26 January 2016

Risk Managers in Uncertain times

Over the past few weeks I have been thinking about the world as we move into 2016. Most of that thinking is not about daisies and pixey dust, but about the changes over the past few years, many of which seem to be leading either to crisis, trouble, or the slow boiling of the frogs. Personally I'm hoping for a few crises that will, although probably fairly terrible at the time, actually bring about some fundamental changes that will create real change and improvement, at least in the medium term.

What's a Risk Manager to do? Below I contrast "the Usual Suspects" that we are (or should be) watching every day as Risk Managers, and then "the Big Stuff" and implications for Risk Managers now.

We are going to see the world change through 2016 and 2017, potentially dramatically - and not necessarily positive change. That is my view. Of course, I could be very wrong, and we could see a world that "muddles along". At heart are our individual answers to the question "how do we best help our businesses manage the coming risk world?"

I am not confident, but that is my view.

So let me suggest, based on my view, the potential impacts on Risk Managers for the coming couple of years. Two years is a very short time in a world of potential regulatory change and economic cycles. Anything shorter than two years would fail to consider the potential impact of major business and economic cycles such as the current commodity depression, the US (and China) manufacturing recession, and the very serious systemic debt and migrant issues that Europe may or may not manage through the coming year.

The Usual Suspects:

Of course the world of Risk will be both immediate and longer term, local or specific as well as systemic and international. We'll start by reminding ourselves of some basic risks that have no direct link to the wider situation.

1. Cyber threats. This category of risk continues to be on the rise, and can be an existential threat to companies from a data-loss or damage perspective, while civil and regulatory sanctions continue to increase. This is a threat that has been growing, and increased access and growth in skill sets will increase the number of hackers and the breadth of tools and techniques they will use. Companies will be taken down by Cyber attacks. Companies can prepare for and attempt to limit the impact of Cyber attacks, but can do little to reduce the likelihood of such attacks (as exogenous threat likelihood is not subject to risk reduction activities on the part of the company). Reducing the impact requires planning, careful review of the potential threat (what are the data-crown jewels, and how are these protected?) and remediation where infrastructure is not adequately protected. Reputation damage limitation if an element of planned responses, and finally, consideration should be given to Cyber Insurance.

2. Fraud, Bribery and Corruption. If the economy continues to grow and unemployment continues to fall, there will be little impact on the likelihood of Fraud, internal or external, though of course these risks remain. However, if we see a degradation in economic conditions, this will probably lead to an increase in fraudulent activity, starting with external fraud and followed by an uptick in potential internal fraud. Of course, some fraud, bribery or corruption is simply due to greedy people, and has no linkage to economics. Exercise skepticism.

3. Solvency. For the insurance industry in Europe, this is the year Solvency II fully comes into effect, and insurers across the continent are getting their reporting houses in order. Yet the risk is not simply that companies may or may not be solvent, it is a question of the quality of internal processes supporting production and maintenance of the ORSA (Own Risk and Solvency Assessment). As risk managers we can learn from companies that have been through the process, such as the importance of the quality of documentation of the process, effectiveness of systems of control (nothing new there), and the ability to demonstrate how the ORSA contributes directly to business decision-making.

4. All Your Risks. Every risk on your Risk Register will remain as critical (or otherwise) through 2016 and 2017 as they are today. Some will increase in potential impact, many will eventuate in actual issues or problems. These risks will become incidents, and you will manage them through to resolution - or not. There will also be a host of issues and incidents that will result in you reviewing the Risk Register, and probably adding risks to the Register.

You can never go wrong keeping your eyes on the day-to-day risks, and ensuring that the business either has effective controls in place, or is building a control environment that can actually be monitored to indicate areas of existing or emerging risk.

