Big-Data – a Small Risk Transformation?

These days big-data seems to be so ‘big’ that it is everywhere.   I have read with some interest ‘Big data’ by Mayer-Schonberger and Cukier.  I was looking to form some views about it reflecting my perspective of risk management in financial services and ‘value enhancement’. These are three of the key points I took from the book. 

1.    Big-data is not about size but about the ability to work with full data sets. 

This means that the constraints that might arise from sampling are avoided.  Interestingly, there will be cases where adopting a big-data approach means handling a relatively small data set. 

2.    The shift from causation (small data) to correlation (big-data). 

The ability to create additional data at low cost and join up data sets means that we are likely to increase our ability spot correlations.  This would help us understand the ‘what’ even if we don’t fully understand the ‘why’ or the causation. 

3.    All data has value and a company’s ability to extract the value depends on the business model and skills.   

The value of data arises from secondary uses which are difficult to predict when the data is collected.  Companies can extract the value by hoarding the data, analysing it and identifying opportunities for big-data. 

This led me to three observations about big-data and risk management:

1.    Risk managers need to identify the aspects of risk management that can be enhanced by understanding correlations (‘what’) and the aspects that can be enhanced by causation (‘why’). 

While the message of big-data is that correlation is becoming cheaper to identify and offers more value in a shorter period of time, there isn’t a one fits all!  For example, insurers’ ability to spot financial crime, cases of fraud and price insurance risks would be enhanced by the ability to identify the correlation between key variables.  On the other hand, understanding correlations between risk drivers may need some plausible stories to make them actionable.

2.    Existing risk management and regulatory concepts would need to be revisited.

One of the features of big-data is that when different data sets are combined the resulting data is ‘messy’ with many empty cells.  How do you apply existing criteria for data quality governance, in particular ‘completeness’?

How do you validate models?  The authors bring in an interesting example where a simple model performs more effectively than any of the alternatives when a significant amount of data is fed into the model.

3.    Extracting value from data would need careful thinking.

One of the fundamental technological changes is that data is generated in many un-suspected places and situations, e.g. internet searches.  Spotting those opportunities requires a big-data mind set.  Capitalising them requires the ability to capture the data and / or use it.  One implication is that the value of data is something that would need to be factored into commercial outsourcing with third parties.

Overall, this could lead to a significant transformation of how risk is managed and become a new ‘normal’.   However, between now and then companies would need to tread carefully to avoid chasing ‘big-data’ opportunities of limited value.   

If you work in financial services, I would be keen to hear your thoughts about big-data and risk management.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

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My Son the Risk Manager?

That’s not a question for me.  I guess I am already there.  It is more of a potential question for my children – and yours as well.  The ultimate question is whether you would be happy to encourage your children (or perhaps the children of one of your best friends) to go into risk management as a career.

Put it differently, has risk management become like accountancy or law? Is risk-management a generic business qualification that can be applied in different business contexts?

Once I started thinking about this I realised that it wasn’t clear to me if risk management is a career in its own right.  The alternative is that risk management would be a common and reasonably well-defined role in many sectors.  This matters because one of the next questions in that hypothetical conversation would be along the lines of “how do I get there”.

The main argument in favour regarding risk management as a career in its own right is that there seems to be an emerging body of risk management theory that cuts across sectors.  This can be evidenced from the emergence of standardised approaches to risks management that cut across sectors, e.g. ISO 31000, and professional associations.

A similar argument would be in terms of the skills needed to perform successfully in the role.  While my experience is limited to financial services, my feeling is that the blend of skills needed in risk roles tend to be slightly different from those required for other roles – in no particular order, they include the ability to see the big-picture, communication, determination, ability to keep things simple.

At the same time, while developing tools and approaches for risk management is a considerable ongoing challenge, the main one is the implementation.  However, implementing successfully risk management and certainly generating value depends on business knowledge and understanding of the corporate environment.

All in all, I am more inclined to suggest to my children the following:

•  choose a degree you like – IT, law, economics, engineering, finance – and a sector; 
•  consider risk management as a role that would help career advancement; and
• explore ways of getting ready for that challenge.

If you work in financial services, I would be keen to hear your thoughts about these suggestions.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

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Enforcement Lessons: 5 Lessons from a Fine Chance*

The UK Financial Conduct Authority (FCA) published recently the details (here) of an enforcement case involving Credit Suisse International (CSI) and Yorkshire Building Society (YBS).  They were fined for failing to meet the requirement that financial promotions are ‘clear, fair and not misleading’ £2m and £1.4m respectively.

