Tuesday, July 22, 2014

Forcing Banks to increase Capital is driving them to take on more risk, sowing the seeds of the next crises.

GARP (the Global Association of Risk Professionals) today forwarded members the following link to a Bloomberg report that notes the “Fed’s Bubble Busting in Junk Loans Seen Failing as Sales Surge” see: http://www.garp.org/risk-news-and-resources/risk-headlines/story.aspx?newsid=114766

While the article includes various explanations as to why Financial Institutions (FIs) are taking on highly risky assets at an alarming rate, and why regulators seem impotent to reign in this dangerous trend, one important underlying cause is not mentioned – the Capital Paradox.

Karamjeet Paul, in his important book ‘Managing Extreme Financial Risk’ describes the Capital Paradox thus:

“If (a Financial Institution) adds capital, then it needs to generate higher earnings to cover the cost of incremental capital. The quest for higher earnings requires the institution to take on more risk to generate these earnings, as risk management primarily drives the current revenue model. In turn, higher risk creates the need for more capital. Therefore, the industry’s dependency on increased capital to maintain the current revenue engine is not sustainable.” Chapter 11 at 11.2

In fact herein lies a dual paradox; since FI executives are measured by return on capital, increasing the capital drives, even licences, the executives to buy and invent more risky financial assets.

Regulators are driving FIs to increase their capital in order to strengthen their ability to survive the next crises, which will be driven by a tail-risk event (occurrence of a negative Black Swan event) a phenomenon Mr Paul calls an Unquantifiable Uncertainty.

Since Banks/FIs changed their revenue model from one based on intermediating loans to one of intermediating risk, they have become risk traders rather than lenders. Funding is provided by ‘the market’ so banks merely underwrite the investment risks, and then trade away risk they cannot afford to hold. This is the revenue model that led to the development of the subprime mortgage market and related complex products. In brief, FIs no longer invest in real businesses directly, they invest in financial instruments.

Unfortunately for the world at large FI Regulators still focus their post 2008 risk management strategies on Quantifiable Uncertainties; those uncertainties (risks) that can be quantified with 99% confidence by use of VaR (Value at Risk) models. Such models ignore the ‘outliers’, the risk instances that occur beyond the third standard deviation. FIs and Regulators are so star-struck by the precision of these models and the multiple academic degrees in quantum physics held by the builders of these models that they tend to forget that the models all contain one dangerous assumption.

The assumption that the future will resemble the past and nothing that has not occurred in the past will occur in the future; however Unknown Unknowns have occurred frequently in the past four decades with devastating financial impact globally.

In his book Karamjeet Paul offers a practical approach to managing an FI’s Tail Risk associated with Unquantifiable Uncertainty, which is well worth serious consideration.

As a reviewer of Mr Paul’s book notes on the jacket; “Managing Extreme Financial Risk should be required reading for regulators, board members, CEOs, and CFOs of large financial institutions.”

In closing it is depressing to think that the words of Henry Ford who said; “A Business that makes nothing but money is a poor kind of business,” so aptly describe the role adopted by too many of today’s global FIs. So many talented and dedicated individuals work hard in those FIs but essentially participate in producing nothing of value, nothing real.

BarrettWells

Sunday, June 29, 2014

Welcome to the beginning of the Machine Age – How will you and your 8.2bn neighbours be gainfully employed?

“Organisations will always strive to replace replaceable elements with cheaper substitutes.

I (Seth Godin) grew up in a world where people did what they were told, followed instructions, found a job, made a living and that was that. Now we live in a world where all the joy and profit have been squeezed out of following the rules. Outsourcing and automation and the new marketing punish anyone who is merely good, merely obedient, and merely reliable. It doesn’t matter if you’re a wedding photographer or an insurance broker; there’s no longer a clear path to satisfaction in working for the man. The factory – that system where organised labour meets patient capital, productivity-improving devices, and leverage – has fallen apart.” (Seth Godin, Linchpin: How to drive your career and create a remarkable future.)

“Just having a job in the future will be a challenge, as machines take over more and more menial work. The key to having a job in the future is to be able to do something machines can’t do.” (Gerd Leonhard, Presentation at Fort Collins Start-up Week, Reported by Steve Porter of InnovatioNews)

Machines have taken over jobs for over 150 years, what’s different now?

