With a level of wisdom for which he was rightly famous, John Keynes (famously!) concluded his General Theory with a paragraph which included the statement
Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.
And so it has proved to be. Many commentators on the financial crisis of 2007 to . . . well, to present, really, have attributed at least the following causes: (a) global macroeconomic imbalances and (b) mis-understanding of the nature of risk and the limitations of the commonly-used tools developed to manage it.
Clearly, the implications of the financial crisis fall most directly on the financial sectors, especially banking, bank regulation and central banking. But outside these sectors, what lessons can we draw and should we draw for management of risk from the financial crisis? And what about failures and crises outside financial services over the same period?
A key player throughout the financial crisis has been the CEO of Deutsche Bank and Chairman of the Board of Directors of the International Institute for Finance (IIF). Swiss-born and educated, Ackermann is also a visiting professor in finance at the London School of Economics. He has had a mixed crisis. At a conference in Frankfurt in September 2011, Ackermann warned that conditions could deteriorate again (and has been proved right). He said, rather tellingly:
We should resign ourselves to the fact that the ‘new normality’ is characterized by volatility and uncertainty.
In the two decades prior to the onset of the financial crisis in 2007, the banking world had made tremendous strides in its technical understanding and management of volatility. Among the best-known approaches evolved out of the market risk management practices of a US firm subsequently acquired by Deutsche Bank, four years before Ackermann became CEO in 2002. The Bankers’ Trust risk-adjusted return on capital or RAROC model led the way in terms of development of the relationship between market risk and capital and in metrics for the exposure of value to volatility (VaR, also developed simultaneously at JP Morgan and elsewhere). Over the following decade, these VaR metrics were applied almost universally across trading books and asset classes; capital was allocated on the basis of asset price volatility, regulatory minima, benefits of portfolio diversification and the firm’s adjustment for conservatism.
As the range of financial instruments available to manage traders’ and their clients’ risks expanded, so did both the knowledge required to assess risk and the data required to support historical analysis of volatility. Crucially, so too did the assumptions about the relationships between the feasible analysis (given the data constraints) and relevant bases for assessment of price volatility and risk. As the extent of over-the-counter instruments grew in some of the most complex classes, so did the backlog of cleared and settled trades. So did the complexity of the documentation and the paper trail required to assess the real risk of the instrument.
Throughout, despite the warnings about growing leverage in the system and the operational problems associated with OTC markets, the benefit was presumed to outweigh the risk. The benefit came in the form of market completeness – the assumption that ever-greater tradeability of risk allowed ever-improving allocation of that risk between market participants. All of which would be priced efficiently. The assumption, which was widespread throughout the US FRB system and among other central bankers and widely supported by academic economists, derived from the almost universal reach of macro-economic models built upon general equilibrium hypotheses of Gerard Debreu and Kenneth Arrow from the 1950s. However, the assumptions behind general equilibrium theory were highly particular and unrealistic and were never intended by their original formulators to be taken literally. But they were and very widely. An entire industry of financial modelling, forecasting and ‘engineering’ grew off the back of these standardized assumptions. The yawning gap between the unreality of the assumptions in the models and the reality of the markets in which they were being applied grew ever-wider. Many practical men became the slaves of these now-defunct economists, in Keynes phrase.
The failure of Lehman Brothers in September 2008, especially following earlier, successfully-managed bailouts orchestrated by the US Treasury, amplified the deepening crisis and changed, materially, its tenor. The crisis had begun perhaps as early as April 2007 with the failure of one of the largest US mortgage broking businesses, New Century Financial Corporation of CA, but had remained largely restricted to real-estate-based instruments and securities made up of bundles of property loans. However, if the US Treasury was going to allow a major and venerable institution such as Lehman Brothers to fail, who else may be affected?
The problem was that the operational constraints with the OTC derivatives and mortgage-backed securities (and other asset-backed securities) markets meant that determining ultimate ownership was a weeks-long exercise – optimistically. Suddenly, the structure of securities – issued by special interest vehicles divorced from the balance sheets of the parents whose imprimatur made selling them easy – became salient where previously it had been largely overlooked. Would parents of the SIV issuers stand behind the securities issued under their sub-brands? Some did, some did not.
Concerns about ultimate ownership levels of poorly-performing debt and written-down asset-backed securities led to a severe tightening of inter-bank liquidity to the point that, between 15 September and 13 October 2008, overnight money became prohibitively expensive. A wholesale funding market ‘run’ was the result – liquidity in the wholesale market evaporated.
The subsequent government bail-outs and extensive central bank liquidity expansion have averted, at least until now, a catastrophic global financial melt-down. But the levels of bail-outs required across financial institutions, combined with previous sovereign indebtedness have created series of sovereign debt crisis in the eurozone since the initial downgrades of Greece in December 2009. The financial crisis precipitated by the failure of securitized mortgage markets in the US and Europe has revealed structural weaknesses in the eurozone that have grown unmanageable since Germany and then France first violated the eurozone’s Stability & Growth Pact in 2003, followed by a succession of other countries thereafter. With the benefit of hindsight, the euro looks like a series of unintended consequences waiting to happen. But the problems were all foreseen. Among others, Milton Friedman was a strong opponent of the euro, writing presciently in private correspondence in 1999 to an Italian economist and former government minister:
What most troubles me as it does you is that members of the euro have thrown away the key. Once the euro physically replaces the separate currencies, how in the world do you get out? It’s a major crisis. . . . I think it would be very desirable for some systematic thought to be given to devising some way to get out of the strait-jacket of the euro after 2002. The least Italy should do is to keep intact the plates which are used to produce lira.
