2010 Risk in Review NY

I went along to a a Prmia event last night "2010 - Risk Year in Review". The event started with a somewhat overwhelming brain dump of economic and credit statistics from John Lonski, Chief Capital Markets Economist at Moody's Analytics. In summary he seems very bullish about corporate credit spreads tightening given the way in which corporate profit growth is surging ahead of debt growth. His main concern for the economy was maybe unsurprisingly the US housing market and whether this will bottom out and start to rise in 2011. Given fiscal imbalances and competition from emerging markets he did not think that inflation was a big risk despite activity such as QE2.

Robert Iommazzo of search firm Seba International did a fairly dry presentation on industry compensation for risk managers. Seba seem to getting around having had a big presence at Riskminds in Geneva last week. This section only livened up when the questions started after the presentation, and is probably worth noting that the UK FSA is being perceived as a "Big Brother" with its involvement in setting compensation policies in financial markets. Obviously the FSA is not heading back to the heady days of the 1970's where central government set industry pay rises (journalists please note this meant you back then!), but it is also obvious that such control over an individual's remuneration is something that goes totally contrary to an American way of thinking. UK Government needs to be mindful of this perception particularly if it leaves itself open to arbitrage on compensation policy from other financial centres.

Panel debate followed, involving Ashish Das of Moody's, Yury Dubrovsky of Lazard Asset Management, Jan H. Voigts of the NY Fed and Christopher Whalen of Institutional Risk Analytics. Main points:

• Chris said that he was one who was predicting a further fall in the housing market next year, and he asked the audience that when they looked at economic statistics, credit spreads,the Vix, bond spreads, did anyone getting the feeling the things are "normal" yet? Using these numbers and plugging them into a model does any believe the results are stable and can be relied upon? The audience fundamentally seemed to agree with these "warning" questions.
• Jan asked the audience to consider how believable is your data and to try to understand what data is critical for your business and that is imperative to create tools to manage this data appropriately. Jan said that the biggest challenge for financial institutions going forward is how to calibrate what rate/volume/type of business you can transact safely and that this needed a lot more consideration.  
• Yury said that he finds that the risks present in 2008 are still around in 2010, but now with the addition of European sovereign credit problems and the raft of regulation heading towards the industry. To add to this pessimistic note, he also said that some of the interest in "hot" emerging markets such as the BRICs was resulting in investments in lower quality IPOs relative to previous years.
• Ashish thought that systemic risk was going to become more important for the industry. With the setting up of the Office of Financial Research (OFR) next year, he suggested that the industry needed to take much more of a lead in sorting out its own house in advance of letting the regulators do so. On the subject of models, he said that models should supplement human judgement but not replace it, and mentioned the quote by George E. P. Box that "all models are wrong, but some are useful".
• Chris suggested that the role of risk managers will become more like that of a credit collector, with more involvement in actually seeing what can be recovered once a default has occurred. He also suggested that the industry should create its own consensus-based ratings (supplemented by the existing CRAs) to get a more reliable view of credit.
• Ashish echoed some of the speakers last week at Riskminds in saying that regulatory compliance is not risk management, and that practitioners should do more to guide the regulators.
• On the subject of risk culture, Yury asked how many risk managers knew data, quant, markets and how to deal with the egos of traders and senior management. This last point seemed to be conceded by the audience as a major weakness of the risk management profession and goes back to whether a risk manager is willing to put his career on the line to go against accepted business strategy.
• Chris added that having worked at several investment banks he had not yet experienced a risk manager attending a senior committee, let alone a risk manager speaking up against a senior trader. He talked of two business models "Paranoid and Nimble" and "Well Documented and Pedantic" with the second one being the only one possible in his view once a business gets to a certain size.
• On the subject of Government Sponsored Enterprises (GSEs like Fannie Mae and Freddie Mac) Chris said that the role of these will be up for review by the end of 2011. He thinks that the banks will head back towards actually holding mortgages and loans and the GSEs will become more conduits rather than direct sources of finance. This was news to me, given that so far the GSEs have been notably left out of recent reviews of what went wrong with the recent crisis.

Panel was very good, all speakers very knowledgeable. "Regulation is not risk", "models are not perfect", "risk governance" and "take control of your data" were all themes that echoed last week's RiskMinds event, allbeit with more of an American rather than international viewpoint on the economy, regulation and markets.

RiskMinds 2010 - Day 3 - Financial Engineering Blueprint

Panel moderated by Ricardo Rebanato of RBS on "Determining The New Blueprint For Financial Engineering". It seems like Ricardo has been busy following up on his talk from last year (see post) with the release of his book on scenarios (no I am not on commission for this but thought it may be interesting to take a look at!).

