Is it possible to prepare for and deal with Black Swans?

Dealing with low-probability, high-impact events that are impossible to forecast or predict is really tough.

According to Nassim Nicholas Taleb (HBR October 2009), managers make 6 common errors when confronting risk:
1.They try to anticipate extreme events.
2.They study the past for guidance.
3.They disregard advice about what not to do.
4.They use standard deviations to measure risk.
5.They fail to recognize that mathematical equivalents can be psychologically different.
6.They believe there's no room for redundancy when it comes to efficiency.

According to Taleb, banks have a tendency to sit on time bombs while convincing themselves that they are conservative and nonvolatile. Furthermore he blames the science of risk management for causing this behavior, and business schools and the financial economics establishment for having a vested interest in promoting risk management models and devaluing common sense.

On this page, you'll find a very good summary of Taleb's Black Swan Theory and a quite lively discussion forum too. Topics covered include:
- How Fragile is your Organization?
- How to Prepare for Black Swan Risks?
- Noise to Signal Ratio in Decision-making
- The Role of Statistics in Predicting Black Swans
- The Role of Entrepreneurs in Antifragility at Society Level
- The Role of Experts in Causing Black Swans
- Decision-making in Uncertain Circumstances
- Fat Tony and Dr. John ...
- Causes of Black Swan Risks
- How can Scenarios Help to Prepare for Black Swans?
- Building Robust Systems
- etc

Islamic finance risk management standard based on Basel II

IFSB (Islamic Financial Services Board) www.ifsb.org/ has issued Risk Management standards which leveraged on Basel II.

Discussion on the above will be interesting indeed.

Catastrophe Modeling

Before Hurricane Hugo swept through Georgia and North and South Carolina in 1989, the insurance industry in the U.S. had never suffered a loss of more than $1 billion from a single disaster. Since then, numerous catastrophes have exceeded that figure. Hurricane Andrew in 1992 caused $15.5 billion in insured losses in southern Florida and Louisiana. Damages from the Northridge earthquake on the Western coast of the U.S. in January 1994 amounted to $12.5 billion.

Residential and commercial development along coastlines and areas that are prone to earthquakes and floods suggest that future insured losses will only grow -- a trend that emphasizes, as never before, the need to assess and manage risk on both a national and a global scale. 'People today are asking the question, 'How do we scientifically evaluate catastrophic risk?' Read on.

Do companies need Risk Management?

Risk is inevitable within business environments. Taking and managing risk is part of what organisations must do to create profits and shareholder value.
However, a market study by DeveloperEye.com discovered that many organisations neither manage risk well nor fully understand the risks they are taking.
The study aims to discuss the level of knowledge about Risk Management amongst organisations, the management of IT risks, government encouragements towards Risk Management, and the advantages/disadvantages with Risk Management.

650 organisations (500+ employees) within Europe were interviewed in order to evaluate the level of knowledge and familiarity with the term; Risk Management. 64% of the respondents had a good knowledge of Risk Management and where able to give us the essence of what Risk Management is all about. Another 31% gave us a fair explanation, but most of them were financial orientated. The remaining 5% of the respondents were unable to give any explanation at all.

To fully understand Risk Management, two characteristics are essential: uncertainty and loss. Risk Management can be seen in relation the organisational response of companies to the challenge posed by dramatic changes of the economic and social impacts of natural hazards. Furthermore, Risk Management also involves evaluation of business strategy risks and the achievement of best practices.

The nature of Risk Management has changed throughout the recent years. Traditionally, management were concerned with risk categories like vendor, technology and project related risk. Nowadays, the impact of IT risks such as government regulations and outsourcing have forced organisations to rethink their risk strategies. Read on".

How to deal with big risks?

According to Denise Caruso in this month's HBR, there is still not much that can be done about true "Acts of God" risks. But when assessing big man-made risks without owners (such as in the case of genetically modified food), companies must involve a broad community that includes experts and all those that might feel the repercussions.

Companies tend to focus on their immediate interests. However big risks affect people and organizations far beyond the risk taker and it's about time companies make sure they are prepared where possible.

Bestselling Risk Analysis Books

Strategic RM

According to Booz Allen Hamilton, to protect shareholder value, companies must link RM with strategic planning and avoid overreacting to regulatory compliance mandates, such as Sarbanes-Oxley.

More shareholder value has been wiped out in the past five years as a result of mismanagement and bad execution of strategy than was lost because of all of the recent compliance scandals combined. Despite its reputation as a panacea for raising the bar on business governance, SOX is essentially a quality-control mechanism piggybacking on financial reporting systems.