Now for the Big Stuff:

A global correction may be underway, with no sign of a low for some time to come. Certainly there may be up days or weeks, but it appears that there is more likelihood of a longer down trend for the coming months. The questions now are "how far, how fast, how long, and how much stimulus"? There are no serious commentators calling for a near-term renewal of a global bull market. The IMF recently downgraded their expectations for global growth from 3.8 (July 2015 forecast) to 3.4 (January 20016) with developed economy growth downgraded from 2.4 to 2.1, the same level as 2015.

The US markets are down 15% from their highs (DJIA - 15,900 from 18,200 in 2015), and China is at 2014 levels (Shanghai is at 2750 from a high of 5100 in 2015). [as at 26 January 2016]  Where will they go?

Total global debt has continued to rise all through the supposed deleveraging after the Global Financial Crisis (GFC), increasing by $(US)57 Trillion since 2007 to almost 200 $(US) Trillion. The majority of this increase has been government debt, yet corporate debt (and personal debt) has also risen through that period. This also cannot continue without impact.

At the same time in developed countries we see a close to stagnation in growth in real incomes. Personal income in the UK has finally (May 2015) caught up with where it was before the GFC, and the strong employment growth has been reflected in falling unemployment and increased wages. The introduction of a "living wage" will also increase personal incomes (although some worry that imposed minimum wages reduce employment growth). All good news, but will the UK continue to grow as the rest of the world slows down, if the UK votes to leave the EU, or if markets continue to fall (the FTSE is now at 5800 from just over 7000 in 2015, and continues to fall). [as at 26 January 2016]

In the US, employment growth appears to be strong, at the same time that the labor participation rate continues to fall. The unemployment rate is around 5%, a level that is close enough to full employment that we should be seeing serious upward pressure on wages. Yet the continued fall in labor participation indicates that there remains a (growing) untapped pool of labor. The picture remains murky.

Recommendations for Risk Managers

The current economic situation is, in my view, as scary as it has been since the GFC. Fear has an impact on risk and companies' and individuals' perceptions of appropriate levels of acceptable risk. How do we translate this into meaningful decision-making by companies, and counsel from Risk Managers?

1. Risk Appetite. There should be no better time than now to review (or write) the Risk Appetite for the business. Risk Appetite will provide a construct for decision-making by management that is in line with the level of risk that is acceptable to the Board and through them the shareholders. Risk Appetite is not a single statement, but needs to be broken into key business activities or processes, and potentially high level business units / companies. When reviewing (or writing) the Risk Appetite, speak directly with the directors and in private companies, with the key shareholders.

2. Identify your Key Risk Indicators (KRIs). These are the indicators whose movement provides insight into the potential increase or decrease in the likelihood of the materialization of any particular risk. For example, this may include items such as average days receivables (expanding may indicate deteriorating customer business conditions), or less obvious indicators such as unplanned staff turnover rates (with falling unplanned turnover being a surrogate for a degrading jobs market for your employees).

3. Stress tests (EKRIs). Build the models, and then test them beyond what your CFO/Finance Director thinks are possible. Build in extremes such as cost of fuel for distribution networks, cost of capital, internal project huddle rates. Stress until the model breaks, then look at why the model broke. That will give you a strong indication of the most important factors to be watching on a daily basis - your External Key Risk Indicators (EKRIs). I know of a very large manufacturing company that failed to hedge fuel costs, resulting in significant business costs when oil did spike. While that may not be the case today, if cheap oil turns out to be transitory, will cost-reduction based profits evaporate?

4. Outside-In. Having built or reviewed the Risk Register, the KRIs and the EKRIs, how are the risks identified reflected in the Risk Registers and risk reporting? Is the current risk environment too inward looking, focusing on the specific risks, controls, actions and people that are within the organization and therefore "observable" to management? How strong is the monitoring of external factors, and how can this be built into risk reporting?

5. Regulation Watch. Times of crisis almost always breed new regulation, or changes to existing regulation. I'm not going to opine on the benefits or otherwise of regulation, but as Risk Managers we must ensure that our organizations has fully considered the potential impact of such changes. When SOx (Sarbanes Oxley) and the section 404 requirements were passed, who predicted $170/hour for bulk standard Internal Auditors spending thousands of hours documenting mundane financial reporting processes and identifying controls - followed then by the massive increases in compliance costs to test those controls? Something like this is in our collective futures.

