Risk

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• Complexity
• Fear
• Reward
• Value - you add value by changing things. If you can't change substance, change the form.

Value crutches: For the avoidance of doubt. Without limitation.

• Risk
• Preservation

Fear: when your web-filter blocks online translation tools

Ship of Theseus aka Stevie Ray Vaughan’s guitar. Eddie the Eagle: If you want to make it to the Olympics, don't go for sprinting. Find the most obscure official sport : the least glamorous, the lowest participation rates, the most widely misunderstood, and make it your life's mission. If you want to climb to the top of a greasy pole, find a pole noone else much fancies climbing.

This is the story of modern professional services occupations - the invention of dreary but important controller roles. Thus the proliferation of senior regulatory change management professionals

The big ideas
A just so Story: netting. History.
The first swap – IBM v world bank
Offsetting positions created wild exposure gaps. Framers of the ISDA came up with some clever techniques to offset these exposures
Banks have to hold liquid reserves against liabilities. To prevent Bank runs
Basel accord of 1989.
When were CSAs invented?

(is this the great falsification of the capitalist dogma? If corporations are the purest expression of the magic that is weaved when the market’s chains are broken, then how do we account for the high paid, low grade tedium that occupies the great majority of professional middle class?

(is it, as David Graeber says, some kind of dastardly stitch-up of the productive workers, born not out of conspiracy but buried resentment of these heroic labourers by the useless bourgeoisie?

(if not that, then what? How can this capitalist machine, with its algorithms and AI, its management consultants, its self-help gurus, its thought leaders and passionate change managers, and with so many trillions of dollars at stake – how can it be so inefficient?

And what can we do to fix it?
There is no perfect marketplace.

Prisoner’s dilemma

(v) So in an environment we have many dynamics – brutish competitions, opportunities for wealthy collaboration, each interaction shapes the market.

(b) The market is a direct analog for the ecosystem.

(i) The two competing views, Hobbesian and Smithian, are not incompatible. In many ways they say the same thing.

(ii) OK not quite. If the market is a game of whist, the biosphere is a game of black bitch.

(1) The biological competition for resources is a straight fight between predators to find prey. The winner gets to EAT the prey.

(a) This is a desired outcome for the winning predator only. It’s a bad outcome for the prey. The competition among the prey is to avoid being the one who gets eaten.

(b) It is asymmetric. It doesn’t work in reverse (prey do not compete among themselves for the best predator; quite the reverse – though the extended phenotype, a cow selects its farmer, perhaps they do?)

(c) That’s a zero to negative sum game: there is some loss of thermal energy or increase in entropy.

(d) It is not iterative:

(i) it has no memory

(ii) eaten prey are not in a position to learn or remember.

(iii) Predators don’t care about their reputation.

(e) Therefore it’s Gaussian: there’s no interdependence between hunting trips.

(2) The commercial competition for resources is a fight between sellers to find a buyer (and vice versa). The winner gets to transact.

(a) That is a desired outcome for both parties. Both are winners

(b) It is therefore a zero to positive sum game (it is only negative if one or other has traded in error)

(c) It is symmetrical – you can view it from either buyer or seller’s perspective and it looks the same

(d) It is iterative. Each party remembers its treatment at the hands of the other, and can learn from and communicate its experience. Also transactions act as market signals : if everyone sells, so do I. Transactions influence each other. The statistical analyses are not normal.

(3) A transaction is, therefore, a cooperation. A cooperation is in a fundamental sense a strike against the open market (even though it is the essence of the market – paradox alert. A transaction is its own mini cartel. It will often be wrapped up in anticompetitive terms:

(a) Confidentiality

(b) Exclusivity

(c) Licencing

(d) Intellectual property

(4) These cartel terms derogate from the fundamental conditions of the market. They undermine the nomological machine.

(c) Basic unit of commercial replication is the individual.

(i) Again, the analogy is close but not perfect

(1) Individuals can move from firm to firm; genes cannot leave one existing individual and join another individual (except by reproduction)

(2) However transfixed their executives might be with evolutionary metaphors, Corporations do not evolve like organisations do, by reproducing and dying. They adapt during life. This is Lamarckian evolution at best. (Lamarckian evolution is a great biological heresy).

(3) But the ability of “crabs to pole-vault” means that Lamarckian approach makes sense.

(ii) The firm is a vessel for replicating individuals. It is not a replicator itself.

(iii) No matter how much we might try to tell ourselves it has a legal personality, legal responsibility and legal “consciousness” these are FICTIONS. The firm has NO consciousness other than that of the individuals comprising it.