In reacting to Sarbanes-Oxley with an exaggerated fear of risk exposure, many companies are tempted to reduce RM to an expensive “box-checking exercise” in regulatory compliance.

However, to thrive in the current business environment, companies need to do much more: They must be proactive in addressing risk by understanding and anticipating the full range of threats to their businesses. And they must embed RM in strategic planning capabilities. Board directors and senior managers need to look beyond traditional risks — typically, capital credit and physical security — and anticipate earnings-driver risks and cultural risks, too.

Read more about the five RM imperatives in this interesting article.

10 Hiding Places for Business Credit Risk

For some of us this article will only confirm what you already know, but I happened to like convenient shopping lists (provided they are good). And I believe this one from Atradius Trade Credit Insurance may come useful for credit managers better manage risk following the recent wave of corporate reporting irregularities. Recent collapses have demonstrated the crucial need for credit professionals to look beyond the figures issued in corporate financial statements. Atradius suggests credit managers should be sure the following areas are evaluated when assessing business credit risk:
1. Capitalization - Evaluate how the firm is capitalized and if it has access to future capital. Determine sources of capital and how the capital is structured.
2. Loss on Derivatives - Find out if complex hedging strategies are in place that may not be actual hedges. Determine if derivatives used are liquid and if there are "naked" positions.
3. Mark-to-Market Accounting - Ensure derivative positives in place are valued correctly and find out valuation rationale. Determine if rationale has material impact on financials.
4. Managing Leverage with New Forms of Debt - Determine if convertibles that look like equity actually act as debt triggers.
5. Goodwill and Intangible Valuations - Assess if valuations are accurate and what assets are being valued and at what price. Check to see if big write offs are coming.
6. Off Balance Sheet Transactions - Determine if there are operating leases that should be capital leases or capital leases that should be operating leases.
7. Calculating Pension Liability - Reconcile estimated needs with the projected returns and see if projections are realistic. Evaluate how options are treated.
8. Financial Engineering with SPE's and JV's - Find out if companies are being set up to assist in product financing to customers of the parent and determine the effect on the parent if the entity fails.
9. Engineering with Mergers and Acquisition Activity - Establish if any mergers or acquisitions impacted the firm's overall debt/risk ratio.
10. Revenue Recognition and Measurement - Determine if company is booking future revenue in current periods for long-term contract deals and if unrealized revenue is being calculated correctly. Check to see if swap transactions overstate revenue and add no realized value. Assess how currency value affects earnings.
A further white paper is available on http://www.atradius.us

Operational Risk Management Survey

A recent survey by Risk Waters Group and SAS shows difficulties in collating clean data and poor awareness among staff are the major obstacles to effective operational risk management.

The survey of more than 250 financial institutions and regulators identified managing data quality as the number one issue, with respondents reporting difficulties in collating sufficient volumes of historical data and in ensuring reliable data. The second most pressing issue was the poor overall awareness of operational risk issues by staff, due largely to lack of clear education programs in operational risk, lack of communication and limited knowledge sharing.

While the survey reveals progress over the past 12 months, there is still a lot to do. Operational risk is less well defined and potentially a greater challenge than credit and market risk. 19 percent of global respondents do not even have a program in place. This can be attributed to an organisation's size; institutions with an annual turnover of less than $100 million are most likely not to have a program.

Respondents quantifying the economic returns of a successful operational risk program revealed expected savings running into tens of millions of dollars annually for large financial institutions. On average respondents expect 17 percent reduction in loss. Order survey results

Managers and investors disagree on primary risks

Executives at Global 1000 companies and investment professionals at the world's leading investment firms hold starkly opposite views on the primary threats to companies' top revenue sources, according to the 2004 Protecting Value Study.
Among the primary findings:
- More than two-thirds (69 percent) of CFOs, treasurers and risk managers at Global 1000 companies in North America and Europe view property-related hazards, including fires, explosions, and supply chain disruptions, as the leading threats to top revenue sources.
- In sharp contrast, most investment professionals (79 percent) say non-property-related hazards, including pricing fluctuations, governmental/regulatory hazards and management/employee malfeasance, pose the greater threat.
- Most CFOs, treasurers and risk managers (80 percent) rate their companies' ability to protect top revenue sources as "excellent" or "good," while nearly one-half of investment professionals (49 percent) rate companies' abilities as "fair" or "poor."
Download a Summary of the 2004 Protecting Value Study.