Black swans and global capital markets

Global Financial Institute Your entry to in-depth knowledge in finance Black Swans and Global Capital Markets: Preparing for the unknowable S2 SPECIAL ISSUE... Deutsche Asset & Wealth

Global Financial Institute Your entry to in-depth knowledge in finance

Black Swans and Global Capital Markets: Preparing for the

unknowable

S2 SPECIAL ISSUE

Deutsche Asset & Wealth Management’s Global Finan-cial Institute asked the Economist Intelligence Unit to produce a series of white papers, custom articles, and info-graphics focused specifically on global capital market trends in 2030

While overall growth has resumed, and the value traded on capital markets is astoundingly large (the world’s financial stock grew to $212 trillion by the end

of 2010, according to McKinsey & Company) since the global financial crisis of 2008, the new growth has been driven mainly by expansion in developing economies, and by a $4.4 trillion increase in sovereign debt in 2010 The trends are clear: Emerging mar-kets, particularly in Asia, are driving capital-raising; in many places debt markets are fragile due to the large

Introduction to “Global Capital Markets in 2030“

component of government debt; and stock markets face weakening demand in many mature markets

In short, while the world’s stock of financial assets (e.g stocks, bonds, currency and commodity futures) is grow-ing, the pattern of that growth suggests that major shifts lie ahead in the shape of capital markets

This series of studies by Global Financial Institute and the Economist Intelligence Unit aims to offer deep insights into the long term future of capital markets It will employ both secondary and primary research, based on surveys and interviews with leading institutional investors, corpo-rate executives, bankers, academics, regulators, and others who will influence the future of capital markets

About the Economist Intelligence Unit

The Economist Intelligence Unit (EIU) is the world’s lead-ing resource for economic and business research, fore-casting and analysis It provides accurate and impartial intelligence for companies, government agencies, finan-cial institutions and academic organisations around the globe, inspiring business leaders to act with confidence since 1946 EIU products include its flagship Country Reports service, providing political and economic analy-sis for 195 countries, and a portfolio of subscription-based data and forecasting services The company also undertakes bespoke research and analysis projects on individual markets and business sectors The EIU is head-quartered in London, UK, with offices in more than 40 cities and a network of some 650 country experts and analysts worldwide It operates independently as the business-to-business arm of The Economist Group, the leading source of analysis on international business and world affairs

This article was written by Dr Paul Kielstra and edited by Brian Gardner

Dr Paul Kielstra is a Contributing Editor at the Economist Intelligence Unit He has written on a wide range of top-ics, from the implications of political violence for busi-ness, through the economic costs of diabetes HIs work

has included a variety of pieces covering the financial services industry including the changing role relation-ship between the risk and finance function in banks, pre-paring for the future bank customer, sanctions compli-ance in the financial services industry, and the future of insurance A published historian, Dr Kielstra has degrees

in history from the Universities of Toronto and Oxford, and a graduate diploma in Economics from the London School of Economics He has worked in business, aca-demia, and the charitable sector

Brian Gardner is a Senior Editor with the EIU’s Thought Leadership Team His work has covered a breadth of business strategy issues across industries ranging from energy and information technology to manufacturing and financial services In this role, he provides analysis as well as editing, project management and the occasional speaking role Prior work included leading investiga-tions into energy systems, governance and regulatory regimes Before that he consulted for the Committee

on Global Thought and the Joint US-China Collabora-tion on Clean Energy He holds a master’s degree from Columbia University in New York City and a bachelor’s degree from American University in Washington, DC He also contributes to The Economist Group’s management thinking portal

Introduction to Global Financial Institute

Global Financial Institute was launched in November

2011 It is a new-concept think tank that seeks to foster a unique category of thought leadership for professional and individual investors by effectively and tastefully combining the perspectives of two worlds: the world of investing and the world of academia While primarily tar-geting an audience within the international fund inves-tor community, Global Financial Institute’s publications are nonetheless highly relevant to anyone who is inter-ested in independent, educated, long-term views on the economic, political, financial, and social issues facing the world To accomplish this mission, Global Financial Insti-tute’s publications combine the views of Deutsche Asset

