Mar 13, 2010

Magic Banking

Based on an idea as presented in a joshing blog by Henry Blodge, CEO of The Business Insider, here's the slightly changed formula for making thousands of investors happy, becoming a millionaire within months while having a successful career as well.

Become a banker!
All it takes, is to start a new bank. Don't worry, it's simple as will be shown.

This is how it works:
  1. Form a cooperative bank called: Cooperative Magic Bank (CMB).
    A cooperative bank is a financial entity which belongs to its members, who are at the same time the owners (shareholders) and the customers of their bank.
  2. Appoint yourself CFO together with two of your best friends as Board members. Set your yearly Board Bonus at a modest 10% of CMB's profits.
  3. Make a business plan (this blog IS the business plan)
  4. Raise $ 100 million of equity and $ 900 million of deposits, as follows
    • Offer your prospects/clients a guaranteed 4.57% guaranteed return on investment.
    • Offer a 70% yearly profit share. First year return on investment guaranteed 13,35% !
    • Everybody who wants to join the bank becomes a 'Lucky-Customer-Owner' (LCO)
    • Every LCO is obliged to invest 10% of his investment as shareholder capital.
    • The other 90% is invested in the CMB-Investment Fund (CMBIF).
    • CBMIF guarantees the return (and value) on the LCO's account based on a 30 year Treasury Bond
  5. Borrow $3 billion from the Fed at an annual cost (Federal Discount Rate) of x=0.75%.
  6. Buy $4 billion of 30-year Treasury Bonds paying y=4.57%
  7. Ready! Sit back and enjoy high client satisfaction and your Risk Free career and bonuses as a professional banker!

Magic Banking
Wrapped up in a 'Opening Balance Sheet and a first year ''Income Statement', this is how it looks like:


This is how the FED helps you to become a millionaire. but the party is not yet over.....

Pension Funds and Insurance Companies
If your the owner of a pension fund or an insurance company, starting a 'Magic Bank' could help you achieve a total 'risk free' return of 4,57% with an upward potential of 13,35% as well.

So why should you set up a complex investment model that you don't really see through, to achieve a risky 6% or 8% of return on investment, if you can have more than a 'high school comprehensible' 10% return without any substantial downside risk by starting a Magic Bank instead?

Together with the new Basel and Solvency regulation, this 'magic bank principle' will cause banks to sell their investments in more risky assets like insurance companies. On the other hand, insurance companies and pension funds will probably be interested in starting new banks to profit from the FED's 'free credit lunch'.

Criticasters and Risk
Some criticasters will rightfully point out that the magic bank is not completely risk free. Indeed there are some risks (e.g. the treasury bond volatility), but they can be adequately (low cost) managed by means of stripping or derivatives (e.g. swaptions).

Of course there's also the risk that the Fed will raise the short rates (Federal Discount Rate).In this case, instead of using derivatives upfront, one might simply swap or (temporarily) pay off the FED loan. Yes, your return will temporarily shrink to a somewhat lower level. But who cares?

Moreover, keep in mind that as long as we're in this crisis, the Fed's short money will be cheap. Don't ask why, just profit! By the time the crisis is over and Federal discount rates are more in line again with treasury notes, simply change your strategy again.

And if - regrettably - the federal discount rate and the treasury bond rate rise at the same time, simply book a life time trip to a save sunny island to enjoy your 'early pension' of $ 11.1 million (ore more).

For those of you who still doubt and for all of you who like a humorous crash course in investment banking, just click on the next video by Bird & Fortune....




Let's get serious
Although for us actuaries it's clear that because of the Asset Liability Mismatch, the magical bank is a running gag, the principles and consequences of the situation as described above are bad for the economy.

Financial Health Management
Banks and financial institutions in general are discouraged to act in their primary role as risk transfer institutes by performing on bases of professional calculated risk.

Why would they take any additional (credit) risk if they can generate their revenues almost 'risk free' with help of the Fed?

We all know that without risk, there's no economic added value either. Continuing this Fed policy will lead to Bob hopes:

A bank is a place that will lend you money, if you can prove that you don't need it.

Maintaining the current Fed policy keeps the banks alive, but ill.

What's needed is a new Federal Financial Health policy.

Over the last decades the relative equity (equity in % of assets) of Banks deteriorated from a 20% level to a 3-5% level in this last decade.

Banks need to be stimulated to take appropriate healthy risks again, while maintaining a sound individual calculated 'equity to assets ratio', increased with an all over (additional) 5% risk margin.

The Fed should therefore act decisively and:
  • stop the ridicule and seducing leverage risk levels
    Redefine the Capital Adequacy Ratio (CAR). The new Basel III leverage, calculated as 'total adjusted assets divided by Tier 1 capital', won't do. Strip the nuances, limit 'adjusting', add a surplus.
  • Limit and make all new financial products subject to (Fed) approval
  • Limit the proportion of participating in products that only spread risk (e.g. Citi's CLX) instead of neutralizing or matching risk
  • Raise the discount rate as fast as possible,

to prevent moral hazard and economical laziness that eventually undoubtedly ends in a global economic melt down.

However, there's one small problem..... The FED has to keep the discount rate low because otherwise financial institutions that run into trouble aren't able to finance their loss in a cheap way and will activate the nuclear systemic risk bomb (chain reaction).

It seems we're totally stuck in a governmental financial policy paradox. Nevertheless the FED should act now!

Links:
- Henry Blodge Video on Modern marketing...
- 30 year treasury bonds
- Historical Federal discount rates
- Can Basel III Work?
- The Economist: Base Camp Basel (2010)
- Citi's Financial Crisis Derivatives Should Be Banished From Earth
- Capital Adequacy Ratio (CAR)
- Treasury yields

Mar 6, 2010

OTC Warning

In a 55 minute Pbs-video it becomes clear what kind of serious derivatives (OTC) problems we still have.

