Faced with Philip Booth’s free market fanaticism, I’d rather be Frank

07. October 2013 · Write a comment · Categories: Economics, Regulation, Risk

This was a letter sent to The Actuary on 12 September, but which they chose to publish neither in the magazine nor on the website.

Dear Sir

In response to the interview with Philip Booth in the September issue, I would just like to point out that the banks did not know during the 2007 financial crisis that they would be bailed out. The day before Alistair Darling announced a £500 billion rescue package in October 2008, shares in RBS fell by almost 40 per cent to a 15-year low, HBOS fell by over 40 per cent, Lloyds TSB dropped by 13 per cent and Barclays by 9 per cent precisely because a bailout was not assumed.

As regards how prudently financial institutions behaved before the changes in insurance regulation in the 1970s and 1980s, I would prefer to listen to the views of someone who was actually there. Frank Redington, in his submission to the Institute of Actuaries in 1981 entitled The Flock and the Sheep and Other Essays, says:

“We have no means now of telling how the profession would have emerged from what would have been the only real test of its collective character which it has had to endure in the last 100 years. When the curtain fell in 1939 the profession was not cutting a very brave figure. Valuation bases were too weak, the rate of bonus was some £5 too high and new business was being sold on prospects which were not achieved until 18 years later. A few reputable offices had their backs to the wall.

“The outcome, if the war had not interrupted the story, would probably have taught us a valuable lesson. As it is we have to conclude regretfully that the profession had not – and, I am sure, has not – learned how to live with its salemen’s promises. To put it another way, we are driving a powerful car but have not yet proved our ability to handle the brakes.”

Regulation was inevitable. The problem which remains is that financial institutions in many cases are too complicated in their current form to regulate effectively. As Robert Reich, former US Secretary of Labor, puts it when arguing for the need to split Wall Street banks, they are “too big to fail, too big to jail, too big to curtail”!

Yours faithfully
Nick Foster

Land mines and bank bailouts

28. August 2013 · Write a comment · Categories: Cartoons, Economics, Prediction, Regulation, Risk

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A man is sentenced to 7 years in prison for selling bomb detectors which had no hope of detecting bombs. The contrast with the fate of those who have continued to sell complex mathematical models to both large financial institutions and their regulators over 20 years, which have no hope of protecting them from massive losses at the precise point when they are required, is illuminating.

The devices made by Gary Bolton were simply boxes with handles and antennae. The “black boxes” used by banks and insurers to determine their worst loss in a 1 in 200 probability scenario (the Value at Risk or “VaR” approach) are instead filled with mathematical models primed with rather a lot of assumptions.

The prosecution said Gary Bolton sold his boxes for up to £10,000 each, claiming they could detect explosives. Towers Watson’s RiskAgility (the dominant model in the UK insurance market) by contrast is difficult to price, as it is “bespoke” for each client. However, according to Insurance ERM magazine in October 2011, for Igloo, their other financial modelling platform, “software solutions range from £50,000 to £500,000 but there is no upper limit as you can keep adding to your solution”.

Gary Bolton’s prosecutors claimed that “soldiers, police officers, customs officers and many others put their trust in a device which worked no better than random chance”. Similar things could be said about bankers during 2008 about a device which worked worse the further the financial variables being modelled strayed from the normal distribution.

As he passed sentence, Judge Richard Hone QC described the equipment as “useless” and “dross” and said Bolton had damaged the reputation of British trade abroad. By contrast, despite a brief consideration of alternatives to the VaR approach by the Basel Committee on Banking Supervision in 2012, it remains firmly in place as the statutory measure of solvency for both banks and insurers.

The court was told Bolton knew the devices – which were also alleged to be able to detect drugs, tobacco, ivory and cash – did not work, but continued to supply them to be sold to overseas businesses. In Value at Risk: Any Lessons from the Crash of Long-Term Capital Management (LTCM)? Mete Feridun of Loughborough University in Spring 2005 set out to analyse the failure of the Long Term Capital Management (LTCM) hedge fund in 1998 from a risk management perspective, aiming at deriving implications for the managers of financial institutions and for the regulating authorities. This study concluded that the LTCM’s failure could be attributed primarily to its VaR system, which failed to estimate the fund’s potential risk exposure correctly. Many other studies agreed.

“You were determined to bolster the illusion that the devices worked and you knew there was a spurious science to produce that end,” Judge Hone said to Bolton. This brings to mind the actions of Philippe Jorion, Professor of Finance at the Graduate School of Management at the University of California at Irvine, who, by the winter of 2009 was already proclaiming that “VaR itself was not the culprit, however. Rather it was the way this risk management tool was employed.” He also helpfully pointed out that LTCM were very profitable in 2005 and 2006. He and others have been muddying the waters ever since.

