Risky business

This morning RBA deputy governor Guy Debelle proved once and for all that our central bankers are much more than grey, faceless men and women, when he opened a speech on risk and uncertainty in global financial markets with a quote from a renowned songster – the late frontman of 1960s rock band, The Doors, Jim Morrison.

The choice quote, from the 1970 hit, Roadhouse Blues, goes something like this: “The future’s uncertain and the end is always near.”

Deep stuff, eh? Actually, Debelle’s speech is very interesting and very entertaining, and well worth a read.

While much of the speech deals with how risk and uncertainty affected the financial system during the GFC, there are some great lessons for entrepreneurs, who, along with banks, governments and just about everyone else, appeared to be lulled into a false sense of security by the economic boom that basically ran from the late 1990s right though the 2000s.

It was this misjudgement of risk that led to the GFC, Debelle argues.

“Risk was mis-assessed by financial institutions, risk managers, investors and regulators,” he says.

“There was a false comfort taken from a misplaced belief that risk was being accurately and appropriately measured. To some extent, the technology provided risk managers with a false sense of security. Risk may well have been accurately measured for the particular regime that the economy and financial markets were operating in.”

“But the risk assessment was not robust to a regime change that took the models out of their historical comfort zone. Not enough account was taken of uncertainty.”

“In the period prior to the onset of the crisis, hubris developed in parts of the financial sector, and in the investor community more generally, that everything could be precisely measured and priced. In particular, that risk was always quantifiable.”

Debelle’s central argument is that while we should continue to strive as hard as we can to measure, judge and price risk, we also need to account for uncertainty.

Further, he argues that the primary tool for this is stress testing. In the banking world, where huge amounts of debt are a part of life, stress tests are common.

But how many entrepreneurs spend time stress testing their own business? How many know how their business would react if something very out of the ordinary happened? Sales dropping 25%? Interest rates going up 3%? Three key staff members leaving at once?

“Taking account of uncertainty is not easy, after all, it is uncertain!” Debelle says.

“But at least a focus on ordinal as well as cardinal probabilities, in part by stress testing with scenarios that fall outside the model’s history, would surely be beneficial. But stress testing and the assessment of uncertainty is still constrained by the difficult decision as to what is the relevant set of stresses that the framework should be subjected and what is the relevant history. A healthy dose of judgement needs to be brought to bear on these decisions.”

The important thing to actually spend time thinking about this stuff. As Debelle argues, we made a mistake in the last boom by forgetting that the world is a volatile and at times uncertain place.

We should not do the same again.