Tag Archives | financial crises

CII: Richard Bookstaber – Dynamic Risk Models

Richard Bookstaber: Human Complexity and the Financial Markets

Richard Bookstaber discusses value at risk modeling — easily the most illuminating talk at #CIIFall2017. It was certainly statistics aimed at the layperson. However, in listening to him, I was glad I completed by PhD comprehensive in statistics 35 years ago.  I scribbled a few notes. Although I can’t guarantee accuracy, if I motivate a few fund managers to read his The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction I will be delighted.

Richard Bookstaber: Shifting From Static to Dynamic Interactions

Value at risk models are moving. Early theorists believed economics would only become a science if approached with mathematical rigor, removing human sentiments, and concentrating on the underlying static causes. After more than 100 years, we began to see that we couldn’t forecast the future by modeling the past. The world isn’t static. Under Dodd-Frank, we began stress tests. What it this happens? If I understand correctly, Richard Bookstaber wants to take modeling a step further – essentially stress testing with agent-based models. Not only does history not repeat itself, people are unpredictable agents. Modeling needs to factor in the dynamic interactions of agents, their models and how activity is ever-changing through feedback loops.

Richard Bookstaber: A Few Key Bullets

  • Agents. Drivers have various heuristics. We can typecast drivers into speeders, lane-changers, etc. to help model defensive driving in autonomous vehicles. 
  • The environment is never the same. Agents act, the environment changes. The cycle repeats.
  • We are not automatons as classical economics assumed. (That’s why I changed majors.)
  • Emergence – we interact with our environment and end up in a stampede. Fire marshals can model human herd behavior.
  • Radical uncertainty – we create and invent, changing our world. Filled with surprises
  • Computational irreducibility – Interactions create dynamic complexity. We can’t solve for life, we have to live it.
  • Non-ergodicity – We change with our experiences. The future will not look like the past.

The Four Horsemen of the Econopolypse – aspects of reality that traditional economics sweeps under the rug… emergence, non-ergodicity, radical uncertainty, and computational irreducibility.

  • Emergence occurs “when systemwide dynamics arise unexpectedly out of the activities of individuals in a way that is not simply an aggregation of that behavior.”
  • Non-ergodicity is a feature of financial markets throughout. That is, markets vary over time; they do not follow the same probabilities today as they did in the past and will in the future.
  • Uncertainty is radical when it cannot be expressed or anticipated, when we’re dealing with unknown unknowns.
  • Computational Irreducibility. Our economic behavior is so complex, our interactions so profound that “there is no mathematical shortcut for determining how they will evolve.”

Richard Bookstaber: More Concepts Discussed

Below are a few more concepts discussed by Richard Bookstaber but I don’t have the notes or time to further decipher. Egress – Liquidity, Flammability – Leverage, Crowding – Concentration, Asset shock or funding shock; Forced sales do to leverage; Price effects do to concentration; Further declines due to illiquidity; Cascades and Contagion; Key Data missing – leverage, concentration, illiquidity, collateral damage. Events have fat tails; they are not symmetric. Movement into tails is not smooth. Risk doesn’t resolve at a constant rate. We must move to an agent-based approach.

The end objectives are to manage risk, generate return, and dampen the crises. Develop scenarios, crowd-source the data and mirror the investment process. High frequency traders have kill switches. That accelerates crisis because trading stops and liquidity drops. Leverage is somewhat tamed but not liquidity. Passive index investing is part of the issue.

If I had my camera, I would have taken some shots of his interesting explanation of cascading impact. See Richard Bookstaber’s YouTube video below, especially starting about 30 minutes in. Read his blog.

My cynical take away is that few will adopt Richard Bookstaber’s methodology because we want simplicity. However, the world isn’t simple. Hopefully, a future CII meeting will feature Bookstaber leading a wise group of investors, feeding cascading scenarios into Watson or some other AI device.

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Financial Darwinism

Financial Darwinism book coverJust as global climate change has increasingly brought us more frequent “once in a century” weather events, increased competition and economic globalization have resulted in lower margins, increased commodification, and increased risk – leading to a similar pattern of economic volatility centered around our financial institutions. Leo M. Tilman’s Financial Darwinism: Create Value or Self-Destruct in a World of Risk paints a rather bleak picture. He sees systemic financial crises as a “permanent feature of the dynamic new world.”

This isn’t a book for those looking for ideas aimed at governments attempting to reregulate the financial industry, although they would certainly benefit from the reading. Instead, the book offers very practical advice to bankers, institutional investors, and other businesses on how to build risk analysis into strategic decision-making.

In the old paradigm, the risk manager was brought in after major strategic decisions had already been made. In the new paradigm, “risk management becomes the very language of enterprise-wide strategic decisions going forward and that the chief risk officer becomes an executive who gets an equal seat at the table where corporate strategy is decided.”

Tillman identifies at least ten forces contributing to this shift, including:

  • Globalization
  • Inflation targeting and control by central banks
  • Disintermediation
  • Greater availability of information
  • Greater financial market efficiency
  • Alternative investment vehicles
  • Financial deregulation
  • Convergence of traditional financial businesses
  • Increasingly complex instruments, such as derivatives and structured products
  • Advances in technology, financial theory, analytics and risk management 

In the simplest formulaic terms we have gone from: Economic performance = return on assets – cost of liabilities + fees – expenses – cost of capital

To: Economic performance = balance sheet arbitrage + principal investments + systematic risks + fees – expenses – cost of capital

Of course, that’s just the beginning of the complexity. Tilman does an excellent job of explaining this paradigm shift, how we got here, what factors need to be examined going forward, and how they can be understood in relatively simple formulaic terms.

Financial Darwinism recognizes that our growing toolbox includes leverage, product design debt management, capital structure, M&A, insurance, securitization, hedging, asset strategies, etc. Each tool must be considered in developing and implementing strategy.

As the world places increasing emphasis on fair valuation, risk-based financial disclosure and risk-focused regulation, Tilman’s guide becomes more important for CEOs, directors and fiduciaries who must build risk evaluation into all fundamental decisions. For another perspective, download Putting risk in the comfort zone: Nine principles for building the Risk Intelligent Enterprise™ from Deloitte. See also Prudent Practices in a Bad Economy, advice from David B. Gail, Mary R. Korby and Michael A. Saslaw for corporate boards.

 

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