Restructuring Basel’s capital buffers

Douglas Elliott at Oliver Wyman has written a short post which I think makes a useful contribution to the question of whether the capital buffers in the BCBS framework are serving their intended purpose.

The short version is that he argues the Countercyclical Capital Buffer (CCyB) has worked well while the Capital Conservation Buffer (CCB) has not. The solution he proposes is that the “the Basel Committee should seriously consider shrinking the CCB and transferring the difference into a target level of the CCyB in normal times”. Exactly how much is up for debate but he uses an example where the base rate for the CCyB is 1.0% and the CCB is reduced by the same amount to maintain the status quo.

The idea of having a non-zero CCyB as the default setting is not new. The Bank of England released a policy statement in April 2016 that had a non zero CCyB at its centre (I wrote about that approach in this post from April 2018). What distinguishes Elliott’s proposal is that he argues that the increased CCyB should be seeded by a transfer from the CCB. While I agree with many of his criticisms of the CCB (mostly that it is simply not usable in practice), my own view is that a sizeable CCB offers a margin of safety that offers a useful second line of defence against the risk that a bank breaches its minimum capital requirement. My perspective is heavily influenced by a concern that both bankers and supervisors are prone to underestimate the extent to which they face an uncertain world.

For anyone interested, this post sets out my views on how the cyclical capital buffer framework should be constructed and calibrated. This issue is especially relevant for Australian banks because APRA has an unresolved discussion paper which includes a proposal to increase the size of the capital buffers the Australian banks are expected to maintain. I covered that discussion paper here. A speech that APRA Chair Wayne Byres gave in May 2020 covering some of the things APRA had learned from dealing with the economic fallout of COVID-19 is also worth checking out (covered in this post).

Tony – From the Outside

RBNZ COVID 19 Stress Tests

The RBNZ just released the results of the stress testing conducted by itself and a selection of the larger NZ banks to test resilience to the risks posed by COVID 19.

The extract below summarises the process the RBNZ followed and its key conclusions:

COVID-19 stress test consisted of two parts. First, a desktop stress test where the Reserve Bank estimated the impact on profitability and capital for nine of New Zealand’s largest banks to the impact of two severe but plausible scenarios. Second, the Reserve Bank coordinated a process in which the five largest banks used their own models to estimate the effect on their banks for the same scenarios.

  The pessimistic baseline scenario can be characterised as a one-in-50 to one-in-75 year event with the unemployment rate rising to 13.4 percent and a 37 percent fall in property prices. In the very severe scenario, the unemployment rate reaches 17.7 percent and house prices fall 50 percent. It should be noted that these scenarios are hypothetical and are significantly more severe than the Reserve Banks’ baseline scenario.

  The overall conclusion from the Reserve Bank’s modelling is that banks could draw on their existing capital buffers and continue lending to support lending in the economy during a downturn of the severity of the pessimistic baseline scenario. However, in the more severe scenario, banks capital fell below the regulatory minimums and would require significant mitigating actions including capital injections to continue lending. This reinforces the need for strong capital buffers to provide resilience against severe but unlikely events.

  The results of this stress test supports decisions that were made as part of the Capital Review to increase bank capital levels. The findings will help to inform Reserve Bank decisions on the timing of the implementation of the Capital Review, and any changes to current dividend restrictions.

“Outcome from a COVID-19 stress test of New Zealand banks”, RBNZ Bulletin Vol 83, No 3 September 2020

I have only skimmed the paper thus far but there is one detail I think worth highlighting for anyone not familiar with the detail of how bank capital adequacy is measured – specifically the impact of Risk Weighted Assets on the decline in capital ratios.

The RBNZ includes two useful charts which decompose the aggregate changes in CET1 capital ratio by year two of the scenario.

In the “Pessimistic Baseline Scenario”(PBS), the aggregate CET1 ratio declines 3.7 percentage points to 7.7 percent. This is above both the regulatory minimum and the threshold for mandatory conversion of Additional Tier 1 Capital. What I found interesting was that RWA growth contributed 2.2 percentage points to the net decline.

The RBNZ quite reasonably points out that banks will amplify the downturn if they restrict the supply of credit to the economy but I think it is also reasonable to assume that the overall level of loan outstandings is not growing and may well be shrinking due to the decline in economic activity. So a substantial portion of the decline in the aggregate CET1 ratio is due to the increase in average risk weights as credit quality declines. The C ET1 ratio is being impacted not only by the increase in impairment expenses reducing the numerator, there is a substantial added decline due to the way that risk weighted assets are measured

In the “Very Severe Scenario”(VSS), the aggregate CET1 ratio declines 5.6 percentage points to 5.8 percent. The first point to note here is that CET1 only remains above the 4.5% prudential minimum by virtue of the conversion of 1.6 percentage points of Additional Tier 1 Capital. Assuming 100% of AT1 was converted, this also implies that the Tier 1 ratio is below the 6.0% prudential minimum.

These outcomes provide food for thought but I few points I think wroth considering further before accepting the headline results at face value:

  • The headline results are materially impacted by the pro cyclicality of the advanced forms of Risk Weighted Asset measurement – risk sensitive measures offer useful insights but we also need to understand they ways in which they can also amplify the impacts of adverse scenarios rather than just taking the numbers at face value
  • The headline numbers are all RBNZ Desktop results – it would be useful to get a sense of exactly how much the internal stress test modelling conducted by the banks varied from the RBNZ Desktop results – The RBNZ stated (page 12) that the bank results were similar to its for the PBS but less severe in the VSS.

As always, it is entirely possible that I am missing something but I feel that the answer to bank resilience is not just a higher capital ratio. A deeper understanding of the pro cyclicality embedded in the system will I think allow us to build a better capital adequacy framework. As yet I don’t see this topic getting the attention it deserves.

Tony – From the Outside

What does the “economic perspective” add to an ICAAP?

… the question I reflected on as I read the ECB Report on Banks’ ICAAP Practices (August 2020).

That I should be asking the question is even more curious given the years I spent working with economic capital but there was something in the ECB position that I was not comfortable with. There is nothing particularly wrong in the ways that the ECB envisages that an economic perspective can add value to a bank’s ICAAP. The problem (for me), I came to realise, is more the lack of emphasis on recognising the fundamental limitations of economic models. In short, my concern is that the detailed focus on risk potentially comes at the expense of an equally useful consideration of the ways in which a bank is subject to radical uncertainty.

