Bank on the Run

Let's dive into the development of banking failures......

How many banks are on the run?

FDIC
The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress to maintain stability and public confidence in the nation's financial system by (1) insuring deposits, (2) examining and supervising financial institutions for safety and soundness and consumer protection, and (3) managing receiverships.

Just have a look at the reported (half May 2010) FDIC Bank Failures (words don't apply):

Things ain't getting better, I'll leave a 2010 Bank Failure forecast to the imagination of your actuarial mind.

Let's hope for the best...

"Thought of giving it all away
To a registered charity
All I need is a pint a day
If I ever get out of here
If we ever get out of here"

Related Links/ resources:
- The Big Picture: FDIC Bank Failures (5.15.10)
- FDIC Failure Stats

Actuary Professional Test

So you think, because you're an actuary, you must be a top professional....

Well.... Put yourself to the test by taking the next two minute IQ-test.
Remember: Don't cheat!

2 Minute Intelligence Test

Online Murphy Risk Calculator

Risk is like quantum mechanics:

If you think you understand Risk, you don't understand Risk
Maggid after : Feynman

If you are not completely confused by Risk, you do not understand it
Maggid after : John Wheeler

Sure, risk is hard to tackle. The more you learn about risk, the more you become aware of it's sneaky characteristics (clustering, tails, etc).

This is why becoming a qualified actuary takes an incredible amount of time, hard study and many years of experience.  As masters in Risk, actuaries understand the limits in modeling and calculating Risk.

Murphy

Probably one of the more intriguing risk quotes is :

Murphy's Law

"Anything that can go wrong, will go wrong"

by the famous Edwin Murphy.

A quote that keeps an actuary mind busy....  After all, as actuaries it is our duty to quantify and explain uncertainty (as much as is possible) in board rooms and on the accounting table. Not only when decisions have to be taken, but also after things turned out wrong or different from what we thought. This is - to put it mildly - no 'easy task' and it's not getting easier in the near future.....


Just like Murphy, actuaries experienced last decades that (statistic) bad luck often collaborates with bad timing. What drives God (i.e. quantum mechanics or 'Murphy probability') to confront us - (poor) actuaries - with 'fair value volatility', 'longevity explosions', 'subprime defeats', 'imploding real estate market's and 'extraordinary solvency demands by supervisors', all at the same time time?


(Un)Luckily, help is on the way....  In 2004 British Gas commissioned some scientists to create a formula to predict Murphy's Law, also known as Sod's Law.

Murphy's Formula
In a 2005 study, based on a survey of 1,023 adults, Murphy’s Law was shown 'statistically significant'. The final report also supplied a formula for predicting occurrences of Murphy’s Law. Here it is....


Let U, C, I, S, and F be integers between 1 and 9, reflecting respectively comparative levels of Urgency, Complexity, Importance, Skills, and Frequency in a given set of circumstances. Let A, which stands for Aggravation, equal 0.7 (Please, don’t ask why). The likelihood (L) of Murphy’s Law obtaining under those circumstances, on a scale of 0 to 8.6, turns out to be:

L = [((U + C + I) x (10 - S)) / 20] x A x 1 / (1 - sin (F / 10))

Murphy's Formula strikes itself
Unfortunately, Murphy's law suffered from self reference, as one of the  authors, the mathematician Phil Obayda, commented on a 2004 blog that this formula is wrong.

The correct formula according to Phil is:

 P= (((U+C+I) * (1-S))/2) * A * (1/(1-Sin F))

with P = probability of Sod's Law Occuring and U, C, I, S and F values greater than 0 and less than 1, keeping the mysterious A = 0.7.

Murphy's formula simplified
Simplifying this last formula leads to Maggid's formula for the probability (%) of Murphy hitting you, whenever you perform a task:

Although application of this formula is not (yet) an obligated part of the actuary's Code of Professional Conduct, please check this equation anytime you're about to defend an actuarial advice on a Board's table.