Many of the macroeconomic imbalances observed globally have also been at work within the eurozone since its inception. What is lacking is either an adjustment mechanism – with exchange rate eliminated – or a mechanism for fiscal discipline and micro-economic reform. These now seem increasingly likely to be achieved through federal mandate in Brussels. Considering the ‘democratic deficit’ this implies seems to be likely to be postponed in the rush to reduce the cost of sovereign debt among the affected countries. Yet again, sin in haste, repent at leisure.
Over the same period as the global financial crisis and eurozone crisis have emerged, the non-financial corporate sector has not been free from incident. Any number of events, crises or failures warrant attention but two stand out: BP’s loss of the Deepwater Horizon platform in the Macondo Prospect in April 2010 and the accident at Tokyo Electric Power Company’s Daiichi nuclear plant in Fukushima, Japan following the tsunami in March 2011. Both these incidents provide examples of the extent to which productive human endeavour requires risk and risks can combine in previously-unanticipated ways.
Nowhere has the nature of uncertainty been more visible than in the overthrows with varying degrees of violence of autocratic regimes in North Africa, in what has become known as the Arab Spring. The course of events and differences in western engagement between, say, Libya and Syria, illustrate very clearly the difficulties in attempting to learn singular lessons from different events and contexts, even within the same continent – from “conditions of things so strictly idiosyncratic,” in Hegel’s words.
So, what of Josef Ackermann’s statement: that the ‘new normality’ is characterized by volatility and uncertainty? The volatility assertion is empirically refutable but stands up to even cursory investigation; here, Ackermann is clearly correct. But what of the implicit claim of greater uncertainty? Given Ackermann’s position at the pinnacle of international finance, this claim is either lost in translation or suggests a worryingly slight understanding of the nature of uncertainty or, more simply, shorthand for what he really meant.
Assuming it is the final of these, presumably Ackermann meant that the ‘new normality’ is characterized by a greater awareness of uncertainty and a less benign operating conditions or more direct exposure and transmission paths between events and consequences/impacts across the firm’s assets (and, potentially, liabilities) and cash flows.
The distinction is an important one and goes to the heart of what the firm can and should do about uncertainty and volatility, as well as other aspects of ‘risk’ including complexity, ambiguity and ‘equivocality’. At any time, the future was and is inherently and irreducibly uncertain. The uncertainty has neither increased or decreased since 2007. What has changed is the level of confidence among executives – in both financial and corporate sectors – that tomorrow will closely resemble yesterday, and also the extent of exposure of firms’ assets and cash-flows to that uncertainty and its reverberating consequences in markets and for consumers.
This implies the need for a different approach to management of risk from that prevailing prior to the financial crisis. While some attempts at adaptation can be observed from the financial services industry, few such signs are available outside financial services. A summary of findings from 2011 by the UK FRC of the role of corporate boards in the management of risk linked to its review of the Combined Code found that the salience of risk had increased at board level. But there was no expression of the need to learn the lessons for management of risk that have emerged from the financial crisis or that risk management may be, in some systematic way, ineffective, as it was in the financial services sector prior to the crisis.
This matters. In order to achieve the corporate performance needed to sustain current levels of wealth and consumption over the next, say, fifty years, we need to get materially better at taking and managing risk. Managing risk within our core areas of strategic focus and operations must become a core competency. The financial crisis, the eurozone crisis, as well as a host of other entity-level crises and key global risks present us with both the need to improve risk management effectiveness and performance and the opportunity to learn how to do so.
The starting point must be risk management practice at entity level. Excluding market and credit risk, financial institutions and other corporate entities alike must address the changing understanding of risk exposure, setting of risk tolerances and preferences, effectiveness of risk response and the appropriate contribution of a risk management function within the firm. In financial institutions and other corporate entities alike, risk practice must reject the myths and self-delusions exposed by the financial crisis and adapt to the changes highlighted by the financial crisis and other crises and failures. Risk managers from all sectors must ensure they do not believe they have conquered risk, as did many risk managers in the financial sector in 2006. There is much still to do.
Our course, Risk: what’s changed and why it matters, addresses these issues and what firms need to do to ensure they learn the lessons of the financial crisis and other crisis and failures. Sub-titled “Lessons from reality”, it looks at the practical steps firms can and should take to ensure their risk management is fit for purpose when so many firms have been shown to have failed to understand or to manage properly their real risk exposures. Aimed at all levels of experience and with examples from a range of sectors, the course is available in London, Manchester, Edinburgh, Dublin, Geneva and Amsterdam in late June and early July 2012. Click here to find out more or to book you place.