Misunderstanding Narratives: The Hero’s Journey – The Big Picture

Joseph Campbell’s “The Hero with a Thousand Faces” is a great book. It offers insights into some deep ideas about how the world does (or should) work that have influenced a wide variety of people including George Lucas and Ray Dalio and was included in Time magazine’s list of the top 100 books.

Barry Ritholz did a short, but insightful, post here where he reminds us that the timeless appeal of the narrative that Campbell explores can also mislead us.

Our narrative bias for compelling stories can prevent us from seeing the forest for trees. Dramatic tales with clearly delineated Good & Evil are more memorable and emotionally resonant than dry data and tedious facts. Try as you might, finding a singular cause of some terrible economic outcome is an exercise in futility. Instead, you will find a long history of political, economic, psychological, and (occasionally) irrational drivers that eventually led to some disaster.

We look for the spark that ignites the room full of hydrogen, instead of 1,000 other factors that created the conditions precedent. You can find example after example of disasters widely thought of as “single event causes;” upon closer examination, they are revealed as the result of far more complex circumstances and countless interactions

https://ritholtz.com/2021/09/misunderstanding-narratives-the-heros-journey/

This for me is an insight that rings very true but is often forgotten to feed our appetite for reducing complex stories to simple morality plays. I like the stories as much as the next person but the downside is that the simple appealing story distracts us from understanding the route causes of why things like the GFC happened and leave us exposed to the risk that they just keep repeating in different forms.

Tony – From the Outside

Andrew Haldane

Claire Jones writing for the Financial Times Alphaville column confesses a fondness for the speeches of Andrew Haldane (departing chief economist at the Bank of England) . She offered a selection of favourites (you can access her column by signing up to Alphaville if you are not an FT subscriber).

I also rate pretty much everything he writes as worth reading often more than once to reflect on the issues he raises. To her top three Haldane speeches, I will add one he did in 2016 titled “The Great Divide” which explored the gap between the way banks perceive themselves and how they are perceived by the community.

Tony – From the Outside

What Can We Learn from a Big Boat Stuck in a Canal?

Interesting post by Matt Stoller on the broader policy issues associated with the current problem in the Sues Canal.

Here is a short extract capturing the main idea …

“Industrial crashes, in other words, are happening in unpredictable ways throughout the economy, shutting down important production systems in semi-random fashion. Such collapses were relatively rare prior to the 1990s. But industrial crashes were built into the nature of our post-1990s production system, which prioritizes efficiency over resiliency. Just as ships like the Ever Given are bigger and more efficient, they are also far riskier. And this tolerance for risk is a pattern reproducing itself far beyond the shipping industry; we’ve off shored production and then consolidated that production in lots of industries, like semiconductors, pharmaceutical precursors, vitamin C, and even book printing.

What is new isn’t the vulnerability of the Suez Canal as a chokepoint, it’s that we’ve intentionally created lots of other artificial chokepoints. And since our production systems have little fat, these systems are tightly coupled, meaning a shortage in one area cascades throughout the global economy, costing us time, money, and lives.”

Irrespective of whether you agree with the solutions he proposes, I think the point he makes (i.e. the tension between efficiency and resilience and the systemic problem with systems that are “tightly coupled”) is a very real issue. We saw this play out in the financial system in 2008 and we saw it play out in global supply chains in 2020. There are differing views on whether the measures have gone far enough but the financial system has been substantially re-engineered to make it more resilient. It remains to be seen how global supply chains will evolve in response to the problems experienced.

Link to the post here

https://mattstoller.substack.com/p/what-we-can-learn-from-a-big-boat

Tony – From the Outside

In Search of a Post-Pandemic Modeling Paradigm – Risk Weighted

Nice post from Tony Hughes discussing the difference between modelling intended to forecast a most likely outcome and modelling tail risk …

“A forecasting mindset yields very tight models, whereas a tail risk mindset demands a far more liberal approach to model specification.”

— Read on riskweighted.com/2021/03/03/in-search-of-a-post-pandemic-modeling-paradigm/

Allowing companies to fail

I suspect (but can’t prove) that creative destruction is one of the under appreciated factors that underpin the health of the economy. There is quite a lot of evidence however that creative destruction has been suppressed since the 2008 Global Financial Crisis. The rights and wrongs of the extent to which bail-outs were and continue to be necessary is too big a topic to cover in this post.

For the record, I do believe that the bail-outs of the banks were necessary at the time but that “bail-in” gives bank supervisors a very real option to avoid having to do this in the future. The increase in capital requirements are also likely to reduce the risk of a bail-in being required. Others may disagree and my views chiefly relate to the Australian banking system which is where my professional expertise is based. The issues associated with COVID-19 raise a whole lot of related but, in many ways, different issues. At the risk of stating the obvious, it’s complicated.

