TAKE-AWAY MESSAGES

Chamber of Commerce of the State of NYPascal vander Straeten

November 5th 2016 – New York

Toolkit: Anti-tail risk defense

What tail risk management IS NOT:

Tail Risk Management is NOT:• Traditional risk management• Enterprise risk management• Capital management• Threat centric• Basel III (Dodd-Frank, CRDIV, etc.)• Hedging strategy• Prediction tool• Based on probability theory• Designed to protect revenue opportunities

What tail risk management IS:

• Just-in-case risk management• Part of Strategic risk management• Building resiliency• Helping Build a sustainable model• Preserve the firm's survivability• Relating to unknown scenarios• Incentivizing redundancy• Uncertainty management

Risk mapping, early warning, reverse stress testing, scenario planning

What is needed is a distinct prism with its own objective parameters for effective tail risk management to protect institutions from becoming casualties in crises. This can be done by turning to the following concepts (some of which (*) have their applications in the manufacturing world), such as:• risk mapping• early warning system• loss, threat & vulnerability assessment (*)• supply chain risk management (*)• scenario planning• reverse stress testing• financial continuity planning• high reliability organizations (*)• sustainable business modelRisk managers need to shift from a threat-centric approach to one that emphasizes resilience. The rash of catastrophic events from 9/11 to the 2008 financial crisis to Hurricane Katrina and Superstorm Sandy - not to mention the onset of cyber risk - have perceptibly disabused risk managers of the notion that the purpose of risk management is to eliminate risk.

Financial continuity planning

• Many financial firms are aware of the Business Continuity Planning (BCP) in relation to operational risk, but oddly enough no BCP exists for financial risk (despite the existence of living will, regulatory requirements for stress testing, and liquidity adequacy rules). Hence, the need to build a Financial Continuity Planning (FCP).

• Instead of invoking a response to a natural or man-made event, the FCP will invoke when a legal entity or institution has a partial or complete financial failure. And, while BCP are focused on the critical resources required to run the business at a business process level, FCPs are focused on critical resources at a legal business entity level.

• Financial Continuity Planning is an essential step in building a robust tail risk management architecture. But, as already mentioned in several previous articles, the key for such a framework is to have a FCP in conjunction with a risk mapping, an early warning system, and (reverse) stress testing tools.

Big Data and tail risk management• The trick - again - is to approach Big Data Analytics with caution. It is not that data cannot

help us anticipate the future. It can. Just ask the City of Chicago, which has a very successful predictive analytics platform used to anticipate crime and health trends, among other things. But there is a reason most enterprises still use Big Data technologies like Hadoop to solve old problems like ETL, rather than analytics.

• We are still early in Big Data, and enterprises rightly suspect that Big Data is not some magic pixie dust that immediately yields insights into how much to charge, where to market, etc. Big Data can help, but it's not The Answer. And it's certainly not the answer to predicting Black Swan events; to do that, you don not need data - you need hindsight.

• As I have already explained in several previous articles, such events as Black Swans are impossible to predict per se, so the only approach is to build robust models to mitigate the effects of the negative ones and to use the positive ones to their fullest potential.

• Yes, Big Data Analytics is an interesting and useful tool for a researcher dealing with a large amount of data, provided that the said researcher also has a keen ornithological eye that knows how to properly see findings coming from Tea Leaf readings.

Supply chain risk management• the risk management of disruptive events is partially covered by operational risk management. Indeed,

operational risk can be created by a wide range of different external events ranging from power failures to floods or earthquakes to terrorist attacks. Similarly, operational risk can arise due to internal events such as the potential for failures or inadequacies in any of the bank’s processes and systems (e.g. its IT, risk management or human resources management processes and systems), or those of its outsourced service providers.

• Operational risk arising from human resources management may refer to a range of issues such as mismanaged or poorly trained employees; the potential of employees for negligence, willful misconduct; conflict of interests; fraud; rogue trading; and so on. Therefore the emergence of mistrust, failure to communicate, low morale and cynicism among staff members, as well as increased turnover of staff, should be regarded as indicative for potential increase in operational risk.

• However, financial events are not covered by operational risk management, such as a market crash, the spill-over effects of the bankruptcy of a systemically important financial institution, the impact of a Grexit and/or Brexit, a very hard landing of the Chinese economy, a military confrontation between the West and Russia in central Europe, the take-over of Saudi Arabia by ISIS, an escalating conflict between China and the Philippines, etc. All these events will in one way or the other from a supply chain management perspective also disrupt the provisions of financial services to the end-customer.