To learn the answer watch a 15 minute TED Talk by Andrew McAfee, titled ‘What will future jobs look like?’ via this link: http://on.ted.com/j0JVk

How will the mass of people be gainfully employed in 2025 and beyond?

If people are not earning money they will not be able to buy goods and services, so all the efficient production by machines will not find a market. Who will have a job, and how can we ensure that we are in that group?

Lynda Gratton in her book ‘The Shift: The Future of Work is Already Here’ published in 2011 notes:

“In a world of more and more complex technology, it is the highly skilled employees, or what I will call those with mastery, who will always find work.”

Writing about the year 2025 she continues later, “With the emergence of mega-cities, instead of connected parts the suburbs are increasingly becoming slums. Far from claiming their own purpose and identity, these concentrated areas of ‘surplus humanity’ exhibit intense poverty and little direction. This disconnection has been exacerbated by vast urbanisation that has seen millions of people leave the land, hoping for a better life in the cities. As the slums around Mumbai or Johannesburg will attest, these hopes are rarely realised.”

SURPLUS HUMANITY!

The term ‘surplus humanity’ is jarring; although taken from the ‘downside’ 2025 scenarios presented by Lynda Gratton it is nevertheless a ‘wake-up call’.

It is clear that having a general skill in future will increasingly mean competing for employment with five billion equally capable and equally connected people, as well as robots and computers. Therefore the need to cultivate mastery – the ability to add value that no one else can match – in a series of fields over a career will be essential.

A career will likely span, not 35 years but up to 50 years, as life expectancy lengthens towards 100. Certainly the days of starting a first job with a corporation and leaving your career to the corporation to decide, then retiring on an adequate pension at 60 or 65 ended more than 20 years ago.

Sadly many companies still see the advantages of having employees think that that is the contract; at the same time corporations have no intention to return such ‘loyalty’. When it no longer suits the next quarter results to retain an employee, or indeed a whole division or business line an unceremonious parting swiftly ensues. In any event the half-life of a successful business model is now three to five years. Therefore most will fail and put all employees out of work well before retirement. Unfortunately the majority of corporate leaders are too busy managing their personal financial affairs and internal politics to focus on continuously transforming the business to ensure survival.

Lynda Gratton’s book gives the reader an opportunity to imagine what a work-day in 2025 could be like. Also provided is guidance as to how to prepare in order to ensure a positive rather than a negative future in work. See: http://www.lyndagratton.com

William Gibson was inspired in 1993 when he said, “The future is already here — it's just not very evenly distributed.”

Look around, see what is already happening and position yourself and those you care about to ensure the best possible future outcome.

BarrettWells

Wednesday, May 7, 2014

Global Credit Management receives 5 Star Reader Rating

On 27 April 2014 a reader awarded Global Credit Management an Executive Summary, published by John Wiley & Sons and written by Ron Wells, a Five Star Rating and commented:
Good book, easy to read and very useful.

The book is a very good addition to my current study in credit management and I would recommend it to any credit manager or professional who wants to become credit manager. The book is written in a nice way and the subjects are short, but concise, which makes it easy for a study.
The review appears on the Amazon.co.uk website.

Wednesday, November 13, 2013

Many businesses will not survive the 3D Printing revolution – start adapting now!

So-called 3D Printing describes the manufacture of a three dimensional object from raw material inputs by a machine, as directed by a design program. That is without the intervention of human labour, except to set up the machine and ensure the raw material is supplied.

The term is used because the operation is similar to the type of printing with which we are familiar. To print a document (a two dimensional product) we set up a machine (printer) with paper and ink, and then send it a computer generated program (software code) based on a document we have designed on-screen. The result is a physical output produced from a design input, albeit in two dimensions. 3D Printing works on the same principle.

The future is already here — it's just not very evenly distributed. (William Ford Gibson)

By way of a quick introduction to this aspect of the future please view the concluding three minutes of the BBC Hard Talk interview with Ms Fu Ping via this link….

