Risk Management Ideas
Risk has as one of its essential elements TRUST as a foundation.
Trust on the other hand has many other factors that interplay and interact on it.
Markets are created when there are needs that are not immediately met from you local environment and therefore scarcity exists. Market participants step in to fill this ‘needs’ void.
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As for any subset of Risk, either Operational, Market, Liquidity, Interest, etc. a big part of the assessment process it not just about looking inward and assessing the risk profiles, risk attitudes, risk systems, etc., but an important part of the process is stepping into the realm of uncertainty and looking outwards and the wider market context we find ourselves in.
Being too prescriptive about the individual risk profiles and control systems will only stifle innovation and growth. Some say we need a very healthy dose of growth right now, whereas others are content with the new world order of the ‘anti growth economic’ bias (our description of austerity) we have already entered in the Western Hemisphere.
Our positive risk management framework, also known as Value Oriented Risk Management encapsulates both risk and uncertainty management and combines it with the best offerings of Value Based Management. (For more information or to contact us, please click on the Contact us link or read the article entitled “The Intersection – Where Risk, Value & Reward“ link by clicking on the embedded link.
Our Value Oriented Risk Management is the positive Risk Management focus, acting as an enabler ensuring that you unlock value in your organisation a midst the regulatory compliance constraints added to your management agenda.
TheMarketSoul ©2010
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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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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?
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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’?
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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.
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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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Short-sighted: Actor behaviour in the market for competitiveness
Competition is a good thing. Of that we are sure.
It is one of the key ingredients of a dynamic market process, yet is competition and the potential negative consequences of short-sightedness a means or an end in itself?
Today we argue that the unfettered aspiration of competing for competition’s sake and the shedding of what is seen as non-core processes and competencies in organisation, will eventually lead to sub-optimal performance and is an unsustainable practice.
In the unrelenting search for shareholder value creation, which is the fiduciary and main responsibility of the board of any shareholder / equity owned organisation, we believe that sub-optimal decisions are being taken, both because of target operating model enhancements and short-term return of investment (ROI)
One of the underlying objectives of International Harmonisation of Financial Regulatory Standards (as currently promoted by the IASB & FASB) is the desire for greater transparency and ultimately more regular and frequent reporting cycles. The view is that the greater the frequency in reporting, the less information asymmetry will be in the market, thereby eliminating insider trading and other undesirable ‘sharp’ market practices that regulatory bodies such as the SEC, London Stock Exchange, NYSE, NASDAQ, DAX, etc., are trying to stamp out.
But if we extend this logic, or rather shorten the current reporting cycles from the regular quarterly updates to say monthly, weekly , daily or even hourly updates, the already short-sighted mentality will become even more sharply focussed. And this begs the question: “How will CEOs and other business leaders have to ‘defend’ their decisions on a minute by minute basis under this unrelenting 24 hour news and sensationalism culture”; thus leading to an even more intense short term focus on their part. Certainly, this must be the worst of all downward spirals and tyranny of information overload?
But, by logical extension, this is exactly where we are heading in a decade or two’s time.
So, if the focus is then on more short-term results and ‘core processes’ where does this leave the current wave of outsourcing, off-shoring or near-shoring of non-core processes?
We contend that the already well established trend of ‘letting go’ of all non-core processes and competencies has a negative effect on the longer-term sustainability of the organisation.
Succession planning could already be outsourced and thus not on the board’s agenda, as recruitment consultancies now fulfil the non-core ‘attraction of suitable candidates’ services, with the traditional Human Resources fulfilling a more Risk mitigation / management functions of ensuring compliance with Health & Safety Executive , employment law, equality laws, etc.
Another unintended consequence is the fact that because organisations more and more frequently utilise professional specialists to deliver projects and programmes, the esprit d corps is disappearing from organisational life. It is difficult for managers to gain this motivational force of esprit de corps when they are managing ‘virtual teams’ and a cadre of temporary service providers through dysfunctional processes of ‘on-boarding’, induction, project management, quality control, motivational traps, engagement, focus, etc.
Therefore, to conclude this opening article in a new series around the ‘new labour market models [1] [2] [3]’, currently being practiced in the western free market democracies, let us ask the key question that is one of the foundations of the factors of production in achieving economic advancement:
“How do we recognise, incubate, nurture, develop and sustain talent and talent management in our organisation, when this critical activity is handed over to outside consultants who have a different business model and agenda to our corporate ambitions?”