Against that background, I found this short article published on the VoxEU website worth reading as another reminder of the value of allowing companies to fail and/or be restructured. The conclusion of the article (copied below) gives you the key points the authors derive from their research

We investigate a large number of stakeholders that could be negatively affected by a fire sale but find little evidence for negative externalities. The main effect of fire sales is a wealth transfer from the seller to the buyer. Thus, from a welfare perspective, the costs associated with fire sales of corporate assets are much lower than previously thought based on an analysis of seller costs only. From a policy perspective, these findings indicate that the merits of bailouts as a response to the potential losses associated with fire sales are limited, especially given the moral hazard and the other distortions caused by these bailouts. 

We recognise that the economic shock caused by the COVID-19 pandemic is unparalleled since the WWII and the Great Depression, and hence, some emergency measures and bailouts were likely necessary to prevent a meltdown of economic activity. However, one difference between the current crisis and the Global Crisis is the apparent lack of fire sales of struggling companies or investments into such companies at fire-sale prices. Warren Buffett’s Berkshire Hathaway, for instance, invested $5 billion in Goldman Sachs in September 2008 and $3 billion in General Electric in October 2008, while Warren Buffett’s firm has not undertaken any major investments during the COVID-19 crisis (Financial Times 2020). Our results therefore suggest that, at least at the margin, fire sales would have been an effective alternative to bailouts, especially for large bailouts such as for the airlines in the US.

“The merits of fire sales and bailouts in light of the COVID-19 pandemic”, Jean-Marie Meier and Henri Servaes, 18 January 2021.

APRA reflects on “… a subtle but important shift in regulatory thinking”

Wayne Byres speech to the Risk Management Association covered a range of developments but, for me, the important part was the discussion of the distinction between strength and resilience referenced in the title of this post.

This extract from the speech sets out how Mr Byres frames the distinction …

… in the post-GFC period, the emphasis of the international reforms was on strengthening the global financial system. Now, the narrative is how to improve its resilience. A perusal of APRA speeches and announcements over time shows a much greater emphasis on resilience in more recent times as well.

What is behind this shift? Put simply, it is possible to be strong, but not resilient. Your car windscreen is a great example – without doubt it is a very strong piece of glass, but one small crack and it is irreparably damaged and ultimately needs to be replaced. That is obviously not the way we want the financial system to be. We want a system that is able to absorb shocks, even from so-called “black swan” events, and have the means to restore itself to full health.

In saying that, financially strong balance sheets undoubtedly help provide resilience, and safeguarding financial strength will certainly remain the cornerstone of prudential regulation and supervision. But it is not the full story. So with that in mind, let me offer some quick reflections on the past year, and what it has revealed about opportunities for the resilience of the financial system to be further improved.

APRA Chair Wayne Byres – Speech to the 2020 Forum of the Risk Management Association – 3 December 2020

To my mind, the introduction of an increased emphasis on resilience is absolutely the right way to go. We saw some indications of the direction APRA intend to pursue in the speech that Mr Byres gave to the AFR Banking and Wealth Summit last month and will get more detail next week (hopefully) when APRA releases a consultation paper setting out a package of bank capital reforms that is likely to include a redesign of the capital buffer framework.

This package of reforms is one to watch. To the extent that it delivers on the promise of increasing the resilience of the Australian banking system, it is potentially as significant as the introduction of the “unquestionably strong” benchmark in response to the Australian Financial System Inquiry.

Tony – From the Outside

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

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

… is 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 that 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

Constructive dissent

I am currently reading “Thinking in Bets” by Annie Duke. It is early days but I suspect that this is a book that has some useful things to say about creating the kinds of corporate culture that truely reflect the values espoused in corporate mission statements. It is a truth that actions speak louder than words and she cites a practice employed by the American Foreign Service Association which has not one but four awards for employees who have exhibited behaviours that demonstrate initiative, integrity, intellectual courage and constructive dissent.

The attached quote comes from the AFSA website setting out the criteria employed for these awards

Criteria for the Dissent Awards

The awards are for Foreign Service employees who have “exhibited extraordinary accomplishment involving initiative, integrity, intellectual courage and constructive dissent”. The awards publicly recognize individuals who have demonstrated the intellectual courage to challenge the system from within, to question the status quo and take a stand, no matter the sensitivity of the issue or the consequences of their actions. The issue does not have to be related to foreign policy. It can involve a management issue, consular policy, or, in the case of the recently established F. Allen “Tex” Harris Award, the willingness of a Foreign Service Specialist to take an unpopular stand, to go out on a limb, or to stick his/her neck out in a way that involves some risk

https://www.afsa.org/constructive-dissent-awards