Summary of main points from the panel debate:

• Regulators would like simpler models but simpler does not mean better, complex models do not mean worse.
• It is the thoughtful application of a model that is important, not the level of complexity in itself.
• Given the more complex world we live in, more complexity in modelling is both needed and desirable if things are to improve in risk.
• Some members of the panel thought that regulation had stifled innovation in risk models (as opposed to valuation models) through insisting on conformity of reporting. The innovation is limited since the regulators simply set the rules and then the game begins of the bank optimising against these rules.
• Evan Picoult of Citi disagreed with this, saying that his own group now look at historical events going back over 100 years for possible scenarios as opposed to the last few years (comment: interesting to see someone using more history as a complement to more forward-looking risk modelling)
• Riccardo asked whether there is a conflict between what a regulator wants (lack of risk) and what a rational CEO wants - should a CEO for example accept a level of risk of disaster for the bank of 1 in 50. Evan argued that the banks should be more transparent to allow investors in bank stock and bonds to decide and price-in the policies implemented by bank management.
• Only around 15% of the audience thought that greater pricing/valuation model validation would have changed the 2007-2009 crisis. John Hull said that he had received many emails trying to apportion blame in this way which he rejected. Concensus seemed to be the route cause was the lack of common sense over the mortgage market.

Good debate with Riccardo doing more than just moderating, but not a great deal new relative to recent years. In summary my feeling for RiskMinds 2010 was high quality speakers but a little subdued from the embarassment of 2008 and the anger against the regulators in 2009. Maybe we should all want more subdued risk management conferences but it will be interesting to see what 2011 brings and whether energy levels are up.

RiskMinds 2010 - Day 2 - Perceptions of Risk

Very interesting presentation by David Spiegelhalter of Cambridge University on "Perceptions of Risk - Communicating Risks and Deeper Uncertainties In Words, Numbers & Pictures". David is the Winton Professor for the Public Understanding of Risk, Department of Mathematics at Cambridge University and is involved with the website understandinguncertainty.org.

David started by saying that when communicating risk what is needed is a user-friendly, easy to understand unit of risk. One example he gave was a one in a million change of death, which he termed a "micromort". He said that on average around 50 people a day die of unnatural causes in England and Wales every year, so this means that with a population of 50 million a person's exposure in England and Wales is 1 micromort. He then compared various means of transport and the distance that would need to be travelled to reach a 1 micromort measure:

• Walking - 12 miles
• Cycling - 20 miles
• Car - 217 miles
• Motor Bike - 6 miles

So I guess those of you with motor bikes should take note above!

He emphasised that also peoples reaction to risk is very interesting, and gave the example of a UK health official recently sacked for suggesting that the hobby (addiction?) to horse riding (he termed it "equesy") was just as risky as taking the drug ecstasy - statistically what the official said stacked up but it was simply not culturally acceptable to suggest such an association. No great advertisement for the NHS, but there are around 3753 deaths a year with an average of around 135,000 people in hospital at any one time. This works out at around 75 micromorts if you are in hospital which is around twice the level faced by troops in Afghanistan!

Obviously the above has a number of biases, but David was trying to illustrate how to compare risks and how people are not used to assessing them objectively. In particular, given a choice between probabilities of 1 in 10, 1 in 100 and 1 in 1000, around a quarter of the public would choose 1 in 1000 as the highest probability given it contains the "highest" number.

Whilst the above refers to the denominator with a constant numerator, given the choice between drawing from a bowl containing 1 sweet and 8 marbles and another bowl containing 5 sweets and 45 marbles, 53% of people choose the one containing 5 sweets (because it contains "the most" chances of getting a sweet).

David went on to test the audience on a few trivia questions using what he termed a "quadratic scoring" scale that asked the participant to select a multi-choice answer but to also associate a level of confidence with it. If right and confident the marks given would be high, but if wrong and confident the penalty mark would be much larger. He said that such scoring often produced interesting results and changed people's views, often with young men doing worse (testosterone not being good for risk seemingly!).

He showed how probability density seemed to better understood if represented by density of ink rather than the usual bell curves etc. He suggested that results should come with some more warning of how reliable they are to stop simple acceptance of the numbers reported as "truth". He described how risk is measurable whereas uncertainty is not, which led to the inevitable references to the wisdom (?) of Donald Rumsfeld.

