by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

Leonardo da Vinci was perhaps the last of the polymaths - a man of many intellectual talents in a wide diversity of fields.  It is interesting to think what he would have thought of risk management as a profession if he were alive today.  It is perhaps even more interesting to ponder what the risk management profession would have thought of him.  He was very good in a wide variety of areas, but it is difficult to say exactly what he was a specific expert in.  da Vinci was a true polymath and a true lateral thinker.  It is an interesting thought experiment to ask how many risk departments would have hired him – after all, he did not have a degree in financial engineering.

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

My favorite is old-fashioned chocolate dipped cake donuts.  Unfortunately, and although I live in Canada – home of the most donut shops per capita – it is hard to find my favorite donut.  However this blog is not about the tempting afternoon coffee snack, but instead about the hole in the middle.

Most companies have professionals that are intuitively very good risk managers at the “ground level”.  These are front line operators and managers, who although they do not have risk manager in their title or their job description, intuitively and instinctively understand risk management as they go about their daily tasks and operations.

Most companies also have very competent risk managers.  These are the managers who do have risk manager in their title and risk management in their job description.  These are the people who design risk management systems and processes for the company.

Thus a company has great risk management at the ground level, and also has great risk management at the upper levels.  The problem is often is the hole in the middle.  The hole in the middle is the lack of a connection between front line workers who understand the tasks and associated risks at hand (but not the strategic risk issues), and risk managers who understand the strategic risk issues and the associated portfolio mathematics (but not the ground level day to day operational issues).  A company needs to ensure this hole in the middle is filled efficiently.

Meanwhile, writing this blog has made me want a donut.  Perhaps I will get a jelly filled donut if they are out of old-fashioned chocolate cake donuts.

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

French and Greek voters are rejecting austerity, forcing politicians to take the austerity debate seriously.  Voters are correct in that it is a bad idea to tighten fiscal policy when growth is so feeble as argued by Charles Wyplosz in recent VOXEU communique (14th May) The impossible hope to an end of austerity.  However, the road away from austerity is blocked by conventional policy views that debt reduction has the highest priority – often used to justify risk taking without considering potential implications.  

Evidence from Greece and elsewhere is that growth is disappointing and the debt-to-GDP decline is negative and deficits are “surprisingly resistant”.  The problem is that most policies take time to work, such as structural reforms that may take several years and do not provide prompt relief. 

It is a poor idea to tighten fiscal policy when growth is feeble or negative.  The results from budget consolidation are disappointing as the levels of gross public debt remain above earlier estimates and in some countries have increased.  European voters do not feel that the economic and personal costs have produced any significant results.  The case for fiscal consolidation remains weak when countercyclical action is required.  

Monetary policy has some importance as lower rates are needed, but with rates near zero any effect would be largely symbolic.  The results from quantitative easing have yet to prove its effectiveness as banks’ focus is on deleveraging.  The recent ECB liquidity facility seems largely used by banks to hoard cash rather than make new loans.  

Fiscal expansion remain a weak option as a number of countries have lost market access or on the verge of losing it.  Financial markets continue to clamor for growth and no austerity, but do not want to provide financing at attractive rates for growth.  Even if countries can borrow at attractive rates, can they serve as a locomotive role for growth?   

Wyplosz offers several ideas around the policy debate to provide some stimulus: 1) The European Investment Bank (EIB) could borrow and finance spending without adding to the members’ public debt burden; 2) The European Commission could speed up spending on infrastructure to produce some stimulus; 3) Eurobonds could be issued and collectively underwritten by member states; 4) The bonds could be made senior to existing bonds: and 5) The debt of some countries could be restructured.  The author concludes that all the policies combined would not be enough of a stimulus.  

The problem is holding governments to infeasible debt reductions for a couple of years that will take decades to resolve.  Otherwise, voters will continue the protest and the austerity debate will remain a “hot” political issue.  As in risk management, conventional wisdom does not always provide the best answer.   

For more on this follow the link: www.voxeu.org/index.php?q=node/7988

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

This past Monday was Victoria Day – a holiday in Canada, but ironically not a holiday in Britain.  Victoria Day of course celebrates Queen Victoria – a queen that no one currently living remembers, and a Queen who ruled over the Victorian era.

Victoria Day is a welcomed holiday in Canada.  It basically marks the first reliable weekend of decent weather and thus it is a weekend for the first tennis tournaments of the season, races, baseball tryouts etc.   In Canada we all like the Victoria Day Holiday.