The rest of this post offers an overview of what the ECB survey observed and some thoughts on the value of explicitly incorporating radical uncertainty into an ICAAP.

The ECB report sample set

The ECB report, based on a survey of 37 significant institutions it supervises, assesses the extent to which these organisations were complying (as at April 2019) with ECB expectations for how the ICAAP should be constructed and executed. The selected sample focuses on the larger (and presumably more sophisticated) banks, including all global systematically important banks supervised by the ECB. I am straying outside my area of expertise (Australian bank capital management) in this post but there is always something to learn from considering another perspective.

The ECB assessment on ICAAP practices

The ECB notes that progress has been made in some areas of the ICAAP. In particular; all banks in the survey have risk identification processes in place, they produce summary documents (“Capital Adequacy Statements” in ECB parlance) that enable bank management (not just the technical specialists) to engage with and take responsibility for the capital strength of their bank and the sample banks do incorporate stress testing into their capital planning process.

The ECB believes however that there is still a lot of room for improvement. The general area of concern is that the banks it supervises are still not paying sufficient attention to the question of business continuity. The ECB cites three key areas as being particularly in need of improvement if the ICAAPs are to play their assigned role in effectively contributing to a bank’s continuity:

  1. Data quality
  2. The application of the “Economic Perspective” in the ICAAP
  3. Stress testing

The value of building the ICAAP on sound data and testing the outcomes of the process under a variety of severe stress scenarios is I think uncontentious.

The value the economic perspective contributes is less black and white. Like many thing in life, the challenge is to get the balance right. My perspective is that economic models are quite useful but they are far from a complete answer and dangerous when they create an illusion of knowledge, certainty and control.

The economic internal perspective

The ECB’s guide to the ICAAP defines the term “economic internal perspective” as follows:

“Under this perspective, the institution’s assessment is expected to cover the full universe of risks that may have a material impact on its capital position from an economic perspective. In order to capture the undisguised economic situation, this perspective is not based on accounting or regulatory provisions. Rather, it should take into account economic value considerations for all economically relevant aspects, including assets, liabilities and risks. …. The institution is expected to manage economic risks and assess them as part of its stress-testing framework and its monitoring and management of capital adequacy”

ECB Guide to the internal capital adequacy assessment process (ICAAP) – Principles, November 2018 (Paragraph 49 / pages 18-19)

So far so good – the key points seem (to me) to be quite fair as statements of principle.

The ECB sees value in looking beyond the accounting and regulatory measures that drive the reported capital ratios (the “normative perspective” in ECB terminology) and wants banks to consider “the full universe of risks that may have a material impact on its capital position”. The ECB Report also emphasises the importance of thinking about capital from a “business continuity” perspective and cites the “… unjustified inclusions of certain capital components (e.g. minority interests, Additional Tier 1 … or Tier 2 … instruments) … which can inflate the internal capital figures” as evidence of banks failing to meet this expectation. Again a fair point in my view.

These are all worthy objectives but I wonder

  • firstly about the capacity of economic capital models to reliably deliver the kinds of insights the ECB expects and
  • secondly whether there are more cost effective ways to achieve similar outcomes.

The value of a different perspective

As a statement of principle, the value of bringing a different perspective to bear clearly has value. The examples that the ECB cites for ways in which the economic perspective can inform and enhance the normative perspective are all perfectly valid and potentially useful. My concern is that the ECB seems to be pursuing an ideal state in which an ICAAP can, with sufficient commitment and resources, achieve a degree of knowledge that enables a bank to control its future.

Business continuity is ultimately founded on a recognition that there are limits to what we can know about the future and I side with the risk philosophy that no amount of analysis will fundamentally change this.

The ECB’s economic perspective does not neccesarily capture radical uncertainty

I have touched on the general topic of uncertainty and what it means for the ICAAP a couple of times in this blog. The ECB report mentions “uncertainty” twice; once in the context of assessing climate change risk

Given the uncertainty surrounding the timing of climate change and its negative consequences, as well as the potentially far-reaching impact in breadth and magnitude along several transmission channels via which climate-related risks may impact banks’ capital adequacy, it is rather concerning that almost one-third of the banks has not even considered these risks in their risk identification processes at all.

Page 39

… and then in the context of making allowances for data quality

However, … in an internal deep dive on risk quantification in 2019, half of the risk quantifications showed material deficiencies. This finding is exacerbated by the data quality issues generally observed and moreover by the fact that one-half of the banks does not systematically ensure that the uncertainty surrounding the accuracy of risk quantifications (model risk) is appropriately addressed by an increased level of conservatism. 

Page 54

This is not a question of whether we should expect that banks can demonstrate that they are thinking about climate change and making allowances for model risk along with a host of other plausible sources of adverse outcomes. It is a surprise that any relatively large and sophisticated banks might be found wanting in the ways in which these risks are being assessed and the ECB is right to call the out.

However, it is equally surprising (for me at least) that the ECB did not seem to see value in systematically exploring the extent to which the ICAAPs of the banks it supervises deal with the potential for radical uncertainty.

Business continuity is far more likely if banks can also demonstrate that they recognise the limits of what they can know about the future and actively plan to deal with being surprised by the unexpected. In short one of the key ICAAP practices I would be looking for is evidence that banks have explicitly made allowances for the potential for their capital plan to have to navigate and absorb “unknown unknowns”.

For what it is worth, my template for how a bank might make explicit allowances in the ICAAP for unknown unknowns is included in this post on the construction of calibration of cyclical capital buffers. My posts on the broader issue of risk versus uncertainty can be found on the following links:

Feel free to let me know what I am missing …

Tony – From the Outside

APRA’s ADI capital regime – Unfinished business

Corporate Plans can be pretty dry reading but I had a quick skim of what is on APRA’s agenda for the next four years. The need to deal with consequences of COVID 19 obviously remains front and centre but APRA has reiterated its commitment to pursue the objectives laid out in its previous corporate plan.

Looking outward (what APRA refers to as “community outcomes”) there are four unchanged objectives

  • maintaining financial system resilience;
  • improving outcomes for superannuation members;
  • transforming governance, culture, remuneration and accountability across all regulated institutions; and
  • improving cyber resilience across the financial system.

Looking inward, APRA’s priorities are:

  • improving and broadening risk-based supervision;
  • improving resolution capacity;
  • improving external engagement and collaboration;
  • transforming data-enabled decision-making; and
  • transforming leadership, culture and ways of working.