Warning!
Watching this video will dramatically change your view on risks and players in the financial system. If you want to protect yourself on the short term against the effects of what is going on in the skyscrapers of the financial markets: don't watch this video! Don't blame yourself, because it's not 'just funny' to become aware of risks you can't handle anyway....

However, if you are professionally active in investment risk or if you're a member of a (pension fund) Investment Committee, hiding is no option and this video is a good investment and a 'must see'......



Enjoy, shiver, learn.....

If you like big numbers, please look for 15 seconds at the size of the 'Over The Counter' (OTC) Market (Q2 2009):

$604,622,000,000,000
(are you still with me?)


There's a dutch proverb that states:

a warned person counts for two.....

Links:
- OTC derivatives statistics
- Financial crisis explained

Feb 27, 2010

Isle of Risk

Last decades, our perceptions of Financial Risk haven been constantly changing and - for sure - they will continue to do so in the future.

In the sixties and seventies of the 20th century 'risk' was mainly plain 'technical risk'. Risk Management was mainly used to support current strategies, as a defensive instrument.

More de-Tailed studies of risk in the nineties, created new instruments and models to manage (investment) risks. This led to the understanding that it was possible to take more risk because we could understand and manage it in a better way.

Next, at the beginning of the 21th century, these new risk models were expanded and transformed from passive to active instruments. New products and markets were developed by combining, cutting and mixing traditional asset products (stock, bonds, mortgages) with derivates. And just like in chemistry, where mixing innocent individual molecules could lead to an explosive new molecule, the asset markets got flooded with toxic, unknown risk-correlated products.

For most of us it became clear that it was not the risk ingredients (bonds, stocks, derivatives, etc) themselves that caused this turmoil, but our own (irresponsible) behavior, e.g. the way we ourselves were managing the asset products and models. Behavioral Finance was born.

After we poisoned the investment market landscape in the second half of this last decade, things turned for the worse. Instead of looking what we had done, where we were on the risk map and how we could clean up this mess, we kept on building debt and - except for sub prime mortgages - refused to restructure the market 0r to restrict the use of derivatives.
No restrictions nor ethical guidelines on making money just from money (who pays for making money of money?).

Instead, with the latest development High Frequency Trading (1,000 orders per second ! ), covering about 60% of all U.S. equity trading and nearly half of U.S. futures trading, we finally lost our site on what is ethical or not.
Main question is: Who has the guts and the power to stop this development?

Anyway, it's clear that our 'behavior' and a 'map of the risk landscape' are critical in understanding where we are heading with Risk......
Let's start with behavioral finance

Behavioral Finance
One of the world’s best experts in the field of behavioral finance is James Montier.
His book Behavioural Finance is a classical must-read.

In a 2002 classic report titled 'Part Man, Part Monkey', Montier gives a number of common mental investment pitfalls. Here's a sum up of those pitfalls that might apply to actuaries just as well:
  • You know less than you think you do
  • Be less certain in your views, aim for timid forecasts and bold choices
  • Don't get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day
  • Listen to those who don't agree with you
  • You didn't know it all along, you just think you did
  • Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs)
  • Don't take information at face value, think carefully about how it was presented to you

Trinity of Risk

According to Montier the word 'Risk' is perhaps the most misunderstood concept in finance. In classical finance, risk is identified as the relative price volatility (beta). However that's not what risk really is about. 'Downside risk' (ie loss) is what really matters when it comes down to performance measurement. From an investment point of view, risk can be split up into three interrelated elements, the so called 'trinity of risk':
  • Business Risk (risk of business going broke)
  • Financial Risk (risk of using leverage)
  • Valuation risk (the margin of safety)

Valuation risk is the most tricky type of risk, as is explained in an excellent article 'The Biggest Mistakes in Valuation...' by Donald R. van Deventer from Kamakura Corporation. Here's the wrap up of the top 7 valuation mistakes in a humorous "daily life analogy"
  1. The Fake Rolex Watch Mistake
    Ask the investment bank which sold you a fake Rolex what the Watch is worth
  2. The Poker Game Mistake
    Ask someone else playing in the same game how you should bet
  3. The War of the Worlds Mistake
    Believe in a valuation technique Because everyone else thinks it's true
  4. The Cash Card Mistake
    Tell an investment banker exactly how your firm evaluates complex securities
  5. The Carton of Eggs Mistake
    Don't check to see if the eggs are broken, just look at the egg carton before buying
  6. The "My Brother-In-Law Told Me It Was a Good Investment" Mistake
    Bernie Madoff and the rating agencies
  7. The 2+2=5 Mistake
    Technical errors in valuation

Financial Crisis 2008-201x
Back to Montier, who's very clear about the role of Bernanke with regard to the role of the FD in the current
Montier believes Bernanke missed the boat, had poor ideas on how to recover and on top of this, failed to learn from his mistakes. Montier guesses: There are none so blind as those who will not see!

Happy Investor
For those of you who -after all this - don't succeed in becoming a happy investor, Montier has a simple advice on improving (plain) happiness. Here's the wrap up:
  • Don’t equate happiness with money.
  • Exercise regularly.
  • Devote time and effort to close relationships.
  • Pause for reflection, meditate on the good things in life.
  • Seek work that engages your skills, look to enjoy your job.
  • Give your body the sleep it needs.
  • Don’t pursue happiness for its own sake, enjoy the moment.
  • Take control of your life, set yourself achievable goals.

Map of Risk

Risk is an interesting and never ending subject of discussion and development. Drawing a map of Risk, literally helps you to oversee the Risk battlefield. Draw your own map of risk in life to remember where you are, where you've been and where you'll be heading.....