How to use Murphy's formula: an Actuarial Example
Let's do a simple exercise to demonstrate the power of Murphy's formula:

You've developed a risk model of the Stock market. In a meeting the Chair of the board asks you how certain you are of your model being right. You know the difference between risk and uncertainty, so you say "one moment please" and pick up your pocket calculator while reflecting: This is a ´U=3, I=9,C=10,F=3´ situation, and I'm a S=9 actuary. That calculates as P=10.4% of Murphy hitting me. Within 20 seconds you (over)confidently answer: I`m about 90% sure of my model!

The Chair of the Board looks desperate... His eyes reflect: ´Is 90% good or bad?` You didn't realize your model was that important to the board.  But.. if that's so, 'Importance' should not be rated at I=9 but at I=10, raising the failure probability to almost 11%. Now you start doubting yourself : What if you overestimated yourself? What if you're only a AA-Actuary (level S=7) instead of a AAA (level S=9)? This would increase the probability of failing to 31.3%. Suddenly you realize you're only one step away from a major personal actuarial meltdown.
You get yourself together, regain your self confidence, realize you're one of the best actuaries in the world (S=10) and full of confidence you reply the questioning eyes of the Chair with: "Sir, I'm almost 100% certain my model is right.

The Board is relieved and content. You're an actuary they can trust. Now they can decide without hesitation.

So next time you want to know the failure probability of a task, use the next Online Murphy Calculater.

Good Luck with Murphy's calculator!

Used sources/Links:
- Sod’s Law: A Proof
- Newyorker: Murphy At the Bat
- The Engineering of Murphy's Law?
- Legend, Inc. Murphy's Laws
- The Stock Market: Risk vs. Uncertainty
- Murphy's Online Calculator

The LORD and Risk Management

The (2010) Louisiana Oil Rig Disaster (LORD) shows that oil industry Risk Management Plans fail.

In general, Risk Management Plans are focusing too much on Risk Control, too little on Risk Prevention and certainly not enough at Damage Control.

The LORD shows us that a sufficient Plan B is missing. The only 'hope'  in the LORD's current Plan B was the Blow-Out Preventer (BOP) at the bottom of the ocean.

Apart from the question whether that BOP has been tested well: what is Plan C if this BOP would fail, as it obvious does?

Plan C ?
Of course not, we don't need a Plan C. All we need is an adequate Plan B. Plan B should simply have included the installing of two other well tested BOPs at an appropriate distance under sea-level.




Supervisors fail as well
It was only after the LORD's appearance, that the House of Representatives began an investigation into "the competency of the companies' risk management and emergency response plans".

This action is a typical case of:

When the steed is stolen, the stable-door is locked

From all this (above) it's clear that not only Risk Managements Plans are failing, but also the preventive control of those plans by national supervisors.

Why care?
As an actuary you might think: BOPs and an exhausting Plan B are perhaps fine regarding the oil industry, but who needs those instruments in the financial industry?

Unfortunately, the financial industry makes the same mistakes as the oil industry. From a long list, in short, two financial examples:

• Only after the dramatic fall of coverage ratios in 2009, Pension Funds started to make recovery plans (Plan Bs)
• Only after Greece's financial crisis and the corresponding decline of the Euro, Europe started thinking whether or not they should help Greece out and developed a Plan B.

Rethinking Risk Management

It's undeniable, we fundamentally need to  rethink and restruct our Risk Management Plans.

Risk Control
First of all we'll have to distinguish more between Risk and Damage. Preventing, reducing and controlling Risk (not just damage!) is key. Testing and supervising (certification!) Risk Management Plans is a must and needs more attention.

Damage Control
Apart from  the probability of a Risk event, Damage Control needs more attention. Here 'Controlling' includes Reducing and definitively Stopping Damage. Both are essential. This implies that a serious Plan B is in place and regularly tested and approved by supervisors. This Plan B should include automatic shut off valves in every line of business and 'triple actions plans' in case a first or second case action plan B unexpectedly fails.

How to deal with Unthinkable Risks?
Moreover, to create effective Risk Management Plans, we have to deal with the issue of "Unthinkable Risks".



No matter how creative you and your organization are, one thing is sure: new 'risks you didn't think of' will always show up . Problem is that - just like the LORD showed us -  you'll only become aware of a new risk after its manifestation; when it's clearly too late.