(iv) Just as the evolutionary fitness of an organism can only be explained by the reproductive capacity of its genes, so the fitness of an organisation is a function of the survival instincts of its employees.

(d) The Firm

(i) Rebuttable presumption: this is the purest form of reaction to the market. This will thrive in the absence of rules Evolutionary advantages for firms (not individuals)

(1) Scale leverage and continuity –

(a) accrues largely to the firm, not to individuals in it – so a natural limit.

(2) Responsibility diffuser

(a) Accrues exclusively to individuals, so a stronger evolutionary advantage to one that accrues to the firm itself (and only indirectly to individuals)

(ii) Limits on evolutionary advantages:

(1) Cross cutting interpersonal relationships

(a) Good and bad relationships

(b) Between individuals at the firm

(i) relative to positions in firm hierarchy

(c) Between individuals at different firms

(2) Scale opportunities bring their own natural costs

(a) The larger the firm the greater opportunity to wring economies from its scale. There are inflection points

(i) The point where the scale opportunities are large enough to go from passive scale management to active scale management

1. Passive: obtaining natural benefits that flow from the simple fact of size (eg adding another user to a flat fee all-you-can-eat licence automatically reduces the per-user cost of the licence)
2. Active: diverting firm’s resources and personnel towards manufacturing scale efficiencies that don’t arise by themselves (eg negotiating law firm panel arrangements, outsourcing, offshoring

(ii) The point where the firm is justified in deploying specific resources solely to leveraging scale. It may engage management consultants, middle managers and eventually a chief operating officer (not to be confused with head of operations – the COO is a separate function, and other departments may have their own COO Groups. Indeed the operations department could have a coo and probably only doesn’t through its own inarticulate chutzpah)

(iii) The point where the scale – leveraging organisation is itself so complex that there are opportunities to leverage its scale. So consolidating all the diaspora of COO groups into a single function, distinct from operations and the main COO function, and now big enough to have its own COO function.

(b) The larger the firm the more complex it becomes.

(i) A sole trader is salesman, receptionist, janitor, legal and operations.

(ii) At a point it becomes necessary and desirable to hire dedicated personnel to carry out these roles.

1. Some (sales, trading) are risk-taking, revenue-generating roles.
2. Some (legal, operations, risk) are revenue-absorbing, risk-reducing roles. These are incentivised by means of cost reduction not revenue generation. Incentives are markedly different from sales and trading roles.

(iii) There is a geometric relationship between number of components and their possible configuration. The more configurations the more scope for complexity. The more complexity the more confusion. The more confusion the more scope for fear. See below

(iv) The COO Function in itself is a source of complexity.

(c) Paradoxically, the pursuit of economies of scale in itself increasingly undermines the natural economies of scale.

(i) There is a natural upper bound to the effective size of the firm beyond which marginal economies drop to/below zero.

(iii) Firms as the vessel for the gene – an extended phenotype for the individual

(iv) Firms as individual responsibility expungers.

(e) The Individual

(i) Motivations:

(1) FEAR. This is the chief motivating factor for any individual.

(a) Types of fear:

(i) Fear of screwing up.

(ii) Fear of the known unknown

(iii) Fear of remote but foreseeable contingencies – the chicken licken scenario

(b) Some legitimate risks do not create fear:

(i) unknown unknowns – black swans – do not create fear. It is hard to blame someone for not anticipating something that, qed, could not be anticipated.

(ii) Emergent risks – risks that only arise at a level of abstraction beyond that for which the employee is directly responsible or accountable.

(c) Behaviour which reduces fear

(i) Repeated tasks

(ii) Familiar tasks

(iii) Pre-established modes of operation

(iv) Behaviour which is characteristic of most people in the organisation (homogeneity)

(v) Decisions for which somebody further up for line or across the organisation has accepted responsibility

(vi) Encouraging others to underwrite risk or collectivise /diffuse risk

(d) Behaviour which accentuates fear

(i) New situations

(ii) Unhedged risks

(2) REWARD. Compensation for what you do.

(a) Generally an employee does not have an equity stake in the business (OK, OK bonuses – we’ll get on to that)

(b) Employee reward is pre-defined: there may be incentive structures but employees for the most part get fixed compensation. They are creditors of the firm for that compensation. Unless the firm is bankrupt, they are paid regardless of performance. The sanction for poor performance is termination. It is very hard to reduce fixed compensation.

(c) The larger the firm the more specialised the staff, the fewer are specifically revenue generating roles. Most of a multinational Bank is infrastructure: operations, risk management, IT and increasingly middle management : infrastructure to manage the infrastructure.