To help you get on the way, take a look at my Isle of Risk

(click the image for a larger image)

James Montier's Links
- Google Book Behavioural investing
- Was It All Just A Bad Dream? (febr. 2010)
- The Little Book of Behavioral Investing
- Applied behavioural Finance (pdf presentation)

Other links:
- High Frequency Trading Is A Scam
- High Frequency Trading Youtube
- FT: Markets: Ghosts in the machine
- High Frequency Trading -- Results from Simulation

Feb 21, 2010

Powerpoint Mortality

Whether you're an actuary, accountant, consultant or salesman, when we take up a new challenging project, we're inclined to spend most of our time on data mining, modeling, reconsidering, detailing, arguing, making things perfect and finally, drawing the conclusions and writing the exhaustive proposal report....

Fortunately - in this case - your right on schedule! You've got exactly one day left before your Board presentation of the project. Still completely in a rush and overexcited about the stunning results of your successful investigation, you start up your laptop to wrap up your proposal report in a full flash Powerpoint presentation.

That night at 01.00 AM, you successfully finish your ppt presentation. Just in time! Completely satisfied about this phenomenal achievement, you e-mail the ppt to Nosica, the Board's secretary you know well. She, as well as the Board, will be impressed by your 'night shift work'. Who said that actuaries had a 9 to 5 job?

The next day, at 14.00 AM you enter the Board room, full of confidence. Your presentation is start-ready, the beamer glows, you're fully concentrated on your audience and in a 'cashing' flow....

After 20 minutes of presentation, including your ten recommended practices and some questions, you leave the 26th floor. All went well...
Time for a drink and a well earned good night sleep...

Next morning, 09.00 AM, the Board's secretary replacement calls you: Your proposal has been declined....

You're flabbergasted, how could this happen? After all this work you've been through.

What went wrong?

The answer is simple, you denied Wayne Burggraff's Law of Presentation:

It takes one hour of preparation
for each minute of presentation time

So next time, in case of a 20 minutes presentation, invest 20 hours of your time in research, development, organizing, outlining, fleshing out, and rehearsing your presentation.
In essence: if you fail to prepare well, you are well prepared to fail.

Tips.....
Here are some practical tips that might help you with your preparation:
  1. Ask yourself: ''If I had only sixty seconds on the stage, what would I absolutely have to say to get my message across."
    -- Jeff Dewar --
  2. The simplest way to customize is to phone members of the audience in advance and ask them what they expect from your session and why they expect it. Then use their quotes throughout your presentation."
    -- Alan Pease --
  3. No one can remember more than three points.
    -- Philip Crosby --

Fear of presentation
As actuaries it's surprising to see that people are more afraid (41%) of speaking to a group than of death (19%).
Now it's clear why we search the help of Powerpoint to 'survive' on stage.

Powerpoint Mortality
We all know Powerpoint..... Powerpoint itself is not good or bad, it's the way you use it.

The mortality rate of Powerpoint is humorously demonstrated by Don McMillan:



Who Needs Powerpoint?

Last January I was heading for a presentation with the help of Powerpoint. Full house. However, on the supreme moment the local beamer gave up. I simply decided to bring my message in an interactive session with my audience, without the help of Powerpoint.

Yes, it was different, challenging and even fun! Because of my thorough preparation - I was able to concentrate on almost everyone of my audience. So...., another Maggid's tip could be:

Prepare your presentation without Powerpoint!

A presentation try out
In the mid nineties my employer's company was heading to get listed at the stock exchange. I remember I had to give a presentation before a panel of 70 international analysts, who would probably raise all kind of difficult questions. In order to prepare 'abap', I called my strategy director as well as my CFO and asked them to act as my 'try out analysts audience'.

I told my colleagues I would give the presentation three times in a row. In the first two presentations they were obliged to interrupt me as much as possible, to raise difficult or weird questions and to put me to test (keeping my humor and concentration). During the third presentation they had to act as normal audience.

To make a long story short: after three presentations, my two colleagues kept their breath in combination with a desperate look in their eyes. I told them not to worry and reassured them my presentation at the analyst session would be successful.

And so it was, as I was fully prepared on every possible question and didn't had the need to look at my ppt presentation, I could fully focus on my audience. Lesson: Make the preparation tough, you'll benefit from it in the final presentation.

The actuarial master
Yes, there are a lot of rules, regarding the use of Powerpoint.
The Golden Rule is that all PowerPoint presentation rules, principles, and guidelines are just secondary to doing what is ultimately right for your audience. Critical point is, you can only break the presentation rules if you know them .

It's just like in actuarial science, once you've become an actuary (a master) the real art of your profession is not anymore in applying equations and methods 'by the book'. Now it comes down to break the existing rules and conventions in a such a professional way, that new risk and social challenges are being (re)solved in a different way. Key point here is that not only your professional skills have to be outrageous, but your presentation skills as well. As the success of a good peace of actuarial craftsmanship, is completely dependent on the way it is presented.

Mindmapping
Let's conclude with some practical free(ware) presentation tips.
Although you're probably aware not to overuse clip art, it's good practice to set up your presentation in a consistent and well polished style.

Of course you can use expensive business packages to illustrate your presentations, but there's also an excellent freeware application called: EDraw Mindmap 4

With the help of Edraw, creating presentations and mind-mapping is a question of minutes.

Enjoy preparing and giving presentations, learn to be(come) yourself on stage and overcome any possible fear of speaking to groups......

Related links:
- EDraw Mindmap 4 (Completely freeware!)
- EDraw Mind Map 1.0
- Edraw Max (not freeware)
- Lovelycharts (free, one application; online)
- Presentation skills (youtube)
- The New Office Math (youtube;Don McMillan )
- Presentation skills (ppt)

Feb 1, 2010

Soft-Risk Management

Never heard of of Soft-Risk Management? After this blog you'll never forget!