Ping Fu: 3D Printing is 'as big as the internet'
http://news.bbc.co.uk/1/hi/programmes/hardtalk/9788066.stm

In the linked article Arnold Geelhoed discusses what 3D Printing will mean for some of the industries likely to be affected. His comments should alert Credit Executives everywhere to the significant implications this disruptive technology will have for credit risk assessment.

The article is made available with the kind permission of the National Association of Credit Management (NACM), via this link: http://www.barrettwells.co.uk/3DPrintingBCJulAug13AGeelhoed.pdf

The industries that Mr Geelhoed highlights in the article are listed below with a brief paraphrase of his comments under each heading.

Transport and Packaging:
When printing (manufacturing) products at home or at a nearby specialised facility becomes commonplace, the packaging and transportation of many finished products will no longer be required. Only the bulk delivery of raw materials, such as chemicals or metals, will be required.

Waste Processing and Disposal:
Production of product that is subsequently not purchased will be avoided; hence fewer wasted finished products will be produced. Used and discarded printed products will be easily recycled to provide raw material for new product to be printed.

Retail and Distribution:
Product designs will be produced and made available through on-line outlets such as Amazon, to be downloaded directly into the printer and manufactured immediately. Therefore the wholesale distribution and retail sectors will be seriously negatively affected; a large portion will disappear.

Warehouses:
The demand for warehouse space will shrink dramatically.

Manufacturing:
Massive job losses will be incurred, vast quantities of machinery will be idled, and many hectares of manufacturing building and real estate will lie fallow or have to be redeployed.

Marketing and Advertising:
Designers will advertise direct to the consumer via the internet.

Designers, Chemists and Nano-Technologists:
Creators, innovators and engineers will be ‘the new heroes’ (as Mr Geelhoed describes) providing the designs and the materials required to make 3D Printing (local manufacturing of single items) a cost effective and practical reality for many millions of people. The branch of Nano-Technology that is referred to here is that which involves the creation of new materials by manipulating the atomic structure of existing substances, such as carbon.

Mr Geelhoed concludes:

“I believe that this new technology is going to dramatically change the world in many and varied ways. It could mean a cleaner environment, due to less fuel required to transport goods …, as well as less waste from packaging. ….whole chains between manufacturer and consumer will disappear.

Working in credit management will be very exciting, challenging and will require a lot of adjustment in order to monitor the new risks…”

A brief survey of other 3D Printing developments indicates that the implications are much more widespread. Other industries will be affected; employment patterns will be significantly disrupted even in the construction sector. Please view the 12 minute linked presentation to learn about machines being developed to manufacture homes in 20 hours without the need for plumbers, electricians, bricklayers, stonemasons and general low skilled labourers.

3D Printer can build a house in 20 hours
http://www.youtube.com/watch?v=ehnzfGP6sq4

The following article published by the Mail Online is also relevant:

3D Printed Room looks like the beautiful interior of a Cathedral
http://www.dailymail.co.uk/sciencetech/article-2425446/3D-printed-ROOM-looks-like-beautiful-interior-cathedral.html

These reports may also be of interest:

‘US space agency NASA announces it will launch a 3D Printer into space next year to test the feasibility of making spare parts in zero-gravity.’ BBC News – Technology Report on September 30, 2013:

NASA plans first 3D Printer space launch in 2014
http://www.bbc.co.uk/news/technology-24329296


Bastian Schaefer: A 3D-Printed jumbo jet? (six minutes)
http://www.youtube.com/watch?v=7oQY0uC52jY


To conclude on a lighter note, watch this video presentation:

3D Food Printer Will Start with Pizza (three minutes)
http://www.youtube.com/watch?v=Qva7uOjbWrQ


BarrettWells

Tuesday, November 12, 2013

The Oman and Brent Crude Oil Markets explained

OMAN CRUDE OIL MARKET

A new article titled “DME Oman Crude Oil Futures (OQD)” that clearly identifies the credit risks involved and covers all important points related to this market, has been posted on BarrettWells.co.uk, see: http://www.barrettwells.co.uk/OmanCrudeMarket.html

The Dubai Mercantile Exchange’s OQD contract is becoming the crude oil pricing benchmark for the Asian market, displacing the Dubai Crude Oil Futures contract. It is important to understand the credit risk implications of trading in these and the associated OTC Oman Crude Oil Contracts.

