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Risk and uncertainty (in Banking)

05 June, 2017Michael Llewelyn-Jones

I was recently asked to give a talk to analysts from Enders Analysis. Enders Analysis provides a subscription research service covering the media, entertainment, mobile and fixed telecommunications industries in Europe, with a special focus on new technologies and media.

I was trying to think of a suitable topic – and not wanting to be found out-of-date in the TMT (technology, media and telecommunications) space amongst industry experts, I plumped for the title above as I thought there was plenty to discuss on the banking sector that also had wider relevance in terms of all businesses.

In general parlance, we use the word risk to mean both a risk that can be estimated by using historical data to extrapolate into the future by attaching probabilities to it; and ambiguity (meaning unclearness by virtue of having more than one outcome).  Hence: risk + ambiguity = uncertainty.stock market

Our generic problem, know as non-ergodicity, is that the future is not an extrapolation of the past (as economists regularly have had to admit ex post facto).  Ludwig Wittgenstein neatly summed up the challenge “when we think of the world’s future, we always mean the destination it will reach, if it keeps going in the same direction we can see it going in now” (Perloff 1999)

As Frank Knight argued, a known risk is “easily converted into an effective certainty,” while “true uncertainty,” is “not susceptible to measurement.” (Knight 1921)  “Some economists have argued that this distinction is overblown. In the real business world, this objection goes, all events are so complex that forecasting is always a matter of grappling with “true uncertainty,” not risk; past data used to forecast risk may not reflect current conditions, anyway. In this view, “risk” would be best applied to a highly controlled environment, like a pure game of chance in a casino, and “uncertainty” would apply to nearly everything else.” (Dizikes 2010)

There is currently a lot of interesting work in academic circles, on ambiguity.  However, whatever the theoretical backdrop, the fact remains that most if not all banks misunderstood the risks they were running leading up to the global financial crisis. There were numerous issues but a lack of awareness of the degree of skewness and height of kurtosis in models and a high degree of reliance on these flawed (generally unquestioned) models was I believe behind much of what followed.

The challenge for banks comes into sharp focus when dealing with clients in the oil industry.  The sheer size of some of the one-off investment such as $10 billion for Shell’s Prelude vessel or the $20 billion Sakhalin-2 project with paybacks of a decade or more, against a background of oil & gas price volatility makes for pretty heroic credit decisions from time to time.

The regulators’ solution is to have increased capital and liquidity and a reduction or prohibition on higher risk assets. This, together with holding senior management to account and plans for ring-fencing, have reduced the likelihood of recourse to tax-payer support.  However, the difficulty for banks remains that servicing and supporting client’s needs is ever more challenging given the complexity, volatility and general uncertainty in the world.

Banks are currently wrestling with how their business models will work in the future in the face of increasing competition from banks and non-banks.

The corollary is that the banker will need ever more sophisticated training – a silver lining for some!

References:

Perloff, M. (1999) Wittgenstein’s Ladder: Poetic Language and the Strangeness of the Ordinary. University of Chicago Press

Knight, F. (1921)  Risk, uncertainty and profit.  Kissimmee: Signalman Publishing

Dizikes, P (2010) Explained: Knightian uncertainty [online]. Available at: http://news.mit.edu/2010/explained-knightian-0602 [Accessed: 29 May 2017]


Michael Llewelyn-Jones is a professor for The London Institute of Banking & Finance focusing on commercial and corporate financial services for the Banking Practice and Management degree.  

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