions of species that

have occurred periodically in the history of life on earth, such as the Cretaceous-Tertiary crisis that killed off the dinosaurs? It is a scenario that many biologists have reason to fear, as man-made climate change wreaks havoc with

natural habitats around the globe. A great dying is also a scenario that financial analysts should worry about, as another man-made disasterthe subprime mortgage crisisworks its way through the global financial system. Niall

Ferguson, The Great Dying (2009)

Source: http://www.oliverwyman.com/ow/pdf_files/OW_OWJ2008-2_TheGreatDying.pdf


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Evolutionary forces

Survival the editor Adapting to changing environments

Competition and alliances

Nurture the common good

Evolutionary leaps the author Extropy & self-organization

Increasing complexity, differentiation, diversityRadical transformation, emergence & evolutionary leaps

When faced with a radical crisis an individual life-form or a species will either die or become extinct or rise above the limitations of its condition through an evolutionary leap.

--Eckhart Tolle


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Super exponential forces shaping the next decades

1. Population growth, demographics, and impact on ecologyEM still growing super-exponentially as developed nations shrinking

Unsustainable growth in some of the riskiest countries in the world: 80% of violentconflicts occur in countries with young populations living in poverty under autocratic ruleplagued with corruption Dr. Albert Bandura, Stanford sociologist

Phase transitions: Climate change, Peak oil

2. Technology & IdeasKevin Kelly defines Technium as that which the mind produces"

Source: kk.org/thetechnium/


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Updated MIT Temperature Study shows warming is much moredevastating than projected in the 2003 IPCC report

97% of climate change scientists are in substantial agreementIts about risk management and damage control now

2009 MIT Study:95% chance thatBusiness-as-usualtemperature increase willexceed 3.5C (6.3F) in2095



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Stern Review for British GovernmentStern Review for British Government

Assumes worst case scenarios Assumes worst case scenarios

Sea rise could be 15Sea rise could be 15 --20 feet in a few decades20 feet in a few decadesFlorida, NYC, London, TokyoFlorida, NYC, London, Tokyo underwaterunderwater1B displaced, sick, dead1B displaced, sick, dead

Flooding, famine and diseaseFlooding, famine and diseaseOriginal 2003 IPCC estimate: 2 feet, but excluding GreenlandOriginal 2003 IPCC estimate: 2 feet, but excluding Greenlandice sheet (20+ feet).ice sheet (20+ feet). Jim Hansen, NASA Climate Scientist:

Certain it will be 6+ feet. If all ice sheets collapse: 280 feetIf all ice sheets collapse: 280 feet

Massive water & crop shortages worldwideMassive water & crop shortages worldwide

$20T+ in worldwide damages$20T+ in worldwide damages (Mitigation estimated at $1T)(Mitigation estimated at $1T) Wars over food and waterWars over food and water

Source: Dan Miller, A Really Inconvenient Truth, climateplac


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Globalization and technology have reduced shortterm variability, but increased systemic tail risk

Certain developments of recent decades, like changes in the structure of financial institutions post Glass- Steagall, have brought the risk of less frequent but more intense upheavals. The diverse income

streams of mega financial conglomerates reduce the effects of the 10-year storm, but their size and ubiquity exacerbate the consequences of the 20- or 30-year storm. -- Lloyd Blankfein

As system s become more connected, danger of cascading failureincreases

Instead of local ecological collapse, w e now risk a global collapseClimate Change (Global Warming), loss of biodiversity

Concentrated food supply: 4 mono-cultured crops account for 60% of global food supply

Nuclear w eapons have greatly increased catastrophic risk 1 golf ball of plutonium could decimate life on earth down to viruses. Since the fall of theSoviet empire, a basketball sized amount has been unaccounted for.

Threat of retaliation & mutually assured destruction is not a deterrent for terrorists

Evolution generates solutions to solve existing problem s, but newcomplex ities invariably arise


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Scenario analysis should focus on structuralweaknesses

Dont forget long term history

Im agine forw ard looking systemic risk scenarios

Continually R everse Stress Tests to find potential b reak pointsDecide on risk management (mitigation) approachIdentify potential tipping points and key factors to monitor

From stress testing to stress simulations & fire drillsNot enough to generate scenarios, simulate them in the context of yourorganizationLearning by doing not just by reporting!

Continually seek to uncover unknown risks not just measuringknown risks


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Historian Niall Fergusons stress scenarios

Two potential 2013 scenarios in The Descent of Finance The Breakdown: S&P 500 at 418 (as in Dec 1991)a decline comparable to that between 1929 and 1934. GDP growth less than 1% per year. half as many banks as in 2009, a third as many hedge funds, and retail banking resembling a

public utility. $20tn govt debt. 45% top income tax rate. China's GDP rising to half that of the U.S. by 2013 and the IMF's Special Drawing Rights replacing the dollar.

