Risk management, modelling and culture - Palisade Corporation

FrankAshefrank@quantstrat.com.au

Risk management, modelling and culture

Oh what a tangled webwe weave!

SummaryRisk analysis and management does not occur in a vacuum within an organisation -it is conducted in the milieu of that organisation's culture.This culture determines the way in which the modelling task is perceived by both the modeller and the end user of the modelling results. Perceptions differ, and this talk discusses why this difference can occur, how to mitigate the riskthat arises, and some ideas on creating a better culture.Case studies will be given from the presenter's experience, the Global Financial Crisis and Public/Private Partnerships.

OutlinePerception

How do you and I notice things

CultureHow do we notice thingsWhat we do with things

ModellingHandling complex things

Risk ManagementHandling dangerous things

PerceptionHow do you and I notice things?Perception is noticing

Perception (ii)An individual’s perception is based on their past experience of a similar event, situation or activity;People focus or pay attention to, different components (information) of the same situation;Individuals have the ability to only process a limited number of facts and pieces of information at a time in order to make a judgment or decision concerning a certain activity, event, or situation;

Perception (iii)In general, it’s human nature to organize information so we can make sense of it

We have a tendency to make new stimuli match with what we already understand and know about our environment

Perception (iv)A stimulus (impulse) that is not received by an individual person has no influence (effect) on their behavior while, the stimulus they believe to be authentic, even though factually inaccurate or unreal, will affect it;Perception is the process by which each individual senses reality and arrives at a specific understanding, opinion, or viewpoint;

Perception (v)What an individual believes he or she perceives may not truly exist;A person’s behavior is based on their perception of what reality is, not necessarily on reality itself; andPerception is an active process of decision making, which results in different people having rather different, even opposing, views of the same event, situation or activity.

Ricciardi (2004) A Risk Perception Primer: A Narrative Research Review of the Risk Perception Literature in Behavioral Accounting and Behavioral Finance

CultureWhat is culture?How do we perceive things?What we do with things

CultureThe way we do things 'round here

Too simple, but effective

Beware of The Fallacy of CompositionOrganisations are different from the sum of the individuals

Culture governs what is perceived at an organisational level

What does a company respond to?Speed of perception and speed of response

What does a company actively look for?What does a company believe is out there?

Culture and perceptionGiven a particular culture, are some things difficult to perceive?Can some things not be talked about?Are certain ideas not believed?

ModellingHow to handle complex things

Thousands of models built into our perception systems by evolution – see optical illusions

Organisations build models of complex systems so they can think about them and act

Inputs, outputs and assumptions are determined by the cultureSo are techniques!

ModellingA culture is not homogeneousDoes the user of the model share the knowledge and beliefs of the creator?

How do you know?

Your own mind isn’t coherent, so how do you expect your organisation to be!

Risk psychologyBeware of:

Overoptimism – profit opportunities overestimated

Overconfidence – bad things won’t happen

Ambiguity aversion – avoid thinking about big uncertainties (disgust)

Availability bias – concentrate on things that are top of mind

Action bias – it’s better if we do something

Risk modelling and managementDictum

If you can’t measure it, you can’t manage it

WRONG !What was Societe Generale’s estimate of losses from a rogue trader?

Don’t need to measure this risk to manage it

OveroptimismInputs too good

Averages too highStandard deviations too lowLow probability of extreme events

Interpretation of outputs to fit beliefsIgnoring negative outcomes

OverconfidenceObjectively low probabilities are made subjectively lower (1% = never)Assume you can handle negative outcomes easilyNegative outcomes are a problem with the model

Ambiguity aversionStochastic vs unknownProcessed by different brain centres

What happens in an organisation?Initiative vs procedure

Is ambiguity avoided by a culture?“I don’t care if the model’s wrong, give me numbers so I can make a decision”

Don’t think about itIgnore it or defer it

Availability biasMore notice taken of easily available things

Model using more recent dataPast events associated with high emotionModelling using easily available data

Easy to assume it’s relevant

Action biasWe must do something!Modelling biased towards an actionInterpret the models to justify actionThe effort of modelling may be seen to be wasted if action is not taken.Modelled = understood

Ambiguity aversion reduced

MitigationNothing new here, move along….

Tone set by the topOpennessCommunicationIndependent evaluation and review

No! This does not mean your usual consultants

Tone set by the top (repeat as necessary)