Risk Management Reports

January, 2003
Volume 30, No. 1
Issues for 2003

A grey cloud of hesitancy hangs over all of us. The political euphoria following the fall of Communism and the economic fantasies of the 1990s are distant memories, blown away by present realities, political, economic and environmental. Global politics dominates the horizon. Will war occur in Iraq? If so, what are the possible repercussions throughout the Middle East? Can the Israeli-Palestinian conflict sink any lower, or will the new elections bring forth some sanity? Can India solve its growing internal problems as well as its continuing disagreement with Pakistan? Will the Sri Lanka and Northern Ireland truces hold? Is Indonesia on the road to disintegration? What will the world do with North Korea? How soon before it implodes? Will the political turmoil in Venezuela and Colombia infect the rest of South and Central America? The economic scene is no less worrisome. The United States, the world’s largest economy, is awash in personal debt, crippled by inadequate saving, and saddled with an enormous current-account deficit, even as a real estate bubble floats precariously over many parts of the country. Is it out of its recession or heading into a “double-dip?” The Economist (September 28, 2002) suggests that “ the business cycle is likely to become more volatile again over the coming years” and that the US recession “is far from over.” Europe watches anxiously as the US stock market dips and surges, signaling little but uncertainty. In South America, Argentina’s economy shrunk more than 10% in 2002, and its difficulties could easily infect Brazil, Uruguay, Paraguay and Bolivia, as well as Colombia and Venezuela. War and many possible aftershocks in the Middle East could dramatically affect the cost and availability of oil, on which so much of the developed world depends. Japan seems chronically unable to repair its wounded banking system, leaving it mired in continued slump.

And if our political and economic worries were not enough, we are warned again about new environmental woes. Global warming is now an acknowledged fact even though we remain uncertain as to whether we are the cause (the pumping of gases into our atmosphere) or it is some periodic climatic anomaly. The answer is probably both, and that we must prepare for radical weather change. The problem of water is one outgrowth of climate change. Shrinking glaciers in the Andes threaten future water supplies for inhabitants on both sides of the mountains. The water from the Colorado River in the US is so sub-divided that not a trickle escapes to Mexico and is tied up in continuing litigation over its ownership. In Central Asia, the monumental plan of the Soviet Union to transform desert into plantation by erecting 45 dams and numerous canals on the Syr and Amu Rivers has disintegrated into a parched morass in which the Aral Sea, at one time the sixth-largest inland lake in the world, has shrunk to a polluted one-third its original size. The New York Times (December 9, 2002) calls it a “shrunken, dustshrouded necklace of brine lakes.” Afghanistan and five new countries, Uzbekistan, Turkmenistan, Kazakhstan, Kyrgyzstan and Tajikistan, depend on these waters, now hopelessly mismanaged and wasted. The conflicts over the use of water—for drinking, for farming or for industry—are global problems that promise to provoke increasing violence in the coming years.

And if these ominous warnings are not enough, the National Academy of Sciences in the US published a startling paper in 2002, “Abrupt Climate Change: Inevitable Surprises.” It suggests that our classic supposition that all climate change is slow and incremental could be wrong. Examination of 11,500 year-old ice-cores taken from Greenland shows that rapid changes, within as little as three to ten years, have occurred several times on the past 100,000 years. How would the population of the Earth adjust to a doubling of annual precipitation is just three years? Or to a 14-degree jump in average temperature in ten years? These ice-cores indicate that such explosive changes are possible. This idea of a precipitous climate change, warmer or colder, is not new. Loren Eiseley, an anthropologist at the University of Pennsylvania, wrote in 1970 in The Invisible Pyramid:

So can you blame us if we are a bit hesitant at the start of 2003?

This issue summarizes some of my thoughts on global, strategic and tactical risk issues for the next twelve months, just as I’ve done for the past decade. In January 1999, my concerns were economic instability and the stock market “bubble,” plus legal mass hysteria in the US court system, the effect of the computer, gambling, the geriatric society and re-defining risk management. In 2000, they were the continuing “bubble” and the decline of trust in institutions. In 2001, I addressed governance and risk management: how it should be structured, led, coordinated and communicated. Last year my three issues were credibility (again), resilience and perspective.

