Deutsche Asset & Wealth Management www.DeAWM.com S2 SPECIAL ISSUE Black Swans and Global Capital Markets: Preparing for the unknowable March 2014 Global Financial Institute Your entry to in-depth knowledge in finance Dr Paul Kielstra Black Swans and Global Capital Markets Global Financial Institute Introduction to “Global Capital Markets in 2030“ Deutsche Asset & Wealth Management’s Global Finan- component of government debt; and stock markets face cial Institute asked the Economist Intelligence Unit to weakening demand in many mature markets produce a series of white papers, custom articles, and info-graphics focused specifically on global capital In short, while the world’s stock of financial assets (e.g market trends in 2030 stocks, bonds, currency and commodity futures) is growing, the pattern of that growth suggests that major shifts While overall growth has resumed, and the value lie ahead in the shape of capital markets traded on capital markets is astoundingly large (the world’s financial stock grew to $212 trillion by the end This series of studies by Global Financial Institute and the of 2010, according to McKinsey & Company) since Economist Intelligence Unit aims to offer deep insights the global financial crisis of 2008, the new growth into the long term future of capital markets It will employ has been driven mainly by expansion in developing both secondary and primary research, based on surveys economies, and by a $4.4 trillion increase in sovereign and interviews with leading institutional investors, corpo- debt in 2010 The trends are clear: Emerging mar- rate executives, bankers, academics, regulators, and others kets, particularly in Asia, are driving capital-raising; in who will influence the future of capital markets many places debt markets are fragile due to the large Black Swans and Global Capital Markets Global Financial Institute Introduction to Global Financial Institute Global Financial Institute was launched in November are hundreds of years old, the perfect place to go to 2011 It is a new-concept think tank that seeks to foster a for long-term insight into the global economy Fur- unique category of thought leadership for professional thermore, in order to present a well-balanced perspec- and individual investors by effectively and tastefully tive, the publications span a wide variety of academic combining the perspectives of two worlds: the world of fields from macroeconomics and finance to sociology investing and the world of academia While primarily tar- Deutsche Asset & Wealth Management invites you to geting an audience within the international fund inves- check the Global Financial Institute website regularly tor community, Global Financial Institute’s publications for white papers, interviews, videos, podcasts, and more are nonetheless highly relevant to anyone who is inter- from Deutsche Asset & Wealth Management’s Co-Chief ested in independent, educated, long-term views on the Investment Officer of Asset Management Dr Asoka economic, political, financial, and social issues facing the Wöhrmann, CIO Office Chief Economist Johannes Mül- world To accomplish this mission, Global Financial Insti- ler, and distinguished professors from institutions like tute’s publications combine the views of Deutsche Asset the University of Cambridge, the University of California & Wealth Management’s investment experts with those Berkeley, the University of Zurich and many more, all of leading academic institutions in Europe, the United made relevant and reader-friendly for investment pro- States, and Asia Many of these academic institutions fessionals like you About the Economist Intelligence Unit The Economist Intelligence Unit (EIU) is the world’s lead- has included a variety of pieces covering the financial ing resource for economic and business research, fore- services industry including the changing role relation- casting and analysis It provides accurate and impartial ship between the risk and finance function in banks, pre- intelligence for companies, government agencies, finan- paring for the future bank customer, sanctions compli- cial institutions and academic organisations around the ance in the financial services industry, and the future of globe, inspiring business leaders to act with confidence insurance A published historian, Dr Kielstra has degrees since 1946 EIU products include its flagship Country in history from the Universities of Toronto and Oxford, Reports service, providing political and economic analy- and a graduate diploma in Economics from the London sis for 195 countries, and a portfolio of subscription- School of Economics He has worked in business, aca- based data and forecasting services The company also demia, and the charitable sector undertakes bespoke research and analysis projects on individual markets and business sectors The EIU is head- Brian Gardner is a Senior Editor with the EIU’s Thought quartered in London, UK, with offices in more than 40 Leadership Team His work has covered a breadth of cities and a network of some 650 country experts and business strategy issues across industries ranging from analysts worldwide It operates independently as the energy and information technology to manufacturing business-to-business arm of The Economist Group, the and financial services In this role, he provides analysis as leading source of analysis on international business and well as editing, project management and the occasional world affairs speaking role Prior work included leading investigations into energy systems, governance and regulatory This article was written by Dr Paul Kielstra and edited by regimes Before that he consulted for the Committee Brian Gardner on Global Thought and the Joint US-China Collaboration on Clean Energy He holds a master’s degree from Dr Paul Kielstra is a Contributing Editor at the Economist Columbia University in New York City