These are a few of the considerations for Risk Managers today. Are these different from what Risk Managers should be doing or concerned with in good times or steady global growth? No. And that is the rub, and the message; times like today provide strong reminders of what we should be doing every day. The increased fear do however provide us with the energy to get this done.

11 January 2016

So what is some good news for 2016?

Well, that last posts of mine did seem a little grim, and I've been asked if there is any good news for 2016. Well, there is. It just won't sound like good news when you read this, but do dig in, and provide your thoughts on 2016.
For example, health sciences continue to progress at a rapid pace, with improvements across the board. Major advances in the diagnosis and treatment of Alzheimer’s for example, and remarkable treatments for cancer. It is well worth noting the comment by Louise Perkins, chief science officer for the Melanoma Research Alliance: "The options were far fewer even a year ago". "My most recent MRI brain scan did not reveal any signs of the original cancer spots nor any new ones," Mr Carter said in a statement.

In the civil war in Syria, and terrorism and the Islamic civil war (ISIS vs the Shi’a world), the entry of Russia to the fray gives real hope. After 4 years of civil war in Syria, backed by the bloodied hands of the West and Saudi Arabia, real progress is now being made. No longer are the waves of fuel trucks streaming from the oil fields of Iraq and Syria to the refineries and tankers of Turkey. This year we will see then end of the civil war in Syria, and not a moment too soon.

Of course, strangely, if the Saudis and the Iranian start throwing exploding things at each other, or a cyber-attack on Aramco is successful this time, then we could see a dramatic reduction in oil production, spiking oil prices, and counter-intuitively, greater economic growth in the West, and a resurgence of the Russian economy. It might even be enough of a bounce to counter the China slowdown. Who said wars are all bad? 

Hopefully while the Saudis and Iranian are throwing exploding things at each other, they will avoid throwing things that go "boom" at US ships in the Gulf. Recently Iran demonstrated that it certainly can, and that it can get close enough to US ships to possibly, if they really mean it, do some damage to those ships. That would not be a good thing to happen this year.

But back to how does that happen to oil, etc? Oil at $35/barrel results in uneconomic wells in North America and Russia (the ‘other’ largest producers) resulting in lost jobs, failing companies, and local economies in trouble throughout their economic supply and support chains. Boost the price of oil, and we will see more ‘domestically’ produced oil and with it booming communities.

We would also see a Saudi Arabia that will desperately need to focus on their own people and economy, instead of exporting terror through individuals supporting, financially, the likes of ISIS and various alternative Sunni terror groups. Saudi Arabia need an oil price of over $100 per barrel to break even. Can they really outlast the West? Even if they try, they will consume their financial reserves in the process, leaving behind a bankrupt desert country with no effective economy, and thousands of princes expecting their monthly subsidy. Things do not look good for Saudi Arabia.

2016 is also the year that Europe will start to fall apart. This won’t be a permanent falling about, but we will see Schengen put on hold. Only yesterday former French President Sarkozy said “Schengen is dead”. No more free flow of people without identification between countries in Europe, allowing for local security and reduction in terrorism. Radical Islam will be on the retreat in Europe, but expect to see a spasm of increased attacks earlier in the year. By the 3rd or 4th quarter, I fully expect Europe to be quieter. Migrants will not find open doors, and those that did get in will be forced, on threat of summary expulsion (forget going to Strasbourg for a legal pass) for almost any offense.

Further good news in Europe will be the Grexit, in which Greece finally adopts the New Drachma and exists the Eurozone. Good news? Absolutely. The only hope that Greece has of recovery is through debt forgiveness or restructuring into a new currency. Otherwise the Germans, the ECB and the IMF will continue to crush the Greek people, in no small part to prove to all others that they must comply, or else.