What is interesting – from a bank capital management perspective

What I found interesting was a reference in APRA’s four year roadmap for strategy execution to a commitment to “Finalisation of ADI capital regime” (page 26). The schematic provides virtually no detail other than a “Milestone” to be achieved by December 2020 and for the project to be completed sometime in 2022/23.

Based on the outline in the strategic roadmap, my guess is that we will see a consultation paper on capital adequacy released later this year. I don’t have any real insights on exactly what APRA has in mind but a discussion paper APRA released in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” may offer some clues.

The DP outlines

“… options to modify the ADI capital framework to improve transparency and comparability of reported capital ratios. The main conceptual approaches APRA is considering and seeking feedback on are:

  • developing more consistent disclosures without modifying the underlying capital framework; and
  • modifying the capital framework by adjusting the methodology for calculating capital ratios.”

The First Approach– “Consistent disclosure” – seems to be a beefed up version of the status quo in which APRA gets more directly involved in the comparability process by adding its imprimatur to the internationally harmonised ratios some Australian banks currently choose to disclose as an additional informal measure of capital strength.

“Under this approach, ADIs would continue to determine regulatory capital ratios using APRA’s definitions of capital and RWA. However, APRA would also specify a methodology for ADIs to determine certain adjustments to capital and RWA that could be used for disclosure (Pillar 3) purposes. As noted above, the methodology would focus on aspects of relative conservatism that are material in size and able to be calculated simply and objectively.”

APRA argues that “The supplementary disclosure would allow all stakeholders to better assess the capital strength of an ADI on a more comparable basis. However, it would result in two APRA-endorsed capital ratios: an APRA regulatory capital ratio to be compared against minimum requirements, and an additional disclosure-only capital ratio for, in particular, international comparison.”

Second Approach – “Capital ratio adjustments” would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA.

The DP explains that this “… alternative approach would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA. This would involve removing certain aspects of relative conservatism from ADIs’ capital ratio calculations and lifting minimum regulatory capital ratio requirements in tandem. This increase in regulatory capital ratio requirements could be in the form of a transparent adjustment to minimum capital ratio requirements—for the purposes of this paper, such an adjustment is termed the ‘APRA Overlay Adjustment’.”

“To maintain overall capital adequacy, the APRA Overlay Adjustment would need to be calculated such that the total dollar amount of Prudential Capital Requirement (PCR) and Capital Conservation Buffer (CCB) would be the same as that required if these measures were not adopted. In other words, the risk-based capital requirements of ADIs would be unchanged in absolute dollar terms, maintaining financial safety, but adjustments to the numerator and the denominator of the capital ratio to be more internationally comparable would increase reported capital ratios.”

APRA clarify that

“These options are not mutually exclusive, and there is potential for both approaches to be adopted and applied in different areas.”

I offered my views on these options here.

Tony – From the Outside

Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective

The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.

This rule is not universal however. The NZ banking system, for example, has a distinctly different approach to bank deposits that not only eschew the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.

I previously had a go at the question of “why” bank deposits should be protected here.

This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.

Multiple layers of protection

Australian bank deposits benefit from multiple layers of protection:

  1. The risk taking activities of the banks are subject to a high level of supervision and regulation (that is true to varying degrees for most banking systems but Australian standards do seem to be at the more conservative end of the spectrum where Basel Committee standards offer a choice),
  2. The target level of Common Equity Tier 1 (CET1) capital required to support that risk must meet the standard of being “Unquestionably Strong”,
  3. This core capital requirement is supported by a series of supplementary layers of loss absorbing capital that can be converted into equity if the viability of the bank as a going concern comes into doubt,
  4. The deposits themselves have a priority super senior claim on the Australian assets of the bank should it fail, and
  5. The timely repayments of AUD deposits up to $250,000 per person per bank is guaranteed by the Australian Government.

Deposit preference rules …

The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.

The other elements are also important but …

Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.

At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in you bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.

In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.

If deposit preference rules, why doesn’t everyone do it?

Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.

I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.

Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.

The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.

There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.

Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)

For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.

Deposit preference potentially strengthens market discipline

I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.

This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.

The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.

Deposit preference plus ex ante funding of the deposit guarantee favours the smaller ADI

Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.

Summing up

If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.

As always, it is entirely possible that I am missing something – if so let me know.

Tony – From The Outside

Banks Are Managing Their Stress – Bloomberg

The ever reliable Matt Levine discusses the latest stress test results for the US banks. In particular the disconnect between the severity of the assumptions in the hypothetical scenario and the actual results observed to date. He notes that it is still early and plenty of room for the actual outcomes to catch up with the hypothetical. However, one of the issues with stress testing is the way you model the way people (and governments) respond to stress.

As Matt puts it …

But another important answer is that, when a crisis actually happens, people do something about it. They react, and try to make it better. In the case of the coronavirus crisis, the Fed and the U.S. government tried to mitigate the effect of a real disaster on economic and financial conditions. Unemployment is really high, but some of the consequences are mitigated by stimulus payments and increased unemployment benefits. Asset prices fell sharply, but then rose sharply as the Fed backstopped markets. Financing markets seized up, and then the Fed fixed them.

The banks themselves also acted to make things better, at least for themselves. One thing that often happens in a financial crisis is that banks’ trading desks make a killing trading for clients in turbulent markets, which helps to make up for some of the money they lose on bad loans. And in fact many banks had blowout first quarters in their trading divisions: Clients wanted to trade and would pay a lot for liquidity, and banks took their money.

In a hypothetical stress test, you can’t really account for any of this. If you’re a bank, and the Fed asks you to model how you’d handle a huge financial crisis, you can’t really write down “I would simply make a ton of money trading derivatives.” It is too cute, too optimistic. But in reality, lots of banks just went and did that.

Similarly, you obviously can’t write down “I would simply rely on the Fed to backstop asset prices and liquidity.” That is super cheating. Much of the purpose of the stress tests is to make it so the Fed doesn’t have to bail out the banking system; the point is to demonstrate that the banks can survive a financial crisis on their own without government support. But in reality, having a functioning financial system is better than not having that, so the Fed did intervene; keeping people in their homes is better than foreclosing on them, so the government supported incomes. So the banks are doing much better than you might expect with 13.3% unemployment.

So it is likely that the Fed’s stress test is both not harsh enough, in its economic scenario, and too harsh, in its assumption about how that scenario will affect banks.