and a bachelor’s Intelligence Unit He has written on a wide range of top- degree from American University in Washington, DC He ics, from the implications of political violence for busi- also contributes to The Economist Group’s management ness, through the economic costs of diabetes HIs work thinking portal 4 Black Swans and Global Capital Markets Global Financial Institute Black Swans and Global Capital Markets Written by A collaboration between Deutsche Asset & Wealth Managment‘s Global Financial Institute and Economist Intelligence Unit March 2014 Black swans: A phrase goes viral Steven Culp – managing director of Accenture Manage- In September 2008, a financial malaise growing for over a ment Consultancy’s Risk Management Group – recalls that year came to a head Lehman Brothers’ bankruptcy – the in 2008 some used such thinking as a partial excuse and largest in US history – rocked markets Existing unease as a way to reassure the world that what was happening about possible contagion rapidly transformed into was a one-off, unforeseeable problem Nonetheless, the pervasive fear Equity markets dropped precipitously; phrase continues to be used too often as a handy justifica- leading financial institutions in major developed countries tion for poor risk management Indeed, the term is often required rapid government intervention to remain applied incorrectly to any extreme event Using the term solvent; capital markets, already constricting under this way, however, represents a misunderstanding of what the weight of devaluing sub-prime mortgage backed Black Swans are, as well as the ongoing challenge which instruments, seized up further, thereby threatening they present to global capital markets, and how best to be the global economy Indeed, the latter phenomenon ready for them provided the original name for what was happening: the credit crunch The Nature of the Problem In Taleb’s analysis, a Black Swan event has three specific Although the world had seen regional economic meltdowns in recent times – the Latin American debt crisis and Asian monetary crisis of the 1980s and 1990s being the most prominent – when the global financial crisis struck, its sheer scope seemed unprecedented At a minimum, the scope and impact of the latest global crisis had similarities only to the Great Depression of the 1930s and, perhaps, to the interlinked, international debt crises of the 1890s To such an unusual set of circumstances, it was tempting to assign a unique cause Conveniently, a way to so seemed to be at hand The Black Swan – an unpredictable, high impact event – was a concept that had recently been popularised by the books of Nassim Nicholas Taleb, a financial trader turned philosopher Writing the crisis off as a Black Swan held a certain emotional appeal: by definition, it would be highly unlikely to recur Moreover, if the crisis were truly unpredictable, and then those involved in capital markets could hardly be blamed for the losses and damage that resulted Nicholas Taleb, The Black Swan, (2010 paperback edition), page xxii 1 characteristics First, it is an unexpected outlier because “nothing in the past can convincingly point to its possibility.” Second, it has an extreme impact Third, in spite of it being an outlier, “human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.” This definition seems to restrict severely what could be a Black Swan and, therefore, the ultimate utility of the concept For example, the numerous historical financial crises before 2008 pointed to the realistic possibility that serious trouble would eventually recur Indeed, at the time various commentators issued warnings ahead of the event, for example Taleb himself, who said in 2007 that Fannie Mae was “sitting on a barrel of dynamite.” More generally, even the flawed risk models in use at the time included the possibility of extreme market losses but estimated their probability as very small, or under the tail of the normal distribution curve (Accordingly, “tail risk” became another gift from the crisis to the general vocabulary) Even if the probability were very poorly appreciated, the models Black Swans and Global Capital Markets Global Financial Institute clearly acknowledged the possibility of extensive losses Sadly, what may appear in retrospect as large-scale, self- and therefore of future turmoil in the markets By this mea- induced myopia is far from a one-off occurrence in capital sure alone, the subsequent crisis would have been a poor markets More recently, confidence in the inevitability of candidate for the label of “Black Swan” ever greater European integration did much to blind policy makers on that continent to the dangers which weak In another sense, though, the financial crisis was indeed a economies like Greece posed for the common currency – Black Swan event, in that even those who were aware of the difficulties which Euro-sceptics of various stripes found it risk tended to under-estimate its magnitude According to much easier to perceive, and to warn of at the inception of Taleb, the hallmark of Black Swan events is that human the project More generally, Hung Tran – Executive Man- mental maps restrict people from assessing their risks As aging Director at the Institute for International Finance, he puts it, “The Black Swan is the result of collective and a global association of financial institutions – notes that individual epistemic limitations (or distortions), mostly major, unexpected crises tend to occur when almost all confidence in knowledge; it is not an objective phenom- actors in the marketplace suddenly change their thinking enon The most severe mistake made in the interpreta- on a particular issue “It is change of mentality or paradigm tion of my Black Swan is to try to define an ‘objective Black or framework of thinking that crystallises tail risks.” Swan’ that would be invariant in the eyes of all observers.” A