(d) Therefore only a small portion of the staff have any grounds for incentive based compensation. Some could be incentivised by cost management, but for many – risk, legal, compliance – performance related pay is largely antithetical.

(i) This will not stop enthusiastic general counsel arguing, in times of feast, that his legal team are skilled enablers of revenue generation, and should be compensated for the profits they help to bring in.

(ii) The stock reply: turning a control function into a profit and loss centre has bee tried before. It didn’t work out so well.

(e) The bonus culture. No doubt to redress the fear / reward balance, investment banks shifted towards a bonus culture throughout the eighties.

(i) Many of these firms started out life as partnerships, where those bringing in the profits were personally liable for losses, and the compensation they shared was specifically the equity. These firms took advantage of regulatory change to incorporate. The partners changed their formal status (if not their titles) from partner to employee, but the compensation structure remained. While these firms encouraged equity participation (to the point of paying compensation in shares) employees main source of income was celery and not share performance. Indeed the manual dilution of equity capital in the bonus round had the typical effect of depressing share performance. In this way and in many others comma employees in these Incorporated partnerships were and continue to be systematically preferred over equity holders. The same pay structure has been adopted by competing banks which have always had a corporate structure full stop the lesson of the last 30 years has been only a mug is long banking stock .

The nature of risk

(a) The real risks are the ones that people don’t recognise as risks AT ALL. All significant market dislocations have come from blind spots.

(b) Known knowns – about which firms naturally obsess, in fact are not generally risks at all, precisely because they are known knowns and are properly identified, managed and controlled.

(i) Black swans AFTER THEY HAVE OCCURRED are no longer black swans. (“Policy is organisational scar tissue”). Our constitutional insistence in reviewing the tape for PAST PERFORMANCE means we obsess about risks in stables from which horses have already bolted.

(ii) Eg close out netting.

(c) Real risks – especially unknown unknowns

(i) Don’t cleave to the organisational structure much less the firm’s own division of responsibility for risk management, which is based on stables from which horses have already bolted

(ii) Therefore susceptible to present in different areas of risk management – the same risk might be partly legal, partly credit, partly market risk. Each in isolation may be containable, but combined effect less so

• Firm

Form over substance

(a) Burgeoning complexity means a preference for substance over form

(i) As previously rehearsed, the more complex the organisation the less likely people are to understand the substance, let alone be responsible for it.

(ii) The form is, by definition, easily articulated. It is measurable, observable, auditable.

(1) “Did you review that template by year end?” has a yes/no answer which is easily given in the affirmative. All you need is a diary and a decent sense of time management.

(2) “Did you review the template properly?” is a harder question to answer.

(a) Did you check it against policy, legal developments and corresponding templates” is a harder question, but it has a yes/no answer. It functions like a checklist.

(b) Did you get the right answers? Is hard to validate.

Checklists

A word on checklists – eyebrow raising book of Atul Gawande. Illustrates the benefit, as well as the limitations, of form as an aide to substance.

(a) A checklist is an aide memoire to assist a person carrying out a standard task to cover easily overlooked basics, rather than a certificate or means of apportioning responsibility.

(b) Checklist solves for the ancient dilemma that humans are good at imaginatively solving new problems, but bad at systematically carrying out repetitive tasks.

(c) In the modern age (at least post information revolution, but really post industrial revolution and even agricultural revolution, progress has been characterised by automating routine tasks and redeploying humans to solve new problems

(i) Machines do the repetitions

(ii) Humans to the automating. This is a difficult and creative job – it involves analysing manual processes and re-engineering to be machine appropriate.

(1) Removing complexity

(2) Making design decisions that trade of flexibility for robustness

(3) Needless to say process reengineering takes skill, subject matter expertise and time. It is expensive.

(4) Natural tension that many subject matter experts will neither have any process reengineering expertise nor is it in their interests to develop it, as it will typically put them out of a job.

(5) Difficult decisions to make fundamental changes to process will lead to radically different ways of working which will mean short term disruption as the firm and its individuals adjust to the new paradigm. As with any organism developing a new skill, a firm will have to develop neural networks and muscle memory before the process is bedded in.

(6) The model will always be challenged by exceptions: special cases, difficult clients, and secular changes (regulatory change, tech developments)

(a) Key is to have a centralised and coordinated approach to those exceptions. This is a combination of:

(i) Being firm and trusting the model: calling the bluff of single clients who insist on doing things differently. (it is amazing how many platinum clients drop their request when they are told, regretfully, that the negotiation cannot continue)

(ii) Recognising what is unreasonable client behaviour and what is an incorrectly configured model. If one client insists it must have peanut butter in its burgers, pass up its business. If they all do, change your burger recipe.