A Risk Sensitive Mindset
This - however - doesn't mean that you can't deal with unthinkable risks. To manage unthinkable risks you'll have to create a 'Risk Sensitive Mindset' in your organization. It takes employees who are vigilant and empowered to take direct action. Creating such an organization pays off in more than one way, as vigilant employees will also have a nose for new business and sales opportunities.
This way, Risk Management costs are not just unavoidable costs but profitable investments.

The LORD and your own responsibility 

As we seem perfectly capable of managing our own personal life without a fifty-page Risk Management Plan, most likely this type of Employee Risk Attitude Development (ERAD) is the most important (but also most disregarded) part of Effective Risk Management. In this case the LORD can't help us, it'll have to be our own insight and decision to take action to develop risk sensitive and responding employees.

Still not convinced that ERAD is the right way ahead? Imagine what difference we actuaries could have made to the (financial) world if we would have been able to spot and address sub-prime mortgages or the weakness of our ALM models in an early stage.....

Many LORD's blesses and Good Luck with this new view on Risk Management!

Related Links / Resources:
- Government Branches Investigate Louisiana Oil Rig Disaster
- UBC: Case Studies of Engineering Failures
- SKY: Emergency Declared As Oil Approaches US Coast
- Strategic, organisational and risk management context

New Actuarial Ethics

As actuaries we have to act in a complex world. This is no easy task. If we're honest, we have to admit that in this last decade we got ourselves dragged along the road of unrealistic and too optimistic ROI outlooks.

'Good' and mathematically sound advices turned out 'Bad'. Pension Plans are in trouble. New ROI-hope seems to be on our doorstep. With a look of weariness and despair, board members and clients seek our advice.

It's our duty to advice them in this financial jungle. Unfortunately we can not look into our Cristal Ball and predict the future. Moreover, topics like the ROI and longevity outlook become more and more an ethical issue instead of a mathematical exercise in uncertainty.

Yes, it's our responsibility to guide insurance companies, pension funds and other financial institutions through an unsure future. As new age risk managers, we have an enormous responsibility on our shoulders to winnow the Bad from the Good advices. One thing is sure, we have to do better than we did in the past, but how?

E=A-L ?
It's not enough to judge whether a 'one point Equity estimate' keeps the Assets and Liabilities in balance. What's even more clear, there is no one point E, A or L. There are only probabilities and to judge those, our personal ethical principles become even more important than our essential technical skills and experiences.

Our main puzzle is that this decade has shown that observations of the past are no convincing guarantee anymore for predictions of the future. This implies that we have to fall back on other, more ethical, principles in our advice. The good old ethical principles and methods to deal with actuarial dilemmas, need a fresh up.

Genuine Moral Intelligence (GMI)

Main issue is, that the more 'objective' and significant our data get and the more sophisticated our models may become, the more our advice becomes susceptible to unpredictable developments.

On top of all this, more control, increasing data or more advanced models, will only create a false sense of certainty. These old instruments won't  help us anymore en will only reduce the long term returns and aggravate the ultimate volatility. The only way out is to throttle back on our 'risk attitude' on basis of some new ethical principles.

These new ethical principles are not just about 'minimal legal compliance'. Modern actuary ethics goes further than that. In fact ethics is reincarnated as 'Genuine Moral Intelligence' (GMI).


GMI, as defined by Richard E. Thompson, is: Aristotelean decency, vision, purpose, and uncommon sense.

The applicable GMI equation is given by:  

GMI = ER + UPVs + RSI

ER = Ethical Reasoning
Rather than "pick an ethical theory and stay the course," one may ask and answer a series of questions.
Some examples: Who are the stakeholders? What ethical principles apply? How do they apply?

UPVs = Underlying Personal Values.
UPVs are used to answer the above questions.
Some examples:

• As a board member, do you vote for continuing a needed community medical service that is losing money, or for cutting the service to avoid financial problems?
• As a pension board member, to what kind of probability are you willing to increase the pension of the pensioners at the risk of having to raise the contribution of future pension fund members?

Underlying personal values also determine whether we act according to our morally intelligent conclusion, or choose to ignore it.

RSI = Reasonable Self Interest
Ethics only makes sense if we can come up with a sound answer to the question "Why act ethically?"