Google
This month Google's world class co-founders Page and Brin announced (SEC filing) they'll sell 17% of their shares (at today’s prices valued at $5.5 billion) in the next five years.

As a consequence their voting rights will be reduced to 48%, implicating they will no longer have a majority control. They are both as committed as ever to Google..., Google said in an e-mailed statement.
Why this statement? Was there anyone who doubted this?

Of course Google is still and will hopefully stay a strong company and a strong brand. Nevertheless - without jumping the conclusions - it's clear that this low-key announcement, although it doesn't seem to have any direct financial consequences, might turn out to be the straw that breaks the camel's back in Google's life cycle development. This kind of company press release is in fact a 'disguised risk indicator', or in other words a :

Soft-Risk Indicator (SRI)

A SRI may be defined as 'knowable' information about a company, that could influence the company's value now or in the future , but doesn't seem to have enough (financial) power to do so now or on its own

Although just one ignored SRI could already be fatal, a combination of two or more SRIs could become a severe risk. A bunch of SRIs could create a chain reaction and lead to a kind of supernova explosion.
It's just like a grain dust explosion. A few grains are no risk, they don't explode. However in an accumulation of grains, one innocent 'hot' grain or a small environmental change in dust concentration, is enough to create a mega explosion. Just like grain dust, SRIs can become a severe risk when the environment (suddenly) changes.
Consequently, an out of the blue 'change of environment' is also a Soft-Ris Indicator on its own.

Don't mix up Soft-Risk with Systemic Risk. Dust particles don't directly 'participate' in one another, in fact they build up to a certain critical density. Soft Risk Loss
SRL = E( SRIi=1,2..n )
It's just the composition of SRIs in combination with the special SRI of 'the change in environment' that creates a major accumulated (explosion) Soft-Risk that may eventually result in a Soft Risk Loss (SRL). However, once the SRL has occurred and has been measured, the corresponding SRI becomes a 'normal' Risk parameter.

Are there more Google SRIs?
Yes! One of the best Soft-Risk Indicator blogs of 2009 is written by Googles leaving lead visual designer Doug Bowman, it's called:


Please read the next extract of Bowman's blog from a risk management perspective, as he explains his decision to leave Google after three years.
- 20 Mar 2009 -
Goodbye, Google
Without a person at (or near) the helm who thoroughly understands the principles and elements of Design, a company eventually runs out of reasons for design decisions. With every new design decision, critics cry foul. Without conviction, doubt creeps in. Instincts fail. “Is this the right move?” When a company is filled with engineers, it turns to engineering to solve problems. Reduce each decision to a simple logic problem. Remove all subjectivity and just look at the data. Data in your favor? Ok, launch it. Data shows negative effects? Back to the drawing board. And that data eventually becomes a crutch for every decision, paralyzing the company and preventing it from making any daring design decisions.

Yes, it’s true that a team at Google couldn’t decide between two blues, so they’re testing 41 shades between each blue to see which one performs better. I had a recent debate over whether a border should be 3, 4 or 5 pixels wide, and was asked to prove my case. I can’t operate in an environment like that. I’ve grown tired of debating such minuscule design decisions. There are more exciting design problems in this world to tackle.

I can’t fault Google for this reliance on data. And I can’t exactly point to financial failure or a shrinking number of users to prove it has done anything wrong. Billions of shareholder dollars are at stake. The company has millions of users around the world to please. That’s no easy task. Google has momentum, and its leadership found a path that works very well. When I joined, I thought there was potential to help the company change course in its design direction. But I learned that Google had set its course long before I arrived. Google was a massive aircraft carrier, and I was just a small dinghy trying to push it a few degrees North.

I’m thankful for the opportunity I had to work at Google. I learned more than I thought I would. I’ll miss the free food. I’ll miss the occasional massage. I’ll miss the authors, politicians, and celebrities that come to speak or perform. I’ll miss early chances to play with cool toys before they’re released to the public. Most of all, I’ll miss working with the incredibly smart and talented people I got to know there. But I won’t miss a design philosophy that lives or dies strictly by the sword of data.

The resemblance between Google and the financial sector is striking.
Can you see it?

Simply replace the next words in the above 'Google, Goodbye' article:
Google => X-Bank, Engineer => Accountant, blue => risk strategy
Design => Risk, border => uncertainty, pixels wide => promille
To help you, just press the next 'replace button' to change the text in the article and read the text again. This looks astonishing familiar, doesn't it?

Replace

More Soft-Risk Indicators
Bowman's blog makes clear that there's another Soft-Risk Indicator, called:

Data Decision Tunnel Vision
  • Every decision in only based on data and models.
  • Intuition and Fingerspitzengefühl are banned.
  • Craftsmanship is not respected, but must be proved in detail with evidence based on facts and data.
  • Possible events that can't be translated into (financial) data are not recognized as risk and are ignored.
  • Events that don't fit into the data model are reformed until they do fit in
  • Micro management confines the development of a helicopter view on the main risks

Although the list of Soft-Risk Indicators is endless, I'll try to list some common examples (mail me if you have more SRIs examples).

Examples of SRIs
  • Frequent or unexpected change of CEO or other board members
  • Unexplainable or untimely Actuary or Accountant change
  • Intentions of board members not in line with policy
  • Too good to be true revenues, profits, reporting or communication
  • Delay in reporting or publishing
  • Lack of transparency
  • Conflicting statements or publications
  • Main (unexplainable) shareholder changes
  • Over-explaining by board members
  • Unexpected main reallocation of assets
  • Vacancy or Recruitment stop; Reorganizations
  • A company takes extremely more risk after a HQ-Risk Analysis
  • Increasing customer dissatisfaction

Soft-Risk or Risk?
Most of the SRIs are not present or recognized as Risk in our models. Why? Simply because SRI losses are not in the data we analyze. This could be (1) because of the very low occurrence probability of a SRI loss (the loss simply didn't occur yet), or (2) because most of the SRIs aren't identified as SRI or Risk at all, as they simply do not exist yet. Just like a sleeping virus, they might come into Risk Existence on basis of (unknown) future (environmental) changes.

