Capricious Markets
The market is capricious. We are paraphrasing a line from one of Bernard Cornwell’s series of historic novels on 9th century England, where he referred to the ‘old gods’ (pagan gods) of the Danes and Vikings as capricious.
So if the impulsive nature of markets is to be appreciated for what they are, then why are we trying so hard to manage risk completely out of existence?
We will focus on two specific factors today in what we refer to as the ‘dumbing down of risk’.
A strict or narrow definition (old financial language) of risk is possibly that it is a quantifiable number with a probability ranking and we can therefore attach a statistical inference to the occurrence of the risk event.
Yet in The Health & Safety Executives language a risk and “Risk management involves you, the employer, looking at the risks that arise in the workplace and then putting sensible health and safety measures in place to control them”. So in the common language in the work place the HSE has managed to destroy the proper use of the work risk and risk management with this dumbed-down version.
In our mind, if the risk cannot be quantified and expresses on a scale of probabilities, then it is not a risk, but an uncertainty. And we can manage both risks and uncertainties, but the emphasis is different.
Maybe any situation or health and safety ‘risk’ can eventually be codified on a risk probability matrix, but the cost involved in getting to this situation is prohibitive, so we shall stick to our guns and call a health and safety issue a ‘Health & Safety Uncertainty’.
Image via Wikipedia
Let’s recap briefly the difference between what risk is (supposed to be) and what uncertainty is:
Risk in investment and market participation is the likelihood of a quantifiable measurable outcome either occurring or not occurring.
Frank Knight In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction between risk and uncertainty.
| “ | … Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. … The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. … It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We … accordingly restrict the term “uncertainty” to cases of the non-quantitive type.” |
Too summarise therefore, risk should be a measurable and quantifiable occurrence, whereas uncertainty is what the HSE addresses, but misinforms as risk, namely the likelihood of something occurring, but that likelihood is not quantifiable.
So where does this detour into the use of language leave us as far as the Capricious Market is concerned?
We suppose that because market participants are both humans and mechanical systems (eg. ETS – Electronic Trading Systems), one of these participant groups, namely the humans have a level of sophistication and complexity (irrationality) that leaves the best construed risk models in tatters, once the uncertainty element of human emotion and the perception factor unleashed.
Therefore, to construct models of rational behaviours, the outcome and predictability of non-human mechanical systems (in other words more models) should be able to predict the behaviours of other models. But to extend this to human actors clearly moves us more firmly into the domain of uncertainty and not risk.
Therefore, we conclude that the markets will always be capricious as long as irrational beings are willing and able participants. Until this ceases to be, let us ensure that we get the use of our risks sorted out from our uncertainties.
theMarketSoul ©2010
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The Morass of Mediocrity
We link today’s article to one of our main themes on our home page, namely the ‘Battle against the Status Quo’, or as per the title of this posting, ‘The Morass of Mediocrity’.
Image via Wikipedia
The underlying intent and theme is that of competition and competitive behaviours and the difference between rules based and principles based standards.
It is our opinion that a rules based culture encourages more insular and introspective behaviours, where the rush is for the middle ground of mediocrity, rather than as the opposite principles based culture would be the encouragement for the search for innovation and competitiveness at the margins and extremes of the ‘functional envelope’. By this we mean the parameters and frameworks set-out in the principles based environment, to ensure that a well-defined playing field (not necessarily level), is established and market participants understand their boundaries and culture norms they have to adhere by as part of the participation process.
Yet, apparently, a more principles based regulatory framework is exactly what is being blamed for the Credit Quake of 2008 – 2010.
And if we analyse the circumstances that led to the regulatory failure and debt driven imbalance we currently experience, we would discover that it is because we operate in a hybrid world with symbiotic elements in the relationships between the private, public and third sectors.
Some of these factors include, but are not limited to:
- Market structure – free market versus socialist structures
- Regulatory framework – the disjointed regulatory frameworks and mixed agendas and the sense of urgency in the global regulatory framework
- Cultural setting – Anglo-Saxon, European, Middle Eastern, Far East, etc.
- Reliance on macro-economic tools including monetary and fiscal policies
- Skewed nature of national performance measurement
- Balance between equilibrium and disequilibrium clearance mechanisms in the economy
- Erosion of moral hazard and other distorting signals
Régulation de la machine à vapeur Merlin (Photo credit: zigazou76)
However, as a mainly libertarian focussed publication, it would be remiss of us not to endorse the principles of minimal interference (small government in other words), yet we also realise that this has to be tempered with personal responsibility. However, because the symbiotic (hybrid) relationships have become so skewed and dysfunctional over the last few decades, was it any surprise that the uncertainty this created led to opportunist behaviours? Because a ‘moral compass’ is a very relative term, is it no surprise that depending on your own individual position and point of view, that the direction it indicates will be different from others?
The G20 are meeting again this weekend and the global regulatory framework will again be in more detailed focus, yet other priorities are again distracting the main thrust and issues on the agenda.
Therefore to conclude this brief interlude into the ‘morass of mediocrity’, the real question is:
If we all run and work hard for the centre ground, who will remain at the margins, pushing the envelope and ensuring that we break the tyranny of the status quo by exploring new unchartered territories and responsible risk taking behaviours?
theMarketSoul ©2010
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Commentary on newly proposed UK Financial Regulation
The news headline: Osborne gives Bank of England top regulatory role
Our response:
Firstly, we are relieved to see no sweeping statements such as abolishing ‘boom and bust’, which by inference must mean that the ‘normal’ business cycles will from now on resume business as usual, albeit with slightly more volatile amplitudes?