“They had a random detection rate. They were useless.” concluded Judge Hone. Whereas VaR had a protective effect only within what were regarded as “possible” market environments, ie something similar to what had been seen before during relatively calm market conditions. In fact, VaR became less helpful the more people adopted it, as everyone using it ended up with similar trading positions, which they then attempted to exit at the same time. This meant that buyers could not be found when they were needed and the positions of the hapless VaR customers tanked even further.

Gary Bolton’s jurors concluded that, if you sell people a box that tells them they are safe when they are not, it is morally reprehensible. I think I agree with them.

Risky business

19. August 2013 · Write a comment · Categories: Risk

I think if I were to ask you what you thought the best way to manage risk was, there would be a significant risk that you would give me a very boring answer. I imagine it would involve complicated mathematical valuation systems, stochastic models and spreadsheets, lots of spreadsheets, risk indicators, traffic light arrangements, risk registers. If you work for an insurance company, particularly on the actuarial side, it would be very quantified, with calculations of the reserves required to meet “1 in 200 year” risks featuring heavily. Recently even operational risk is increasingly being approached from a more quantifiable angle, with Big Data being collected across many users to pool and estimate risk probabilities.

Now you can argue about these approaches, and particularly about the Value at Risk (VaR) tool which has brought this 1 in 200 probability over the next year into nearly every risk calculation carried out in the financial sector, and the Gaussian copula which allows you to take advantage of a correlation matrix to take credit for the “fact” that combinations of very bad things happening are vanishingly rare (the “Gaussian” referring to the normal distribution that makes events more than three standard deviations or “sigma” away from the average vanishingly rare), rather than actually quite likely once the market environment gets bleak enough. The losses at Fortis and AIG 2008 were over 5 and 16 sigma above their averages respectively.

The news last week that the US Attorney for the Southern District of New York had charged two JP Morgan traders with fraud in connection with the recent $6.2 billion “London whale” trading losses reminded me that VaR as it is currently used was largely cooked up at JP Morgan in the early 90s. VaR is now inescapable in the financial industry, having now effectively been baked into both the Basel 2 regulatory structure for banks and Solvency 2 for insurers.

The common approaches to so-called “quantifiable” risk may have their critics, but at least they are being widely discussed (the famous debate from 1997 between Phillippe Jorion and Nassim Nicholas Taleb just one such discussion). However, one of the other big problems with risk management is that we rarely get off the above “boring” topics, and people who don’t get the maths often think therefore that risk management is difficult to understand. In my view we should be talking much more about what companies are famous for (because this is also where their vulnerability lies) and the small number of key people they totally rely on (not all of whom they may even be aware of).

If you asked most financial firms what they were famous for, I imagine that having a good reputation as a company that can be trusted with your money would score pretty highly.

A recent survey of the impact of the loss of reputation amongst financial services companies on Wall Street revealed that 44% of them lost 5% or more in business in the past 12 months due to ongoing reputation and customer satisfaction issues. Losses based on total sales of these companies are estimated at hundreds of millions of dollars. There was an average loss of 9% of business among all companies surveyed.

And the key people we totally rely on? Well, just looking at the top five rogue traders (before the London Whale), we have:

1. SocGen losing 4.9 billion Euros in 2008 when Jerome Kerviel was found guilty of breach of trust, forgery and unauthorized use of the bank’s computers in their Paris office with respect to European Stock Index futures.
2. Sumitomo Corp losing $2.6 billion in 1996 when Yasuo Hamanaka made unauthorised trades while controlling 5% of the world’s copper market from Tokyo.
3. UBS losing $2.3 billion in 2011 when Kweku Adoboli was found guilty of abusing his position as an equity trade support analyst in London with unauthorised futures trading.
4. Barings Bank losing $1.3 billion in 1995 when Nick Leeson made unauthorised speculative trades (specifically in Nikkei Index futures) as a derivatives broker also in London.
5. Resona Holdings losing $1.1 billion in 1995 when Toshihide Iguchi made 30,000 unauthorized trades over a period of 11 years beginning in 1984 in US Treasury bonds in Osaka and New York.

None of these traders will, of course, have done anything for the reputations of their respective organisations either.

These are risks that can’t be managed by just throwing money at them or constructing complicated mathematical models. Managing them effectively requires intimate knowledge of your customers and what is most important in your relationship with them, who your key people are (not necessarily the most senior, Jerome Kerviel was only a junior trader at his bank) and what they are up to on a daily basis, ie what has always been understood as good business management.

And that doesn’t involve any boring mathematics at all.

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