Who’d be a central banker…?

In the current, idealized model of central banking, the primary goals of a central bank are usually one or both of maintaining a slightly positive rate of domestic inflation (say, 2% +/- 0.5% per annum) and promoting “full employment” (whatever that means in the real world!) And central bankers are supposed to be rational individuals who exude competence and calm.

Of course, as recent events in Switzerland, Russia, Canada and elsewhere have shown, the reality is somewhat more messy, confusing and unexpected. To be fair, central banks do not and cannot operate in a political “vacuum”, even if they are nominally or legislatively independent of external control or influence; yet, periodically, they demonstrate that those who do not consider their motivations, or ignore the context in which they operate (including such supposedly mundane matters as ownership and governance) do so at their peril.

As events this week surrounding the decision of the European Central Bank (ECB) on implementing a Eurozone Quantitative Easing (QE) programme have shown, context matters. The European Court of Justice’s (ECJ), Advocate-General had issued a preliminary opinion beforehand  that gave some “treaty cover” to the ECB’s actions, but the ECB faced a prolonged and unusually public dissent from its 2 Bundesbank board members on the appropriateness, purpose and legality of QE in principle; and most of Germany’s political class either has concerns about the consequences of QE, or is overtly hostile.

Naturally, because even central bankers are human, this affects behaviour and actions. This is visible in how the ECB is choosing to implement QE, as announced on January 22nd . On the one hand, its has indicated that it will purchase assets, including sovereign bonds, at a rate of up to EUR 60BN per month until “at least” September 2016; on the other its has weakened an underlying principle of a currency union of the mutualization of losses, by declaring that, in effect, 80% of the risks will be borne by the 19  individual central banks which now form the EuroSystem. A “fudge” has also been applied to enable the purchase of obligations issued by very weak entities such as Greece, adding some “spice” to the consequences of the Greek elections, but also hedging its bets by deferring the start of such purchases until well after the outcome of those elections.

All this ECB action is with the stated goal of anchoring medium- to long-term inflationary expectations at levels that will reduce the risk of deflation; but, by its actions, the ECB has, in reality, not only created another baroque confection; but also given Eurozone governments yet another opportunity to avoid undertaking the necessary and difficult structural reforms that their economies desperately need to reduce unemployment and stimulate demand.

Thus, the Awbury view is that, while we sympathize with the ECB’s dilemma, and are loth to criticize it for at least attempting to avoid Euro-sclerosis, nevertheless we doubt that it will have the desired effects and will thus help prolong the underlying problems. Of course, while we shall continue to pay close attention to assessing and monitoring the risks and consequences of the ECB’s actions, in the midst of doubt and uncertainty lies opportunity for those willing to be dispassionate and apolitical in calculating risk vs. reward.

-The Awbury Team

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Swiss Cheese…or the Revenge of the Gnomes of Zurich…

Markets are still reeling from the effects of the Swiss National Bank’s (SNB) decision on 15th January to remove the peg between the Swiss Franc (CHF) and the Euro, with the concomitant further reduction in deposit rates to -0.75% almost incidental. To say that the move was unheralded and unexpected is an understatement. When two of the world’s reserve currencies move against each other within minutes by up to 40% (sic), it gives a new meaning to the term “gap risk”, and emphasizes how event risk is rightly the stuff of risk managers’ nightmares.

Of course, hindsight is a wonderful thing; and there are those now claiming that they foresaw such an event as inevitable. Perhaps so; but the consequences demonstrate that few, if any, expected what occurred. The SNB’s actions may have been unexpected, but they were not irrational, even if one might disagree with the supposed reasons, including concern about being a “one way street” and about a hugely inflating balance sheet.

As always, one now has to think about the medium- to longer-term impacts, in a world already grappling with the rapid fall in the price of crude oil; geopolitical concerns over the future of the Euro in light of the forthcoming Greek elections; signs of deflation in certain economies; and available spreads and margins that often do not reflect the real level of risk because of the actions of key central banks.