BRENT CRUDE OIL MARKET

An updated article titled “25 Day BFOEs - Understanding the related Credit Risk” that clearly identifies the credit risks involved and covers all important points related to this market, has been posted on BarrettWells.co.uk, see: http://www.barrettwells.co.uk/25daybfoes.html

ICE Brent Crude Futures and 25 Day BFOE (Brent-Forties-Oseberg-Ekofisk) Forward contracts create the basis for the determination of the cost of more than 65% of the crude oil bought and sold in the world. However the jargon and processes related to the wider Brent Futures and BFOE market are not easy to unravel. Understanding the credit risk implications is even more challenging. This article clearly covers all important points.

BarrettWells

Thursday, October 31, 2013

There is a naïve belief that mathematical models can foretell future risks…

The article titled “Well Short of Model Behaviour” written by Brandon Davies (CEO of dRisk.biz) and published in the October 2013 edition of Financial World (www.financialworld.co.uk) provides an excellent description of the development and abject failure of financial risk modelling, as currently practiced. Reading the article is highly recommended.

Mr Davies’ perceptive conclusion is quoted here to pique your interest:

‘There seems to be a naïve belief, often encouraged by risk professionals, that models are a modern crystal ball. They are not. Models can, and do, bring greater insight into risk and its management but, whatever their sophistication, they are simply guides to action – not a substitute for individual expertise or collective responsibility.

Risk management should be based on expertise informed by a variety of models. Whether this fits with the current risk governance process within banks is, however, questionable. Boards, in general, do not understand the limitations of the financial models. It is, therefore, not only the models that need changing; it is also the governance structure in which they sit.’

The GCMG Blog of August 15, 2013 “Complex Systems such as ‘Economic Risk’ demand a new approach to potential modelling”, and the Blog posted on April 22, 2012 “The Art of Predicting Failure” also touch on this subject but from different perspectives.

BarrettWells
info@t3plimited.com

Thursday, August 15, 2013

Complex Systems such as ‘economic risk’ demand a new approach to potential modelling?

“Many people in various fields tend to follow the Young method. If they are studying economics, or the human body and health, or the workings of the brain, they tend to work with abstractions and simplifications, reducing highly complex and interactive problems into modules, formulas, tidy statistics, and isolated organs that can be dissected. This approach can yield a partial picture of reality, much in the way that dissecting a corpse can tell you some things about the human body. But with these simplifications the living, breathing element is missing. You want to follow instead the Champollion model. You are not in a hurry. You prefer the holistic approach. You look at the object of study from as many angles as possible, giving your thoughts added dimensions. You assume that the parts of any whole interact with one another and cannot be completely separated. In your mind, you get as close to the complicated truth and reality of your object of study as possible. In the process, great mysteries will unravel themselves before your eyes.”

This quotation from the book ‘Mastery’ written by Robert Greene, addresses the limitations of the formulaic, mathematics based approach to studying what are now called ‘Complex Systems’.

Complex Systems are systems that operate on the basis of so many random variables that they cannot be successfully expressed within mathematical models. You will find a fascinating explanation of Complex Systems, and the technique recently developed in order to understand them, on the TED website – TED.com - in a presentation by James B Glattfelder, titled ‘Who Controls the World?’

The global economy is a Complex System since it is created and influenced by the actions and decisions of billions of global citizens. Each action and decision is potentially a random variable.

Credit risk, particularly Probability of Default, is a Complex System as it is impacted by many variables both within a business entity and external to a business. That is the reason why Probability of Default has not been successfully modelled at the enterprise level.

Statistically derived Probability of Default does have a use at the portfolio level – provided the potential failure of one customer or supplier is a sufficiently small portion of the whole portfolio so as to be survivable. In other words, provided the portfolio is large enough and diverse enough.

This supports the contention that credit risk at the enterprise level should not be managed on the basis of Probability of Default, as derived from a mathematical model. It should rather be based on a holistic assessment of the forces shaping the future viability of the enterprise, and therefore on the practical probability that it will pay or fail to pay its debts in full and on time.

BarrettWells
info@t3plimited.com