Notwithstanding the potential for people to respond to and mitigate stress, there is still plenty of room for reality to catch up with and exceed the hypothetical scenario. Back to Matt…

But the fact that the stress test imagines an economic crisis that is much nicer than reality is still a little embarrassing, and the Fed can’t really say “everything is fine even in the terrible downside case of 10% unemployment, the banks are doing great.” So it also produced some new stress-test results (well, not quite a full stress test but a “sensitivity analysis”) assuming various scenarios about the recovery from the Covid crisis (“a rapid V-shaped recovery,” “a slower, more U-shaped recovery,” and “a W-shaped double dip recession”). The banks are much less well capitalized in those scenarios than they are either (1) now or (2) in the original stress tests, though mostly still okay, and the Fed is asking the banks to reconsider stress and capital based on current reality. Also stop share buybacks:

Worth reading

Tony – From the Outside

Climate change – a central banking perspective

A BIS paper titled “Green Swan 2 – Climate change and Covid-19: reflections on efficiency versus resilience” initially caught my attention because of the reference to the tension between efficiency versus resilience. This tension is, for me at least, one of the issues that has tended to be ignored in the pursuit of growth and optimised solutions. The papers mainly deal with the challenges that climate change creates for central banks but I think there are also some insights to be drawn on what it means for bank capital management.

A core argument in the paper is that challenges like climate change and pandemics ….

“… require us to rethink the trade-offs between efficiency and resilience of our socio-economic systems … one way to address this issue is to think about buffers or some necessary degree of redundancy for absorbing such large shocks. Countries build FX reserves, banks maintain capital buffers as required by regulators, and so on. Perhaps similar “buffers” could be used in other areas of our societies. For example, could it be time to reassess our production systems, which are meant to be lean and less costly for maximum efficiency?”

The paper draws on a (much longer and more technical) BIS research paper titled “The green swan: Central banking and financial stability in the age of climate change”. Both papers contain the usual caveat that the views expressed do not necessarily reflect those of their respective institutions. With that warning noted, this post draws on both papers to make some observations about what the papers say, and what this means for bank capital management.

There is a lot of content in the combined papers but the points that resonated the most with me were

  1. Climate change shares some of the features of a Black Swan event but is better thought of a distinct type of risk which the authors label a “Green Swan”.
  2. Green swan problems are created in part by choices we have made regarding the value of efficiency over resilience – part of the solution lies in rethinking these choices but this will not be easy.
  3. Climate change is a “collective action” problem which cannot be addressed by individual actors (including banks) operating independently – market based solutions like a carbon price may also be insufficient to bring about a solution that does not involve an unacceptable level of financial disruption.
  4. Scenario analysis (including stress testing) appears to be one of the better tools for dealing with climate change and similar types of risk – but it needs to be used differently (by both the supervised and the supervisors) from the way it is applied to conventional risks.

I am not an expert on climate change modelling, but Chapter 3 of the second paper also has what looks to be a useful overview of the models used to analyse climate change and how the outputs of these models are used to generate economic impacts.

Black, white and green swans

Climate change clearly operates in the domain of radical uncertainty. As such it shares some common elements with “black swan” events; in particular the fact that conventional risk models and analysis are not well suited to measuring and managing the potential adverse impacts. It is equally important however to understand the ways in which climate change differs from a classic black swan event. There is a longer list but the ones that I found most relevant were:

  1. Predictability – Black Swans are, by definition, not predictable whereas the potential for adverse Climate Change outcomes is well understood even if not universally accepted. The point is that understanding the potential for adverse impact means we have a choice about what to do about it.
  2. Impact – Black Swan events can have substantial impacts but the system can recover (e.g. the GFC has left a lasting impact but economic activity did recover once the losses were absorbed). The impacts of climate change, in contrast, may be irreversible and have the potential to result in people dying in large numbers.

Given the conceptual differences, the authors classify Climate Change as a distinct form which they label a “Green Swan”. To the best of my knowledge, this may be the first time the term has been used in this way. That said, the general point they are making seems to be quite similar to what other authors have labelled as “Grey Rhinos” or “Black Elephants” (the latter an obvious allusion to the “elephant in the room”, a large risk that is visible to everyone but no one wants to address).

A typology of swans
Categorising climate risk

The papers distinguish two main channels through which climate change can affect financial stability – physical risks and transition risks.

Physical risks are defined as

… “those risks that arise from the interaction of climate-related hazards […] with the vulnerability of exposure to human and natural systems” (Batten et al (2016)). They represent the economic costs and financial losses due to increasing frequency and severity of climate-related weather events (eg storms, floods or heat waves) and the effects of long-term changes in climate patterns (eg ocean acidification, rising sea levels or changes in precipitation). The losses incurred by firms across different financial portfolios (eg loans, equities, bonds) can make them more fragile.

Transition risks are defined as those

“… associated with the uncertain financial impacts that could result from a rapid low-carbon transition, including policy changes, reputational impacts, technological breakthroughs or limitations, and shifts in market preferences and social norms.

A rapid and ambitious transition to lower emissions, for example, would obviously be desirable from the perspective of addressing climate change but might also mean that a large fraction of proven reserves of fossil fuel cannot be extracted, becoming “stranded assets”. The write down of the value of these assets may have potentially systemic consequences for the financial system. This transition might occur in response to policy changes or by virtue of some technological breakthrough (e.g. problem of generating cheap energy by nuclear fusion is solved).

Efficiency versus resilience

I started this post with a quote from the first (shorter) paper regarding the way in which the Covid 19 had drawn attention to the extent to which the pursuit of efficiency had made our economies more fragile. The paper explores the ways in which the COVID 19 pandemic exhibits many of the same features that we see in the climate change problem and how the global response to the COVID 19 pandemic might offer some insights into how we should respond to climate change.

The paper is a useful reminder of the nature of the problem but I am less confident that it offers a solution that will work without some form of regulation or public sector investment in the desired level of redundancy. The paper cites bank capital buffers introduced post GFC as an example of what to do but this was a regulated outcome that would most likely not be acceptable for non-financial companies in countries that remain committed to free market ideology.

The Economist published an article on this question that offered numerous examples of similar problems that illustrate the propensity of “humanity, at least as represented by the world’s governments … to ignore them until forced to react” .