We know that there are some ‘labour supply aggregators’ or forward thinking recruitment consultancies that realise that their own models of engagement has to change, in order for them to move into the value creation and value addition space, but there are still far too many ‘factories’ with conveyor belt mentalities out there. Not to let the corporate ‘talent managers’ off the hook, because if you don’t have people and processes in place to manage the talent anymore, you only have yourself to blame when the ‘transparency machine’ of financial regulatory reform forces you down the channel of short-term decline…
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Does Law inform or enforce culture?
If ‘the Law’ is the codification of cultural norms and practices, does the Law then not inform culture?
Policy, social malice and engineering of social outcomes bend these laws into legislative blunt instruments designed to enforce cultural behavioural changes on a grand scale, trouncing the common law of good judgment, neighbourly relations and common sense and thus freedom in their wake?
Within the above question and assertion lies the ‘malice of the free market’; where misguided and misinformed regulation channels behaviour and economic interactions in directions and with outcomes not anticipated or foreseen. Thus unleashing the ‘law of unintended consequences’.
Take as an example the economic condition referred to as Moral Hazard.
A definition is:
Moral Hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk.
Moral Hazard therefore flies in the face of the principles of personal responsibility and thus accountability for our actions to a wider stakeholder community.
Is Moral Hazard perhaps promoted and therefore amplified by the fact that business leaders are not more formally educated in their fiduciary responsibilities?
Is this a function of weak or inefficient corporate governance structures and frameworks, or merely an oversight that is readily addressed by ‘occupational licensure’ or the professionalization of directors by only allowing formally qualified persons to serve on certain corporate boards?
Would this formalisation process of understanding fiduciary responsibility hinder the spirit of free enterprise and risk-taking or enhance the governance and risk aptitudes in a controlled and more channelled and focussed practice? Would it have as a positive consequence an amplifier effect for raising the corporate governance and Enterprise-wide Risk Management practices?
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The Sustainability Gene
The CBI published a report entitled “The shape of business – the next ten years” in late 2009.
The authors identified 5 key drivers affecting the business environment, namely:
1. Changing finance and capital conditions,
2. The decline of trust in business and markets,
3. A less benign macroeconomic environment,
4. Social and demographic change where the recession will have a major influence,
5. Sustainability and resource issue.
We pick up our cue from the fifth driver being Sustainability for today’s post.
Our comment serves more as an aide-mémoire to return to in more detail in future articles. This post also does not serve as a commentary on the CBI’s report, but rather as a general opinion on the nature of sustainability and human a nature and is therefore pure conjecture.
We believe that sustainability as understood to mean the impact we have on the planet and the resources we consume, is not a natural human phenomenon, in the face of self-interest (as per the economic definition of the term) and competition for scarce resources.
In other words sustainability flies in the face of human kind‘s natural tendencies to compete for resources, either by war and confiscation, or by trade and exchange for those scarce resources.
We therefore contend that as human actors interacting with and through the free market mechanism, we do not naturally possess a ‘sustainability gene’, but instead have to develop a new model and framework for ensuring that this objective is effectively pursued and becomes part of the underlying psyche of being in business and discharging our fiduciary responsibilities.
Linking to our previous post ‘The Markets do not need certainty’, we contend that it is structure that helps shape markets and creates the conditions conducive to the effective operation of those markets. Other factors will ultimately affect the efficiency of the markets and some of these factors include Innovation and such like.
In conclusion, let us wrap up with a few quotes on sustainability:
- You can never have an impact on society if you have not changed yourself. Nelson Mandela
- The very process of the restoring the land to health is the process through which we become attuned to Nature and, through Nature, with ourselves. Chris Maser
- We can learn whatever we need in nature because we are part of nature. Human beings are part of Creation. We live by the same laws as all of nature. Anne Wilson Schaef
And in the final quote above we possibly see a glimmer of hope for a possible answer to our ‘Sustainability Gene’ deficiency. Somehow Adam Smith’s ‘self interest’ and the modern free(ish) market system require an injection of nature law and justice.
Whatever that shall be.
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The Markets do not need certainty
There has again been a short period of drift and volatility in ‘The Markets’ recently.
And yet again we have heard the old refrain:
“Markets hate uncertainty”.
This we assert is yet again a misused turn of phrase. It is not uncertainty that markets hate, because inherent within market processes and market operations is the principle of uncertainty. This is also known as - Information Asymmetry.
