Risk Anatomy
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Risk Anatomy™
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Ecosystem versus Market
- Benign and brutish interpretations of the Prisoner’s dilemma
- Market
- Government
- The firm
- The individual
Cooperation
- 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.
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?
- (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?
And what can we do to fix it?
There is no perfect marketplace.
- (v) So in an environment we have many dynamics – brutish competitions, opportunities for wealthy collaboration, each interaction shapes the market.
- (v) So in an environment we have many dynamics – brutish competitions, opportunities for wealthy collaboration, each interaction shapes the market.
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.
- (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)
- (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.
- (i) it should be as simple as humanly – and mechanically – possible, but no simpler).
- (c) Great energy should be expended on keeping it simple.
- (a) Key is to have a centralised and coordinated approach to those exceptions. This is a combination of:
- (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.
- 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.
- (i) Instead the existing process is lifted wholesale and outsourced. This meets one criteria, superficially at least (cost reduction) but fails on the others.
- (a) Complexity is such that the cost or required expertise to simplify the process to be automatable is not done.
- (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
- (i) lack subject matter expertise (they will be management consultants, not lawyers)
- (a) For reasons given above, process reengineering will be carried out by people who
- (1) Removing complexity
- (i) Machines do the repetitions
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
- (i) Substantive unfairness
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)
- (i) Selective escalation piecemeal to different risk controllers.
- (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
- (1) Which are genuinely inadvertent - no one’s fault and no one takes responsibility for them
- (ii) Good outcomes
- (1) Which are genuinely inadvertent will not go unclaimed
- (2) Which result from good decisions will be claimed by everyone
- (1) Which are genuinely inadvertent will not go unclaimed
- (i) Bad outcomes
- (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.
- (i) Fear leads to confusion leads to complexity leads to confusion leads to fear.
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
- (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.
- (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)
- (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.
- (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).