Thomas Friedman’s article (“How we broke the world”) is also worth reading on this question …

If recent weeks have shown us anything, it’s that the world is not just flat. It’s fragile.

And we’re the ones who made it that way with our own hands. Just look around. Over the past 20 years, we’ve been steadily removing man-made and natural buffers, redundancies, regulations and norms that provide resilience and protection when big systems — be they ecological, geopolitical or financial — get stressed. We’ve been recklessly removing these buffers out of an obsession with short-term efficiency and growth, or without thinking at all.

The New York Times, 30 May 2020
Managing collective action problems

The second paper, in particular, argues that it is important to improve our understanding of the costs of climate change and to ensure that these costs are incorporated into the prices that drive the resources we allocate to dealing with the challenge (e.g. via a carbon price or tax). However one of its key conclusions is that relying on markets to solve the problem is unlikely to be sufficient even with the help of some form of carbon price that reflects a more complete account of the costs of our current carbon based economy.

In short, the development and improvement of forward-looking risk assessment and climate- related regulation will be essential, but they will not suffice to preserve financial stability in the age of climate change: the deep uncertainty involved and the need for structural transformation of the global socioeconomic system mean that no single model or scenario can provide sufficient information to private and public decision-makers. A corollary is that the integration of climate-related risks into prudential regulation and (to the extent possible) into monetary policy would not suffice to trigger a shift capable of hedging the whole system again against green swan events.

The green swan: Central banking and financial stability in the age of climate change; Chapter 5 (page 66)
Using scenario based methodologies to assess climate related risks

Both papers highlight the limitations of trying to measure and understand climate change using conventional probability based risk management tools. The one area they do see as worth pursuing is using scenario based approaches. This makes sense to me but it is also important to distinguish this kind of analysis from the standard stress testing used to help calibrate capital buffers.

The standard application of stress testing takes a severe but plausible macro economic scenario such as a severe recession and determines what are the likely impacts on capital adequacy ratios. This offers a disciplined way of deciding how much capital surplus is required to support the risk appetite choices a bank has made in pursuit of its business objectives.

A simplistic application of climate based stress testing scenarios might take the same approach; i.e. work out how much the scenario impacts the capital and ensure that the buffer is sufficient to absorb the impact. That I think is not the right conclusion and my read of the BIS papers is that they are not advocating that either. The value of the scenario based modelling is to first get a handle on the size of the problem and how exposed the bank is to it. A capital response may be required but the answer may also be to change the nature of your exposure to the risk. That may involve reduced risk limits but it may also involve active participation in collective action to address the underlying problem. A capital management response may be part of the solution but it is far from the first step.

Conclusion

I have only scratched the surface of this topic in this post but the two papers it references are worth reading if you are interested in the question of what climate change, and related Green Swan or Black Elephant problems, mean for the banking system and for central banking. There is a bit more technical detail in the appendix below but it is likely only of interest for people working at the sharp end of trying to measure and manage the problem.

I want to dig deeper into the question of how you use stress testing to assess climate change and related types of risk but that is a topic best left for another post.

Tony – From the outside

Appendix – Modelling the impacts of climate change

Section 3 of the longer paper (“Measuring climate-related risks with scenario-based approaches”) discusses the limitations of the models that are typically used to generate estimates of the ecological and financial impacts of climate change scenarios. There is plenty of material there for climate sceptics but it also assists true believers to understand the limits of what they can actually know and how coming to terms with the radical uncertainty of how climate change plays out shapes the nature of our response.

I have copied some extracts from the chapter below that will give you a flavour of what it has to say. It is pretty technical so be warned …

“… the standard approach to modelling financial risk consisting in extrapolating historical values (eg PD, market prices) is no longer valid in a world that is fundamentally reshaped by climate change (Weitzman (2011), Kunreuther et al (2013)). In other words, green swan events cannot be captured by traditional risk management.

The current situation can be characterised as an “epistemological obstacle” (Bachelard (1938)). The latter refers to how scientific methods and “intellectual habits that were useful and healthy” under certain circumstances, can progressively become problematic and hamper scientific research. Epistemological obstacles do not refer to the difficulty or complexity inherent to the object studied (eg measuring climate-related risks) but to the difficulty related to the need of redefining the problem”

Page 21

nothing less than an epistemological break (Bachelard, 1938) or a “paradigm shift” (Kuhn (1962)) is needed today to overcome this obstacle and more adequately approach climate-relate risks (Pereira da Silva (2019a)).

In fact, precisely an epistemological break may be taking place in the financial sector: recently emerged methodologies aim to assess climate-related risks while relying on the fundamental hypothesis that, given the lack of historical financial data related to climate change and the deep uncertainty involved, new approaches based on the analysis of prospective scenarios are needed. Unlike probabilistic approaches to financial risk management, they seek to set up plausible hypotheses for the future. This can help financial institutions integrate climate-related risks into their strategic and operational procedures (eg for the purpose of asset allocation, credit rating or insurance underwriting) and financial supervisors assess the vulnerability of specific institutions or the financial system as a whole

Climate-economic models and forward-looking risk analysis are important and can still be improved, but they will not suffice to provide all the information required to hedge against “green swan” events.

As a result of these limitations, two main avenues of action have been proposed. We argue that they should be pursued in parallel rather than in an exclusive manner. First, central banks and supervisors could explore different approaches that can better account for the uncertain and nonlinear features of climate-related risks. Three particular research avenues (see Box 5 below) consist in: (i) working with non- equilibrium models; (ii) conducting sensitivity analyses; and (iii) conducting case studies focusing on specific risks and/or transmission channels. Nevertheless, the descriptive and normative power of these alternative approaches remain limited by the sources of deep and radical uncertainty related to climate change discussed above. That is, the catalytic power of scenario-based analysis, even when grounded in approaches such as non-equilibrium models, will not be sufficient to guide decision-making towards a low-carbon transition.

As a result of this, the second avenue from the perspective of maintaining system stability consists in “going beyond models” and in developing more holistic approaches that can better embrace the deep or radical uncertainty of climate change as well as the need for system-wide action (Aglietta and Espagne (2016), Barmes (2019), Chenet et al (2019a), Ryan-Collins (2019), Svartzman et al (2019)). 