(b) The interests of the organisation and the dictates of robust system design are perfectly aligned :

(i) it should be as simple as humanly – and mechanically – possible, but no simpler).

(ii) That said, there is no existing business process, no legal document, no internal organisation, that could not be simplified.

(c) Great energy should be expended on keeping it simple.

(7) Same is true of business – the design heuristic is exactly that (Roger Martin)

(a) Complexity is such that the cost or required expertise to simplify the process to be automatable is not done.

(i) Instead the existing process is lifted wholesale and outsourced. This meets one criteria, superficially at least (cost reduction) but fails on the others.

1. The process is still too complex to be automated, and is instead carried out by people with even less comprehension of the details, even less incentive to get things right (no bonuses in Bangalore) and none at all (nor any mandate) to take a view.

2. Result is more escalation, to a smaller group of remaining subject matter experts (most of whom have been outsourced) who are less expert, and slower to respond.

(8) Middle management ought to be the process of overseeing that automation.

(a) For reasons given above, process reengineering will be carried out by people who

(i) lack subject matter expertise (they will be management consultants, not lawyers)

(ii) Are focusing purely on short term cost savings. Long-term benefits will accrue after they have gone

Escalation as a subject in itself

(a) Diffusion

(b) Speed

(c) Resources

(d) Organisational Complexity

Process over substance

(a) Proof of governance was that the meeting took place and was minuted, not what was said – though records are dangerous things in hindsight, after an accident has happened, so expect great attention to be taken on the content of the minutes – the trick being to neuter their content as much as possible so that nothing sensitive or incriminating is in them – the idea being to evidence the form of governance without revealing any more than is absolutely necessary about the content of the governance.

(b) Unjustified dismissal

(i) Substantive unfairness

(ii) Procedural unfairness

The perils of the corporate person

(a) Unlike a real person, the interior monologue is not private.

(b) Unlike a real person, a multinational firm has an utterly verbose interior monologue, everyone is shouting at the same time adding each other to conversations they don’t care to be a part of. Joel Bakan says a corporation is like a psychopath. It might be run by them – that’s plausible – but in its own personality it is more like a paranoid schizophrenic with multiple personality disorder.

(c) This has proved in this information age to be a far greater bane than anyone realised. Everything is discoverable and like all masses of communication that can be pulled of context it inevitably looks worse in hindsight than it did when it was written down.

(d) The audit trail fulfils following functions –

(i) evidence of compliance with process without reference to substance

(ii) To evidence and memorialise decisionmaking.

(iii) to evidence qualifications, derogations, assumptions and conditions upon those decisions. Ie to diffuse responsibility for the decision.

(iv) The key for SMEs is to articulate conditions of a qualitative (ie requiring comprehension of the subject matter) and not quantitative nature. Ie “assuming sufficiently robust operational setup to satisfy the legal and regulatory requirements”. This allows the operations SME, to whom the consultant will inevitably turn, to create her own qualitative conditions. If she is experienced, her conditions will be in the gift of a third SME, who will create her own qualitative conditions in the gift of a fourth. Eventually the trail will lead in a bureaucratic Möbius loop back to legal, and the circle of diffusion will be complete.

(e) For employees who are part of the infrastructure rather than revenue generation – and that is most of them – there is a sharp asymmetry.

(i) You are not rewarded for ambition or risk taking – that is not your job.

(ii) You are not rewarded for actually avoiding risks – a bad outcome that did not eventuate is not just dog that did not bark in the night-time, it is part of the infinite set of possible but non-existent events. (option pricing)

(1) before it materialises, a risk has a positive value, albeit one that is usually impossible to quantify.

(2) After the risk has passed untriggered, it has no value. It is like an option that expired out of the money.

(3) If the risk comes about but the firm has defended against it, again it has no value. The firm’s resulting profit and loss is flat

(4) If the risk comes about and the firm has not defended against it, then notionally, someone is responsible. But see diffusion tactics – here the primacy of the individual’s survival instinct over the organisation kicks in.

Motivations

(a) Individuals who wants to get things done that involve taking new risks or Crossing into unknown territory must develop tools and techniques for disarming natural employee risk avoidance strategies. for example,

(i) Selective escalation piecemeal to different risk controllers.