• Therefore, it is highly useful to map the process that allows a description of the front-to-back process in relation to payments, lending, investments, etc., and look at how a disruption would impact one of the nodes alongside the supply chain for each of those financial activities, and how long it would take for the system to recover its senses, ie. re-conduct the business as a going concern to the benefit of the customers.

Mutualizing resources with Finance

Sustainable business model

• there is a need for a crucial shift in regulatory as well as risk management philosophy which looks at systemic risks and the sustainability of business models rather than assuming that all risk can be identified and managed at the level of the individual firm.

• Sadly, however, all of these proposed solutions are incomplete as they emphasise the mechanics and not the people. The 18 high profile risk management crises analysed in the “Roads to Ruin” report were classified as being caused by poor board leadership, a limited field of vision in identifying risks, poor communication, inappropriate incentives and a glass ceiling that prevents risk managers from being heard at the highest level in an organization.

• So, how do cope with this false of certainty? The answer is simple: We should try to create institutions that won’t fall apart when we encounter black swans.

• To create strong institutions, the focus needs to shift from event definition to damage definition, or to a damage-centric approach. By addressing maximum potential damage, or extreme-tail risk, regardless of the event that causes damage, banks can ensure they will not fall apart in crises. This is not easy today, as there is no damage-centric metric for extreme risk. Bear Stearns and Lehman didn’t just have too much extreme-tail risk; they also didn’t know how close to the precipice they were operating. Such a metric is needed to address extreme-tail risk from Unknown-Unknowns.

Geofinance

• geopolitics in combination with finance remain both strong determinants of future actions.

• Tail risks in relation to geofinance is a hot topic.• That’s my attention-grabbing opening. The tandem "tail-risks-

plus-geofinance" is really, really hot today. It’s important to be provocative in publishing.

• But, tail risks and geofinance are also really complicated. By asset-type, by industry, by risk type, by business, by region, and by just about every other metric, tail risks keep getting more and more complicated when put into relation to geofinance. Tail risks combined with geofinance are now both really hot and really complicated – not unlike, say, riding a bicycle.

• Spotting future financial-industrial-trading markets trends and political events can be difficult to quantify, particularly fat tail events. But without any doubt they count. Market participants today cannot afford to step into the world without having made sense of phenomena that might not express themselves in numbers.

• In the years following the end of the Cold War, market participants focused primarily on 'normalized' macroeconomic trends when attempting to determine financial market outcomes. Black swan market events and even geofinancial & country risks were treated as an afterthought, a mere blip on the radar screen.

• And even prior to the Eurozone crisis no one had predicted that the countries of South Europe would fall into financial disarray. Most companies, whether be it financial institutions, corporates or government agencies did not allocate meaningful resources to fat tail risk management and lack the vision to adopt a holistic approach which would embed for instance country & geopolitical risk into an investment and lending process.

• Now, however, geopolitics and country risks are a much more potent force that can undermine global financial markets — not only can fat tail events shape the economic environment and fundamental investment outlook, driving economic growth and asset returns, they can potentially blindside an investment portfolio.

• Geofinancial and country risks refer for instance to fat tail events, or in other words low-probability, high-impact events. They are the proverbial "bolts out of the blue" and are unpredictable and highly uncertain. The 9/11 terrorists attacks and the global credit crunch took nearly everyone by surprise.

• So a “fat tail” is industry shorthand for a fat-tailed distribution, a probability distribution which exhibits extremely large “skewness,” meaning there are a number, sometimes a large number, of data that lie outside a normal distribution pattern. Tails can be skewed negatively (very low prices to the left of normal) or positively (extremely high prices to the right).

• In this environment, understanding fat tail geofinancial risk is important to determining outcomes for the economy and financial markets. The type of geofinancial event can determine how financial markets behave and whether the reaction is temporary or sustained, localized or global. But since probability, causality, timing, magnitude and impact are difficult to assess, market participants rarely give geofinance the full attention it deserves.

• All of this points out that risk managers are usually aware that fat tails exist, and they are familiar with the power laws that reveal themselves through statistical modelling. However, having no other rational way to model the effects of tails, to say nothing about hedge against them, they ignore them when modelling risks and hedge performance. By extension, risk controls are often inadequate.