Here, Aristotle comes in with a helping answer: "To serve one's own self-interest".
Keep in mind there's a difference between self-interest and greed. The wise Aristotle explains: "Love of self is a feeling implanted by nature, but selfishness is rightly censured, because selfishness is not mere love of self but the love of self in excess, like the miser's need for money."

So self-interest is nothing unethical in itself. An example from the famous Adam Smith stresses this:

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest." (reasonable self-interest)

From now on actuarial advice is different!

GMI could be the new key to economic recovery. We have to get back into realistic pension plans. We need to establish the necessary changes (due to aging) in our social security systems. It's our task as actuaries to share and discuss the above principles with our clients and the boards we advice, in order to force the crucial (economic) change that's needed. This is no easy task, as board members are often not used to such transparent en open discussions involving their own underlying personal values, preferences and (reasonable) self-interest.

So from now on, when you discuss an actuarial report or advice on board level, it's different! From now on, we've got New Actuarial Ethics, where GMI is inclusive. 

This new ethical theme, including the communication and discussing techniques, should be incorporated in our actuarial education program....


Used Sources/ Related Links:
- Thompson: Ethics is dead, what do we do next?
- The crystal ball 
- When Bad Things Happen to Good Plans
- Actuarial Ethical Dilemmas(2010,ppt)
- Actuary Duty (Vrystaat)
- Clay Bennett Cartoons

Pension Fund Gambling

The essence of a DB pension fund's risk strategy can be captured in a single graph:

Key issue is that the portfolio duration of a DB-plan's Liabilities varies between 12 and 14 years, whereas the duration of the DB plan’s Assets is generally much shorter, 4.5 to 5 years (Moore 2007).

Secondly, 2008, 2009 and 2010 have proven that investment statistics and models have failed. Sustainable models are nearby dead.

All this implies that, despite all (developed) models, risk strategies, derivatives and experts, ultimately, a Pension Board has to take a decision without a reasonable amount of certainty. In other words they have to gamble.... And to brighten up your day, it's your responsibility as an actuary to advice this pension board!

Read more about this fundamental pension challenge in:

The Prudent Man Standard

Legal and Investing Implications of LDI Safeguards for Pension Risk

Links:
-Public Pension Funds Gamble With Risky Investments
-The Prudent Man Standard

Actuarial Risk Management Humor

During the pause of a Risk Management conference, a professional risk manager, an accountant and an actuary were in the gents room standing at the urinals. The risk manager, who finished first, walked over to the sink to wash his hands. He then proceeded to dry his hands very carefully. He used paper towel after paper towel to ensure that every single spot of water on his hands was dried. Turning to the accountant and actuary, he said, "We risk managers are trained to be extremely thorough to prevent any risk at all."

Then the accountant finished his task at the urinal and proceeded to wash his hands. He used a 'single paper towel' and made sure that he dried his hands using every available portion of the paper towel. He turned and said, "We accountants are not only trained to be extremely thorough in preventing risk, but we are also trained to be extremely efficient in managing and controlling risk as well."

Finally the actuary finished and walked straight for the door, shouting over his shoulder, "We actuaries, we never get our hands dirty"


Links:
- If people think other people are watching them, then they are more likely to wash hands

ABP Pension Fund ROI Travesty

What is a 'good' return on investment?

Dutch Pension Fund ABP, the industry-wide pension fund for employers and employees ( 2.8 million participants) in government and educational institutions in the Netherlands and the world’s third largest pension fund, reported a 20.2% return on investment in 2009.

In the 2nd half 2009 Press Release, ABP qualifies it's own performance as a 'Good Rate of Return'.
Now theologists as well as actuaries are familiar with the risk of calling something 'Good' ....

ABP ROI Stress Test
Let's put the ABP investment strategy to the test.

In the same Press Release,  ABP publishes the long-term rate of return from 1993 to 2009. ABP's average annual rate of return over this period of 17 years is 6.7%.

ABP's 'Signs of Hope Strategy'
To achieve this phenomenal return, ABP has developed a spectacular - every three years changing - Investment Strategy Plan (latest plan is confidently called: 'Signs of Hope') with a strong diversified 'winning' (?)  investment mix in combination with zero transparency or accountability information with regard to 'investment costs'.