Already, there have been corporate failures in the FX broker market, seemingly because the companies involved, having allowed their clients significant levels of leverage and required modest levels of collateral, were “surprised” when those same clients, on the wrong side of a CHF transaction, were unable to cover their obligations, leaving the broker’s capital exposed.  News is also trickling out of possible hedge fund failures. These consequences just reinforce how effective risk management has to look at tail or extreme scenarios (assuming that it is proper to designate the SNB’s actions as such) and ask the “what if?” questions. As those defaulting have found, a single event can blow up your balance sheet or business in a matter of minutes; and leverage is always dangerous if it is not controllable. Just think back to the failure of LTCM, or the “certainties” of the “carry trade”!

However, the FX broker and hedge fund failures are merely “collateral damage” and unlikely to be economically important. Of much more concern are the potential impact on the export component of the Swiss economy; the hidden linkages in financial institution balance sheets; and the consequences for countries such as Poland and Hungary, where CHF mortgages have historically been quite prevalent.

At Awbury, we would not claim to have foreseen the timing of the SNB’s abrupt change in policy, but we would not have said it was in any sense a “black swan” event. The reasons for it are explicable and within the central banking “playbook”. However, as always, we will factor into our risk analyses for ourselves and our clients the likely consequences.

Now, where is that hunk of Emmentaler…?

 

-The Awbury Team

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Decisions, decisions…! (Part 2)

In a previous post we began discussing the work of 2 researchers from the well-respected Max Planck Institutes, on how financial professionals make decisions in the face of uncertainty rather than probability; and stated that the research could be instructive in understanding how a financial counterparty might behave in addressing the negotiation of a complex transaction.

In this further post, we explore some of the approaches followed by individuals in such circumstances.

Our readers will no doubt be familiar with the concept of heuristics, mental “rules of thumb” which all of us employ, whether we admit it or not, in making decisions, complex or simple. Not surprisingly, the subjects of the research made use of a range of such approaches in addressing two related factors, i) model uncertainty: trying to address the fact that the economic world is so complex that no single participant can hope to identify and assess all the probabilistic factors; and ii), strategic uncertainty: the fact that a participant cannot always identify or understand what the actions of other parties might be, whose own decisions may further influence outcomes.

In this post, we shall focus on model uncertainty.

The authors identified a number of ways in which participants addressed this risk; but 3 in particular seemed to stand out across both sets of interviewees (from a large investment bank, and from a significant central bank):

  •  A “scientific approach”, in which hypotheses were developed and attempts made to test them with data. Of course, this might simply lead to the conclusion that the problem was one of uncertainty, not probability;
  • Institutionalizing group discussion by having a process that involved some element of formal committee structure that was part of the decision-making process, or available to offer advice and criticism (in the proper, neutral sense) to decision-makers. Naturally, that then raised issues of governance and group dynamics, but was a widely-adopted mechanism; and
  • Constructing and evaluating narratives to put “flesh” on the bones of statistical and quantitative models and thus enable those involved to have frames of reference on which to base decisions. This, of course, raises the issue, which we have mentioned in previous posts, of “framing”, in which participants manage to limit their analysis and discussion to areas within their level of understanding and “comfort” and thus ignore or miss potential tail risks.

Interestingly, managing risk per se was frequently also considered as being as important as predicting uncertain outcomes. Frankly, this should be considered a statement of the obvious and the essential; but can sometimes be forgotten in the “excitement” of making a decision that may bring significant rewards, but also bears significant risk. After all, uncontrolled, or uncontrollable risks are what tend to blow up seemingly sound institutions.

Each of the above approaches has its own limitations; and it is clear to us at Awbury (as it was to the study’s authors) that what is needed is a multi-disciplinary approach to decision-making, in which those involved are aware of the boundaries of the their own knowledge and understanding of the model(s) they are using; are able to assess the extent to which these factors may or should limit their ability to make an effective decision that is properly risk-aware and risk-adjusted; understand the limitations of the model(s) used; and have the capacity both to recognize and assess “tail risks”, and the discipline to walk away from a risk that is not capable of being “boxed”. In short, process, knowledge, experience, maturity and dispassionate judgement are essential factors in being able to manage the risks faced by all those who operate in our markets. At Awbury, we strive to practice such an approach consistently and, by doing so, provide our clients with timely and effective solutions to their often complex and seemingly intractable problems.