& Wealth Management’s investment experts with those

of leading academic institutions in Europe, the United States, and Asia Many of these academic institutions

are hundreds of years old, the perfect place to go to for long-term insight into the global economy Fur-thermore, in order to present a well-balanced perspec-tive, the publications span a wide variety of academic fields from macroeconomics and finance to sociology Deutsche Asset & Wealth Management invites you to check the Global Financial Institute website regularly for white papers, interviews, videos, podcasts, and more from Deutsche Asset & Wealth Management’s Co-Chief Investment Officer of Asset Management Dr Asoka Wöhrmann, CIO Office Chief Economist Johannes Mül-ler, and distinguished professors from institutions like the University of Cambridge, the University of California Berkeley, the University of Zurich and many more, all made relevant and reader-friendly for investment pro-fessionals like you

Black swans: A phrase goes viral

In September 2008, a financial malaise growing for over a year came to a head Lehman Brothers’ bankruptcy – the largest in US history – rocked markets Existing unease about possible contagion rapidly transformed into pervasive fear Equity markets dropped precipitously;

leading financial institutions in major developed countries required rapid government intervention to remain solvent; capital markets, already constricting under the weight of devaluing sub-prime mortgage backed instruments, seized up further, thereby threatening the global economy Indeed, the latter phenomenon provided the original name for what was happening: the credit crunch

Although the world had seen regional economic melt-downs in recent times – the Latin American debt crisis and Asian monetary crisis of the 1980s and 1990s being the most prominent – when the global financial crisis struck, its sheer scope seemed unprecedented At a minimum, the scope and impact of the latest global crisis had similarities only to the Great Depression of the 1930s and, perhaps, to the interlinked, international debt crises of the 1890s To such an unusual set of circumstances, it was tempting to assign a unique cause

Conveniently, a way to do so seemed to be at hand The Black Swan – an unpredictable, high impact event – was a concept that had recently been popularised by the books

of Nassim Nicholas Taleb, a financial trader turned philoso-pher Writing the crisis off as a Black Swan held a certain emotional appeal: by definition, it would be highly unlikely

to recur Moreover, if the crisis were truly unpredictable, and then those involved in capital markets could hardly be blamed for the losses and damage that resulted

Steven Culp – managing director of Accenture Manage-ment Consultancy’s Risk ManageManage-ment Group – recalls that

in 2008 some used such thinking as a partial excuse and

as a way to reassure the world that what was happening was a one-off, unforeseeable problem Nonetheless, the phrase continues to be used too often as a handy justifica-tion for poor risk management Indeed, the term is often applied incorrectly to any extreme event Using the term this way, however, represents a misunderstanding of what Black Swans are, as well as the ongoing challenge which they present to global capital markets, and how best to be ready for them

The Nature of the Problem

In Taleb’s analysis, a Black Swan event has three specific characteristics First, it is an unexpected outlier because

“nothing in the past can convincingly point to its possibil-ity.” Second, it has an extreme impact Third, in spite of it being an outlier, “human nature makes us concoct expla-nations for its occurrence after the fact, making it explain-able and predictexplain-able.” 1

This definition seems to restrict severely what could be a Black Swan and, therefore, the ultimate utility of the con-cept For example, the numerous historical financial crises before 2008 pointed to the realistic possibility that serious trouble would eventually recur Indeed, at the time vari-ous commentators issued warnings ahead of the event, for example Taleb himself, who said in 2007 that Fannie Mae was “sitting on a barrel of dynamite.” More generally, even the flawed risk models in use at the time included the possibility of extreme market losses but estimated their probability as very small, or under the tail of the normal distribution curve (Accordingly, “tail risk” became another gift from the crisis to the general vocabulary) Even if the probability were very poorly appreciated, the models

Black Swans and Global Capital Markets

A collaboration between Deutsche Asset & Wealth Managment‘s Global Financial Institute and Economist Intelligence Unit March 2014

1 Nicholas Taleb, The Black Swan, (2010 paperback edition), page xxii

Written by

clearly acknowledged the possibility of extensive losses and therefore of future turmoil in the markets By this mea-sure alone, the subsequent crisis would have been a poor candidate for the label of “Black Swan”

In another sense, though, the financial crisis was indeed a Black Swan event, in that even those who were aware of the risk tended to under-estimate its magnitude According to Taleb, the hallmark of Black Swan events is that human mental maps restrict people from assessing their risks As

he puts it, “The Black Swan is the result of collective and individual epistemic limitations (or distortions), mostly confidence in knowledge; it is not an objective phenom-enon The most severe mistake made in the interpreta-tion of my Black Swan is to try to define an ‘objective Black Swan’ that would be invariant in the eyes of all observers.”