In a better case a remarkable number of new banks have appeared, the top income tax rate is 35%, and the S&P 500 stands at 976. Because the world has become more dangerous as well as poorer, everyone looks to the United States to continue acting as a global policeman-and the greenback is still the world's currency of choice

Source: Ferguson, Niall. "The Descent of Finance." Harvard Business Review (July - August 2009)

From Chimerica to ChimeraWhat if war broke out between U.S. and China? (see Ascent of Money)


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Agenda

1. Industry trends & risk management themes

2. Systemic risk management

3. Organizational risk managem ent

4. Conclusions


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Integral Framework: The Four Quadrants

Need to consider subjective internal perspectives in addition to measurableexternal ones

Source: Integrallife.com


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Integral perspective of risk management themes

Objective/ ExteriorSubjective/ Interior

Individual

Collective

Individual risk factors Time series analysis Early w arning signs Tipping points

Systems theory & P ow er Law Financial I nstability Hypothesis Theory of Evolution

Cognitive psychology P eak performance Expertise

Behavioral Economics Learning organizations

Ins pired by Ken Wil bers Integral Theory

I

We

It

Its


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Behavioral Economics and Robert Shiller

We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature -- G. Akerlof and R. Shiller in Animal

Spirits: How Human Psychology Drives the Economy And Why It Matters for Global Capitalism

Shillers Integral analysis of Bubbles (Irrational Exuberance 2005)

Objective/ ExteriorSubjective/ Interior

Individual

Collective

P recipitating Factor(exogenous shock)

Amplificationmechanisms (systemstheory)

Psychologicalbiases

Culturalbiases


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Cognitive Bias #1: Overconfidence

It is hard for us, without being flippant, to even see a scenario within any k ind of realm of reason that would see us losing $1 on any of those transactions. -- Joe Cassano, former

head of AIGFP at a 20 07 new s conference, shortly before the division incurred $4 5bn losses that forced AIG s $182bn Govt bailout.

OverconfidenceOverly narrow view of possibilities (95% or even 99% confidence corresponds to60% range)ComplacencyOverestimation of own capabilities

Niall Ferguson gave prescient w arnings, having observed all th e classicalhistori cal bubble signs (e.g., overconfidence, low spreads, asset valuations) :

Just before the onset of WW1, the world enjoyed unparalleled globalization, liquidity, and prosperity.Except for profligate Greece and Nicaragua, all sovereign bond spreads were less than 2%. The assassination of Franz Ferdinand on 28 June 1914 in Serbia changed everything. Markets did not react significantly for weeks, but a stampede for liquidity eventually resulted in the close of major

stock markets for months and losses that might have eclipsed the crash of 1929 (Ascent of Money)

Y l h l f t t k k t


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Yale school of management stock marketconfidence indexes

Observe high individual confidence prior to 2001 crash, vs high level of institutional confidence at the peak of 2006 cycle

Source: http://icf.som.yale.edu/confidence.index/


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Yale Crash Confidence Index

Institutions viewed 2 nd lowest chance in observed history of a crash in2006/7 just before the subprime meltdown

Source: http://icf.som.yale.edu/confidence.index/

Other systemic cognitive biases lets just say


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Other systemic cognitive biases let s just saywere not purely rational beings

As long as the music is playing, you've got to get up and dance. W e're still dancing. Citis CEO Chuck Prince in July 2007

Herding (im itation, conform ity, obedience)

Optimism Attribution ErrorDiffusion of responsibilityCognitive dissonanceOverreaction

Ambiguity aversionGreed & FearMomentum investingEndowment effectHome biasSunk cost fallacy etc

For a more extended list of know n cognitive biases seehttp://en.wikipedia.org/wiki/List_of_cognitive_biases

Why Dont We Act On Systemic Risks?


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Why Don t We Act On Systemic Risks?Failure of the Risk Thermostat

We respond strongestto threats that are: Climate Change is:

Visible Invisible

With historical precedent Unprecedented

Immediate Drawn out

With simple causality With complex causality

Caused by another tribe Caused by all of us

Have direct personal impacts Unpredictable & indirect impacts


GroupThink was a major cause of organizational


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GroupThink was a major cause of organizationalrisk management failure

Key conditions for GroupThink 1. Directive leader

2. Group isolated from outside sources of information and analysis

3. Stressful situation

Conscious strategies to overcome GroupThink

Compare leadership of Jamie Dimon (JPM) w/Richard Fuld (LEH) or Stan ONeal (ML)

At my first meeting, I was shocked," says Bill Daley, 60, the head of corporate responsibility and a former Secretary of Commerce. "People were challenging Jamie, debating him, telling him he was wrong. Dimon stakes

out strong positions - but he's no dictator. He will also listen, and surprisingly, he'll even change fervently held opinions when a team member presents an argument that's sufficiently convincing

Source: Shawn Tully, Fortune.com, Jamie Dimon's swat team September 2008


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Foster collective intelligence

Organizations can be structured to overcome evolut ionary biasesand to mak e better decisions

Environment matters (Zimbardo)

Create a Learning Organization (Senge)

Develop expertiseKahneman vs. Gladwell on expert intuition

Practice with feedback loop is the key


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Build sustainable personal performance

Tony Schwartzs Energy/Emotion Quadrants

Emotional State

Energy

Source: w w w .theenergyproject.comSee Tony Schwartz Manage Your Energy talk (Leading@Google)

http://www.youtube.com/watch?v=tke6X2eME3c


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Conclusions

Macro risk view based on understanding of systemic risk is an essential start Analyze structural risks using an Integral approach

Listen to early warning signs, use adaptive risk models

Foster better collective intelligence and risk management Awareness of group psychology

Harness interdisciplinary intelligence (from systems theory to psychology)

Greater risk transparency and sharing of cross-industry information

Risk aware leadership and culture

Reduce systemic risk through proactive collective actionCountercyclical capital, fiscal and monetary policy

Promote sustainability financial and ecologicalMopping up the mess afterwards is NOT risk management

As risk managers, we have a responsibility to protect our institutions, and theunderlying ecosystem that supports it


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Questions?

Thank you

Alan Laubsch

[email protected]

2009_EMEA_Laubsch print

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