Our greatest export is democracy

Published in the Australian Financial Review 27 June 2018

James Laurenceson’s “We need China in an age of Trump” (June 19) lacks basic rigour and balance. It’s a propaganda style piece presented as a scholarly work from the Australia China Relations Institute attached to the University of Technology Sydney.

Laurenceson refers to an open letter by “80 of Australia’s leading China scholars” concluding there is “no evidence” that China’s actions aim to compromise Australia’s sovereignty. No mention of the near 50 leading China scholars who signed an opposing open letter, many of whom are Chinese Australian.

The “no evidence” scholars group includes experts in things like Chinese gardens in the Ming dynasty. They invite expression of “as wide a range of viewpoints as possible, Chinese and non-Chinese alike”, yet in the same letter smear those expressing concern about the Chinese regime’s influence, by alleging a “racialised narrative of a vast official Chinese conspiracy”.

To understand the threat to Australia look to the invasion and suppression in Tibet, the tightening noose around Taiwan, the betrayed people of Hong Kong, the gross mis-treatment of Nobel Peace Prize laureates the Dalai Lama and Liu Xiaobo and many more, the cunning no-shot-fired military capture of the South China Sea, and Clive Hamilton’s book “Silent Invasion“.  The Chinese regime is intolerant of opposing opinions and balanced debate.

Laurenceson is an economist. His repeated calls not to offend the Chinese regime rest solely on the growing dominance of Australia’s exports to China. Instead, he should be calling for an exposure limit to high risk economies, and more diversity.  India, the largest democracy in the world also has the fastest growing economy.

With tinted glasses Laurenceson ignores that which trumps all else – protection of basic human rights, fairness and freedom of expression. Over-trading with a country controlled by an authoritarian regime and shocking human rights record endangers the wellbeing of all Australians.

Compared to the Chinese regime Australia is a super power of democracy and human rights. Australia can use this power. Apply export limits to countries with governments that view democracy as its enemy. This will help seal the risk hole that Laurenceson wants to dig deeper. It will restore balance between long term security and short term profit. It will support the majority of Chinese who did not choose their dictatorial government.

Version submitted to the Australian Financial Review

James Laurenceson’s, June 19 commentary, “We need China in an age of Trump” lacks basic rigour and balance. It’s a propaganda style piece presented as a scholarly work from the Australia China Relations Instituteattached to the University of Technology Sydney, published first by the Australian Financial Reviewthen republished by the ACRI.

Laurenceson refers to an open letter by “80 of Australia’s leading China scholars” concluding there is “no evidence” that China’s actions aim to compromise Australia’s sovereignty. No mention of the near 50 leading China scholars who signed an opposing open letter, many of whom are Chinese Australian.

The “no evidence” scholars group includes experts in things like Chinese gardens in the Ming dynasty. They invite expression of “as wide a range of viewpoints as possible, Chinese and non-Chinese alike”, yet in the same letter smear those expressing concern about the Chinese regime’s influence, by alleging a “racialised narrative of a vast official Chinese conspiracy”. Of course many of the most concerned are Chinese Australians.

While the evidence of interference in Australia is clear, none need exist on Australian soil to warrant concern. To understand the threat to Australia look to the invasion and suppression in Tibet, the tightening noose around Taiwan, the betrayed people of Hong Kong, the gross mis-treatment of Nobel Peace Prize laureates the Dalai Lama and Liu Xiaobo and many more, the cunning no-shot-fired military capture of the South China Sea, and Clive Hamilton’s book “Silent Invasion“.

The Tibetian people have been silenced totally. Hundreds of monks have self-immolated in deadly silent protest. Our political leaders will not meet with the Dalai Lama. Qantas and many others no longer refer to the democratic country of Taiwan as a country separate from China. All from fear of offending the Chinese regime. The Chinese regime is intolerant in the extreme of opposing opinions and balanced debate.

Laurenceson is an economist. His repeated calls not to offend the Chinese regime rest solely on the growing dominance of Australia’s exports to China. Instead, he should be calling for an exposure limit to high risk economies with opaque risk holes, as with China — basic economic risk management. More diversity. India, the largest democracy in the world also has the fastest growing economy.

With tinted glasses Laurenceson ignores that which trumps all else – protection of basic human rights, fairness and freedom of expression. Over-trading with a country controlled by an authoritarian regime and shocking human rights record endangers the well-being of all Australians. It’s the same short sighted focus on short term profit that infects, and failed, the finance industry.

Compared to the Chinese regime Australia is a super power of democracy and human rights. Australia can use this power. Apply export limits to countries with governments that view democracy as its enemy. This will help seal the risk hole that Laurenceson wants to dig deeper. It will restore balance between long term security and short term profit. It will support the majority of people in China who did not choose their dictatorial government.