A major terrorist attack by a relatively unheard of group, for example, might be a Black Swan for most, but certainly not for the terrorists themselves.2 In this sense, the global financial crisis was a Black Swan not because it was impos-sible for anyone to predict but because the pervasive risk models of the time so discounted the possibility of trouble

on such a scale as to make it inconceivable to many in the market, as well as to ratings agencies and regulators

This was partly because extreme events are sufficiently rare that modelling them is nearly impossible anyway It is also because so many placed excessive reliance on models that proved to be highly inappropriate and which should have been seen to be so at the time David Viniar, then CFO of Goldman Sachs, reported in August 2007 that during a week of turbulence “[w]e were seeing 25-standard devia-tion moves [from the norm], several days in a row.” Never-theless he believed that the company’s quantitative strate-gies were sound, if in need of adjustments to account for certain specific situations.3 He differed from most others only in having made a memorable quote The widespread adoption of David Li’s Gaussian Copula function, despite its creators own public misgiving, as a way to measure the risk associated with collateralised debt obligations – fre-quently made up of bundled mortgages –created wide-spread belief in the underlying stability of asset prices, and ultimately of financial markets, that was unjustified for any number of reasons

Sadly, what may appear in retrospect as large-scale, self-induced myopia is far from a one-off occurrence in capital markets More recently, confidence in the inevitability of ever greater European integration did much to blind pol-icy makers on that continent to the dangers which weak economies like Greece posed for the common currency – difficulties which Euro-sceptics of various stripes found it much easier to perceive, and to warn of at the inception of the project More generally, Hung Tran – Executive Man-aging Director at the Institute for International Finance,

a global association of financial institutions – notes that major, unexpected crises tend to occur when almost all actors in the marketplace suddenly change their thinking

on a particular issue “It is change of mentality or paradigm

or framework of thinking that crystallises tail risks.”

Thus, Black Swans do not provide a fatalistic justification for those involved in the capital markets, or anybody else, failing to see that which was impossible to predict anyway Rather, they raise at least two crucial, forward-looking questions The first is the extent to which the models and other inputs which shape how we see the world help or inhibit the discovery and analysis of significant, heretofore unperceived risks The second is, given that even with the best models it is impossible to foresee many novel chal-lenges accurately, how can companies, and markets as a whole, be made more robust so that they can weather the inevitable, unexpected storms

Are companies better placed to cope?

Preparing for Black Swan events begins, perhaps ironically,

by recognising that they cannot be a leading focus of risk management Theoretically, Mr Tran notes, if a company recognises and correctly assesses an unexpected risk, by definition that event ceases to be a Black Swan On the practical side, Mr Culp adds that “If Black Swans are the only thing your organisation is focussed on preventing,

a lot of other challenges will trip you up in the interim Financial institutions today are rightly focussing more of their energy on things closer to home than on long tail events.”

Instead, Mr Culp argues, a correctly configured approach

to risk management, while not a guarantee of safety,

2 Page xxiii

3 “Goldman pays the price of being big”, Financial Times, 13 August 2007

improves the ability to cope with low probability, high impact events “Effective risk management is an everyday activity,” adds Mr Culp, “maintaining the connectivity with the business and investing in the culture are critical and will help to provide early indications of where problems may be Through normal, effective risk management, and the mentality of getting the little things right, you get bet-ter insights earlier and can course correct to limit exposure

to bigger challenges.”

At least three broad elements of effective risk manage-ment are central in developing and maintaining this men-tality One is taking risk seriously This on its own can help tremendously in dealing with unexpected upheavals An academic study of US banks, for example, found that those with independent risk management functions and strong internal risk controls suffered less during the peak years

of the global financial crisis in part because they were less likely to invest in mortgage-backed securities and off balance-sheet derivatives They also did better financially during the preceding boom.4

Another element is the need to go beyond box-checking

to operate in the spirit of the law which, says Mr Culp, “gives

a broader understanding of risk in a holistic way.” Finally, companies need to maintain humility about the extent of their understanding of the risks they face Mr Culp recalls that before the crisis “people often acted as if the models were reality and gained excessive confidence as a result.”