(ii) Appeals to authority (EG the CEO wants this to happen)

(iii) Appeals to precedent in the market (EG all our other brokers have given this)

(b) A secondary motivation is taking credit for things that go well.

(c) A profound asymmetry, therefore:

(i) Bad outcomes

(1) Which are genuinely inadvertent - no one’s fault and no one takes responsibility for them

(2) Which result from bad decisions, if socialised correctly, are also left un-penalised

(ii) Good outcomes

(1) Which are genuinely inadvertent will not go unclaimed

(2) Which result from good decisions will be claimed by everyone

(d) Vicious circles

(i) Fear leads to confusion leads to complexity leads to confusion leads to fear.

(ii) Complexity leads to specialisation. Specialisation leads to siloification. Siloification encourages diffusion of responsibility. Specialisation leads to diffusion of specialist knowledge. Central office techniques for measuring performance cannot cope with the diffused complexity and the specialised knowledge and language in the silos. Also those measuring are themselves specialists with their own arcane knowledge and language which is as impenetrable to the subject matter experts whose data they seek to run their measurements. So measurement is by proxy, by reference to measurable data points. These tend to be numeric, calculatable values.

(iii) Subject matter experts (eg lawyers) will complain that, for example, the value in a well crafted indemnity – its enforceability, its scope, its flexibility for unexpected contingency – cannot be sensibly expressed in numerical terms. The evaluator accepts this, and therefore assigns those ineffable features a value of zero. The values they can measure: is there an indemnity (yes/no) and how long did the lawyer take to agree it (what was its direct cost).

(iv) Yet these ineffable are precisely what you pay your lawyers to provide.

Themes

(a) No one got fired for hiring IBM.

(b) Corollary: no business was revolutionised by hiring IBM either.

(c) The profound secular changes that shape businesses do not spring fully – formed from the brow of Mckinsey & Co. They exist out there, in the market. The personal computer. The invention of the swap in 1982. In invention of the Internet.

(d) See also the doctrine of precedent. But past performances is no indication of future performance.

(e) Natural caution, tendency to run with herd and go with flow

(f) Payment of lip-service to politically astute norms. Diversity a case in point.

(g) Most insurance is a mug’s game

(h) Chicken Licken - we spend large parts of our daily life catering for contingencies that will never happen. Look upon a control function as a sort of insurance against risks : you pay a cost up front ( in time and organisational resources) to have someone manage the risk. Ask

(i) Are these live contingencies or comfort blankets – paper tigers and imaginary monsters that we are professionally incentivised to treat as real?

(ii) Let’s go with it and allow that these are real risks

(1) Are these tail risks or every day risks?

(a) If they’re everyday risks then the decision what to do about them differs. You can reliably predict the incidence. It becomes an actuarial matter. You can quantify it. Average cost. Expected probability. This is what insurance underwriters do.

(i) Make a binary decision to accept the risk – self insurance) or reject it (no risk, so no insurance) . Either way, don’t buy insurance. No need for a risk manager

(ii) If you accept the risk, reprice the service. This is a bau cost of doing business. Charge your customers the insurance premium. For them it may be tail risk; they may only trade once a year. for You it’s a cost of business.

(iii) If you can’t reprice – if the market won’t stand it - then get out of the fucking business. If someone else has mispriced the risk, they will blow up. OR--- have you?

(b) If it’s a tail risk then, okay, its in principle insurable. But still you’ve got some questions.

(i) How big is the risk? How bad would any risk event be?

1. If it is containable (my toaster blew up) given your volume then take the risk. If you buy one toaster, you might buy a warranty. If you buy a toaster a day, save the daily warranty and use that fund to replace defective toasters.

2. If it is catastrophic then you still have done questions.

a. Is the business worth it? Have you priced it correctly?

b. How effective is your insurance? Will the risk manager get it right? Will she protect against the risk? Are you sure?

(i) Risk and trade off

(j) Dumb risk management: we will make this concession for a platinum client but not for a small Client.

(i) Per dollar of revenue, small clients should represent less risk than big ones – they don’t gain from volume discounts or economies of scale. You should already be making more per trade out of small clients than big ones (or you’ve got your model wrong).

(ii) Unlike operating costs, trading risks do not benefit from economies of scale. In fact they are exaggerated by scale.

(1) Failure of a small firm is absorbable in the ordinary course (assuming you have a lot of small clients you can and should price it in to your service - it self-insures)

(2) Failure of a large firm may not be, and may trigger correlation losses.

(iii) Conceding credit terms based on volume of business, rather than assessed credit standing, gets things exactly backward: the more risk you take, the more lax my controls will be.