The key difference between 'Risk as we now it' and a SRI is that a SRI is by definition 'not measurable'. SRIs manifest themselves directly in practice as a (non-directly traceable) loss occurrence.

VaR Models fail
This also implicates that our traditional VaR models are definitely wrong, because they only include 'risks of the past' en no 'future risks', e.g. Soft-Risks. These VaR-models significantly underestimate the risk in the tail.
Problem is that as VaR-probabilities are getting smaller and smaller (0.5% or less) it also gets increasingly more difficult to prove the models are right. Consequently the VaR-model loses his power.
Backtesting and recent studies show that we ought to be able to identify most bad VaR models, but the worrying issue is that we can't find any good models, moreover because SRIs are not in the model.

Denying Soft-Risk Indicators: The Meltdown
You might think 'Who cares about SRIs if you can't measure them?". Well, let's see what happens if we deny Soft Risk Indicators.

The most likely dead-end meltdown scenario of denying Soft-Risk Indicators goes something like this:
  • The first years of a company's life is a race for revenues. Risk Management is on the second plan, as there's little to lose.
  • After a few years revenues and profits grow, but become vulnerable and volatile. A new Board is appointed and a Risk Management Plan (RMP) comes in place to stabilize and improve results and to guarantee continuity.
  • After the RMP has shown fantastic results for some years, some strange unexpected serials of events (SRIs) happen. The Board consciously discusses the effects of these events and concludes their company's results are not infected by the events. Moreover, company results are better than ever and the company's RMP has proven to be (Titanic) watertight.
  • To be sure and transparent the Board checks its conclusions by ordering an external risk audit. The external auditor is just as biased as the Board and confirms the Board's conclusions: RMP is O.K.!
  • Suddenly there's a totally unexpected big accident, a substantial one of loss. At first things still look under control, but soon the situation takes over. The board is no more in control. The company is lost.
  • Soon all stakeholders are flabbergasted. How could this happen?!
Well it's clear, what happened is that the Board misinterpreted and neglected early warning signs and SRIs, resulting in a company meltdown.

How to prevent a melt down?
To prevent a situation like the one above, the board should
  1. Set up a SRI-Register
  2. Order the RM-Department to include SRIs in their risk model
  3. Discuss the integral SRI-register monthly in the Board meeting
  4. Interprete the SRIs, and take proactive actions to prevent the SRIs from becoming critical. This is Board's Craftsmanship!
As continuity is a company's main goal, managing uncertainty is the Board's main responsibility.

Redefining Risk
Once we realize that Soft-Risks are crucial in Risk Management, how can we include them in our Integral Risk Model (IRM)?
First we'll have to redefine Integral Risk as follows:

(1) I-Risk = Integral Risk = Measurable Risk + Unmeasurable Risk
(2) I-Risk = Integral Risk = Hard Risk + Soft Risk
(3) I-Risk =( Threatj x Vulnerabilityj x Costj ) + E(SRIi=1,2..n)

Keep in mind that the Integral Risk is not a number, as the SRL is not measurable. If you can't force your brain to 'quantum think' this way, just imagine the Integral Risk as the total company value (at stake).

Cleaning up
First 'cleaning up' action we can do is to investigate the relationship (correlation, covariance matrix, etc.) between each past assumed Soft-Risk event and the Vulnerability of each Hard Risk event. This tells us probably something of the influence (correlation) of certain (combination of) SRIs on the traditional Hard Risk parameters.

Probably this research will show that some of the SRIs could even be defined as Hard Risk variables. Unfortunately this investigation - as explained -won't tell us anything about the real unmeasurable Soft-Risks. The problem remains.....

Managing Soft-Risk
The real main problem is : If you can't measure Soft-Risk, how can you be sure your 'Soft-Risk Management' (SRM) is successful, as you can't measure the effects of your actions either?

This seems to be an insolvable problem. Insolvable because of what Bowman in fact calls our 'mono data mind set'. We are not trained in taking decisions without data. As we are not trained, we become unsure. Unsure about the risk of the impact of our decision, that is unmeasurable as well. Full circle, we're back where we started.

However, there's a way out of this paradox, it's called

Principle Based Risk Management

Before we dive deep, let's first take a step back and have a look at two important actual developments, (1) the Global Warming Problem and (2) Solvency II.

(1) Global Warming Problem
During recent decades scientists have developed different global warming models that contradict each other. The real climate is far too complex to be modelled. We could spend millions of dollars on research to find the ideal model, we will never succeed!

Step by step the leaders of this world recognize that they'll have to manage the global warming in a different way. It's no longer important whether or not there exists a provable global warming problem. The main question is whether we are willing to live up to the principle: "You don't foul your own nest"

This way of principle-based thinking requires reflection on the level of 'spaceship earth', on a 'global' level. However, simultaneously, it urges for acting in line on a 'local' level.

Although related with The Precautionary Principle, Principle Based Risk Management is much more fundamental. It's an adequate tool for fighting Soft-Risks.

(2) Solvency II
In our aim to strengthen the insurance industry solvency, implementation of Solvency II bears the a risk of an overshoot. Instead of managing risks first and in a better way, we translate every risk into capital requirements, consequently increasing the cost of doing business and insurance premiums. It's the perfect example of putting the cart before the horse. Although we expect Solvency II measures to work out in a better solvency, in reality we don't know, as this 'capital-increase scenario' hasn't been tested before and can't be tested. The presumed positive effect could just as well be adverse.