Since the Financial Crisis, capital market firms have invested substantially in risk management Adjusting to new regulation alone – probably the leading focus of this activity – has required a massive shift and the changes are still very much a work in progress But have the accompa-nying shifts made companies better prepared for rapidly emerging risks and the completely unexpected?

Mr Tran sees a mixed situation: “Risk managers since the crisis have been busy engaging in all kinds of analysis informed by what went wrong To that extent, the room for unexpected events is quite a bit smaller Having said that, we can still be surprised by things that can completely change what we thought.”

Mr Culp also sees hopeful signs but remains cautious Driven by both regulatory change and business necessity,

he says, “the understanding of risk and its importance have dramatically changed at both board and senior leadership levels They are much more informed and asking better questions than pre-crisis Risk awareness is heightened.” Unlike in previous eras, where elevated concern about risk often dropped during periods of economic growth, Mr Culp also hopes that the structural changes of recent years – such as the greater number of Chief Risk Officers on at the leadership table – will give some permanence to this appreciation of risk as a critical function

Companies also seem to be taking steps toward a more holistic understanding of risk and have a healthier appreci-ation that models are not the same as reality Nevertheless, says Mr Culp, “the core of the weakness [in risk manage-ment] remains around complexity.” Better data gathering and the elimination of data silos is occurring, but how best

to turn these mountains of information into insight is an ongoing challenge Overall, he believes that “We are defi-nitely moving in the right direction In terms of levels of capital, investments in talent, connectivity with regulators, sharing of information, we are in a better place The real-ity is, though, that the broader economic situation does remain fragile and the regulations are still forming We are early into this process.”

Regulating for robustness

What about capital markets as a whole? Although the Global Financial Crisis revealed any number of weaknesses, two issues of these could most exacerbate the impact of a Black Swan event: the greater degree of global inter-con-nectedness of the national markets than in the past, and the growth of a variety of private companies into strategi-cally important financial institutions whose failure would have potentially catastrophic consequences

Here again, Mr Tran sees some progress but notes that sig-nificant issues remain He observes that the Dodd-Frank Act has at least put in place a legal framework for a resolu-tion authority in the United States to manage too-big-to-fail institutions that get in trouble European Union propos-als for a similar body are propos-also progressing “What is lacking,”

4 Andrew Ellul and Vijay Yerramilli, “Stronger Risk Controls, Lower Risk: Evidence From US Bank Holding Companies”, National Bureau of Economic Research, Working Paper 16178, July 2010

Mr Tran believes, “is a cross border framework to deal with global firms.” Failures of the latter would presumably pres-ent the biggest systemic risks Similarly, in dealing with the inter-connectedness of global markets, greater levels of transparency and disclosure – to provide enhanced under-standing of how given institutions might be exposed to any emergent, or other, risk – remains desirable

Even sensible regulation, though, might unintentionally bring new dangers Mr Tran notes that “the thrust of regu-latory reform has put similar risk-based capital require-ments on non-bank institutions and inadvertently reduced the diversity of different institutions This may risk produc-ing a more uniform reaction to market developments and these tend to produce a bigger risk, because if everyone buying or selling at the same time, you get extreme market movements.”

Are we better prepared for the next Black Swan?

Companies and regulators have made substantial efforts

to improve risk management This certainly reduces the probability of a repeat of a chain of events similar to that

of 2008 The bigger question, however, is how well these changes will reinforce the system against future Black Swan events

At the corporate and market level, the news is decid-edly mixed Improvements have occurred since 2008

Although the undoubted improvement in risk manage-ment by companies is not designed specifically with Black Swan events in mind, more businesses should be in better shape to cope with them once the current wave of change has taken place If nothing else, they are more alert to risk and may even be able to maintain this heightened aware-ness when good economic times return Similarly, regu-lators are at least addressing the “too big to fail” problem, which can create a disincentive for large organisations to manage their risks vigilantly In both cases, progress is only partial and still has far to go: perfection is never truly possible in a world where unintended consequences are common As one senior banking executive predicted to the Economist Intelligence Unit in 2011, while lessons can

be learned from the past, “We will mess up in a different fashion the next time.”

Ultimately, because of they are impossible to predict, the ability of capital markets to withstand the next Black Swan will only be apparent once it appears Given the history of finance, the safest bet is that one will come along sooner

or later

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