The statement regarding more tools is interesting, because as far as we are aware there are two, maybe three specific tools available in the toolbox at the moment. Fiscal policy and monetary policy and the third one possibly being risk management. Therefore, as with the debate currently evolving between Efficient Market Hypothesis and the behaviourally focussed irrationality school of (economic) thought, that there is no unifying theory yet offered to explain market events, we are still searching for the ‘unifying toolbox’ or rather the Swiss army knife of financial stability and regulation?
Image via Wikipedia
So we can read into the statement that we will add more tools, rather than take tools out of the box never to be returned, such as the retention of Sterling and thus monetary policy.
Therefore, the one important tool at the moment that requires sharpening is the regulatory framework and structures that support both regulation, monitoring, enforcement and dare we say it ‘rehabilitation’, because just like of criminal justice system, even though we have both the laws and enforcement framework, we will always have the offenders and ultimately it is the ‘how to rehabilitate and re-integrate’ them issue that we have to deal with. If moral hazard has now been replaced by having to swallow ‘TARP’-entine (poetic licence evoked) and senior investment grade civil servants (RBS and the half of Lloyds they own), then the compensation schemes being touted and created via banking levies, is the wrong approach and signal to send to the market participants.
The G20 seems to be driving the urgency of the regulatory reform agenda, timeframe and tripartite of Financial Regulatory Standards, capital adequacy and strengthening Corporate Governance regimes as outlined by the Bank for International Settlements. However, some framework agreements have been in place for some time, such as the Norwalk Agreement between the IASB & FASB. Thus, it is not a case of the lack of effort and focus, but rather a lack of urgency and clear objectives in creating a global regulatory and governance framework.
As the BP debacle has illustrated, it does take some time to formulate a coherent response and action plan and if the Global Regulatory Framework is not given sufficient debate, design and implementation time (due to political expediencies), all we will do is sow the seeds of the next crisis, which, as stated before is definitely on the billing in a country near you very soon.
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The Cost of a ‘Licence to Operate’
Reputation Risk and damage mitigation must be some of the watch words and the top priorities at BP at the moment. So how are they faring in the management this agenda item?
What ‘price’ or cost must we attach to a ‘licence to operate’?
Image via Wikipedia
It is interesting to observe behaviours of Chief Executives under the probing scrutiny of a congressional committee’s line of questioning and investigation.
Are we busy reshaping the competitive landscape and entrenching further oligopolistic market skewing structures? And this running in parallel with Financial Regulatory reforms encouraging more of an ‘imperfect competitive’ and fragmented (read more costly) landscape.
It is interesting how the issues and debates are being shaped by political expediency, rather than the true and honest ‘economic landscape re-alignment’ agenda we all deserve. And yet again timetables are being set to accommodate political schedules, rather than the issues and factors that we really need to address in order to encourage enlightened and informed re-balancing and redress within the economic frameworks we operate under. So the people who ultimately ‘pay the bill’ are having the fundamental issues clouded and waters muddied, with needless ill-informed debates and noise around reforms that are ill-conceived and containing basic design flaws.
We felt that there was hope back in late January 2010, when the Volcker Rule [video reference]was first muted, but as is now apparent, the agenda has been filled with noisy distractions and unfortunate detours that will ultimately deliver half-baked reforms and regulations that will sow the seeds of the next cyclical bubble of euphoria and the subsequent eye watering ‘pop’ once we come down with the inevitable painful bump. Timing is of the essence, yet the timeframes are uncertain and so they shall remain.
Image via Wikipedia
The next few days and weeks will be crucial ones that will reveal what exactly the true (life-cycle) cost of a ‘Licence to Operate’ is and what price we have to attach to monitoring and managing a global reputation risk framework and infrastructure.
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Sustainability I
The focus on sustainability and sustainable practices is a self defeating objective. Sustainability means that business leaders take their eye off the equity holder’s value creation ideal, as it flies in the face of self-interest as promoted by Adam Smith some 234 years ago (The Wealth of Nations , 1776).
Image via Wikipedia
Self-interest and the pursuit therefore is being clouded by a multitude of other non value adding factors that is diluting the message and contributing to more uncertainty and risk and therefore capital flight and volatility in the financial and capital markets as we have experienced over the last 2 years.
This process and Zeitgeist will not disappear or be properly understood, unless we develop a deeper understanding and familiarity with uncertainty as a driver of the innovative spirit of human endeavour.
Risk management per se is not the answer and panacea it is held out to be, and if it promotes a more risk-averse society, then we are heading for the middle ground of mediocrity, tyranny and decline in social values and structures that have taken many hundreds of years to create.
Being part of the system with a myopic view, rather than standing outside the system with a holistic and reflective frame of mind is causing more damage than good.
Yet how are we to live and deal with the cognitive dissonance that these two views by the very nature induce?
Let’s open up to good honest debate, search and reflection, rather than to dogma and a narrow focus on defending vested interests and old world models.
We are in the midst of a major cultural, economic and world order paradigm shift and the outcome is uncertain, potentially destabilising, but we must embrace this exploration of uncertainty and chaos the will inevitably ensue.
theMarketSoul ©2010
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