So, if it is not uncertainty that markets hate, then what is the missing ingredient that delivers these periods of volatility?
We believe what markets require above all else is:
Structure.
Yes, structure and clear operating parameters, in other words a framework within which to operate is the key.
Whether that structure and framework is delivered via regulatory mechanisms or liquidity or a political landscape that sets the parameters in terms of policy guidelines and fiscal and monetary controls, it does not matters.
Remove the nebulous shifting and drifting borders and put in place a framework that sets the framework and outline of the playing fields and markets respond positively to these signals.
Refrain from doing the work of ‘framework establishment processes’ and markets and their participants become ‘restless souls’ aimlessly drifting within the ‘nebulous fog’ of uncertainty, clearly waiting and anticipating the regularity that structure delivers to the ‘Market’
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The Value of the Synthesist (as opposed to the Analyst)
We had some very rewarding conversations recently with business partners and peers regarding the Value of Synthesis versus Analysis.
Synthesis we believe to be a ‘higher level’ skill and experience set than traditional analysis. Synthesis requires a natural ‘incubation period’. Very few people are natural ‘synthesists’. You grow and mature into a ‘natural Synthisist’.
Analysts can be taught. In fact a very lucrative business education industrial complex has been built on the back of ‘creating a production line of analysts’. We call them Business Schools churning out master’s level analysts with the three-letter MBA title behind their names.
Don’t get us wrong on this one. We are not criticising MBAs or the Business Schools that produce them. Far from it; because we believe that part of the ‘evolutionary process’ of ‘incubating a mature synthesist’ is having a deep and fundamental understanding of analysis and the factors that contribute to making a good analyst.
Two of the key words we used in the above paragraphs were:
- Incubate
- Mature
We pause to reflect on these two words, because they are part of a natural evolutionary cycle.
Synthesis is a development process. It doesn’t just occur overnight. The process takes many years, many forms, much frustration, heart-ache, high failure rates, desperation, etc. We hope you understand the philosophical underpinnings of the argument.
The drivers that help define and shape good synthesists are many fold, however, two of the more basic building blocks include:
- The Tyranny of the Status Quo
- The Language of the Artist
What do we mean by these two concepts?
The Tyranny of the Status Quo
Mediocrity, lack of risk taking and proper risk management, a ‘level playing field’, universal access, no economic ladder to climb and a social ideology that creates an amorphous mass of despair is what drives the tyranny of the status quo. It is the antithesis of Innovation and Creative Thought. It is the Socialist ideology that drags us all down to the lowest common denominator.
The Language of the Artists
We believe it was Peter Block who claimed in that business life has become ‘infected’ with the language of the Engineer and Scientist. We ‘Business Process Reengineer’ this and that; we ‘Reverse Engineer’ this or that process. We contain, seal and measures finite risks and processes, much like a scientist would work in a ‘Controlled Laboratory Environment’.
But what we really need is the language of the artist and philosopher. We require poetry, motion, flow and creativity in order to establish the correct environment for innovation to ‘spring forth’ naturally and spontaneously.
Even though you would think this to be a natural phenomenon, it is very difficult to achieve in the ‘controlled environment’ of Shareholder Value Creation, due to the narrow focus on hard facts and cool numbers, underpinned by the ‘negative risk management cycle’.
In an article we recently published in a boutique Risk Management Training and Consultancy’s Quarterly Risk Update, we referred to both the positive and negative risk management perspectives.
Negative risk management is “[the] approach in an organisation that is designed to prevent the downside consequences of a transaction, such as (1) mitigating a potential loss or (2) the cost of not complying with regulatory requirements”, whereas in positive risk management “the upside is managed in conjunction with a risk based approach to general management. This is the starting point of Enterprise Risk Management”.
Financial Controllers and CFOs have to ensure that shareholder value is continuously created and then as measured and reported within the framework of Internationally Accepted Financial Reporting Standards and the generally ‘rules based approach’ to compiling those Financial Reports.
This is not a simple task and should we ‘interfere’ here with the language of the artist and philosopher in this process, we are certainly dead set on the course that will lead to ‘confusion, value destruction and financial ruin’. But aren’t we there already?
Has the most recent ‘crisis of confidence’ in the financial system as practiced by the ‘Financial Engineers’ and ‘Quant-type’ mathematicians and scientists not just proved that the old paradigm does not create value, but is still subject to ‘deep-rooted and fundamental’ long-term business cycles?