• Fat tail risks should be understood as a type of risk that interacts with other sources of risk in a business or investment portfolio. A negative event will tend to increase the risk premium and alter the direction of (business) asset prices. One that depresses economic growth and changes the course of inflation is likely to have a sustained effect. Meanwhile, the direction of the impact will depend on the asset in question, and the magnitude will depend on the severity and resolution of the incident.

• The key to assessing the investment implications of fat tail risks lies in understanding how it affects the main drivers of a company's investment returns. Fortunately, the same variables that are relevant in any generic investment context are relevant here.

• Investors and entrepreneurs need to remain aware of the critical and ever changing geofinancial landscape, understand how these shocks can impact various assets within a portfolio and regard geopolitics as central to the investment decision, rather than simply as an afterthought. My company, Value4Risk, believes that investors are better served by following a more pragmatic approach based on diversification across countries and assets, fat tail hedging, ongoing risk assessment, actively managing exposure and tactical investing.

Tail risks for 2016

Tail risks below the radar

• Euro debt crisis• US QE wind down and interest rate hike• Cold war 2.0 w/ Russia• Oil price slump & impact on US oil industry• Middle East and nuclear arms race• Middle East – redrawing of maps (Syria, Iraq, Yemen, Libya,

Lebanon)• China – hard landing• Japan – refinancing risk• Emerging markets currency crisis• Confrontation w/ China in South China Sea and East China Sea

Last but not least: Senior leadership still does not get it, so spread the word

• senior leadership still does not get it, as financial firms - despite recent regulatory rules (Dodd-Frank, EMIR, Basel III)) - continue to operate only in the context of known risks that can be priced.

• However, uncertainty management needs to focus beyond the pricing of risk as actual results are also determined by how unknown events and market conditions can unfold. And, in extreme scenarios, unexpected losses can exceed the capital, and thus threaten the survival of the institution. Therefore, tail risk management's objective must have as a goal to leverage resources to mitigate and absorb unexpected losses in such a way that the capital (firm) is always (to the best of its ability) protected and preserved.

• Enthralled by new revenue opportunities, the industry, over the last 25 years, has been focussing on what quants and models could do at the expense of realizing what they couldn't do (cf. there has always been a tendency since the 80s to attempt transforming economics into an exact science while it will always remain a social science). And, in the frenzy to drive revenue models, the downside was so totally eclipsed by the upside that institutions, rating agencies, and regulators neglected to focus on or even ask about the downside. The so-called sophistication of these quant models have blinded people from remembering what models can and can't do. In many cases, people could not even comprehend these limitations. Models often are meant to convey one thing through "resemblance," but due to the lack of an understanding of the full picture, their meaning can become something else.

• Interestingly, the answer to sophistication and complexity is de facto simplicity. Risk management is based upon the theory of probability and thus has an implied assumption that events can be predicted. Therefore effective decision-making that relies on data mining, such as today in risk management, requires turning complexities into simpler inputs. And even with modern quant models that pretend to have an ability to predict all events up to 99% or higher probabilities, at the end of the day they are always relying on assumptions. While unknown uncertainty cannot be quantified, it can be effectively managed through a priori contrarian approach/ process as applying complex decision rules in a complex environment is a recipe for disaster.

• unfortunately, existing regulatory developments (Basel III, EMIR, Dodd-Frank) are no real impetus for safeguards against extreme financial events. Meeting regulatory requirements does not equal managing extreme tail risk adequately, and senior leadership - for the sake of preserving the interests of the various stakeholders - should think beyond what is legally required from them. Bottom line, tail risk management is about spelling out needed counteractions if there is a disruption of operations regardless of the cause of the interruption. Tail risk management must go beyond going concern objectives; it's about survival. Now, granted, measures like living well, higher capital adequacy and liquidity constraints do improve the survivability of the firm, but they do not prepare the firm in the event of extreme financial volatility.

• banking has been around for many centuries, and unfortunately there have been bank failures before. But except for cases of financial misconduct or fraud, these bank failures have always been caused by problems with tail risks, being the culprit. In today's world, financial institutions derive a much larger proportion of their revenues from market risk instead of from credit policies, thereby changing the magnitude and severity of tail risks, particularly as on the one hand risks can be today transferred through securitization and CDS for instance, and/or on the other hand the world has become much more interconnected and global. With this in mind, market risk policies also need the robustness and objectivity of credit policies as a way to shield the firm from extreme financial market risks