In control through better communication!

End of November 2010 the Dutch Regulator (DNB) met with certifying actuaries as well as external auditors. Both meetings were dominated by the theme of "accuracy of reporting" for pension funds, an important DNB monitoring theme.

DNB stressed that all pension fund reports are a key source of surveillance information. With confidence, every Pension Fund stakeholder should be able to rely on the accuracy and completeness of the information in pension fund reports. In practice, this is not always the case. DNB will increasingly hold pension fund boards, certifying actuaries and accountants responsible for taking appropriate actions and - if  necessary - DNB will enforce action.

Topics
Main topics on the accountant-Actuary table are:
- the valuation of technical provisions
- the valuation of the required equity and
- compliance with the prudent person rule.

In control through better communication

The introduction in 2011 of so called 'multi-party meetings' (ie consultation between pension fund management, actuary, accountant (auditor) and regulator DNB) with some larger pension funds will certainly help to improve communication between all concerned parties.

This excellent initiative will also certainly help pension funds to increase control.
Key issue is that the pension Board has (to keep) final responsibility and DNB has to take care that they do not implicitly take over part of this responsibility. Secondly DNB is responsible for an efficient and clear regulation/governance structure. Too many informal consultation meetings might not be efficient and bear the risk of unclear responsibilities. 


Sources:
- Newsletter Pensions DNB (Dutch, 2011)
- Source: Four leaved clover Coin

Control Leverage

Key question is whether 'adding more control' will stabilize financial institutions like banks, insurance companies or pension funds.....

With all the - apparently failing - new legislation of the last decade already in place and new control measures like Solvency II and the strengthening of the Basel II Framework ahead, one might - at least - question whether we're on the right track with this intensified 'control approach'.

Will adding more control
empower or paralyze financial institutions?

In other words: Is the Control Leverage Effect positive or negative?

Insurance
In an FT-Adviser article called 'Solvency II costs are unsustainable', Joy Dunbar reports that the ABI (Association of British Insurers) has warned that the costs of implementing Solvency II regulations could destabilize the industry across Europe.

To gain more control (financial stability), European Insurers are obliged to implement Solvency II measures by the end of 2012, starting already in 2010.

Impact Solvency II
The increasing control costs and capital demands of Solvency II will have an enormous impact om the insurance market:

• Recapitalization: Insurers need to acquire fresh equity capital (billions of Euros) in the market
  
• Over-Capitalization: More 'dead' capital is created in financial institutions, resulting in declining investment returns in insurance.
• Market shake out: Companies will exit the market
• Pricing effects: prices (premiums) will rise, cover will be reduced

Banks
Whereas the European Insurers are on a more or less 'blind track' with regard to the implementation of Solvency II, the banks - according to chairman of the Basel Committee Mr Wellink - stressed that "decisions on the final proposals and their calibration will be made only after a thorough analysis of the impact assessment and the comments received on the consultative documents. The Committee will ensure that implementation of the new standards is consistent with financial market stability and sustainable economic growth".

The real problem
One doesn't have to be an actuary or financial expert to conclude that we're at the end of the road where adding more of the same type of control measures will substantially stabilize our system.

Without diving deep into real life quantitative analyses, let's get a helicopter-view and take a look at an average 'Control-Return Matrix' to do some 'rule of thumb' exercises...

Rule of thumb Control-Return analyses

Phase I
A few decades ago, starting in the good old sixties of the twentieth century, there where only limited control measures in place (control=0). The average Return on Equity (ROE) of a company was (e.g.) 6% and although Value at Risk (VaR) didn't yet exist as such, the 6% ROE could easily swap between (e.g.) +15% and -50%.

Financial markets where not that developed as today (no derivatives, , CDS, etc). Systemic risk was almost non-existent and accounting principles where based on the simple and relatively stable method of 'historical cost'.