Quarterly stress test of banks not enough

Published in The Australian Financial Review

In “Not enough stress in US bank test,” (June 24), Professor Lucian Bebchuk, Harvard Law School, says, “As long as banks are permitted to operate this way, the banks’ supervisors are betting on the banks’ ability to earn their way out.” Bedchuk is referring to the recent flawed stress testing of US banks. His message is that stress testing is essential but that it must be rigorous. As the author of a book on the finer details of stress testing after many years experience of building stress testing related technologies and using them to successfully manage billions of dollars of complex financial exposures, I agree.

A rigorous stress test measures bank exposure to wide ranging movements in all relevant economic variables. There are many ways to get a stress test wrong or be tricked. The value of a stress test depends critically on its frequency and transparency. The prudential regulator, APRA, requires banks to report quarterly and results are not published. Bank trading is a daily activity. A quarterly stress test leaves 99 per cent to trust.

I have repeatedly invited the authorities through my letters to publish rigorous bank stress tests daily in a website. Nothing could be more efficient or cost effective as a regulator of excessive bank risk.

Why not reduce risk and cost with an automated bank risk watch website? Minister Nick Sherry, answered in a letter to me dated 16 April 09, then as Minister for Superannuation and Corporate Law, “To require daily reporting as proposed in your email (to the Treasurer) would impose significant additional costs. These costs would ultimately be paid by the bank customers.” The Minister was poorly advised. Bank customers now know the much higher cost of weak risk management.

What is the cost of rigorous daily bank stress testing and reporting? Daily stress testing is already core risk management for a well managed bank — the entire process is electronic and automated. So the additional cost of daily electronic reporting to a central website is insignificant. There is no reason in the public interest to withhold risk transparency from taxpayers now underwriting bank deposits.

There is another cost however. Banks will lose the freedom to speculate in darkness. It will become apparent that even the current quarterly stress testing ignores the housing price risk — something US investment banks do too. And what about exposure to US sub-prime mortgages?

Governments and regulators have not understood where risk hides. Many senior bankers will fail a rigorous risk test. On the current course, the risk-free prediction is that more avoidable banking disasters will follow, in similar frequency to recent decades.

Published version - AFR- 1 Jul 2009

Why were voices of reason on risk ignored in the US?

Published in The Australian Financial Review

Many myths are circulating about the root cause of the crisis in financial markets created by Wall Street. The root cause was none of securitization, the housing price collapse, predatory lending, free markets, short selling, innovation or borrowing short lending long. Not even greed, regulation or lack of it was the direct cause. Sound risk management can cope with all these simultaneously.

Risk management relies on accurate measurement of risk. If the risk is not measured and seen it cannot be managed. The root cause of this crisis was announced in 1996 in a report published in Euromoney’s Corporate Finance. The report exposed a devastating flaw in a risk measurement method called VaR (Value at Risk) imposed on the financial markets by Wall Street. I was the report’s author. It warned that widespread reliance on VaR left the financial markets exposed to a risk Tunguska, as I called it. Named after a massive aerial explosion 8km above Eastern Siberia on June 30, 1908 which devastated 500,000 acres. My point was to emphasis the seriousness of the problem, now exploded closer to home in 2008. I published many other papers in the 90s on the same theme including the book Risk Mechanics, finding and fixing risk holes.

VaR hides the many complexities of market risk. In particular, it ignores elements of risk associated with catastrophic loss. Yet, in the 1990s, Wall Street “rocket scientists” aggressively marketed VaR establishing it as the accepted standard of market risk measurement.

Imagine a fruit and veg trader from main street attempting to value a concealed bag of fruit and veg by its weight only. He has no idea if the bag contains potatoes, a mixed bag or bad apples. The single statistic of weight alone does not enable the fruit and veg trader to price the bag or understand the risk of holding it. Yet VaR is every bit as naive as the fruit and veg trader attempting to value his investment on weight alone. Less is not always more.

A long term solution to this crisis must answer why so many investment banker “rocket scientists” embraced a risk measurement method as naive as VaR. Why were voices of reason ignored? Whatever the motive, the rise of VaR made it easy to sell financial instruments with catastrophic elements in their payoffs. Promoters of these instruments are rewarded on a time scale much shorter than the expected time scale of these catastrophes.

Senior managers and regulators felt relaxed and comfortable with a risk measurement process with a name like “Value at Risk”. As the volume of financial instruments with hidden but massive risk holes ballooned the day of reckoning in the financial markets, the risk Tunguska, was inevitable.

Published version - AFR - 6 Oct 2008

Value_At_Risk – Var Is a Dangerous Technique

Published in Euromoney’s Corporate Finance 1996 by Ralph McKay & T Erle Keefer

A means of representing risk as a single statistic is very appealing- and highly flawed, argue Ralph McKay and T Erle Keefer of consultancy Risk Technology. The value-at-risk method can conceal large risk holes, is insensitive to the possibility of catastrophic market events and ignores risk reshaping difficulties.