However, there is one thing about Victoria Day that bothers Canadians and it comes up every year.  That issue is, “Why the heck do we celebrate this monarch who no one really remembers and what exactly did this monarch do for Canada that is worthy of celebrating?”  Now before the monarchists send me angry letters, I am highly confident that there are many legitimate reasons for this holiday, but the point is very few people know why we do.

It is a bit like many risk management systems and procedures.  There may (or may not) have been legitimate reasons for why they were put in place originally, but few people now know or understand why.  Other systems and procedures have been in place for so long that no one questions why they exist.  Perhaps it is a good time to ask some questions and see if things need to be freshened-up.

In the meantime, I am going to enjoy the beautiful weather we have on this holiday Monday.

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

Bankers, policymakers and regulators continue to debate on the content of new bank capital requirements rather than setting global standards.  In the view of recent losses by JP Morgan and recent research reports calling for more bank capital, the need for global harmonization of standards takes on a new sense of urgency.

Nicholas Veron, in a recent VOXEU communique of May 4^th, The European Debate on Bank Capital is Not Just About Europe looks at the European experience.  European officials are deciding on the legislation to implement Basel III agreement on bank capital, leverage, liquidity and risk management. 

Officials, however, have severely underestimated the importance for reaching a global standard for financial regulation.  There are two unresolved issues in Europe: (1) the legislation’s departure from Basel III provisions; and (2) whether member states would be allowed to impose their own core requirements in regards to bank capital ratios. 

The first issue exists for both Europe and globally since it is about the definition of bank capital and how it should be applied to subsidiaries.  EU institutions regard global harmonization as overriding good, superseding misgivings about individual provisions or national authority.  Although, EU banking regulations are done at the national level and are not standardized creating a problem to see what is “liked” or “disliked”.  This makes the regulations vulnerable to special-interest groups. 

The crisis has changed the dynamics between the EU and global standards.  Institutions are now focused more on content than global harmonization.  This is complicated by a lack of a consistent approach by EU policymakers and the U.S. SEC’s delay in endorsing the proposed implementation schedule for global financial reform.  An American proposal that is compliant with Basel III would encourage EU and other doubters to comply. 

Global harmonization would help minimize competitive distortions inside the EU.  The main problem specific to the EU is that banking services remain under national authorities.  This results in a lack of a unified approach to bank supervision/resolution and pegs banks financial health to national authorities.  A more timely U.S. response combined with a unified EU approach could help reduce risk.

Although, Basel III requirements do not resolve all financial regulatory issues, a global harmonization of regulatory standards would be far better than our current fragmented system.  Perhaps the losses by JP Morgan Chase might force regulators to focus on implementation of a global standard.  The alternative of a fragmented regulatory environment could be costly.

For more on this simply follow the link: http://www.voxeu.org/index.php?q=node/7948

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

So your company operates only domestically and you are satisfied that all its purchases and sales are in the domestic currency.  No need then to spend any more time thinking about exchange rate volatility.  Are you sure?  How about your major suppliers?  Or your major customers?  Their currency exposures could affect you greatly. 

If your supplier gets a lot of inputs from abroad, he may be forced to jack up his prices to you if the domestic currency weakens.  Or if you sell inputs to a major customer who sells much of his product abroad, you are vulnerable to him passing on some or all of his currency exposures to you.  And of course, if your currency strengthens, you may suddenly be hit by a flood of cheap imports competing with your products.

So are your risk systems geared up to look at the bigger picture?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

The recent losses by JP Morgan Chase on their hedging portfolio again raise questions about the use of derivatives and the risk profile they may create.  While we do not know the exact strategy they implemented, the positions they were hedging, or the risk profile created by the derivatives, it does raise questions about the use of complex derivatives and their risk management.

One place to look at the application of complex derivative strategies in their impact upon hedge funds and their potential benefit to investors.  A recent working paper by Jarkko Peltomaki called Do Investors Really Need Complex Derivative Strategies? The author investigates the benefits of using a more complex derivative strategy in relation to their performance and risk characteristics from a sample of hedge funds and funds of hedge funds.  The results of the study suggest that the use of a complex derivative strategy may increase the probability of suffering large losses and expose investors to weaker performance.

Earlier studies suggest that with mutual funds, the use of derivatives does not improve fund performance.  In this study, the use of a complex derivative strategy may actually have a negative impact on the performance of hedge funds.  However, there was a negative relationship between complex derivative strategies and performance of funds of funds.  This suggests that a good risk management system may prove a benefit to investors.

The author suggests that derivative strategies employed by hedge funds may be related to “hidden risks” due to larger tail distribution of returns.  This risk is more difficult to find in funds of funds since the use of derivatives has the opposite effect to that of complexity.  It may be the use of complexity and not just the use of derivatives which is associated with hidden risk in the returns of funds of funds.