This year I focus on a wider range of risk management issues within the three areas that sub-divide the discipline: market, operational and public policy risks.

First, market risks. In international currency the US dollar is beginning to fall, as the euro gains strength. Sweden is to vote on adopting the euro and the admission of new members to Europe means a wider spread and perhaps greater stability of the euro in the next few years. Interest rates have nowhere to go but up in the US, Europe and Japan. Our techniques for hedging and sharing these risks are sophisticated and effective, but, as organizations grow in size and global spread, these techniques may diminish in importance. Yet it is in credit risk that I see the greatest rumblings of discontent. In RMR, April 2001, I noted the forebodings of Avinash Persaud, a Managing Director of State Street Bank, in which he suggested that the proposed Basel 2 accords could lead to an increase in systemic risk for banks if they adopted a herd-like response to the new rules and played follow-the-leader. He elaborated on that thesis in his first Mercer Memorial Lecture at London’s Gresham College on October 3, 2002, “The Macroeconomics of Basel.”

Persaud suggested “the starting point of good regulation is aligning the points of government intervention with the points of market failure.” He then cited three characteristics of banks: they pose systemic risks, they are part of the information industry, and they exhibit herd behavior. He went on: “But the irony is that the accoutrements of sophisticated risk management, daily marking-to-market and marketsensitive risk limits, only provide a defense if a handful of banks use them. If regulators encourage all banks to use them they will provide no defense and will make the financial system as a whole riskier.” His conclusion was that “Basel 2 will lead to more amplified cycles and more instability. It is complex where it should be simple. It focuses on processes when it should focus on outcomes. And it is implicitly pro-cyclical when it should be explicitly contra-cyclical.” For Persaud’s full arguments, go to www.gresham.ac.uk/commerce/. He presents a refreshing contrarian view.

So much for systemic credit risk. What about the reliability of individual financial institutions? Avinash Persaud raises intriguing questions about the security of many insurance and reinsurance companies, especially those in Europe, that have aggressively added global credit derivatives to their balance sheets. In his second Gresham College lecture, on November 14, 2002, Persaud asked, “where have all the credit risks gone?” He noted that non-performing loans are at an all-time high of almost $900 billion, having increased by 20% in 2002 alone, yet bank balance sheets continue to look healthy. Why?

He attributes this anomaly to the increased use of credit derivatives, with a ten-fold increase to $2 trillion in only five years. “Financial innovation has enabled risks to be sliced and diced,” leading to better matching and spreading. But many of these instruments went to insurance companies as they sought higher yields than government bonds and non-existent underwriting profits. As Persaud noted, “whenever financial institutions go after yield as a group, regulators should sit up!” The insurers and reinsurers in turn hedged the “toxic slice” of credit swaps into the secondary bond and equity markets, the very markets that are currently so volatile. He concluded that the “folly of what insurance companies have been up to” is the “reckless pursuit of yield. Banks have shifted credit risks to insurance companies, which have hedged themselves by going short the equity markets, which has significantly added to their volatility.” He warned, “In today’s fluid financial markets, the spread of risks has less to do with exactly who owns the risk, and more to do with how risks are treated. The more risks are valued, traded and hedged in the same way (Editor’s italics), in the same markets, the greater are systemic risks.” So both Basel and credit swaps create greater, not less, systemic risk!