Good fun talk with some great points to make - how humans (and bank management boards?) understand risk is interesting and to some extent surprising (see earlier post for a different slant on human perception of maths). Obviously it is accepted now that simple VAR measures are not enough, but even with the move towards scenario based methods then how to produce a simple but meaningful summary of risk for management is still challenging.

RiskMinds 2010 - Day 2 - Hugo Banziger - New Risk Management Agenda

Hugo Banziger of Deutsche Bank gave a presentation entitled "Reshaping The New Agenda for Risk Management".

Hugo started by saying by outlining the ways in which regulation is changing the markets. Whilst positive overall on the benefits of regulation, he expressed surprise at the regulation on OTC derivatives which he say as helpful in managing risk, and not the cause of the crisis.

He emphasised that whilst regulation is important, that regulation should not be a substitute for risk management and said that regulation in particular does not address:

• The quality of assets held
• The quality of management
• The quality of infrastructure

He additionally mentioned that whilst welcoming Basel III, the economic effect will be to make the supply of credit more expensive to the detriment of economic growth in the real economy.

Given the quality issues he identified above, he then moved on to show what he had done about them in terms of:

• People - what quality of people do you have?
• Processes - where are the holes that things will fall through?
• Systems - can you get a complete picture of risk?
• Portfolio Level Risk - across all asset classes and business units

On people, he advocated a "home grown" risk management team, with people rotated across different roles within risk. He takes the fact that other institutions hire his staff as a frustrating complement to Deutsche Bank risk management. He has implemented a "passport" for his staff which shows what they are trained/competent in and how they are annually tested against this, across both technical and softer management skills. He was funny and quite dismissive that if "anyone does not know what an option is and how it works they are out!" even for lawyers as well as risk managers.

On processes, he has set up a new "risk operations" centre of competence to centralise form filling for risk managers, enabling risk managers to spend more time on risk and less on admin. He stated flatly that just because you find that risk managers spend 50% of their time on admin does not mean you have to accept this and you can do something about it. He also said that he is moving the jobs to where the people are, rather than asking people to move (e.g. risk centre in Berlin to catch Berlin maths graduates).

On systems he has spent EUR30 million in 20 months on sorting out the consistency of data and models within market risk. During the crisis it took DB 48 hours to pull together their mortgage portfolio exposure which was too long. He says that initiatives like this are part of a 10 year investment in systems, data and analytics. His ultimate aim is to have an interactive real-time control centre for all risks in the bank and to move away from paper-based daily reporting. He also mentioned that he had grown his market risk team from 70 to 200 post-crisis.

On Portfolio Risk he says that more time needs to spent on knowing risk apetite and knowing how this fits against risk capacity for the bank. He emphasised that risk managers are there to defend P&L and not capital. He said that portfolio/business model risks were his biggest source of risk.

Inspiring speaker, very confident, open about past losses and mistakes made. Biggest difference to many speakers here was that he put forward tangible actions to address things such as risk culture rather than just talking around them.

 

RiskMinds 2010 - Day 2 - Paul Embrechts on Financial Engineering

I started the day with a presentation by Paul Embrechts (see previous RiskMinds post here) entitled "Financial Engineering And The Financial Crisis: Warnings, Guilt and Lessons Hopefully Learned".

Paul first pointed out that if ever there was a bubble, it was a "bubble" of books on the crisis and its causes. He listed a number of reasons for the crisis, most interesting/new of which was in addition to "too big to fail", was "too big to save" as a new risk given the size of some financial institutions relative to the economies they operate in. Paul has an extensive academic background in both financial risk management and actuarial studies, and I guess it was with his actuary hat on he said that the three main problems for financial engineers going forward were "social insurance, social insurance and social insurance".

By social insurance Paul was referring to medical, life and health insurance and saw this as his big concern for the future. He illustrated this through showing the age distribution of the Japanese population from 1950, 2007 and 2050. Basically the 1950 distribution was like a pyramid with a very young population underneath the middle and old-aged. This shape changed to being fatter in middle age for 2007, and is predicted to be inverted with more older people that younger in 2050. Given that this will result in a percentage reduction of more than 10% in working population supporting an increasingly older population it was not difficult to see what he was meaning.

Paul spent some time going through old papers from him and others (particularly Joseph Stiglitz on securitisation in 1992) warning of the 2008 crisis - I do not know his work well enough to know how much this was "wise after the fact" but what he mentioned on securitisation and correlation made sense given what has since happened. Worth taking a look on his website for some of his papers on Basel and risk management I guess.

One key point he made was simply about volume. Working admittedly on a notional basis, he said that having an OTC derivatives market with notional value of $583 trillion is interesting in the context of a world economy with GDP of only $58 trillion. Even netting notional down you get around $30 trillion of OTC derivatives which still deserves our attention and our efforts to make things better in risk management. I guess his simple message here was "pay attention to volume".