Peltomaki notes that there is a difference in the origin of hidden risks between hedge funds and fund of funds.  For hedge funds, the risk is hidden in their exposures to market based factors while funds of funds risk are hidden in idiosyncratic returns.  Hedge funds take risk using market based factors following herding behavior that may serve to mitigate the difference in their relative performance.  Funds of funds are limited in their exposure to hedge funds and their hidden risks are more related fund-specific exposures.  Regulators need to be concerned about hidden risks used in derivative strategies used by hedge funds since they may have a more systemic feature.

Is JP Morgan Chase a large hedge fund or fund of funds – more disclosure may tell?  The lessons that we can draw from the JP Morgan Chase experience is that complex derivative strategies may not have a favorable benefit for investors and make increase their exposure to systemic risk.  The key lesson is simple derivative strategies combined with good risk management produce better outcomes and reduce exposure to hidden risks.

What is your derivative exposure?  Is it overly complex with hidden risks?

For more on this follow the link:  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344656

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

There’s a giant game of chicken going on and many are predicting that it will end up with Greece exiting the Euro and returning to the Drachma.  This is seen as likely to lead to disaster for the Eurozone and many others, but especially for Greece.  However, there is a simple way to make it beneficial for all.  Why should Greece return to the Drachma?  If Greece is first out, the name “Mark” is going spare.  An announcement that Greece will adopt the Mark as its currency would calm markets and lead to a dramatic reduction in Greek debt yields ……….

OK, totally crazy and irrational I know.  But if rationality had anything to do with things, there likely would not have been a Euro in the first place.  Even if there had been, it’s a racing certainty that Greece would not have been a participant.  Politicians running currencies and economies is a bit like the animals running the zoo.  One thing we can rely on is a mess and sub optimal outcomes.  I hope your risk management systems and processes have this assumption.

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

The push toward austerity as cure-all for rising debt levels resulting from the financial crisis is losing credibility with the euro zone electorate.  The elections in Greece and France have served as a shift in the electorate toward a more pro-growth view.  Charles Wyplosz discusses these issues in a recent VOXEU communique dated May 2^nd. 

Wyplosz argues that governments should not mix long-term growth and fiscal discipline objectives with short-term goals to contain rising debt levels.  Instead, countries should focus on a framework for fiscal policy cooperation, restructure debts, and implement fiscal discipline in the long-run.  The German view, however, is that countries with excessive debt levels should focus on deficit reduction. 

This recipe has produced two years of economic contraction and surging unemployment for Greece.  There is growing debate among academics and international agencies that advocacy of pro-cyclical austerity is not producing the desired results as the situation is more complicated.

The sovereign debt crisis implies that highly indebted countries cannot simply borrow their way out of the crisis.  Financial markets want growth as a necessary condition for deficit reduction, but this is complicated by the fact countries cannot borrow their way out of their predicament nor borrow at reasonable interest rates. 

Wyplosz makes five recommendations: (1) do not mix long-term growth with fiscal discipline since they should be treated as independent objectives since there is only evidence that high debt levels can stunt growth, not fiscal discipline; (2) do not create another Lisbon accord that produces another layer of regulations and bureaucrats and serves as a means for politicians to avoid making hard decisions; (3) establish a framework for fiscal policy cooperation at the Eurozone level since recent results implemented by national authorities have been sub-optimal – a fiscal framework may allow for countercyclical policies as needed; (4) authorities should implement debt restructuring ahead of the curve limiting contagion before the market imposes penalty rates and limit market access; and (5) de-emphasize  short-term deficit targets which do not have economic justification. 

National cooperation on long-term objectives is needed to limit potential risks.  However, these types of national agreements need to include short-term flexibility so as to any problems created by short-term market fluctuations.  The rigid structure of the infamous Stability and Growth Pact is the exact opposite of what is needed.

As more countries question the role of austerity and attempt to establish long-term fiscal policy cooperation and restructure debt, what kind of surprises can we expect?  Risk managers need to focus on this shift to avoid any JP Morgan Chase type of surprises.

For more on this, please follow the link:  www.voxeu.org/index.php?q=node/7933

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

My daughter is currently studying Macbeth in her high school English class.  I studied Macbeth as well.  For kicks I thought it would be fun to reread Macbeth (I need some better hobbies!).  While reading Shakespeare for the first time in about 30 years a question came to mind.  If Shakespeare was alive today and creating a play about risk management, what genre of play would it be?  Would it be a comedy, a tragedy, a farce, a political ode, a drama …  ?