Not much new so far but the circumstances of the case indicate how financial services are evolving and the challenges for risks management.

The case involves a structured product providing capital protection, a guaranteed minimum return and the potential for achieving a higher return under certain conditions related to the performance of FTSE100 index.  CSI manufactured the product and YBS distributed (most of) it.  The product raised nearly £800m and reached 84 thousand customers.

At the heart of this case there is a concern that product complexity can reach a level such that it is difficult to ensure that disclosures to retail customers are clear, fair and not misleading.  For example, the FCA was concerned that the disclosures suggested that this was a simple index tracker – it wasn’t.  This can distort customers’ ability to infer the likelihood of a maximum return. 

In addition, there are five interesting points to take away from this case:

1.    Distribution arrangements give rise to significant conduct risk, even if no financial advice is provided.    

2.    The chances of relevant events need to be taken into account in financial promotions.  A ‘maximum return’ that can be achieved with nearly zero probability based on past history is not really a ‘maximum return’!

3.    Third party consumer advocates can have an impact.  The UK Consumers Association (‘Which?’) approached YBS and CSI in September 2010 with concerns about financial promotions and the chance of achieving the maximum return advertised.  This resulted in limited changes to disclosures: more emphasis on the conditions required to achieve the maximum return and less emphasis on the presentation of the maximum return.

4.    The target consumer group has practical importance.  The disclosures will be crucial to ensure appropriate consumer outcomes if you are targeting ‘stepping stone customers’, ‘typically conservative, risk averse customers’, with a structured product and don’t offer advice.

5.    Slow reaction to regulatory developments persists.   The relevant period when the breach took place stretches to 30 months from November 2009 to June 2012.  The earlier intervention by ‘Which?’ and concerns raised by the FCA had limited effect. 

It is interesting to see all these different factors coming together in a case.  This may be one of the few occasions (if not the first) where a fine results because financial promotions did not take into account the chances of the underlying events. 

If you work in financial services, I would be keen to hear your thoughts about these lessons for the management of conduct risk.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

* Thanks to my colleagues for suggesting a title.

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The Objective of Risk Management

This is a continuation of an earlier post about identifying the value of risk management (here).  I would like to focus on the objective of risk management.  I hasten to say that I am writing from the perspective of financial services and that there may also be different views. These thoughts are inspired by an article by Stulz from 1996 (here).  

The starting point is that the aim of risk management as seeing in the traditional academic literature is minimising the variance in profits.  Not surprisingly, this would imply much more hedging and risk management that it’s generally observed from surveys and other sources, which is puzzling.

On the other hand, a company will have certain ‘comparative advantage’ in terms of skills, resources, or location that it can profitably exploit.  Today, we would see this as part of the ‘business model’.  If risk management seeks to reduce the variance in profits, it will also eliminate the upside that might exist as a result of the company’s business model.  If that upside is to be preserved, then the objective of risk management becomes the elimination of costly lower tail outcomes while preserving as much as possible of the upside. 

The key to risk management is therefore the firm's business model (earlier posts here and 
here).  It shapes the strategy and creates the risks that need to be managed and probably points at those risks that will emerge.  In practice, this means understanding the source of profits and being able to put this in the context of how the business operates and its strategy. 

Consider the business strategy of a currency trading desk.  The main question is whether profits arise from position taking (with the firm’s capital) or from market-making.  Incidentally, the evidence quoted in the paper suggests that profits arise from market-making rather than position taking.  For an insurer, this would involve understanding the extent to which profits arise from underwriting, investment performance or fees and the alignment with the business strategy. 

Where this understanding forms the basis of how risk management operates, it makes financial distress less likely.  In turn, this means that risk management can be regarded as a substitute for equity capital; the same amount of equity capital can go further in terms of supporting a wider set of profitable activities. 

Unfortunately, a similar outcome can be observed when the risks are under-estimated.  How can a company that adopts this approach to risk management distinguish itself?  I don't think that there is a simple answer.  It is important that risk management takes a truly holistic perspective and seeks to demonstrate the alignment between business model, strategy, risk assessment and senior management incentives.   

If you work in financial services, I would be keen to hear your thoughts.  If you don’t, I would be keen to know if this articulation of the objective of risk management resonates with your experience.  