Pages 42 – 43

Embracing deep or radical uncertainty therefore calls for a second “epistemological break” to shift from a management of risks approach to one that seeks to assure the resilience of complex adaptive systems in the face of such uncertainty (Fath et al (2015), Schoon and van der Leeuw (2015)).38 In this view, the current efforts aimed at measuring, managing and supervising climate-related risks will only make sense if they take place within a much broader evolution involving coordination with monetary and fiscal authorities, as well as broader societal changes such as a better integration of sustainability into financial and economic decision-making.

Page 48

Capital adequacy reform – new learnings from the crisis

A speech by APRA Chair Wayne Byres released today had some useful remarks on the post 2008 capital adequacy reforms and what we have learned thus far. A few observations stood out for me. Firstly, a statement of the obvious is that the reforms are getting their first real test and we are likely to find areas for improvement

“… the post-2008 reforms will be properly tested, and inevitably we will find areas they can be improved.”

The speech clarifies that just how much, if any, change is required is not clear at this stage

“Before anyone misinterprets that comment, I am not advocating a watering down of the post-2008 reforms. It may in fact turn out they’re insufficient, and we need to do more. Maybe they just need to be reshaped a bit. I do not know. But inevitably there will be things we learn, and we should not allow a determination not to backtrack on reforms to deter us from improving them.”

Everyone is focused on fighting the COVID 19 fire at the moment but a discussion paper released in 2018 offered some insights into the kinds of reforms that APRA was contemplating before the crisis took priority. It will be interesting to see how the ideas floated in this discussion paper are refined or revised in the light of what we and APRA learn from this crisis. One of the options discussed in that 2018 paper involved “APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA“. It was interesting therefore to note that the speech released today referred to the internationally comparable ratios rather than APRA’s local interpretation of Basel III.

“We had been working for some years to position our largest banks in the top quartile of international peers from a capital adequacy perspective, and fortuitously they had achieved that positioning before the crisis struck. On an internationally comparable basis, our largest banks are operating with CET1 ratios in the order of 15-16 per cent, and capital within the broader banking system is at a historical high – and about twice the level heading into the 2008 crisis.”

The speech makes a particular note of what we are learning about the capacity to use capital buffers.

“One area where I think we are learning a lot at present is the ability to use buffers. It is not as easy as hoped, despite them having been explicitly created for use during a crisis. One blockage does seem to be that markets, investors and rating agencies have all adjusted to contemporary capital adequacy ratios as (as the name implies) ‘adequate capital’. But in many jurisdictions, like Australia, ratios are at historical highs. We often hear concern about our major banks’ CET1 ratios falling below 10 per cent. This is even though, until a few years ago, their CET1 ratios had never been above 10 per cent and yet they were regarded as strong banks with AA ratings. So expectations seem to have shifted and created a new de facto minimum. We need to think about how to reset that expectation.”

I definitely agree that there is more to do on the use of capital buffers and have set out my own thoughts on the topic here. One thing not mentioned in the speech is the impact of procyclicality on the use of capital ratios.

This chart from a recent Macquarie Wealth Management report summarises the disclosure made by the big four Australian banks on the estimated impact of the deterioration in credit quality that banks inevitably experience under adverse economic conditions such as are playing out now. The estimated impacts collated here are a function of average risk weights calculated under the IRB approach increasing as average credit deteriorates. This is obviously related to the impact of increased loan loss provisioning on the capital adequacy numerator but a separate factor driving the capital ratios down via its impact on the denominator of the capital ratio.

There are almost certainly issues with the consistency and comparability of the disclosure but it does give a rough sense of the materiality of this factor which I think is not especially well understood. This is relevant to some some observations in Wayne Byres speech about the capital rebuilding process.

A second possible blockage is possibly that regulatory statements permitting banks to use their buffers are only providing half the story. Quite reasonably, what banks (and their investors) need to understand before they contemplate using buffers is the expectation as to their restoration. But we bank supervisors do not have a crystal ball – we cannot confidently predict the economic pathway, so we cannot provide a firm timetable. The best I can offer is that it should be as soon a circumstances reasonably allow, but no sooner. In Australia, I would point to the example of the way we allowed Australian banks to build up capital to meet their ‘unquestionably strong’ benchmarks in an orderly way over a number of years. We should not be complacent about the rebuild, but there are also risks from rushing it.”

Given that the estimated impacts summarised in the chart above are entirely due to “RWA inflation” as credit quality deteriorates, it seems reasonable to assume that part of the capital buffer rebuild will be generated by the expected decline in average risk weights as credit quality improves. The capital buffers will in a sense partly self repair independent of what is happening to the capital adequacy numerator.

I think we had an academic understanding of the capital ratio impact of this RWA inflation and deflation process pre COVID 19 but will have learned a lot more once the dust settles.

Tony – From the Outside

When safety proves dangerous …

… is the title of a post on the Farnham Street blog that provides a useful reminder of the problem of “risk compensation”; i.e. the way in which measures designed to make us safer can be a perverse prompt for us to take more risk because we feel safer. I want to explore how these ideas apply to bank capital requirements but will first outline the basic ideas covered by Farnham Street.

we all internally have a desired level of risk that varies depending on who we are and the context we are in. Our risk tolerance is like a thermostat—we take more risks if we feel too safe, and vice versa, in order to remain at our desired “temperature.” It all comes down to the costs and benefits we expect from taking on more or less risk.

The notion of risk homeostasis, although controversial, can help explain risk compensation.

The classic example is car safety measures such as improved tyres, ABS braking systems, seat belts and crumple zones designed to protect the driver and passengers. These have helped reduce car fatality rates for the people inside the car but not necessarily reduced accident rates given that drivers tend to drive faster and more aggressively because they can. Pedestrians are also at greater risk.

Farnham Street suggests the following lessons for dealing with the problem risk compensation:

  1. Safety measures are likely to be more effective is they are less visible
  2. Measures designed to promote prudent behaviour are likely to be more effective than measures which make risky behaviour safer
  3. Recognise that sometimes it is better to do nothing if the actions we take just leads to an offset in risk behaviour somewhere else
  4. If we do make changes then recognise that we may have to put in place other rules to ensure the offsetting risk compensating behaviour is controlled
  5. Finally (and a variation on #3), recognise that making people feel less safe can actually lead to safer behaviour.

If you are interested in this topic then I can also recommend Greg Ip’s book “Foolproof” which offers a good overview of the problem of risk compensation.