Next, consider operational risks. Many of these risks fall into the arena of insurance underwriting, the same industry that Persaud faulted in its handling of credit risks. So another major issue for 2003 is the financial integrity of the non-life business, especially North America and Europe. Despite radical, and some say unconscionable, rate increases post- September 11, 2001, most of the increased revenue went to reinforce inadequate reserves. The overall financial capacity of the non-life business to underwrite risk dropped by almost 25% in 2002, according to the US-based Insurance Information Institute (from $920 billion to $690 billion). This occurred despite the addition of new capital by entrepreneurs taking advantage of the higher rates. The anguished plea by insurance CEOs in the US for government reinsurance for future terrorism was answered and now these same insurers, many of which cancelled terrorism coverage, must actually underwrite the risk, something they seem latently incapable of doing, despite the government’s excess largesse. The Hart-Rudman Report, in October 2002, warned that the US remains vulnerable to and unprepared for further acts of terrorism. Given the deteriorating global situation, insurers and their reinsurers must expect a higher frequency of terrorist acts. While the individual severity of these acts may not be as terrible as September 11, their aggregate cost could easily exceed the overall industry deductibles that start at $10.5 billion and end at $22.5 billion in the third year. And note that the US government reinsurance will lapse after three years! Add to this gloomy assessment the mounting claims from past uses of asbestos. The Rand Institute for Civil Justice reported more than $54 billion already spent on asbestos lawsuits, a total that may mount to as much as $260 billion by 2050. Much of this loss will hit the non-life insurance business, even if the US Congress passes some legislation to limit liability. The primary issue in operational risk must be the security of financial counterparties. The non-life industry, especially in the US, doesn’t look any stronger for its upswing in premiums.

The third area of risk is public policy. The global risks I mentioned earlier such as climate change and our shrinking water supply, plus population growth, aging and the pandemic of AIDS, are government concerns that inevitably affect all corporations and organizations. I see two interesting strategic issues for risk managers in 2003. The first is how individual corporations respond to environmental problems. Corporations like BP have decided to take a constructive and pro-active approach to their pollution by setting, and meeting, their own reduction goals. If the US and some other governments won’t respond to Kyoto, then some corporations will and, in so doing, will earn credit from the public. Like-minded companies now also trade pollution credits on the Chicago Exchange, a process that proves to be effective in creating overall reductions. These are areas where risk managers can demonstrate that an early and creative response to environmental degradation results in the opportunity of differentiation from the pack and favorable publicity with stakeholders. After all, the basic goal of risk management is building and maintaining confidence with these groups.

The second issue is the on-going debate about the application of excessive caution concerning new services and goods, such as pharmaceuticals, chemicals and bio-engineered products. The so-called “Precautionary Principle,” which states that we should err on the side of caution at all times, is under serious discussion when it appears to limit or restrain needed innovation. Here again corporate risk managers can inform themselves on the debate and suggest that leaders of their organizations participate. Excessive precaution may cripple incentives and new applications. The discipline of risk management will help demonstrate the proper balance between possible benefits and potential harms. The current discussion in the US over renewed smallpox vaccinations is a case in point.

I raised the issue of trust in January 2000 and repeated it in January 2002. It is still paramount. Political and profit-making organizations alike must re-establish and then maintain organizational credibility with stakeholders. Organizational governance is now the focal issue in both Europe and North America, and risk management, on an integrated or enterprise-wide base, is one response that contributes to improvement. New rules and regulations (like the Sarbanes-Oxley Law in the US), new “standards” (like the 2002 UK “Standard” issued by the Institute of Risk Management), and lists of “best practices” will help but not solve the underlying problem: changing the organizational culture. That must be the continuous goal of the risk management practice.

These global, market, operational, public policy, and credibility risk issues are opportunities for the risk management discipline to dispel the fog of hesitancy that inhibits our decision-making. Our discipline gives managers the tools to cast light through uncertainty, delineating risks in terms of their probable likelihoods and consequences. Risk management enables us to make better decisions.

We have a full plate of challenging issues for 2003, just as we now have a menu of tools to dissipate that demoralizing grey cloud of hesitancy. I’d like to think that I see a shaft of sunlight breaking through this gloom. I’m always the optimist. As William Safire of The New York Times wrote in early December, now is the time to “launch the war on uncertainty.” That could well be the risk managers’ mantra for 2003.

The media will be bulging with economists’ forecasts of business, stocks, bonds, and the kitchen sink in 2003. Read these predictions with care. Better yet, skip them and read something useful like the book reviews or the jokes column.

Peter Bernstein, Economics and Portfolio Strategy, December 15, 2002

Copyright 2003, by H. Felix Kloman and Seawrack Press, Inc.

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