major terrorist attack by a relatively unheard of group, Thus, Black Swans not provide a fatalistic justification for example, might be a Black Swan for most, but certainly for those involved in the capital markets, or anybody else, not for the terrorists themselves In this sense, the global failing to see that which was impossible to predict anyway financial crisis was a Black Swan not because it was impos- Rather, they raise at least two crucial, forward-looking sible for anyone to predict but because the pervasive risk questions The first is the extent to which the models and models of the time so discounted the possibility of trouble other inputs which shape how we see the world help or on such a scale as to make it inconceivable to many in the inhibit the discovery and analysis of significant, heretofore market, as well as to ratings agencies and regulators unperceived risks The second is, given that even with the best models it is impossible to foresee many novel chalThis was partly because extreme events are sufficiently rare lenges accurately, how can companies, and markets as a that modelling them is nearly impossible anyway It is also whole, be made more robust so that they can weather the because so many placed excessive reliance on models that inevitable, unexpected storms proved to be highly inappropriate and which should have been seen to be so at the time David Viniar, then CFO of Are companies better placed to cope? Goldman Sachs, reported in August 2007 that during a Preparing for Black Swan events begins, perhaps ironically, week of turbulence “[w]e were seeing 25-standard devia- by recognising that they cannot be a leading focus of risk tion moves [from the norm], several days in a row.” Never- management Theoretically, Mr Tran notes, if a company theless he believed that the company’s quantitative strate- recognises and correctly assesses an unexpected risk, by gies were sound, if in need of adjustments to account for definition that event ceases to be a Black Swan On the certain specific situations.3 He differed from most others practical side, Mr Culp adds that “If Black Swans are the only in having made a memorable quote The widespread only thing your organisation is focussed on preventing, adoption of David Li’s Gaussian Copula function, despite a lot of other challenges will trip you up in the interim its creators own public misgiving, as a way to measure the Financial institutions today are rightly focussing more of risk associated with collateralised debt obligations – fre- their energy on things closer to home than on long tail quently made up of bundled mortgages –created wide- events.” spread belief in the underlying stability of asset prices, and ultimately of financial markets, that was unjustified for any Instead, Mr Culp argues, a correctly configured approach number of reasons to risk management, while not a guarantee of safety, Page xxiii “Goldman pays the price of being big”, Financial Times, 13 August 2007 3 Black Swans and Global Capital Markets Global Financial Institute improves the ability to cope with low probability, high Mr Culp also sees hopeful signs but remains cautious impact events “Effective risk management is an everyday Driven by both regulatory change and business necessity, activity,” adds Mr Culp, “maintaining the connectivity with he says, “the understanding of risk and its importance have the business and investing in the culture are critical and dramatically changed at both board and senior leadership will help to provide early indications of where problems levels They are much more informed and asking better may be Through normal, effective risk management, and questions than pre-crisis Risk awareness is heightened.” the mentality of getting the little things right, you get bet- Unlike in previous eras, where elevated concern about risk ter insights earlier and can course correct to limit exposure often dropped during periods of economic growth, Mr to bigger challenges.” Culp also hopes that the structural changes of recent years – such as the greater number of Chief Risk Officers on at At least three broad elements of effective risk manage- the leadership table – will give some permanence to this ment are central in developing and maintaining this men- appreciation of risk as a critical function tality One is taking risk seriously This on its own can help tremendously in dealing with unexpected upheavals An Companies also seem to be taking steps toward a more academic study of US banks, for example, found that those holistic understanding of risk and have a healthier appreci- with independent risk management functions and strong ation that models are not the same as reality Nevertheless, internal risk controls suffered less during the peak years says Mr Culp, “the core of the weakness [in risk manage- of the global financial crisis in part because they were ment] remains around complexity.” Better data gathering less likely to invest in mortgage-backed securities and off and the elimination of data silos is occurring, but how best balance-sheet derivatives They also did better financially to turn these mountains of information into insight is an during the preceding boom ongoing challenge Overall, he believes that “We are defi- 4 nitely moving in the right direction In terms of levels of Another element is the need to go beyond box-checking capital, investments in talent, connectivity with regulators, to operate in the spirit of the law which, says Mr Culp, “gives sharing of information, we are in a better place The real- a broader understanding of risk in a holistic way.” Finally, ity is, though, that the broader economic situation does companies need to maintain humility about the extent of remain fragile and the regulations are still forming We are their understanding of the risks they face Mr Culp recalls early into this process.” that before