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The Cost and Benefits of EU Membership

A lot that has been said about the recent elections to the European Parliament.  (Full disclosure: I am an EU national living in the UK.)  For me, part of the debate in the UK represents a useful reminder of the challenge of cost-benefit analysis.  Not surprisingly, there isn’t an accepted view about the balance between costs and benefits of EU membership.  Here is an illustration of the range of estimates (as of 2013) from a research paper of the UK Parliament:

I reviewed some of what has been written and have also read with interest Hugo Dixon's recent book - 'The in / out question'.  I thought that rather than develop another cost-benefit analysis, I would set out the main considerations to take into account if you choose to read one of them to form your own views.

It seems uncontroversial – I think – that the economic benefit from EU membership is the access to supply products and services to a market of 510 million consumers and an economy the size of the US.  Hugh Dixon quotes an estimated benefit of the order of 4% to 5% of UK GDP.  If you accept this, then the key questions are whether: 

•  the costs to the UK of achieving that benefit offset it; and  
•  the benefit can be achieved through an alternative arrangement. 

To consider this, a cost-benefit analysis must set out the ‘counterfactual’, i.e. what would happen in the absence of EU membership, and identify what is incremental as a result.  However, there are a number of options.  The ‘do nothing’ option means trading with the EU based on the UK membership of the World Trade Organisation (WT0).  This does not mean free-trade; it will entail custom duties for certain products such as cars.  There are also other options as represented by the cases of Norway, Switzerland and Turkey.  The bottom line is that you cannot seriously consider the costs and benefits of EU membership without taking an explicit view on an alternative from the very beginning.

If so, here are a number of questions and answers to identify what is incremental (including the benchmark of EU membership).  A "smiley" indicates that the change (or lack of it) is a positive development from a cost-benefit perspective.

A couple of points to note about the table.

Firstly, UK manufacturers exporting to the EU will need to comply with EU product regulations.  They are likely to end up manufacturing to UK and EU product regulation standards so (at best) cost savings would be limited. 

Secondly, the distinction between goods and services in the table is the reality of “free trade”, which does not usually apply to services, such as financial, business and legal services.  They represent 78% of the UK GDP. 

The table suggests that being outside the EU could be cheaper on a ‘cash’ basis.  However, none of the options would appear to replicate the benefits of a single market.  Norway replicates many of the benefits at a reduced cost.  However, note that they are bound to follow EU legislation without having a saying on it – an interesting view about sovereignty! 

Overall, I struggle to see how the UK would be able to replicate the economic benefit of the single market in products and services outside the EU. 

However, the real value of cost-benefit analysis is the impetus to focus on increasing benefits and reducing costs.  This means considering how to reform the EU and get the best from a single market of 510 millions of consumers and a GDP that is as large as the US.  Dixon suggestions include cutting red-tape, negotiating trade deals with US, Japan and China.  For me, one of the more interesting suggestions is the potential gains from banking disintermediation and providing long-term finance to industry through capital markets.  As he puts it, the crisis was a banking crisis not a financial crisis.  Something for another post …  

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‘Start With Why’ and the Value of Risk Management in Financial Services

A conversation with a friend about a book called ‘Start with Why’ helped me to put some order to my thoughts about the value of risk management. 

At one level the question of ‘why risk management’ can be answered by saying that it adds value to the business in the medium to long term. 

This is not a rhetorical question given the sums of money and senior management time that are being devoted (or is it diverted?) to risk management.

But, how can we identify the value of risk management? 

This is not a simple question.  I believe that there are two broad aspects to consider to answer this question.  Firstly, it is about identifying the right objective.  Secondly, it is about evidencing that pursuing the objective of risk management generates value. 

I intend to cover these issues in future posts from the perspective of financial services.  It will also be interesting to hear your thoughts and evidence about the value of risk management.

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The Map and The Territory - Alan Greenspan Book

The latest issue of the Central Banking Journal includes my review of the latest book from Alan Greenspan.  It is an interesting book with insights about economics and about the man.  You can read the review here or below.

Book review of ‘The Map and The Territory. Risk, Human Nature and the Future of Forecasting’ by Alan Greenspan, Allen Lane, 2013

‘The Map and the Territory’ is an enigmatic title for a book written by a former Chairman of the US Federal Reserve, which also seeks to cover ‘risk, human nature and the future of forecasting’.  I set out to review the book thinking how long it will take me to understand the rationale for the title. 

The introduction made an impression.  A reasonable acknowledgement that economic forecasting failed in the lead up to the crisis and of the need “to understand how we all got it so wrong”.  I use the word ‘reasonable’ judiciously.  Given the author’s position as Chairman of the US Federal Reserve before the crisis, I was not expecting an acknowledgement that the Fed or the US authorities fell asleep under Greenspan’s watch so “we all got it so wrong” – my emphasis.   Equally, I am not sure if other central bankers have acknowledged that much.  The assessment is usually about bankers going bonkers. 

