Every year is an un-exceptional year. And, as usual, many unexpected and surprising things happened in this one. What is Risk Management but the art of reminding ourselves that preparing for uncertainty is essential, because uncertainty is a given.
Yet it is worth looking back at this year and learning from some of the significant events. It is worth looking at what really happened and using these real events to backtest our scenario sets.
Ukraine and Commodities
The thing about surprises is that some of them are banging you on the head with a brick, and we somehow fail to notice them. The reason the Ukrainian conflict came as a shock seems to be twofold:
Firstly, the majority believed that the actions of the Russian state would always be precisely along the efficient risk/return line of their long-term strategy. It may still be – but it doesn't look that way today, as the invasion looked a risky venture from the start.
Secondly, there has been a long-term, low-intensity war in Ukraine for a while, and the world has just adjusted to the jeopardy this represents. It is easy to forget that this war always had the possibility of escalation; leading to sanction retaliation, coupled with a possible significant period of volatility, and price rises, for gas and oil.
With hindsight for most – or with preparation for some – it is clear that baking in a higher risk quotient for Russia and making sure you planned for an escalation scenario was sensible. Testing this for a continuous extension of sanctions over time would be even more realistic. Even this may have seemed relatively extreme at the time. Today not so.
Fingers crossed for Ukraine.
China
Never forget about the dragon. Lots of things have happened this year in China. It's hard to know as a business how to make sure one's approach to China is fit for purpose. It's almost a given for a global business that you have a presence there. You must make sure you are resilient to the loss of assets and local bankruptcies with low recoveries and that the business done is giving appropriate returns given the risks. And if not, the excess risk is clearly understood as the strategic cost of building a business in China. Lastly, as I have been writing this, we have seen more protests in China against COVID restrictions. No doubt these die out slowly with some pain, but they may not.
Inflation
The world has been waiting for inflationary signs since 2014, arguably longer. 2022 is the year they arrived. It is another example of an easily predictable – and hence preparable - event. A good inflation scare likes to get started with an oil shock. But don't be complacent, this will cause much pain in many countries. It is likely to get some less well- prepared countries and blocs – especially those with little room for manoeuvre in the debt markets – into a nasty-looking stagflationary condition. The UK is most likely to do so, but the surprises here may come from other economies.
UK Heading South plus Gilt Yields and LDI
If a thing doesn't work, then one day you will discover it broken. The UK's defined benefit plans are underfunded in many states of the world (as in financial scenario states), often in all of them. Hence they use leverage so at least in some states of the world, they can fund their liabilities. The world tends to find the points where there are these inflexions, especially if there is any positive convexity to kick the markets in the direction of pain for the majority. Hence gilt players have discovered that yields can change quickly. Gilt yields don't necessarily feel in the wrong neck of the woods in terms of magnitude; it is the volatility and speed of change that is surprising people. This is because most market players expect some smooth transition between yield states. But this is not true. Markets are not complete nor continuous. No surprise then that smooth transitions are in short supply.
The UK has become a troubling place. It's likely to have a tougher economic climate and more difficulty taming inflation than its peers in the G20. But the surprises for next year may come from others in the G20 who get found out in some different way.
Credit Suisse
Pressure on European banks continues. Especially at Credit Suisse. As the summer went on, analysts began to ask, 'how big is the capital hole at CS?' if they wanted to shut down the investment bank and focus only on private wealth and associated businesses. The share price fell, the credit widened, and they have not recovered (as I write CS at chf3.565, 52WL of 3.518; a price to book of 0.23 and a market cap of chf10bn, with a chf750bn balance sheet). And now we have a profit warning triggered because the withdrawal of assets will likely lead to a reasonable loss this quarter. A difficult place for Switzerland's second-largest bank. Hopefully, the separation strategy will work, Michael Klein will get the Investment bank part up and running, and CS will revive its fortunes. Other banks are waiting to fall out of favour with investors.
Capital is important to banks, as is preserving liquidity. But a bank must avoid simply following regulatory requirements. Investors and counter-parties have their views, and they are the ones who must be kept on-side if you want to stay independent. This takes a good strategy, clear execution and real risk management. If a bank focuses its risk approach only on the regulators and regulatory capital, important though these are, it will crash land somewhere, sometime, with a bump. The same is true for strategy and execution.
Crypto repricing and instability from stable coins and pricing mechanisms
So there's now a whole financial ecosystem out there. You either know a little about it, a lot about it, or it weirds you out.
It will change the financial world. It has assets with unclear valuations. It is inventing new products related to the ones we developed in the 90s and 2000s, created in roughly equivalent forms back into history.
But this world will continue to discover why the TradFi dinosaurs are as they are via costly failures, market interruptions and crashes.
Great fun, though. Stay active, informed and be involved. But follow granny's advice on eggs.
FTX
See above. Hollow laughs from old CRO types – never take specific wrong-way risk. And never gear it. Ever. Not to mention any other woes.
Climate change
Start worrying a lot. And invest more time and treasure to learn about it.
Lewis O'Donald
Arboreal Risk Advisors
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