This will also be wonderful news for Democracy in Europe, a land that has forgotten that people can vote out those that have cheated them and on them, and they can repudiate the bribes accepted on their behalf. Yes, Greece needs to pay back its loans. Absolutely. But when there is no ‘moral hazard’ then there are not incentives for lenders to act prudently. Greece is guilty, but equally guilty are those that provided loans knowing that they wold never be repaid, and that the Greek people would be skinned of everything they have.

I think my summary would be that there is very good news also, but some of it will not look very good as it happens…

06 January 2016

2016 - The Year the Frogs Boil?

"The premise is that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for the inability or unwillingness of people to react to or be aware of threats that occur gradually." From the Wikipedia article "Boiling frog".

Looking back over 2015 I see that I stopped writing mid-year. What I didn't stop doing was starting new articles, only to close them unfinished, or deleted them when they were done. There were so many topics, but self-censorship got the better of me - imagine that. There were just too many stories in the news, and too many desired knee-jerk reactions. The topics have ranged from terrorism and Islam, to economics and Greece.

In summary, 2015 feels in retrospect, as the year the frogs began to feel the heat. Some are getting even more lethargic, others are getting worried. I'm in the worried camp. While I'm not making any predictions about 2016, it certainly felt like 2015 was the year the heat was turned up on the Frogs (that would be all of us, not just the French). 

That, or the frog in a blender.  (Go on, you know you want to...

2015 certainly was a full year, so let's begin.

The Police State

2015 may be seen as the year in which the "modern" world died. In the United States it has become clear that the system is broken, that guns and Trump are viewed as acceptable, possibly even desirable antidotes to an imagined breakdown of central government. Police killed over 1000 people in the United States in 2015, compared with 3 (yes, 3) in the UK in 2015. In a land where 30,000 or more people are killed by guns each year, if you want to see how many people were killed near you, there is now a handy tool to help.


In addition, Asset Seizure in the US (the "legal" seizure of a persons money or other assets by police because the police think the assets might be used for or gained from criminal activity) for 2014 exceeded the total estimated value of burglaries in the US. Apparently police seized $4.5 billion from citizens, while burglars stole only $3.9 billion.

So the United States has become a corrupt police kleptocracy, in which the very act of living can result in you being killed by the police, or having your assets seized simply because they need your money to boost their budgets, becoming "self funding gangs".

The Police State came to Europe in the form of the selective oppression of the peoples of a member state through economic terrorism and abrogation of democracy. Institutional Terror is equally the tool of "liberal" nations. In Greece, the ECB, IMF and the Germans effectively enforced a coup d'état against the Greek government and people. After years of failure of policy, resulting in the enrichment of a few and impoverishment of millions, the Greek people voted over 60% against the austerity programme imposed on them. The ECB (but not the ECB alone, oh no) effectively said "Do what we tell you, not what your people demand, or we will starve you all to death".

This is the New Europe, one in which as un-elected cabal in Brussels, backed by (elected) leaders of (a few) of the major powers of Europe, simply impose their will on all. Democracy is allowed to continue as a joke at the local level, but no longer permissible as a mechanism for the expression of the will of peoples.

Terrorism, ISIS and others

While ISIS enjoys distributing videos of beheadings, apparently our ally Saudi Arabia has beheaded more people (144) in 2015 than ISIS. You can have your head separated from the rest of your body if you are foolish enough to express unauthorised thoughts or actions such as Apostasy (oops, I don't want to be a Muslim any longer), Adultery, Witchcraft and Sorcery.  And Saudi Arabia celebrated the new year with an additional 47 executions.

Turkey, our NATO ally, has been exposed as supporting ISIS, possibly at as high as level as the son of the president, by buying, shipping and refining ISIS oil. Meanwhile, Turkey holds a snap election at the same time as, strangely, terrorist attacks suddenly increase, driving voters back into the arms of the existing government party. Using that 'mandate', the Turkish government begins to pound the crap out of the Kurds, reminding them of their place. Interesting that the Ankara government is apparently supporting ISIS while suppressing their Kurds - "The enemy of my enemy is my friend"?