In our aim to avoid risk, we've created another additional risk. A risk we can't measure (yet). Yes, unfortunately, Solvency II is a SRI as well.

Instead of making Solvency II obligatory, a far more effective Principle Based response from the Regulator would have been:

"Prove us that you manage your own risks"

Back to Soft-Risk Management
It's not that difficult managing Soft Risks Principle Based. In fact we all have experience with Soft Risk Principle Based decisions when we decided to have friendship, marry, or to have a child. Or did you calculate the 'lifetime present value' of your child?

Try to apply the above principles in your own company or in your own department. Just start by investigating your Soft-Risk Indicators and start managing soft and hard risks Principle Based.

What principles can we formulate to manage Soft-Risk?


Well actuarial folks.... that's food for another blog as this blog is getting far too long..... O.K. .... I wont keep you waiting, just one Principle Based one-liner that tackles a whole bunch of SRIs at once

Bonuses are only paid in case of
High Customer Satisfaction

Related (additional) Sources:

- Unmeasurable measures: The lawlessness of great numbers
- The Risk Equation
- An Additional Way of Thinking... :The Quantum Perspective
- From Principle Based Risk Management to Solvency Requirements
- Measuring the unmeasurable
- Managing Extraordinary Risk (2009, Towers Perrin)
- Measuring the Unmeasurable: Balanced Scorecard
- NYT: Risk Mismanagement
- Backtesting Value-at-Risk Models (2009)
- Quality control of risk measures: backtesting VAR models
- Metrics: Overmeasuring Our Way to Management

Jan 17, 2010

Once-in-a-Century Credit Tsunami

When will the next crisis happen and what magnitude will it be?
Investor or actuary, this question puzzles our mind, isn't it?

In the Financial Analysts Journal (January/February 2010) professors Guofu Zhou and Yingzi Zhu raised a similar key question:


Actually Zhou and Zhu did research on a 'October 2008 congress quote' by Alan Greenspan:

We are in the midst of a 'once in a century' credit tsunami
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Zhou and Zhu Research
Given the fact that the Dow Jones Industrial Average (DJIA) dropped more than 50 percent, from 14,164 on 9 October 2007 to 6,547 on 9 March 2009, Zhou and Zhu answered the question whether a drop of 50% would be likely to occur once in a century.

Using daily data on the DJIA from 26 May 1896 to 19 June 2008, Zhou and Zhu estimated the long-term average DJIA-return (sample) at µ = 7.4% (excluding dividends) and the long-term volatility, known as the sample standard deviation, at s = 18.2% a year.

DowJones Industrial Average
May 1896 - June 2008
Average return: 7,4%
Standard deviation: 18.2%

On basis of the long-term data, Zhou and Zhu calculated the probability for the market to drop more than 50 percent from a high to a low over a 100-year horizon, considering two different models:
  1. Random Walk Model, excluding dividend
  2. Long Run Risks Model: complex dynamic simulation model, including consumption growth, dividend growth and asset prices

Here is the summarized outcome of their calculations:


As is clear on basis of the Long-Term Risks Model (LTR-Model), no matter what average return or standard deviation, the probability of a 50% draw down over a 100-year horizon is practically almost 100%.

50% draw down over an n-year horizon?
Given these results of Zhou and Zhu, we can now easily and (very) roughly approximate the probability, P(n), of a 50% draw down over an n-year horizon.


with r= P(1). We now roughly 'fit' P(n) to the results of the Long-Term Risks Model as follows:


It turns out the LTR-Models roughly corresponds with one year '50% draw downs probabilities' between r=4% and r=10% [r=P(1)].
As is clear from the table above, even over a 10-year period there's a substantial probability, somewhere between 33% and 65%, of a 50% market breakdown.

Also we can be more than 90% sure to become a witness of a market tsunami once in a lifetime......

The next market tsunami
Up to the next market tsunami, I would guess...., as tsunamis don't have a memory or allow themselves to fit into statistics or models like the ones mentioned above. Unlike natural sea-tsunamis, we - ourselves - are responsible for creating these 'financial tsunamis'.

Irrational Risk Attitude
But even if we are aware of the risk and are not responsible for creating the risk, we have an irrational risk attitude as human beings.
With the recent (2010) Haiti earthquake fresh in mind, let's take a look at the way we deal with the probability of an earthquake.

Los(t) Angeles .....................?
According to the 2007 Working Group on California Earthquake Probabilities (WGCEP 2007) the probability of a magnitude 6.7 or larger earthquake over the next 30 years striking the greater Los Angeles area is 67% (mark the similarity in our P(n) table!).

Yet we deny this reality and 'hope' for the better. Perhaps if every city would have to value the estimated fair value of this earthquake expectation in his balance sheet, things would change. However, I doubt.....

People act irrational with regard to Risk. If we can't manage it, we deny it. If we can manage it, we screw it up!

Sources
- Article Is the Recent Financial Crisis Really a ‘Once-in-a-Century’ Event?
- Wall Street Journal article, October 2008: Greenspan
- Credits: CFA Institute
- California Earthquake Probabilities
- Download Spreadsheet of tables used in this blog

Jan 10, 2010

US Employment Rate Halleluja

As a professional actuary, just take a look at the next selected "Dave Rosenberg's charts" , showing:

  • Chrt2: The true measure of US Joblessness end 2009: 17%
  • Chrt3: Median duration of unemployment rose to 20.5 weeks
  • Chrt5: Overall employment rate is 58%, lowest since 1983





You don't have be an actuary to understand the importance of a healthy Employment-to-population ratio, given the increase of the 'aging population' in the next decades....

As an expert in statistics, would you say we're on the right track?
What would you advice US?

