The Evolutionary Memory Palace…

KBRA, a “non-legacy, non-Big 3” rating agency recently published an interesting short note, entitled “Counting on Evolution”. In it, KBRA argues in the context of the banking industry in particular that since the Great Financial Crisis (GFC) there have been sufficient changes as a result of “learning” (in effect, adaptation and evolution) that developed banking systems such as those in the US now represent less rather than more risk than prior to the GFC. Therefore (according to KBRA), the fact that, almost invariably, the ratings applied to the major US banks are currently several notches below those applicable pre-GFC is misguided and overly conservative. Naturally, KBRA “aspires to get to the right rating.”

Such thinking is, on the face of it, not unreasonable. However, it begs or omits a number of questions:

– The ratings, pre-crisis, were appropriate
– Published ratings are easily comparable in terms of assumptions made
– That the Directors and senior executives of said banks (as well as their regulators) have truly learnt (i.e., evolved) as a result of the GFC and have stored the appropriate facts in their individual and institutional memory palaces
– That these “evolved” institutions are no longer vulnerable to market spasms and panics

Let us consider each of these points in turn.

Firstly, given that none of the 3 dominant “legacy” rating agencies forecast the credit consequences of the GFC ex ante, their ratings process demonstrably failed the test of providing any meaningful predictive power of credit quality, particularly in respect of the monoline “doom loop” or systemic failings within the banking system. Of course, hindsight is a wonderful thing, but arguably there was serial “over-rating” going on pre-GFC.

Secondly, in the dim and distant past, ratings scales were relatively simple and essentially unified, with each main agency arguing that a “AAA was a AAA was a AAA”- in other words ratings across different obligor categories were essentially directly comparable. Now there are enough different scales, modifiers and suffixes to make one’s head spin. On the one hand, this indicates that precision about assumptions is critical; but, on the other it, the increased complexity tends to reduce the informational quality of what is published.

Thirdly, while one would expect that rational self-interest would cause bank executives to modify their behaviour (i.e., adapt) in order to avoid the possibility of another GFC, the continuing misalignment of incentives and general lack of accountability make one somewhat skeptical that lessons truly have been learnt. Similarly, post-GFC, regulatory agencies significantly toughened and enhanced requirements for their charges, which should have at least have increased the “survivability” of individual banks and the financial system which depends upon them. Nevertheless, signs of relaxation of these rules have appeared, so one might question how vigilant regulators will actually be if standards within what remains a highly-leveraged, inter-connected system erode.

Finally, all banks within a fractional reserve system are vulnerable to “runs, panics and spasms”; and every time one hears or reads “but this time is different”, one knows that, sooner or later, there will be another financial crisis in which commercial, for-profit institutions will, yet again, try to socialize risk, even if regulators and politicians will, ex ante, be adamant that “this time” major banks will be allowed to fail and that they have the tools necessary to cauterize and confine the risk of contagion.

So, while KBRA may have a point that institutions and systems evolve (as one would hope!), and thus current public ratings are unduly harsh in relative terms, one needs to be cautious that this “evolution” is irreversible.

At Awbury, we believe strongly in analyzing risk based upon an exhaustive fundamental and quantitative analysis. While we respect the service performed by the rating agencies, we prefer to operate without reliance upon the convenient crutch of public ratings, which are simply another piece of information.

The Awbury Team

The Fat Tail and Feedback Loop at the End of the World…

In these somewhat strange times, we have been musing about how individuals and enterprises still have a habit of trying to avoid contemplating “the end of the world” (as opposed to coping with the “news”), even if the (re)insurance industry exists at least in part to mitigate extreme risks for it clients.

Nassim Nicholas Taleb has made a career out of pointing out the risks of “fat tails” and unexpected events, with a series of books which remain essential reading, even if one does not agree with all of his views or conclusions. In addition, Mr. Taleb has run investment vehicles intended to protect against scenarios in which systemic fragility overwhelms the financial markets.

And now, in a more easily accessible form, Algebris Investments (a UK-based investment manager) has announced the launch of its own “end of the world fund”, officially a “Tail Risk Fund”.

The firm points out, quite reasonably, that after a decade of a generally benign overall investment climate in which those adding risk have been rewarded, a number of large investors have begun to seek mechanisms to limit potential portfolio losses. As Hyman Minsky wrote: “Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”

Given all the noise around the likes of Argentina, Turkey and Italy; Middle East conflicts; the recently failed G7 summit; US/PRC trade tensions (we could go on!), one might well ask: “But how can you say the markets are stable?”

This is a fair question. However, it remains the fact that there have been no real market breaks, nor stampedes for the exit as yet, minimal “tantrums” (outside country-specific ones), and the appetite for risk shows little sign of abating, which begs the question of what happens when sentiment changes (as it surely will at some point.) At that point, George Soros’ Theory of Reflexivity is likely to get another workout, as the thinking (panic) of market participants feeds on itself, creating negative feedback loops and further increasing instability, uncertainty and volatility.

The Great Financial Crisis is beginning to recede into memory, and one is led to believe that regulatory and macro-economic steps taken since then have significantly reduced the probability of a recurrence. While it may be reasonable to assume that the causes of the next GFC will be different from those of the last, to assume that there will not be another extreme financial crisis (whether or not correlated with a political one) is the height of foolishness.

At Awbury, of course, our business is based around our E-CAT franchise (providing protection against high severity/low frequency credit, economic and financial risks). So, we are always scanning the horizon for the first signs of factors that could generate the next GFC, as well as idiosyncratic and seemingly isolated events that can cascade into something systemic. It is why our clients and Insureds seek out our bespoke coverages, backed by our diverse panel of (re)insurers, whose ability to withstand systemic shocks has been amply demonstrated over many decades, and why the Awbury team also works hard to build structural and economic mitigants into those coverages in order to continue to deliver a highly attractive risk/reward ratio to its reinsurance partners.