Then, in what could only be considered a major provocation, Turkey shoots down a Russian aircraft over Syria, claiming that it had violated Turkish airspace. No doubt it did, and the flight paths released showed that it did, for a few kilometers are most. All this in a year in which, by October 2015, Turkey had violated Greek airspace over  1400 times (suddenly stopping on the day that it shoots down a Russian fighter). In 2014, Turkey violated Greek airspace over 2200 times.

NATO clearly is on the verge of falling apart, if one NATO country openly violates the territory of another with impunity, while receiving military aid from the US, and at the same time apparently supporting a common enemy, and shooting down the aircraft of a common partner in the fight against ISIS.

Of course, the year began with the terrible attacks in Paris on Charlie Hebdo (and the Jewish supermarket). If only that were the end of the terror for Paris. Bookmarking the year was the November 13th attacks, killing of 130 people. In both cases, these were acts of terror carried out by Muslims against a liberal and mostly free society, in which secularism is deeply embedded, and religious rule has no place. The people who carried out these attacks were scum that had found "God" in the religion of their elders, and read only the bits of that religion that sanctified them for their barbarity.

What remains equally shocking is the depth of feeling within the UK Muslim community against the values of the liberal Western country that they live in. A February survey by the BBC was supposed to show that the majority of UK Muslims are opposed to the attacks on Charlie Hebdo and others, and reject violence as a mechanism to achieve an Islamic culture / state / law in the UK. Unfortunately the headline should actually read "27% of UK Muslims have some sympathy for the motives behind the Charlie Hebdo attacks in Paris". 27% of UK Muslims. That is sickening. Even as Paris was under attack again, UK Muslim "leaders" called for UK Muslims to struggle for an Islamic State in the UK.

Some of the dead (source unknown)

In April in Kenya a university was attacked, with captives being asked if they were Muslim or Christian - the Christians were then murdered.From the Wikipedia article accessed on 3 January 2015: "On 2 April 2015, gunmen stormed the Garissa University College in Garissa, Kenya, killing 148 people,[1][2] and injuring 79 or more. The militant group and Al-Qaeda offshoot, Al-Shabaab, which the gunmen claimed to be from, took responsibility for the attack. The gunmen took over 700 students hostage, freeing Muslims and killing those who identified as Christians. The siege ended the same day, when all four of the attackers were killed. Five men were later arrested in connection with the attack, and a bounty was placed for the arrest of a suspected organizer."

Economic News

The US economy is in a dubious state as 2016 arrives. After all of that news from 2015, we haven't even come near the economic news, unless you include the continued rape of Greece as economic news. And what a year. Markets ended effectively flat at the end of the year, as printing money slows down in the US, but ramps up in Europe. Yet for all that pumping, the velocity of money continues to fall. The question is what will happen to inflation when velocity increases? And velocity must increase for economies to grow again, and to actually employ people more people.

In the US, Amazon (AMZN) reached a PE Ratio of x900. Compare that to Cisco which, during the Dot-Com bubble went from a PE of x40 to x200 before crashing. How can any company be valued at 900 times earnings? Then look at Netflix (NFLX) at x440, making Google's (GOOG) PE ratio of "only" 36 look downright cheap. While the financial press has all sorts of good reasons why these PE Ratios still represent value, these remain historically scary ratios.

Meanwhile in the US again, the "Middle Income" (Middle class?) has shrunk to 51% (some say less than 50%) of the population. This is not news, nor is it an unexpected or unknown trend. This continues a trend that I was first introduced to in a university level demographics course in 1981.