Applying these principles to bank capital requirements

The one area where I would take issue with the Farnham Street post is where it argues that bailouts and other protective mechanisms contributed to scale of the 2008 financial crisis because they led banks to take greater risks. There is no question that the scale of the crisis was amplified by the risks that banks took but it is less obvious to me that the bailouts created this problem.

The bailouts were a response to the problem that banks were too big to fail but I can’t see how they created this problem; especially given that the build up of risk preceded the bailouts. Bailouts were a response to the fact that the conventional bankruptcy and restructure process employed to deal with the failure of non-financial firms simply did not work for financial firms.

It is often asserted that bankers took risks because they expected that they would be bailed out; i.e/ that banks deliberately and consciously took risk on the basis that they would be bailed out. I can’t speak for banks as a whole but I have never witnessed that belief in the four decades that I worked in the Australian banking system. Never attribute to malice what can be equally explained by mistaken beliefs. I did see bankers placing excessive faith in the economic capital models that told them they could safely operate with reduced levels of capital. That illusion of knowledge and control is however a different problem altogether, largely to do with not properly understanding the distinction between risk and uncertainty (see here and here).

If I am right, that would suggest that making banks hold more capital might initially make them safer but might also lead to banks looking for ways to take more risk. This is a key reason why I think the answer to safer banks is not just making them hold higher and higher levels of common equity. More common equity is definitely a big part of the answer but one of the real innovations of Basel 3 was the development of new forms of loss absorbing capital that allow banks to be recapitalised by bail-in rather than bail-out.

If you want to go down the common equity is the only solution path then it will be important to ensure that Farnham Street Rule #4 above is respected; i.e. bank supervisors will need to ensure that banks do not simply end up taking risks in places that regulation or supervision does not cover. This is not a set and forget strategy based on the idea that increased “skin in the game” will automatically lead to better risk management.

Based on my experience, the risk of common equity ownership being diluted by the conversion of this “bail-in” capital is a far more effective constraint on risk taking than simply requiring banks to hold very large amounts of common equity. I think the Australian banking system has this balance about right. The Common Equity Tier 1 requirement is calibrated to a level intended to make banks “Unquestionably Strong”. Stress testing suggest that this level of capital is likely to be more than sufficient for well managed banks operating with sensible risk appetites but banks (the larger ones in particular) are also required to maintain a supplementary pool of capital that can be converted to common equity should it be required. The risk that this might be converted into a new pool of dilutive equity is a powerful incentive to not push the boundaries of risk appetite.

Tony – From the Outside

Navigating a radically uncertain world

The distinction between risk and uncertainty is a long running area of interest for me so I have enjoyed reading John Kay and Mervyn King’s book “Radical Uncertainty: Decision-Making for an Unknowable Future”. My initial post on the book offered an overview of the content and a subsequent post explored Kay and King’s analysis of why the world is prone to radical uncertainty.

This post looks at how Kay and King propose that we navigate a world that is prone to radical uncertainty. Kay and King start (Ch 8) with the question of what it means to make rational choices.

No surprises that the answer from their perspective is not the pursuit of maximum expected value based on a priori assumptions of what is rational in a world ruled by probability (“axiomatic reasoning”). They concede that there are some problems that can be solved this way. Games of chance where you get repeated opportunities to play the odds is one, but Kay and King are firmly in the camp that the real world is, for the most part, too complex and unknowable to rely on this approach for the big issues.

It is not just that these models do not offer any useful insight into these bigger world choices. They argue, convincingly I think, that these types of precise quantitative models can also tend to create an illusion of knowledge and control that can render the systems we are seeking to understand and manage even more fragile and more prone to uncertainty. An obvious example of this risk is the way in which the advanced measures of bank capital requirements introduced under Basel II tended to encourage banks to take (and bank supervisors to approve) more leverage.

Their argument broadly makes sense to me but there was nothing particularly new or noteworthy in this part of the book. It goes over familiar ground covered equally well by other writers – see for example these posts Epsilon Theory, Bank Underground, Paul Wilmott and David Orrell, Andrew Haldane which discuss contributions these authors have made to the debate.

However, there were two things I found especially interesting in their analysis.

  • One was the argument that the “biases” catalogued by behavioural finance were not necessarily irrational when applied to a radically uncertain world.
  • The other was the emphasis they place on the idea of employing abductive reasoning and reference narratives to help navigate this radically uncertain future.

Behavioural Finance

Kay and King argue that some of the behaviours that behavioural finance deems to be irrational or biased might be better interpreted as sensible rules of thumbs that people have developed to deal with an uncertain world. They are particularly critical of the way behavioural finance is used to justify “nudging” people to what behavioural finance deems to be rational.

Behavioural economics has contributed to our understanding of decision-making in business, finance and government by introducing observation of how people actually behave. But, like the proselytisers for the universal application of probabilistic reasoning, practitioners and admirers of behavioural economics have made claims far more extensive than could be justified by their findings…

…. a philosophy of nudging carries the risk that nudgers claim to know more about an uncertain world than they and their nudgees do or could know.

I struggled with this part of the book because I have generally found behavioural finance insights quite useful for understanding what is going on. The book reads at times like behavioural finance as a whole was a wrong turn but I think the quote above clarifies that they do see value in it provided the proponents don’t push the arguments too far. In particular they are arguing that rules of thumb that have been tested and developed over time deserve greater respect.

Abductive Reasoning and Reference Narratives

The part of Kay and King’s book I found most interesting was their argument that “abductive reasoning” and “reference narratives” are a useful way of mapping our understanding of what is going on and helping us make the right choices to navigate a world prone to enter the domain of radical uncertainty.

If we go back to first principles it could be argued that the test of rationality is that the decisions we make are based on reasonable beliefs about the world and internal consistency. The problem, Kay and King argue, is that this approach still does not address the fundamental question of whether we can ever really understand a radically uncertain world. The truely rational approach to decision making has to be resilient to the fact that our future is shaped by external events taking paths that we have no way of predicting.

The rational answer for Kay and King lies in an “abductive” approach to reasoning. I must confess that I had to look this up (and my spell checker still struggles with it) but it turns out that this is a style of reasoning that works with the available (not to mention often incomplete and ambiguous) information to form educated guesses that seek to explain what we are seeing.

Abduction is similar to induction in that it starts with observations. Where it differs is what the abductive process does with the evidence. Induction seeks to derive general or universal principles from the evidence. Abduction in contrast is context specific. It looks at the evidence and tries to fit “an explanation” of what is going on while being careful to avoid treating it as “the explanation” of what is going on.