the crisis “people often acted as if the models were reality and gained excessive confidence as a result.” Regulating for robustness What about capital markets as a whole? Although the Since the Financial Crisis, capital market firms have Global Financial Crisis revealed any number of weaknesses, invested substantially in risk management Adjusting to two issues of these could most exacerbate the impact of a new regulation alone – probably the leading focus of this Black Swan event: the greater degree of global inter-con- activity – has required a massive shift and the changes are nectedness of the national markets than in the past, and still very much a work in progress But have the accompa- the growth of a variety of private companies into strategi- nying shifts made companies better prepared for rapidly cally important financial institutions whose failure would emerging risks and the completely unexpected? have potentially catastrophic consequences Mr Tran sees a mixed situation: “Risk managers since the Here again, Mr Tran sees some progress but notes that sig- crisis have been busy engaging in all kinds of analysis nificant issues remain He observes that the Dodd-Frank informed by what went wrong To that extent, the room Act has at least put in place a legal framework for a resolu- for unexpected events is quite a bit smaller Having said tion authority in the United States to manage too-big-to- that, we can still be surprised by things that can completely fail institutions that get in trouble European Union propos- change what we thought.” als for a similar body are also progressing “What is lacking,” ndrew Ellul and Vijay Yerramilli, “Stronger Risk Controls, Lower Risk: Evidence From US Bank Holding Companies”, National Bureau of A Economic Research, Working Paper 16178, July 2010 4 Black Swans and Global Capital Markets Global Financial Institute Mr Tran believes, “is a cross border framework to deal with Ultimately, because of they are impossible to predict, the global firms.” Failures of the latter would presumably pres- ability of capital markets to withstand the next Black Swan ent the biggest systemic risks Similarly, in dealing with the will only be apparent once it appears Given the history of inter-connectedness of global markets, greater levels of finance, the safest bet is that one will come along sooner transparency and disclosure – to provide enhanced under- or later standing of how given institutions might be exposed to any emergent, or other, risk – remains desirable Even sensible regulation, though, might unintentionally bring new dangers Mr Tran notes that “the thrust of regulatory reform has put similar risk-based capital requirements on non-bank institutions and inadvertently reduced the diversity of different institutions This may risk producing a more uniform reaction to market developments and these tend to produce a bigger risk, because if everyone buying or selling at the same time, you get extreme market movements.” Are we better prepared for the next Black Swan? Companies and regulators have made substantial efforts to improve risk management This certainly reduces the probability of a repeat of a chain of events similar to that of 2008 The bigger question, however, is how well these changes will reinforce the system against future Black Swan events At the corporate and market level, the news is decidedly mixed Improvements have occurred since 2008 Although the undoubted improvement in risk management by companies is not designed specifically with Black Swan events in mind, more businesses should be in better shape to cope with them once the current wave of change has taken place If nothing else, they are more alert to risk and may even be able to maintain this heightened awareness when good economic times return Similarly, regulators are at least addressing the “too big to fail” problem, which can create a disincentive for large organisations to manage their risks vigilantly In both cases, progress is only partial and still has far to go: perfection is never truly possible in a world where unintended consequences are common As one senior banking executive predicted to the Economist Intelligence Unit in 2011, while lessons can be learned from the past, “We will mess up in a different fashion the next time.” Disclaimer Global Financial Institute Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person The opinions and views presented in this document are solely the views of the author and may differ from those of Deutsche Asset & Wealth Management and the other business units of Deutsche Bank The views expressed in this document constitute the author’s judgment at the time of issue and are subject to change The value of shares/units and their derived income may fall as well as rise Past performance or any prediction or forecast is not indicative of future results Any forecasts provided herein are based upon the author’s opinion of the market at this date and are subject to change, dependent on future changes in the market Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance Investments are subject to risks, including possible loss of principal amount invested Publication and distribution of this document may be subject to restrictions in certain jurisdictions © Deutsche Bank · March 2014 R-31717-1 (6/13) ... portal 4 Black Swans and Global Capital Markets Global Financial Institute Black Swans and Global Capital Markets Written by A collaboration between Deutsche Asset & Wealth Managment‘s Global Financial... Asia, are driving capital- raising; in who will influence the future of capital markets many places debt markets are fragile due to the large Black Swans and Global Capital Markets Global Financial...2 Black Swans and Global Capital Markets Global Financial Institute Introduction to Global Capital Markets in 2030“ Deutsche Asset & Wealth Management’s Global Finan- component