Alternative T-Bond Strategy
Alternatively, ABP would have been better of if it would have applied a no-risky defensive European (10 years) Treasury Bond Strategy from the start. In this case the yearly average 1993-2009 ROI would have been around 6.9%.

Take a look at the next chart and decide for yourself. What pension fund would you prefer, Red or Blue?

ABP stated in their objectives that, in order to keep pensions affordable in the future, the return on investments must attain an average of 7% per year. It's clear that this objective will never be met on basis of the developed investment strategies in the past.

ABP's Future perspective?
Let's 'hope' that, after the recent step down of Ed Nijpels, ABP's new to be appointed chairman will have enough power, (pension) experience and time available to resist and combat the opportunistic and risky plans of the headstrong APG investment specialists.
Anyhow, the new chairman should be at least someone who knows how to spell the word 'Risk Management' and is experienced in (ac)counting from 1 to 10.... maybe an actuary?

Solution
Perhaps the best thing to do is to:

• turn the ABP scheme into a "pay as you go system",
  
• transfer the ABP administration to the efficient Dutch Social Insurance Bank,
  
• fire most of the ABP Asset Management Department (APG) (as they are confused about time and cannot tell the difference between Tomorrow and Today anyway) and finally,
  
• use the € 208 billion on assets to reduce most of the Dutch National Debt ( € 375 billion)

Good Luck ABP!

Links
- Top 10 largest pension funds in the world
- ABP Press release 2nd half 2009
- APG: Tomorrow is Today 
- Joshua Maggid: Excel ABP (.xls) 

Actuarial Smurf

Question is whether actuaries are best positioned for the role of Chief Risk Officer (CRO)....

More and more the CRO becomes one of the most important positions at board level to analyze, control and optimize risks in (financial) institutions. Qualified actuaries are pre-eminently positioned to qualify as CRO. After all, managing risk has been their primary task for decades. Rolling out the new Chartered Enterprise Risk Analyst (CERA) credential, actuaries will get better trained and educated than ever before.

CRO Role at Risk
Despite of all this, the CRO role is 'at risk' itself. CRO responsibilities and position are by definition conflicting with certain other stakeholder roles.

This is clearly demonstrated in a graph developed by Professor Emeritus Harry Panjer(Actuarial Science University of Waterloo).

Let's take a look at the slightly adapted graph of Harry Panjer:

• Regulator
  Regulators’ primary responsibility is to protect customers. Thus avoiding downside risk is their focus.
  
• Rating agencies
  Rating agencies focus on both the possibility of large losses as well as the possible gains to shareholders.
  
• Investors
  Investors are interested in both gains and losses and are willing to take the risk of the loss of capital as long as there is compensatory opportunity for gains.
  
• CEO
  The CEO with big stock options, has huge upside potential but little downside risk. Getting fired is one of the embedded options of the CEO's personal strategy.
  
• CFO
  The CFO's first responsibility is to stay 'in control'. The CFO will try to prevent excessive unforeseeable or unexplainable results, whether down- or upward.
  
• Clients
  Clients are primarily interested in value for money, service, quality and the continuity of the (financial) institution. Clients will keep satisfied as long as the financial results of the company remain stable and (average) positive within limits.
  
• CRO
  The CRO is trying to control the downside risk. The CRO is a kind of 'Risk Management Smurf' who only has a big STOP sign to limit the CEO and shareholders in their (short term return) demands. 

It's clear, acting as a CRO is like:

• Walking on eggshells
• Communicating with a silver tongue
• Listening like a fly on the wall
• Looking like a policeman
• Convincing like a missionary
• Calculating like an actuary

Don't wait any longer, become a professional Actuarial Smurf!

Links:
- Panjer: ERM and the Role of Actuaries (2009,pdf)

Return of a U.S. Debt Dollar

Take a (compressed) look at what author and business owner Nathan Martin calls:

The Most Important Chart of the Century!

This chart, based on the latest (March 11, 2010) U.S. Treasury Z1 Flow of Funds report, shows the change in GDP divided by the change in Debt. Or in other words: it illustrates how much extra economic productivity is gained by pumping one extra dollar of debt into our debt backed money system.