The Awbury Team

The end of oil will/may arrive, but when/how…?

The Oil Age has had quite a run over the past 100 years or so, and its possible demise is a source of constant debate, as competing forecasts and scenarios try to illuminate when and how such factors as alternative energy sources; non-ICE*-powered vehicles; and concerted action on “climate change” will cause a significant decline in use of oil-derived fuels.

What seems sometimes to be overlooked is that a) forecasts are usually wrong in terms of timing and scale; b) one has to have the appropriate assumptions; and c) there are often unexpected linkages or factors that can significantly affect actual outcome(s).

So, let us think about some of the variables involved, and how they might affect the supposed outcome:

Firstly, while the rise of the EV** may seem inexorable and rapid, Bloomberg recently forecast that the displacement of oil usage by EVs would be some 7MM bpd by 2040. Compare this figure with current global oil production of c. 100MM bpd. An incremental change over the next 20+ years will not happen in isolation, and it is hard to take into account how demand for more ICE vehicles in so-called emerging markets may rise over the same timeframe, offsetting likely declines in terms of generating capacity and industrial processes. Yet even in the case of industrial processes, demand for petro-chemicals is likely to continue to rise for the foreseeable future, absent a radical re-think or rapid replacement of those same processes.

Secondly, the rise in demand for EVs is unlikely to be smooth, as it creates its own economic and geopolitical consequences and risks. Consider the days when the Middle East completely dominated oil production, and the fact that now mining house Glencore is seeking to expand production of cobalt (essential for most EV batteries), when over 50% of reserves come from the chronically unstable DRC; or that it seems quite clear that the PRC has set its sights on controlling the supply of the lithium (another essential component) needed to support its own push towards EV usage. And what of copper? While its mineable resources may be more widely spread geographically, the amounts required to create clean energy infrastructure are so large that it seems likely that there will be a push to consolidate that market.

Thirdly, all those new EVs will require a network of charging stations in the same way that ICE vehicles now have gas/petrol stations, leading to disruption in real estate markets as those seeking prime locations (which cannot be replicated) are constrained by lack of supply. The ICE re-fueling network is hardly going to be re-purposed that easily. And more EVs will lead also to increased (not lower!) demand for reliable 365/24/7 electric power generation from baseload sources. While oil itself may form a smaller part of the fuel for such capacity, its “sibling” natural gas is likely to see demand rise.

As Sanford Bernstein pointed out in a recent report (The Future of Oil Demand) “…the pace and the path of ending an extractive industry [i.e., oil] are measurably slow and uncertain.”

Therefore, it seems that the probability of any near-term “death of oil” has been greatly exaggerated. Decline over the forthcoming decades may at some point become first relative and then absolute, yet many of us are likely to be in our dotage (or worse!) before the end of oil arrives.

As always, the Awbury team constantly assesses key scenarios such as the future demand for oil to ensure its ability to make appropriately-informed judgements on existing and future portfolio risks and opportunities.

The Awbury Team

*Internal Combustion Engine
**Electric Vehicle

Vollgeld or Fool’s Gold…?

On June 10th the good burghers of Switzerland will vote in a federal popular initiative (referendum) that is causing some consternation amongst the country’s banking institutions, including the Swiss National Bank (SNB), the central bank. The proponents of the referendum seek to end the system of fractional reserve banking within Switzerland, through which local banks (as in all other major global banking systems) in effect create so-called “private money” when they create new assets through lending, and hold only a fraction of their reserves in “central bank money” as created by, e.g., the SNB (or the Federal Reserve, ECB, or Bank of England) and backed by the full faith and credit of the sovereign.

This may all seem rather arcane, but the reality of the modern world is that most “money” in an advanced economy (often over 90%) does not consist of notes and coins, but rather exists because of the activities of its banking system as it makes loans and takes deposits. “Runs” on banks occur (with the film It’s a Wonderful Life being the paradigm in popular culture) when a bank’s customers all want “their money” back (in the form of true cash) at once- something which no modern bank can do because of its inherent leverage. The entire system is based upon confidence.

The idea of having at least some sectors of the banking system (usually those which deal with individuals or small businesses) operate more as utilities with a “full reserve” model is not new (President Roosevelt rejected the Chicago Plan in 1933, creating the FDIC instead), but the Vollgeld referendum proposal represents an extreme version in that it would require the SNB to become the sole provider of Swiss Francs to the financial system, as all Swiss Franc sight deposits (some CHF 555BN at end-March 2018) would be required to be held at the SNB. This has caused the usually apolitical institution to characterize the referendum as a “dangerous experiment”.

In effect, if the referendum were to pass (which still appears unlikely, although certainly a “fat tail” risk in an era of populism), the SNB would determine the amount of money provided to the Swiss economy, effectively controlling directly one of its key levers. Of course, historically, central banks have used various mechanisms to control money supply and lending (who can forget the Bank of England’s “corsets”?), but have stopped short of being the sole source of money, allowing regulated banks to create the above-mentioned “private money”.

While implementation of the Vollgeld Initiative would be unlikely to cause the Swiss banking system or the economy to seize up, it would increase friction with unforeseeable consequences, as the “experiment” has not been tried before in a developed economy. As such, in a world in which economic stability is often hard won, and easily disrupted, the Initiative represents another factor potentially adding volatility and uncertainty.

At Awbury, the existence of the Vollgeld Initiative counts as a “known unknown”- an observable potential event, but one with as yet uncertain parameters in terms of outcomes. As such, we shall continue our monitoring of it as another factor in the ever-changing risk matrix that makes life as underwriters of credit, economic and financial risks so “interesting”!

The Awbury Team