Deductive, inductive and abductive reasoning each have a role to play in understanding the world, and as we move to larger worlds the role of the inductive and abductive increases relative to the deductive. And when events are essentially one-of-a-kind, which is often the case in the world of radical uncertainty, abductive reasoning is indispensable.

Reference Narratives

If I have understood their argument correctly, the explanations or hypotheses generated by this abductive style of reasoning are expressed in “reference narratives” which we use to explain to ourselves and others what we are observing. These high level reference narratives can then provide a basis for longer term planning and a framework for day-to-day choices.

Deductive, inductive and abductive reasoning each have a role to play in understanding the world, and as we move to larger worlds the role of the inductive and abductive increases relative to the deductive. And when events are essentially one-of-a-kind, which is often the case in the world of radical uncertainty, abductive reasoning is indispensable.

Kay and King acknowledge that this approach is far from foolproof and devote a considerable part of their book to what distinguishes good narratives from bad and how to avoid the narrative being corrupted by groupthink.

Good and Bad Reference Narratives

Kay and King argue that credibility is a core feature distinguishing good and bad narratives. A good narrative offers a coherent and internally consistent explanation but it also needs to avoid over-reach. A warning sign for a bad narrative is one that seeks to explain everything. This is especially important given that our species seems to be irresistibly drawn to grand narratives – the simpler the better.

Our need for narratives is so strong that many people experience a need for an overarching narrative–some unifying explanatory theme or group of related themes with very general applicability. These grand narratives may help them believe that complexity can be managed, that there exists some story which describes ‘the world as it really is’. Every new experience or piece of information can be interpreted in the light of that overarching narrative.

Kay and King use the fox and the hedgehog analogy to illustrate their arguement that we should always be sceptical of the capacity of any one narrative to explain everything,

…. The hedgehog knows one big thing, the fox many little things. The hedgehog subscribes to some overarching narrative; the fox is sceptical about the power of any overarching narrative. The hedgehog approaches most uncertainties with strong priors; the fox attempts to assemble evidence before forming a view of ‘what is going on here’.

Using Reference Narratives

Kay and King cite the use of scenario based planing as an example of using a reference narrative to explore exposure to radical uncertainty and build resilience but they caution against trying too hard to assign probabilities to scenarios. This I think is a point well made and something that I have covered in other posts (see here and here).

Scenarios are useful ways of beginning to come to terms with an uncertain future. But to ascribe a probability to any particular scenario is misconceived…..

Scenario planning is a way of ordering thoughts about the future, not of predicting it.

The purpose is … to provide a comprehensive framework for setting out the issues with which any business must deal: identifying markets, meeting competition, hiring people, premises and equipment. Even though the business plan is mostly numbers–many people will describe the spreadsheet as a model–it is best thought of as a narrative. The exercise of preparing the plan forces the author to translate a vision into words and numbers in order to tell a coherent and credible story.

Kay and King argue that reference narratives are a way of bringing structure and conviction to the judgment, instinct and emotion that people bring to making decisions about an uncertain future

We make decisions using judgement, instinct and emotions. And when we explain the decisions we have made, either to ourselves or to others, our explanation usually takes narrative form. As David Tuckett, a social scientist and psychoanalyst, has argued, decisions require us ‘to feel sufficiently convinced about the anticipated outcomes to act’. Narratives are the mechanism by which conviction is developed. Narratives underpin our sense of identity, and enable us to recreate decisions of the past and imagine decisions we will face in the future.

Given the importance they assign to narratives, Kay and King similarly emphasise the importance of having a good process for challenging the narrative and avoiding groupthink.

‘Gentlemen, I take it we are all in complete agreement on the decision here. Then, I propose we postpone further discussion of this matter until the next meeting to give ourselves time to develop disagreement, and perhaps gain some understanding of what the decision is all about.’

Alfred P. Sloan (Long time president chairman and CEO of General Motors Corporation) quoted in the introduction to Ch 16: Challenging Narratives

These extracts from their book nicely captures the essence of their argument

Knowledge does not advance through a mechanical process of revising the probabilities people attach to a known list of possible future outcomes as they watch for the twitches on the Bayesian dial. Instead, current conventional wisdom is embodied in a collective narrative which changes in response to debate and challenge. Mostly, the narrative changes incrementally, as the prevalent account of ‘what is going on here’ becomes more complete. Sometimes, the narrative changes discontinuously – the process of paradigm shift described by the American philosopher of science Thomas Kuhn.

the mark of the first-rate decision-maker confronted by radical uncertainty is to organise action around a reference narrative while still being open to both the possibility that this narrative is false and that alternative narratives might be relevant. This is a very different style of reasoning from Bayesian updating.

Kay and King argue that the aim in challenging the reference narrative is not simply to find the best possible explanation of what is going on. That in a sense is an almost impossible task given the premise that the world is inherently unpredictable. The objective is to find a narrative that seems to offer a useful guide to what is going on but not hold too tightly to it. The challenge process also tests the weaknesses of plans of action based on the reference narrative and, in doing so, progressively secures greater robustness and resilience.


The quote below repeats a point covered above but it does nicely capture their argument that the pursuit of quantitative precision can be a distraction from the broader objective of having a robust and resilient process. By all means be as rigorous and precise as possible but recognise the risk that the probabilities you assign to scenarios and “risks” may end up simply serving to disguise inherent uncertainties that cannot be managed by measurement.

The attempt to construct probabilities is a distraction from the more useful task of trying to produce a robust and resilient defence capability to deal with many contingencies, few of which can be described in any but the sketchiest of detail.

robustness and resilience, not the assignment of arbitrary probabilities to a more or less infinite list of possible contingencies, are the key characteristics of a considered military response to radical uncertainty. And we believe the same is true of strategy formulation in business and finance, for companies and households.

Summing Up

Overall a thought provoking book. I am not yet sure that I am ready to embrace all of their proposed solutions. In particular, I am not entirely comfortable with the criticisms they make of risk maps, bayesian decision models and behavioural finance. That said, I do think they are starting with the right questions and the reference narrative approach is something that I plan to explore in more depth.

I had not thought of it this way previously but the objective of being “Unquestionably Strong” that was recommended by the 2014 Australian Financial System Inquiry and subsequently fleshed out by APRA can be interpreted as an example of a reference narrative that has guided the capital management strategies of the Australian banks.

Tony – From The Outside