As is clear, the economic return of one dollar of 'debt infusion' declined from a positive $ 0.70 in the sixties to a negative $ 0.45 return by the end of 2009!

From a macroeconomic point of view the U.S. economy is fully saturated with debt. Flushing more debt in the U.S. economy will no longer help the economy out. Moreover, it will damage the economic growth!

Interested? Read the full blog of Nathan A. Martin

Links:
- Source: The Most Important Chart of the Century!
- U.S. Treasury Z1 Flow of Funds report (March 11, 2010)

Country Default Probability

National debts are growing worldwide. It seems we're drowning in a sea of debt. Who's gonna survive?


By experience we know that whenever our gut-feeling takes us for a ride, help of statistical models is necessary to rebalance and get sight at the real problem.

Sovereign Risk Monitor
In this case of 'national debt', the help of CMA's Sovereign Risk Monitor comes in. The CMA Sovereign Risk Monitor identifies and ranks the world’s most volatile sovereign debt issuers according to percentage changes in their 5 year CDS. CMA also calculates the Cumulative Probability of Default (CPD), the 5 year probability of a country being unable to honour its debt obligations.

Let's take a look at the world's most risky countries in Q4 2009:




Yet, the 'Default Landscape' is rapidly changing as becomes clear in CMA's interesting daily 19 March 2010 report showing Greece 'Cumulative Probability of Default' rising to 24.27%.

On the other hand we've got the world's best Countries, with Norway on top....

More actual information is available at CMA (registration required).

Latest CMA Update

Let's hope for the best....

Links:
- CMA Sovereign Risk Report for Q4 2009
- Source: CMA
- Latest CMA Update

Hedge Fun

Do you recognize the next situation?

You're at a birthday party or having a social evening. Everybody is having fun, talking to each other and - like usual - discussing the latest financial topics, scandals and solutions.

Suddenly someone turns to you and says: Heee.. you're an actuary, you can tell us what a a hedge fund is!

Of course as born or raised actuaries we all know what a hedge fund is. But when it comes down to explaining what a hedge fund is to clients, board members, friends or family, probably not one of us can explain it better than Paddy Hirsch, Senior Editor at Marketplace, can in the next Youtube video:

Video: What is a Hedgefund?

Now, when a Hedge Fund or a (Lehman)bank 'unexpectedly' gets into trouble, it simply uses the Repo 105 technique to to survive. Paddy Hirsch explains again.....

Video: Repo 105

As professional risk managers we would expect these high risk Hedge Funds to operate under excessively severe capital requirements. Too bad...., this is not the case, as Mr. Timothy Geithner explains in the next video......

Video: Geithner: No Capital Requirements For Hedge Funds

From Mr. Geithner's statements it's clear that Hedge Funds are de facto treated as 'Hedge Fun' until the systemic risk shows up.

However, when this risk becomes manifest, it will be to late to take appropriate measures.

Misunderstanding: Risk management
One of the great public misunderstandings of Risk Management is that most people - obviously including Government -think that Risk management is all about 'Managing Damage' after the corresponding loss has occurred.

As we know, Risk Management is about something else:

I. Identify, Analize & Prevent Risk
About 70% of Risk Management is about constantly identifying, analyzing and preventing risks from happening.

II. Emergency Response Plan
Another 20% is about proactively creating and updating Emergency Response Plans (ERP's) on how to deal with loss and how to limit and reduce that loss in case of the unfortunate event that a risk materializes in a loss.

III. Damage Reduction
Only the last 10% is about 'damage reduction' by executing the ERP's and tackling losses in case a risk - notwithstanding the measures taken - has resulted in a loss.

Perhaps we should offer (one volunteer is worth two pressed men) Mr. Geither a free Risk Management Course from the institute of actuaries.....

Read more about (the regulation of) Hegde Funds in an excellent (2006) paper by Dale A. Oesterle called Regulating Hedge Funds.

It's clear: there's nothing funny about fundy hedge funds....

Corresponding Links:
- Derivatives study center : Hedge Fund
- Regulating Hedge Funds (2006)
- Marketplace videos
- Will Lehman Brothers and Repo 105 allegations bring down Ernst & Young?
- Wikipedia: Repurchase agreement, Repo 105