Value-at-risk and its new incarnations represent a form of risk appeasement. It ignores the real market risk problems. It is fashioned to impart a feeling of security to the people that it is supposed to give comfort to – central bankers, directors of banks and financial institutions, regulators and politicians. Objective scrutiny exposes this as unwarranted.

Given the notorious billion-dollar derivatives losses and absence of senior supervision, the clamour for a simplified risk measure such as value-at-risk is understandable. And the arrival of value-at-risk has served positively to focus attention on the need for risk measurement.

What is wrong with value-at-risk? Popular, broadly accepted definitions eschew too much essential information. They represent market risks as a single statistic. This single statistic is appealing and easy to explain. Unfortunately, it is even easier to use it to hide large risk holes. Managers consequently oblivious to the actual risk can increase systemic risk of derivatives bungles.

The manager presented with a value-at-risk number is like a fruit and vegetable trader who has a basket of fruit to sell but knows only the weight of the basket. He, along with the rest of the market-place, does not know from this single parameter whether the basket contains potatoes, mangoes, a mixed bag or bad apples. Thus he cannot determine what price to ask – he cannot assess the risk. To the fruit and veg trader, weight is not a market risk measure. Similarly, on a detailed analysis conventional values-at-risk are barely worthy of being treated as a measure of market risk.

Beware Tunguska Events

Even as a simple measure of risk, value-at-risk is highly exposed to criticism. Values-at-risk assume well-behaved markets but ignore the impact of real worry, the financial markets’ Tunguska events , such as the stock market crash of October 1987.

Derivative markets are very young. There is little data from which to predict the frequency of market crashes – that is the size and frequency of so-called outliers. But the limited data that exists is alarming and the only prudent approach is to assume that the big crashes have not happened yet. A prudent risk measurement must highlight exposure to the totally unexpected – because, in truth, it should be expected.
The value-at-risk concept of measuring risk in terms of a 99% probability of market movements is dangerous and misleading. For example, portfolios with deep out-of-the-money short option positions frequently show little sensitivity to the 99% movement. However, for even larger movements they may incur accelerating losses. Values-at-risk can be blind to this form of market jump risk.

Value-at-risk relies heavily on past statistics as a guide to the future. Another example of this is the actual or implied use of correlations between different markets and risk diversification. Negative correlations produce cancelling risks in the value-at—risk. Most of the time, diversification helps to minimize losses. However, when the security of diversification distracts attention from absolute protection risk management practice – as value-at-risk appears to be doing now its effect can be destructive in the medium to long term. This is because correlation and diversification assumptions can prove inadequate when the risk Tunguskas hit.

An absolute risk measure seeks to protect wealth in a defined manner regardless of the probability of adverse market movement. For example, the maximum wealth loss may be limited to an acceptable level. Compared with the value-at-risk 99% probability-type protection, outcomes between OK and destruction may be different when a Tunguska hits.

Risk reshaping

Quality risk management is only half the story; risk reshaping is its complement. For example, two portfolios may have identical value-at-risk numbers. However, the risk may be eliminated easily in one of the portfolios, whereas the other may be difficult to modify because of the bumps-to-the-risk-carpet problem. That is, attempts to control one aspect of the market risk may worsen other aspects.

The value-at-risk statistic ignores these risk-reshaping difficulties. Frequently, such complexities of risk reshaping may be the real risk problem, even though value-at-risk numbers may appear benign. Value-at-risk hides all information required to assess reshaping risk. Using the value-at-risk, it is impossible to determine which transactions are required to reshape market risks.

A single risk number ignores market asymmetry. A portfolio may be more exposed to loss than profit, but this cannot be known from the value-at-risk number. Its limitations extend to overall trading philosophy.

Value-at-risk tends to give validity to the popular notion that financial institutions make money by incurring market risks. The more risk, the higher the potential returns. This is a myth. The target value—at-risk number should be zero. All risks should be fully hedged — particularly in zero-sum markets. The objective should be to eliminate market risk, leaving only counterparty and operational risks to worry about.

This is the case when a bank sees itself as a manufacturer of financial instruments. Such a manufacturer may not be able to achieve the ideal zero-risk position at all times, but how many senior bankers hold the misguided belief that a zero value-at-risk means zero profit?

The underlying reality is that market risk management is a complex problem. It is dangerous to oversimplify the issues. An effective set of risk numbers should indicate the present value change in the portfolio in response to all economic parameters affecting the portfolio, whether correlated on not, and indicate exposure to both small and and very large moves. If the portfolio is properly hedged, the exposure to a very large market jump may be the same as the exposure to smaller moves — zero.■

The ‘Tunguska event was a large mysterious aerial explosion in Siberia at 7.40am on June 30 1908. It devastated 500,000 acres. It is thought to have been caused by a comet. June 30 remains the financial day of reckoning for many companies.

Published version – Euromoney’s Corporate Finance – 1996