Used Sources:
- Excellent original article by Dave Rosenberg (pdf)
- The lost decade
- Forget Unemployment, The Real Nightmare Is EMPLOYMENT
- Dutch: De Amerikaanse banenhoax

Jan 7, 2010

Actuary - Best Job in the World

'Actuary' ranks as the best job for 2010, based on research into 200 different positions in this year's exclusive CareerCast.com Jobs Rated report and published by The Wall Street Journal.

Using five key measurement criteria – stress, working environment, physical demands, income and hiring outlook – the Jobs Rated report seeks to compare and contrast careers across a multitude of industries, skill levels and salary ranges, sorting them into a definitive ranked list of jobs.

So why is Actuary rated number one?
For starters, the position ranks especially well for its low physical demands and stress levels, finishing 2nd and 3rd, respectively, out of all 200 jobs. But more importantly, it is actuary's consistently strong performance overall that helped the job rise to the top of the 2010 Jobs Rated list.

Who says being an actuary is boring?
Interested in a zero unemployment profession?


Jan 4, 2010

Risk Management Humor

Happy new year! At the start of 2010 let's have some 'serious fun' with the next

Actuarial Risk Management Puzzle Joke

Three actuaries and three accountants are traveling by train to visit a 'Risk Management Conference'. At the station, the three accountants each buy tickets and watch as the three actuaries buy only a single ticket.

"This looks very risky. How are three people going to travel on only one ticket?", one of the accountants asks.

"Watch and you'll see! Take notice of our brand new risk management approach", one of the actuaries answers.

They all board the train. The accountants take their respective first class seats, but all three actuaries cram into a restroom and close the door behind them.


Shortly after the train has departed, the conductor comes around collecting tickets. He knocks on the restroom door and says, "Ticket, please." The door opens just a crack and a single arm emerges with a ticket in hand. The conductor takes it and moves on.

The accountants were deeply impressed by the actuarial approach and agreed it was - after all - quite a clever idea without any substantial risk.

So, completely confident and with even more Risk Management skills gained at the inspiring Conference, the accountants decide to copy the actuaries new risk approach on the return trip and save some money (accountants have always been clever with money!). When they get to the station they buy a single ticket for the return trip.


To their astonishment, this time the actuaries don't buy a ticket at all. "This is reckless, how are you going to travel without a single ticket?", one of the perplexed accountants asked. "Watch and you'll see! Take full notice of our latest risk management approach" answered an actuary.

When they board the train the three accountants cram into a restroom and the three actuaries cram into another one nearby. The train departs.

Stop
Here the story stops for a moment. Let's find out if you qualify as a Actuary Risk Manager (ARM) or - otherwise - could better have become an accountant.

Can you finish the story? What was the alternative Risk management Plan of the actuaries?

Just check the next box (or go to the original Actuary-Info Blog site) to find the right answer.......

Solution




Conclusions
What conclusions can we draw from this simple story?

  • Risk Management is a game without end

  • The effect of Risk Management Conferences is threefold:
    1. Some attendants get smarter
    2. Others get overconfident
    3. Final result: Increasing Risk, instead of decreasing Risk

  • There's an old Dutch saying that expresses the danger of increased Risk Management :

    "A warned man counts for two"

  • If we want to reap the fruits of Risk Management, accountants and actuaries have to start working together, instead of struggling and competing each other.

  • Risk Manager Profile and qualifications
    Insight, creativity and integrity are important requirements to become a professional Risk Manager. Unfortunately, this is not enough.

    To tackle Risk Management in a company, you need the best potential crook around. One who's willing to settle his salary and earnings for a little less than he would have earned as a real crook, in return for having a respectable job and not risking to end up in jail. You could call it the Personal Risk management of the Risk manager. Employers that settle for an inferior Risk Manager, know one thing for sure: someday somebody more 'crooky' than 'your risk manager' will tear your company down!

With some humor, we've gained new insights in the challenging world of Risk Management. Anyway, a Happy & Healthy 2010 !

Dec 28, 2009

Control Leverage

Key question is whether 'adding more control' will stabilize financial institutions like banks, insurance companies or pension funds.....

With all the - apparently failing - new legislation of the last decade already in place and new control measures like Solvency II and the strengthening of the Basel II Framework ahead, one might - at least - question whether we're on the right track with this intensified 'control approach'.

Will adding more control
empower or paralyze financial institutions?



In other words: Is the Control Leverage Effect positive or negative?

Insurance
In an FT-Adviser article called 'Solvency II costs are unsustainable', Joy Dunbar reports that the ABI (Association of British Insurers) has warned that the costs of implementing Solvency II regulations could destabilize the industry across Europe.

To gain more control (financial stability), European Insurers are obliged to implement Solvency II measures by the end of 2012, starting already in 2010.

Impact Solvency II
The increasing control costs and capital demands of Solvency II will have an enormous impact om the insurance market:
  • Recapitalization: Insurers need to acquire fresh equity capital (billions of Euros) in the market
  • Over-Capitalization: More 'dead' capital is created in financial institutions, resulting in declining investment returns in insurance.
  • Market shake out: Companies will exit the market
  • Pricing effects: prices (premiums) will rise, cover will be reduced

Banks

Whereas the European Insurers are on a more or less 'blind track' with regard to the implementation of Solvency II, the banks - according to chairman of the Basel Committee Mr Wellink - stressed that "decisions on the final proposals and their calibration will be made only after a thorough analysis of the impact assessment and the comments received on the consultative documents. The Committee will ensure that implementation of the new standards is consistent with financial market stability and sustainable economic growth".

The real problem
One doesn't have to be an actuary or financial expert to conclude that we're at the end of the road where adding more of the same type of control measures will substantially stabilize our system.

Without diving deep into real life quantitative analyses, let's get a helicopter-view and take a look at an average 'Control-Return Matrix' to do some 'rule of thumb' exercises...