And yet what do we do? We blame the ‘selfish and selfless’ market capitalists for the problem, rather than address the basic condition that drive the imbalance, namely the ‘imperfect market’ that we create with over burdensome regulation, control and ‘dare we mention the term again ‘financial and business process (re-)engineering’.
We continuously oscillate on the pendulum between the free and ‘planned or controlled’ market forces.
Until we recognise the fact that our policy interventions, ill conceived regulatory frameworks and processes and the financial reporting and ‘engineering’ standards help drive the market mechanism to points of ‘disequilibrium’ where the natural ‘clearing mechanism’ of matched supply and demand cannot function normally; then we will just have to accept the consequences of the natural ‘boom and bust’ economic cycles.
To have ever utter the immortal, nay, ‘notorious’ phrase “we have abolished boom and bust” was not just arrogant but utterly naive and demonstrated a lack of a basic understanding of market forces in the ‘planned and controlled’ market economy camp.
Therefore, to conclude this brief post on the Value of Synthesis, we challenge mature ‘incubated’ professionals to step up to the challenge of redefining the new economic landscape by utilising the language of the artist and philosopher and to practice just a little bit of ‘Loony Intelligence’ in the process.
For further information and more in-depth discussion on this subject, please contact us by clicking this link:
Increased Friction Costs
We start today’s article with a cry for a return to common sense and a reduction in the unnecessary Friction Cost in the economic system (especially here in Britain).
Friction Cost, in economic terms is defined as:
- The implicit and explicit costs associated with market transactions.
- The total cost, both direct and indirect, of a transaction after commissions, interest rates, taxes, research, time, and other expenses. (Financial Dictionary)
What we will be focussing on today is the ‘hidden cost’ element of Friction Costs. As in definition 2 above, it is the Total Cost, including the economist’s ‘Opportunity Cost’ than needs to be considered in this discussion:
We start of the debate with a quote from Dean LeBaron:
“Market inefficiency exists because we do not root out their basic causes. These causes are easy enough to identify, if one looks with enough dispassion and rigor.”
As we are entering a politically charged season, we want to remind everyone of the key word in the above quotation:
Dispassion
We believe that too many decisions and arguments are framed in the ‘emotionally charged world’ and that too few dispassionate thinking and analysis is applied to the really big questions and problems facing us today…
Let us briefly focus on an example of what we mean by ‘hidden costs’:
This is a criticism of British legislative fervour and spurious targeted ‘efficiency’ gains. This leads to sub-optimal solutions.
Our actual real life example:
By April 2011, most businesses and individual subject to the ‘Self-Assessment’ tax regime must file online, irrespective of size or individual circumstance. Nothing wrong with these facts so far. However, we are still embroiled and faced with legacy Information Technology systems that cannot cope with the 21st Century IT revolution and government collection tax collection regime aspirations.
A typical example is where certain legal entities (Limited Liability Partnerships) are forced to file online, not with the HMRC’s system and software, but have to purchase additional commercial software to file (An example of a friction cost, that is not very clearly recognised).
Further to this, should the entity actually comply and file their tax return online and in time, the legacy systems at the HMRC, does not automatically recognise this fact, even though an acknowledgement of receipt has been issued by the HMRC’s system.
The actual Tax Return submission is acknowledged, but not the physical filing of the data. The consequence is that a penalty notice is sent to each partner (another friction cost) and has two consequences:
- HMRC and The Treasury has made a false penalty determination, but the revenue gets recognised in the HMRC’s accounts, therefore falsely inflating the tax takes
- The business has to incur another Friction Cost as they have to respond to the penalty determination and dispute the claim.
Therefore a compliance costs has escalated into an opportunity cost as the individuals in the firm have to allocate time and resources in dealing with more unnecessary compliance mitigation work by refuting the spurious penalty determinations.
When will we recognise in this country that the process should not be:
- Create a target
- Legislate the target
- Then build the solution process
- Beat up the citizens for not being able to comply
But Should be:
- Build the solution
- Integrate the solution
- Test the solution
- Create the target
- Legislate the target…
This way we will create a new culture of efficiency, compliance and citizenship that respects and endures the necessity of tax regimes to deliver wealth creating opportunities for all willing and able participants in the system.
Should you experience any taxation compliance challenges, please do contact us on theMarketSoul ©1999 – 2012
(Click the name for a link to your email client)
Further themes and related issue to the above debate are:
- XBRL compliance
- Annual Accounts submissions at Companies House