The need for 'more control' was clear to everybody. More control implied lower costs, 'more opportunity insight' and 'more risk control'.
More control turned out to be a good investment and would lead to realizing a better return (ROE) in combination with a lower risk (Var) and a higher 'upward potential'. Every stakeholder was happy.

Phase II
Getting into the eighties and nineties of the twentieth century, 'control' had done its major job and still did, as it was able to manage the few relatively small recessions in those years.

With the help of the oncoming heavy computers, the first baby steps regarding new risk management techniques and ALM (Asset Liability management) were taken.

This way major risks (VaR) could further reduced, sometimes at the cost (expense) of a small reduction of the ROE. But this small effect was largely compensated by the 'fallacy high returns' in the high trust market.

Phase III
At the beginning of the Twenty First Century a new recession made clear the financial environment had substantially changed:

• New techniques, models and the use of modern computer software led to new markets and new products like derivatives
• Markets became global, (on face) transparent, in open competition
• A lack of insight with regard to systemic risks
  
• Differences in local supervision, legislation, administration and accounting rules, led to a complex, non-transparent global market.
• In order to be able to compare companies, they had to be valued at 'market value', implicating the birth of more volatile (stock) markets....
• Step by step, the public and media became more conscious. Investors and consumers understood that even if a 0.5% VaR level would be further reduced, it wouldn't make any sense because it would be always overshadowed by the non-trackable, nor manageable, risk of let's say 1 à 2%. And moreover, who would trust his money to a bank that would go bankrupt once every 50 or 100 years....
  
  

Investors, Boards, Managers, everyone lost their handrail....

In the recent decade (2000-2010) things got worse :

• Existing control and accounting systems would locally differ and failed to meet the complex demands of the new markets
  
• Supervisors en regulators, normally ahead of the market, were suddenly one step behind and unable to catch up given the actual system of supervision
  
• It had become clear that new financial products ( e.g. CDOs, CDSs, subprime mortgages, swaps, swaptions) had been introduced without a good understanding of their financial construction or risk
• Turbulence in the markets. Relatively stable stocks of big international firms, suddenly appeared remarkably unstable, due to new volatile markets/products and 'fair value accounting'.
• The once so well controlled VaR risk exploded, due to these new types of risk in the market, the fair value accounting principles and the spooky systemic risk.

Way out
Like everyone else - totally flabbergasted - supervisors and regulators immediately grabbed the traditional emergency brake of 'more control'.

Unfortunately, more 'traditional' control in phase III will not have the same effect as in phase I or II. The effects of more traditional control in phase III will be:

• Substantial but unsure decrease of ROE and 'upward potential'.
  The effects are not known upfront and can't be estimated well.
  Sure is that the costs of extra control and 'dead money' will have a negative impact on the ROE.
  
  
• Unknown and questionable reduction of VaR risks, as one thing is sure: the new type(s) of (VaR) risks can not be estimated by our retrospective based models. Probably, all efforts in vain, the remaining actu(ari)al risk level will not be substantially reduced.
  
  
• Trying to 'catch' more 'safe' risk levels (lower α , VaR) will lead to over-capitalization and 'dead' money in the balance sheet and an unbalanced growth of derivatives.
  
  

• The market of derivatives continuous to grow.
  
  The notional value of derivatives held by U.S. commercial banks increased $804 billion in the third quarter to $204.3 trillion.
  
  This, despite the statements of Fed Chairman Bernanke who says he wants to avoid the possible risk of a future speculative bubble.
  
  And despite of Treasury Secretary Geithner who says he wants to reform financial regulation to avoid a future debt disaster.
  
  
• Because the real issues of the financial crisis where not solved, but only covered up with government help (money), new uncontrollable 'bubbles' will keep showing up.
  