Rule of thumb Control-Return analyses

Phase I
A few decades ago, starting in the good old sixties of the twentieth century, there where only limited control measures in place (control=0). The average Return on Equity (ROE) of a company was (e.g.) 6% and although Value at Risk (VaR) didn't yet exist as such, the 6% ROE could easily swap between (e.g.) +15% and -50%.

Financial markets where not that developed as today (no derivatives, , CDS, etc). Systemic risk was almost non-existent and accounting principles where based on the simple and relatively stable method of 'historical cost'.

The need for 'more control' was clear to everybody. More control implied lower costs, 'more opportunity insight' and 'more risk control'.
More control turned out to be a good investment and would lead to realizing a better return (ROE) in combination with a lower risk (Var) and a higher 'upward potential'. Every stakeholder was happy.

Phase II
Getting into the eighties and nineties of the twentieth century, 'control' had done its major job and still did, as it was able to manage the few relatively small recessions in those years.

With the help of the oncoming heavy computers, the first baby steps regarding new risk management techniques and ALM (Asset Liability management) were taken.

This way major risks (VaR) could further reduced, sometimes at the cost (expense) of a small reduction of the ROE. But this small effect was largely compensated by the 'fallacy high returns' in the high trust market.

Phase III
At the beginning of the Twenty First Century a new recession made clear the financial environment had substantially changed:
  • New techniques, models and the use of modern computer software led to new markets and new products like derivatives
  • Markets became global, (on face) transparent, in open competition
  • A lack of insight with regard to systemic risks
  • Differences in local supervision, legislation, administration and accounting rules, led to a complex, non-transparent global market.
  • In order to be able to compare companies, they had to be valued at 'market value', implicating the birth of more volatile (stock) markets....
  • Step by step, the public and media became more conscious. Investors and consumers understood that even if a 0.5% VaR level would be further reduced, it wouldn't make any sense because it would be always overshadowed by the non-trackable, nor manageable, risk of let's say 1 à 2%. And moreover, who would trust his money to a bank that would go bankrupt once every 50 or 100 years....

Investors, Boards, Managers, everyone lost their handrail....

In the recent decade (2000-2010) things got worse :
  • Existing control and accounting systems would locally differ and failed to meet the complex demands of the new markets
  • Supervisors en regulators, normally ahead of the market, were suddenly one step behind and unable to catch up given the actual system of supervision
  • It had become clear that new financial products ( e.g. CDOs, CDSs, subprime mortgages, swaps, swaptions) had been introduced without a good understanding of their financial construction or risk
  • Turbulence in the markets. Relatively stable stocks of big international firms, suddenly appeared remarkably unstable, due to new volatile markets/products and 'fair value accounting'.
  • The once so well controlled VaR risk exploded, due to these new types of risk in the market, the fair value accounting principles and the spooky systemic risk.

Way out

Like everyone else - totally flabbergasted - supervisors and regulators immediately grabbed the traditional emergency brake of 'more control'.

Unfortunately, more 'traditional' control in phase III will not have the same effect as in phase I or II. The effects of more traditional control in phase III will be:
  • Substantial but unsure decrease of ROE and 'upward potential'.
    The effects are not known upfront and can't be estimated well.
    Sure is that the costs of extra control and 'dead money' will have a negative impact on the ROE.

  • Unknown and questionable reduction of VaR risks, as one thing is sure: the new type(s) of (VaR) risks can not be estimated by our retrospective based models. Probably, all efforts in vain, the remaining actu(ari)al risk level will not be substantially reduced.

  • Trying to 'catch' more 'safe' risk levels (lower α , VaR) will lead to over-capitalization and 'dead' money in the balance sheet and an unbalanced growth of derivatives.

  • The market of derivatives continuous to grow.

    The notional value of derivatives held by U.S. commercial banks increased $804 billion in the third quarter to $204.3 trillion.

    This, despite the statements of Fed Chairman Bernanke who says he wants to avoid the possible risk of a future speculative bubble.

    And despite of Treasury Secretary Geithner who says he wants to reform financial regulation to avoid a future debt disaster.

  • Because the real issues of the financial crisis where not solved, but only covered up with government help (money), new uncontrollable 'bubbles' will keep showing up.

Solutions
probably the best solution is not 'more control', but

Other Control

Examples of 'other control' are:

  • Obligatory report and central registration of all derivatives under one worldwide supervisory. This way systemic risk analyses won't be 'guess statistics' anymore and can be managed. System risk is one of the weirdest risks to tackle, as is illustrated by the next article:

    Why Your Friends Have More Friends Than You Do

    Although the Exchange Commission has taken some serious steps in 2009 to regulate and strengthen the over-the-counter ("OTC") derivatives, this process will probably not be rigorous and fast enough to prevent a possible new bubble or collapse.
    All OTC market products should be asap standardized on a centrally administered basis.

  • Limit and control the derivatives market. Maximize the derivative market in respect to the 'normal' market. Limit each companies derivatives in line with his equity. New regulation should also be developed with regard to participating in non defensive (strange) derivatives (e.g. define max. exposure multipliers).
    If not the next bubble is a fact!

  • New derivatives should be subject to approval ('no objection') by the regulator before market launch.

So it all comes down to the 'right control' leverage.
It's either positive leverage with 'new other control' or negative leverage with 'more of the same traditional control' and waiting for the next bubble. What do you prefer as an actuary?

Sources:
- Contagion in Financial Networks
- Testimony Concerning OTCs (Over-the-Counter Derivatives )
- OCC’s Q3 2009 Report on Bank Trading and Derivatives Activities
- The bigger and riskier monster....
- Tarp facts: The Troubled Asset Relief Program
- The Investment Fallacy