In our third post on this topic, we shall explore decision-making as applied to strategic uncertainty.

-The Awbury Team

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So, most of us survived 2014 in one piece…

In our first post of 2015, we thought we’d look forward (slightly “tongue in cheek”) to some topics which we see as remaining significant in 2015. In doing so, the opening line of Dickens’ A Tale of Two Cities comes to mind: “It was the best of times, it was the worst of times”- not because we believe that we are in the midst of another Great Recession, or “irrational exuberance”, but because the “market” seems to swing from expectations that the global economy is beginning to recover (led by that of the US), to concerns that the number of negative factors will stop economic growth in its tracks (as in Euro-sclerosis or a “Grexit”).

Certainly, there are enough factors that grab the headlines to induce pessimism, and drive the dismal scientists and PRI analysts further into their cups, but focusing always on the negative, because “bad news sells”, is just as irrational as being an unreasoning optimist and ignoring the risks that do exist.

Of course, at Awbury, being battle-hardened and scarred by past crises and business downcycles, we tend to err on the side of looking for the worst outcome in any particular transaction; but that is simply because we need to do so in order to make rational judgments about risk vs. reward; to be comfortable that we understand the tail risks; and that they can be properly managed and mitigated.

Here’s is our short “sampler” of topics that still need bearing in mind:

  • The Fourth Russian Revolution: the Russian Bear, in the macho but decaying form of the Russian President, remains at bay; beset by enemies on all sides; unloved and “misunderstood” The regime relies on corruption, extortion, nationalism and hydrocarbon revenues to maintain control, but demographics and economics are against it. Brittle regimes can suddenly collapse if a cowed population loses its fear. The problem in this case is that the Bear controls a nuclear arsenal and its military doctrine is becoming more open to the their use for “tactical” reasons. One of the more interesting tail risks;
  • Cyber-paranoia: as the recent Sony “hack” and serial and sundry embarrassments of both banks and corporates demonstrate, cyber-malignancy is now endemic and increasingly dangerous. (Re)insurance companies are turning intellectual somersaults trying to work out whether, and if so what to cover. Time to go back to pen and ink?
  • Whipsawed by the Fed: Define the meaning of “patient”…As usual a central bank is trying to signal with being too obvious what its near term intentions are. Certainly the markets continue to expect some form of interest rate rise by Q3 of 2015. However, the question is: will they still be “shocked” when it actually happens?
  • Oh! The pain, the pain… Where’s the Excedrin?: while, in certain jurisdictions, banks may be clawing back some influence over policy-making, the list of further forms of capital and balance sheet constraints keeps growing, as does the one of mind-numbing acronyms such as BRRD, TLAC, MREL and NSFR. Being a banker is definitely not fun for most, but provides opportunity for Awbury, as demand for our range of products increases;
  • Cash; who wants it? Or the Return of the Mattress: increasingly a supposedly “safe” asset is becoming a wasting one (inflation aside), because governments and banks are, for various reasons imposing penalties on those who have the temerity to try to store it in electronic form. Perhaps we should invest in mattress safes?
  • Any old iron…? Or, over a barrel: First it was gold, then the prices of iron ore and of natural gas (primarily in North America); now it is crude oil. Many commodity prices have experienced significant price declines, with the 50%+ drop in the price of crude oil in recent months causing pain not only at the corporate, but also at the sovereign level, as government budgets, many of which were already based on fantasy prices, are now in a shambles. Those producing countries (think Saudi Arabia in particular) which have the greatest financial capacity are, contrary to “precedent” allowing prices to find their own levels, being willing to send the weak to the wall. This has potentially significant knock-on effects in behaviour that will require close monitoring.

Happy New Year!!

-The Awbury Team

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