One of the issues that Greenspan tackles in the book is the extent to which it is appropriate to rely on rationality assumptions for forecasting economic behaviour.   One of the challenges that Greenspan identifies for forecasters is that behavioural responses are unlikely to be symmetric.  For example, the collapse of asset prices would be sharp and, probably, deep while recovery would be gradual.  Overall, Greenspan concludes that economic behaviour is not random and that most economic choices are stable over the long run.  In his own words, ‘we are driven by a whole array of propensities ... but, ultimately, our intuitions are subject to reasoned confirmation.’

This does not mean that errors would not occur.  Greenspan singles out the secular underestimation of tail risks based on the last quarter century of observations.   As for the ability to eradicate those propensities that can give rise to the tail risks, Greenspan dryly note that ‘there was no irrational exuberance in the Soviet Union and none in today’s North Korea’.

It is difficult not to read the book seeking to understand the man – the musician, the economist (or is he a forecaster), the businessman and the economic technician.   Greenspan uses the term economist and forecaster in ways that seem fully synonyms.  I can only wonder how many people in his position would see things that way.  Typically, I guess they don’t but I found it an honest recognition of the main economic role of leading a central bank. 

For Greenspan, there is also small gap between the forecaster and the businessman.  His business, Townsend-Greenspan & Co, was industry forecasting so he had to delve into the details of markets such as oil, natural gas, coal, pharmaceuticals.  I remember learning about price elasticity of demand and about the challenge of estimating it.  As I recall it, the example that Samuelson’s textbook mentioned was the elasticity of the global demand for oil.  Here is someone who saw that challenge from the first row.  Greenspan admits getting his estimates about the oil consumption after the rapid escalation of oil prices in 1973 off the mark.

The interest in the detail of the economic forecaster is evident through the book.  There is a fair amount of slicing and dicing of US statistics to understand the underlying reality.  I was particularly interested on (I believe) his development of an indicator of a time series of maturity of GDP and his use to measure the degree of risk aversion in the economy.  Another example that caught my attention was the use of patent data to measure productivity.  The examples could be particularly useful to any Central Bank analyst looking for innovative ways to analyse the economy.

In terms of banking regulation, Greenspan acknowledges – not surprisingly – that regulatory capital requirements were too low before the crisis.   His analysis suggests an increase of regulatory capital from 10% before the crisis in terms of book value to 13% and 14% in 2015.  Greenspan is also clear that designating banks as “systemic” is simply enhancing their ability to fund themselves at a lower cost.  Greenspan quotes IMF estimates of 40 to 80 basis points funding advantage, which, as he also points out, is a significant advantage in a competitive financial market.

The books also looks beyond financial regulation to wider economic issues around productivity and the rise of entitlements culture, which makes for an interesting reading.  I would recommend it to post-graduates that want to develop an appreciation of the breadth of economic thinking and analytical skills that can be accumulated over a lifetime, even if you do not necessarily share every idea or conclusion.

As I completed reading the book, I still had not found an explanation for the rationale of the ‘map and the territory’.  I had a few hypotheses but nothing.  I was worried that I might have missed something fundamental about the book.   I was reassured to find references to maps in the inside cover of the book. 

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The Godfather of Freakonomics has passed away

Last week it was announced that Gary Becker had passed away.  He formulated his economic career around the application of the tools of economic analysis to broader social issues like human capital, crime, racial discrimination and family.  This wider application of economic analysis makes him the godfather of Freakonomics.  As a recognition for his research contribution, he received the Nobel Prize in Economics in 1992.

Becker’s Nobel lecture provides a good overview of his work and how he extended the traditional analysis of individual rational choice by incorporating a much richer class of attitudes, preferences, and calculations.  In this lecture, he also shared his inspiration to apply the tools of economic analysis to crime.  He was driving to an examination and was late.   He realised that to arrive on time, he would need to park his car and risk a parking fine.  He knew that enforcement was patchy so there was a chance of not getting a fine.   He made a decision to risk a fine.  The private benefits exceeded the costs!     

Understanding these cost-benefit considerations and non-market interactions matters to economic and social policy.   As he aptly said in one of the speeches at the Nobel Prize award:  “the widespread poverty, misery and crises in many parts of the world, much of it unnecessary, are strong reminders that understanding economic and social laws can make an enormous contribution to the welfare of people.” 

Daniel Finkelstein wrote an interesting article in The Times in which he stressed Becker’s contribution to the world of economics, by emphasising that economics is much broader than understanding how money moves in the economy and that it’s about: “understanding people’s incentives, and structuring social institutions in response to them”.  

