What Usain Bolt can teach banks about financial risk

Go Lean Commentary

Runner GuyThere were 465 US bank failures between 2008 and 2012.[a]

Joke: “The bank returned a check to me this morning, stamped: ‘insufficient funds.’ Is it them or me?”

The foregoing article shows the type of functions that technocrats do: evaluating risk. Any risk that can imperil the complete financial system must be monitored and mitigated. The “extreme value theory” is a model for evaluating risk and predicting future performance; and while not perfect, it is better than doing nothing.

There was no one performing this role in the Caribbean in 2008.

The foregoing article and its reliance on calculus, quantitative methods and econometric modeling is an example of the required technocratic oversight in managing an economy. Usain Bolt is used here as an allegory, a fable. The Economist magazine thusly explains how complex issues can be taught with simplified analogies and illustrations. Banking is more complex than track-and-field; but the pursuit of excellence is similar. Just like any world-class athletic pursuit, this goal is hard to master.

The Economist explains…

THE banking industry did a bad job in the run-up to the financial crisis of assessing “tail risks”, extreme events that represent the least likely of a range of probable outcomes. The Basel Committee on Banking Supervision, which is the international standard-setter for bank capital, has proposed changes in the internal risk models that financial institutions use. In particular, it wants banks to shift from a technique called “value-at-risk” (VaR) to one called “expected shortfall” (ES).

VaR is a way of measuring a firm’s risk of suffering really big losses over a certain period (a day, a week, a month) to a certain level of “confidence”. A daily VaR of $1m at 1% probability means that there is a 99% chance that you will not lose more than $1 [million] on any one day. The problem is that if you have that one bad day in 100, the potential losses could go much higher than $1 [million]. VaR doesn’t have much to say about what those losses might be. The expected-shortfall approach is meant to provide an answer to that question. Instead of asking, “What are the chances that things get so bad that we lose $1 [million]?” it asks, “If things do get that bad, how much would we actually lose?”

To do this, it uses a statistical method called “extreme value theory”, which looks specifically at what happens in the tail of distributions. To take a more trivial example of where extreme-value theory has been used, a 2011 paper by two researchers at Tilburg University collected data on the personal bests of elite athletes between 1991 and 2008, in order to try and calculate the “ultimate world record” for 100m sprints—the absolute edge of human performance given the times, equipment and drugs-policies that then prevailed. For the 100[meter] for men, the boffins (British slang for technical expert) put the ultimate world record at 9.51 seconds, compared with the record that then prevailed of 9.72, and a current world best of 9.58, set by Usain Bolt in 2009. That looks pretty good: the model came up with a number that was well inside the mark that then prevailed, and is still a hefty improvement on the current record. If extreme-value theory is meant to help banks think through the extremes, this is encouraging.

But like every model in history, expected shortfall cannot predict the future. In an earlier 2006 paper, researchers from the same university tried to calculate ultimate world records for a wider range of events, including the men’s marathon. The researchers reckoned back in 2006 that the best possible running of that distance would yield a time of two hours, four minutes and six seconds. Yet the world record today stands at two hours, three minutes and 23 seconds (Wilson Kipsang in 2013). To be fair to the researchers, they did not claim that their ultimate record could not be broken. But whether bankers will remember that reality can be worse than expected is a different question. Expected shortfall is an improvement on VaR; it is not a crystal ball.
The Economist (Retrieved 04/09/2014) – http://www.economist.com/blogs/economist-explains/2014/04/economist-explains-4

EquasionThe book, Go Lean…Caribbean, serves as a roadmap for the implementation of the Caribbean Union Trade Federation (CU). The book presents the CU as a technocracy, to ensure economic failures of the past do not re-occur. From the outset, the book identified that the Caribbean is in crisis, with the pronouncement that a “crisis is a terrible thing to waste”. The prime directive of the CU is to optimize economic, security and governing engines to impact the Caribbean’s Greater Good, for residents … and bank depositors. This was pronounced in the Declaration of Interdependence – (Page 13):

xxv. Whereas the legacy of international democracies had been imperiled due to a global financial crisis, the structure of the Federation must allow for financial stability and assurance of the Federation’s institutions. To mandate the economic vibrancy of the region, monetary and fiscal controls and policies must be incorporated as proactive and reactive measures. These measures must address threats against the financial integrity of the CU and of the member-states.

In line with the foregoing article, the Go Lean book details some infrastructural enhancements/advocacies to the region’s financial eco-system; to facilitate efficient management of the economy:

  • Fostering a Technocracy (Page 64)
  • Caribbean Central Bank (Page 73)
  • Deposit Insurance Regulations (Page 73)
  • Securities Regulatory Authority (Page 74)
  • Modeling the European Union / Central Bank (Page 130)
  • Lessons from 2008 (Page 136)
  • Banking Reforms (Page 199)

The mis-management of the economy has led to many episodes of “fight-or-flight” among Caribbean society. For many member-states, their Diaspora is more than half their population; i.e. Jamaica and Puerto Rico.

While there is no crystal ball, according to the foregoing article, there is much that can be done. Now is the time for the CU!

The purpose of this roadmap is to make the Caribbean, a better place to live, work and play. No more flight! Now we stand and fight with these technocratic weapons of modern economics.

Download the book Go Lean … Caribbean – now!


Appendix Reference:
[a]. https://news.yahoo.com/facts-numbers-us-bank-failures-183852568.html

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