He said the use and abuse of the Repo 105 rule was worth looking at (so I will, anyone with knowledge please let me know), and also questioned the societal benefit of high frequency trading (HFT). Looking back at the Flash Crash Paul said that this was a new kind of risk for risk managers and he had no idea how to hedge it.

Paul defended mathematics as the solution to some of the problems of the crisis and not as the cause - fundamentally he thinks the press have given maths bad PR. He said that we should all watch out for the word "new" being used, as this indicates the start of a bubble with phrases such as the "new economy". Overall a great speaker very comfortable with his subject matter.

 

 

 

RiskMinds 2010 - Day 1 - Risk Governance

I am over in Geneva at the moment (taking a break from the harsh English winter?..) for the RiskMinds 2010 event. Despite its slightly pretentious title (I leave it to you to assess how appropriate the name seemed in 2008...) it is one of the best attended risk management events where risk managers discuss what is going on and what is new to risk management. You can find some posts from the 2009 event here, and the 2008 event here - both make interesting reading given that we are out of the crisis now (aren't we?).

I arrived late for the first day, just to catch a panelist Pippa Malmgren of the Canonbury Group saying that during the crisis everyone knew they were long highly leveraged, very risky assets that were potentially in a pricing "bubble" but when asked about whether this bubble, most used one of the three responses:

• Asset managers said it didn't matter so long as all of our peers go down too...
• Hedge fund managers said that there business was to surf market waves and they could restart the fund afterwards anyway...
• I know it's a bubble but I will be able to get out before it bursts...

Pippa added that the last was the most worrying response, although I guess all are still relevant negative insights into the attitudes of some financial market participants.

The next panel was on Risk Culture & Ethics with Richard Evans  of Citi first up presenting on issues resulting from the crisis. Richard suggested that the following key issues were missed during the crisis:

• Silo Mentality - Risk reports were not comprehensive enough, covering all assets, regions and business units in one; risk management focussed too much on validating individual deal flow (transactions) rather than the portfolio; there were no incents for business managers to share resources and information.
• Short Term Revenue Focus - Focus was on short-term bonuses were not related to profitability after costs and cost of risk capital were taken into account.
• Backward-Looking Models - Models looked backwards (historic VAR for instance) rather than being forward-looking, scenario-based. Richard said that Citi now combine both backward-looking VAR and multiple (severe) scenarios on an approximately 50-50 basis when assessing overall risk now.
• Poor Teamwork - Trading and risk management staff did not work together effectively during the crisis. Richard now suggests this must be addressed through greater involvement of the business in risk management, the introduction of the risk committee and fighting against risk management "ivory towers".
• Board Weakness - Richard said that boards and senior management committees were not set up to react to "alarm bells" such as triggers resulting from limit breaches; Also many boards were simply very weak in their basic understanding of the risks being taken by the business.

I don't think the above will come as any surprise to anyone who has followed the crisis but Richard is a good speaker and so his presentation was entertaining. He later went on to criticise regulators for asking him to replace staff members with 20 years experience with others with 20 years experience - he said that he had not yet found a way to cram 10 years experience in 2 years although maybe recent times have come close to this aim! He also said that firms where the "mood" of the CRO affected what approval decisions were made obviously did not have strong enough governance in place. Richard wants risk and trading staff to work closer together, although he admits that two years on it is difficult to get business level compensation to get traders to work in risk - in this regard he also mentioned his days at JPMorgan when trading and risk staff spent time seconded to the regulators for a time.

There were a variety of other speakers during the day, all dealing with risk governance and culture. Whilst vital to the changes that must be made in the culture of the majority of institutions, I think it is a difficult topic to talk about, since it is hard to express just what needs to be "done" in some pragmatic way. Put another way, the conversations on this topic tend to focus on the need for a risk management culture and become very wooly when discussing how one is implemented. A presentation by Alden Toevs of the Commonwealth Bank Australia attracted discussion by some of the attendees over coffee. The presentation was about how to formalise/make a process of the discussion and agreement of risk appetite (a Risk Appetite Statement) between board, risk management and the business. Alden suggested that the use of anonymous "voting" technology at board level encouraged more openness and discussion, and getting the business involved in this process was a great way to encourage the involvement of trading in risk management. A good presentation in both content and effects (an iMac user I think!) and an amusing speaker who pointed out that visiting the Australian parliament is interesting for a risk manager given that you are surrounding by genuine Black Swans in the lake outside...