When I studied economics, I don't think I appreciated the extent of this imbalance. Furthermore, there is a lot to be done and said to address it beyond the scope of this post.  Though I am with Becker that this is not about re-inventing economics and abandoning rationality, or as he put it eloquently: "no approach of comparable generality has yet been developed that offers serious competition to rational choice theory".  The key test is the generality of the predictions that arise from rational choice.   

So the Godfather of Freakonomics is not with us anymore.  Finkelstein summed it up much better:  “The world has lost one of its great thinkers.  Fortunately, we still have the power of his thoughts.”

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More on the ‘C-factor’ in Regulation: Business Model Analysis

Business model analysis (BMA) is one of those terms that are becoming common currency in regulatory discussions, hence the reference to a ‘c-factor’ or common factor in an earlier post (here).  

The PRA published a useful article in the Bank of England March Quarterly Bulletin setting out how they intend to apply BMA to insurance.  It suggests that there are two aspects to a BMA.

Firstly, there is a company dimension, which is obviously not spelt out in great detail for the obvious confidentiality reasons.  In general terms, this would recognise that:

• there is an ‘inverse production function’ in insurance – the fact that insurers collect premium before the service has been delivered and can earn an investment return until claims are paid; and
• insurers must price the product without full knowledge of production costs – hence the ‘experience analysis’ of reserves.

Secondly, there is a market dimension, which recognises that a business model is not static and will respond to changes in regulation, culture, society and technology.  This is evidenced in the article by reference to two developments:

• price comparison web-sites in the UK motor industry; and
• non-standard annuities.

Overall, the PRA sets out a helpful and clear vision about BMA:

‘The PRA’s capital requirements help to make insurers resilient against short-term shocks.  But to be confident that insurers will remain viable over the longer term, the PRA needs to know whether an insurer’s profits are sustainable.  In other words, the PRA will need to analyse the risks of an insurer’s particular business model.’

I found quite remarkable and refreshing to see this level of clarity from supervisors. 

The recent UK budget announcement about removing the requirement for compulsory annuitisation will provide wide ground to test the practice of BMA from a regulatory perspective and, probably, from a company perspective as well.

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Risk and Compliance Management: Horizons for 2014/15

The UK’s FCA published recently its Risk Outlook and its Business Plan for 2014/15.  They provide a useful indication of the breadth of the regulatory challenges and evidence of a top-down approach to address them. 

The structure of the Risk Outlook is similar to last year’s.  The inherent risk factors such as information asymmetries, do not change overnight unlike the economic and market environment.  The main aspects of the changing market environment that caught my attention were:

1.    the continuing household indebtedness reflecting the growth of unsecured lending, mainly credit card, and forecast increasing household leverage (Figures 6, 18 and 19 of the paper);

2.     lenders’ forbearance in the mortgage market, supported by low interest rates; and the FCA concerns about the cost to consumers (fees and accrued interest);

3.     the stable and risky profile of mortgage lending; about 40% of mortgages have high-risk features – LTV in excess of 90%, loan to income ratios in excess of 3.5 and terms in excess of 25 years (Figure 22);   

4.     the differential impact of increasing interest rates (mortgage customers, those accumulating wealth and near retirement and those considering an annuity purchase).

The FCA then translates these observations into statement about risks.  Again, the ones that caught my attention were:

1.     the challenge of making ‘appropriate’ profits; for example, making profits from non-core activities could undermine fair treatment of consumers or financial crime responsibilities; for insurers, this could manifest itself in the response to the Retail Distribution Review and moves to direct sales;

2.     the implications of short term cost-cutting strategies materialise as demand starts to grow and could result in poor management of firms’ back book;

3.     the adoption of technology may not be supported by adequate systems and controls or expertise; this could manifest itself on insufficient spending on existing technology or the use of big data without appropriate controls;

4.     plans to mitigate the risk of failures do not give adequate consideration to conduct implications such as in respect of the changes to terms and conditions in stress conditions.

The Business Plan then identifies priorities for the key sectors.  For life insurance, the priorities appear to be:

1.       suitability of products and services sold;

2.       fair treatment of the back book;

3.       the governance of with-profits funds.  

Interestingly, the FCA business plan also reflects new responsibilities which include supervising 50,000 firms in respect of consumer credit, enforcing competition law, implementing changes to the approved persons regime and the establishing a new payment systems regulator.   

All in all, it’s going to be a busy 2014/15 for everyone.

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