US Labor Participation Rate

Percentage of workforce employed has dropped to levels not seen since the Jimmy Carter presidency. While President Carter is truly a great man, he is not remembered for managing a great economy, even though labor market participation did grown under his tenure. Month on month the BLS (Bureau of Labor Statistics) has reported gains in employment, yet the rate of employment growth has trailed the number of workers coming into the workforce, resulting in a continuing net reduction in participation rates. Looking at this BLS link, expand the period from default 10 years back to 1975 to see the full growth and fall of the participation rate.
US Inventories to Sales Ratio
Throughout 2015, the inventories-to-sales ratio has been growing, and at 1.38 is the highest that it has been since the middle of the Great Recession. Fundamentally, companies are building inventories faster than sales, a trend whose reversion to mean can come through a recession. Equally, long term trends have allowed for a reduction in the ratio without recession. None the less, it is a worrying indicator.

In December the Fed raise the discount rate by .25%, the first rate risk in nine years, offically because the economy is showing strength. Of course every increase in the Fed rate also increases the cost of borrowing by the Government. Some commentators suggest that the real motive is to protect the reputation of the Fed after too many years of policies not delivering what was promised, and suggest that an additional reason for the rate hike is to provide the Fed with some ability to ease when the next recession arrives. 2016 or 2017?

So, what about the rest of the world?

China is slowing - not stopping, but slowing, and China slows only if the rest of the world slows, and the rest of the world slows as China slows. First it was seen in collapse in commodity prices, followed by a collapse in the "Baltic Dry Index" - the benchmark cost of transporting goods by ship. The Baltic Dry Index has dropped to historic lows in the past months. The last time the Index dropped so low was 2008, as the Global Financial Crisis (GFC) was in full swing. Why does this matter? In growth periods excess new shipping was laid down in shipyards, and that new capacity is now online, and with that excess capacity, prices naturally fall. But this should result in capacity being removed from the stock of global shipping capacity. This is not happening yet.

It will, because the total volume of shipping has also dropped, not just the value of products shipped. This is not a seasonal problem.

As the markets opened for 2016, we saw the Shanghai market drop by 7% before the stops kicked in, ostensibly due to "weaker-than-expected manufacturing data".  We will see how this plays out over the coming weeks and months.

Around the world, easy central bank money has fueled share buybacks that add nothing to the productive capacity of companies, but that serve only as an additional mechanism to the transfer of wealth. Share buybacks simply transfer financial wealth out of the company by increasing company’s debt (at very low interest rates it must be said) to equity, effectively creating a future obligation on the part of the company. So while companies’ future obligations increase with little or no corresponding increase in productive capability, institutional shareholders, which today means funds that hold equities (typically, for relatively short periods of time) take the direct financial benefits of the buyback, and move on to the next company that offered the potential for significant return. No value is added, debt is increase, productive capacity stagnates, and the underlying “real” economy sees no benefit.

It is important to note that share buybacks are a logical response to central bank purchases of bonds and otherwise “printing” money. When almost free money is being pumped into the system, it will find a place to land, but not necessarily achieving the desired results. Unintended consequences abound.

Turning our eyes to Europe and the anti-austerity movements are gaining traction, with no idea that their imposed versions of "austerity’ are a joke compared with what Greece has had to endure. Countries like the UK have made big noise about their austerity budgets, while increasing their total debt loads. In fact total debt (i.e sovereign, corporate and household debt) has increase apace around the world, reaching 289% of global GDP (excluding unfunded commitments and mandates). These debt levels are unsustainable, and are already reducing potential growth.

Austerity has become the euphemism for not having enough national income to meet the basic fantacies of enough of the people to ensure that the ruling party has a chance of staying in power. In France for example, the inability to Chirac, then Sarkozy and followed by Hollande to implement even basic reforms has resulted in a government that continues to drop deeper into debt while at the sime time pretending to be implementing a programme of austerity. Basically, France is a country waiting for its own “Greek” moment.
French banks are poorly capitalized, and the myth of financial system reforms will only exacerbate the coming recession / depression.