Solutions
probably the best solution is not 'more control', but

Other Control

Examples of 'other control' are:

• Obligatory report and central registration of all derivatives under one worldwide supervisory. This way systemic risk analyses won't be 'guess statistics' anymore and can be managed. System risk is one of the weirdest risks to tackle, as is illustrated by the next article:
  
  Why Your Friends Have More Friends Than You Do
  
  Although the Exchange Commission has taken some serious steps in 2009 to regulate and strengthen the over-the-counter ("OTC") derivatives, this process will probably not be rigorous and fast enough to prevent a possible new bubble or collapse.
  All OTC market products should be asap standardized on a centrally administered basis.
  
  
• Limit and control the derivatives market. Maximize the derivative market in respect to the 'normal' market. Limit each companies derivatives in line with his equity. New regulation should also be developed with regard to participating in non defensive (strange) derivatives (e.g. define max. exposure multipliers).
  If not the next bubble is a fact!
  
  
• New derivatives should be subject to approval ('no objection') by the regulator before market launch.
  
  

So it all comes down to the 'right control' leverage.
It's either positive leverage with 'new other control' or negative leverage with 'more of the same traditional control' and waiting for the next bubble. What do you prefer as an actuary?

Sources:
- Contagion in Financial Networks
- Testimony Concerning OTCs (Over-the-Counter Derivatives )
- OCC’s Q3 2009 Report on Bank Trading and Derivatives Activities
- The bigger and riskier monster....
- Tarp facts: The Troubled Asset Relief Program
- The Investment Fallacy

Credit Crisis Manageable?

In order to succeed in a certain action, we often develop an action plan, a process that defines sub-actions in terms of who, what, when and where.

To guarantee that we succeed as much as possible, we have to maximize the control of this process of sub-actions. Make the process manageable.



In managing this process it's important to identify the nature and co-dependency of your sub-actions.

In general it's important to characterize sub-actions as follows:

Characteristic	Understandable	Predictable	Solvable
Simple	++	++	++
Complicated	+	+	++
Complex	-	-	+
Chaotic	--	--	-

Examples

Characteristic	Example	Description
Simple	Doorbell	Single component/ process with defined output
Complicated	Watch	Several components working together with defined output
Complex	Weather	Many interdependent components with hardly predictable output.
Chaotic	Clouds (form)	No sub components to identify, output unpredictable

Always analyze and characterize the components or sub actions of your action plan.
Not doing so will certainly cause trouble.

Example
One of the causes of the 2008 credit crisis is that we try to manage an in essential 'chaotic process' as a 'complicated process'. More traditional regulation rules (or governance back up) won't stabilize the banking system on the long run (in fact they make it worse), because these rules would imply that the nature of the financial markets is known and can be captured in a controllable mathematical linear system.

Financial markets are complex and chaotic systems, just like the weather. This implicates that regulation should be much more focused on "Plan B" measures than on detailed rule based regulation.

This means that regulation has to be formulated in such a way that Banks, instead of proving more and more that they will 'never' be insolvent (e.g. calculated risk=0,5%, that can't be calculated!), are forced to deliver Plan B's in which they state how they'll act in the 'unexpected' case of insolvency or iliquidity (average at least once in 200 years).

Just like you've got an umbrella in your car (Plan B), because you know that even though the weather forecast was 'sunny', you never can tell precisely when it's going to rain.

Most processes in life turn out to be chaotic on the long run. Analyze and control them, but don't forget to (always) carry your "Plan B" in your pocket.

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Lessons from the Credit Crisis

Which car can travel faster around a race track, one with brakes or one without?

A car will face many obstacles, let alone many bends in the track before it reaches the finish line. The ability to brake allows the race car driver to slow down to meet these challenges and to accelerate only when there is the most gain to be had.

Similarly, companies want to be resilient in the face of risk and also to be able to exploit it should opportunities for gain arise. Especially in the financial community, an enterprise risk management system that is quick and responsive to change is central to ensuring success.

More at: Actuaries Abroad: ERM Lessons from the Credit Crisis

However, if you think everything is under control, remember Andretti's one liner:

Even in risk management: Think twice.....