Read Taleb’s Black Swan?....twice?…..so now what?

The Black Swan is an enthralling and instructive read for anyone concerned about future risk; such as any member of the Global Credit Management Group. A thorough study of this work and its predecessor Fooled by Randomness is highly recommended. Nassim Nicholas Taleb (NNT) draws together a large number of references and anecdotes to illustrate his points. He repeatedly attacks the received wisdom of those who model the future and who, being lulled into a false sense of security by the elegant mathematics of their models, are repeatedly surprised when the future does not adhere to their script.

In essence NNT persuades the reader that the most impactful social and technological changes – the changes that will drastically alter the course of future history - cannot be predicted since they are ‘unknown unknowns’. Such events – which he calls Black Swans – will happen for the first time so cannot be imagined in advance, and cannot be predicted by models that extrapolate forward the past. The past cannot be a basis on which to predict the future; ask any turkey just before the butcher’s cleaver falls if he thought his today would be any different from the preceding 1000 days when he ate heartily and potted around a garden or dozed in the sunshine….

With such thoughts in mind, NNT is particularly critical of the use of past trends and volatility statistics to model future risk probabilities. The omnipresent use of Value at Risk (VaR) and Credit Value at Risk (CVaR) calculations to ‘predict’ future losses, with 95% or 99% confidence, NNT shows to be particularly dangerous; as has proved to be the case time and again. Yet the majority of academics and the decision makers they train persist in the use of VaR and CVaR - by inference bowing at the Alter of the ‘bell curve’ – because ‘The demand for certainty is one which is natural to man…’ (Bertrand Russell) even if that certainty is built on mathematical models that cannot predict pivotal events. Thus building on sand, trusting in false predictors, all of the unconverted – those who chose to ignore Benoît Mandelbrot’s theories as expounded by NNT in The Black Swan – created the instruments and conditions that caused the global financial firestorm (Credit Crunch) that followed the collapse of US house prices and the bankruptcy of Lehman Brothers.

NNT refers to the ‘bell curve’ as ‘that great intellectual fraud’.

This is all very interesting however the burning question after reading this seminal work is; what does it mean for someone in the business of Credit (Performance and Payment) Risk Management?

Read the full article at this address http://www.barrettwells.co.uk/blackswan.html

Ron Wells

Black Swan events mean that ordinary (anticipated) events have become increasingly inconsequential...

The future is where we will be paid or not paid by our customers. Hence as credit managers we need to understand what the future may hold so we can prepare a range of plans that we can adapt to best fit what materializes in the fullness of time.

An understanding of what the future may hold can be gained through use of the Scenario Planning technique.

‘Scenario planning derives from the observation that, given the impossibility of knowing precisely how the future will play out, a good decision or strategy to adopt is one that plays out well across several possible futures. These sets of scenarios are, essentially, specially constructed stories about the future, each one modelling a distinct, plausible world in which we might someday have to live and work.’

(How to Build Scenarios – Lawrence Wilkinson)

The way forward for credit managers then (not being bean-counters of the 19^th century but rather a remarkable synthesis of economist, commercial lawyer, negotiator, management accountant, business manager, detective and master strategist) is to create scenarios of the future for the market or industry in which their customers will be operating. Then to look back from the vantage point of those futures to identify which customers are most likely to have failed along the way.

A Scenario is not a plan, it is not a projection of current trends, yes the future begins from where we find ourselves today, yes the future is shaped by forces we see existent today - if we open our eyes wide enough and shake off assumptions - but it is also shaped by the future actions of men and women of vision, it is shaped by disruptive technology, and unexpected pivotal events; like the fall of the Berlin Wall.

Nassim Nicholas Taleb wrote in his important book on risk assessment, the following:

‘Before the discovery of Australia, people in the old world were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence.

The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the colouring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird.

I push one step beyond this philosophical-logical question into an empirical reality, and one that has obsessed me since childhood. What we call here a Black Swan (and capitalize it) is an event with the following three attributes.

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. Ever since we left the Pleistocene, some ten millennia ago, the effect of these Black Swans has been increasing. It started accelerating during the industrial revolution, as the world started getting more complicated, while ordinary events, the ones we study and discuss and try to predict from reading the newspapers, have become increasingly inconsequential.’

(Extracted from The Black Swan: The Impact of the Highly Improbable, written by Nassim Nicholas Taleb, published: April 22, 2007)

Please refer to articles found at the following addresses for more discussion on the need for and plausible use of scenario planning:

http://www.barrettwells.co.uk/credit_2010.html

http://www.barrettwells.co.uk/performance.html

http://www.barrettwells.co.uk/customersfail.html

http://www.barrettwells.co.uk/imagination.html

Ron Wells

Time for Thinking

I’m sure we have all endured management practices that seemed to be more examples of how not to manage successfully rather than the role models we had hoped to find. Nevertheless these management practices all too often seem to be successful as organisations are carried along on the tide of a benign market cycle. They are only tested when the cycle turns negative.

The result of a negative turn of events is usually howls of anguish from those who have done little, thought little, cared little, planned and strategized little; yet drained their organisations of much. Executives with no vision and no leadership skills but big pay-packets, no, obscenely large pay and benefits packets, wonder how their genius could have suddenly escaped them…..

Robert Heller writing in the January 2009 Letter to Thinking Managers remarked:

‘….the effects of working for the largest company in the industry for so long; managers become ‘comfortable, insular, self-referential and too wedded to the status quo’. Such habits, folklore would argue, will get driven out of supine corporations by the threat of failure and the impact of competition. But this process is not automatic at all.

….twin cults have played a noxious part in the fall of America’s one-time world champions. The Cult of the Chief Executive elevated some quite ordinary men into mini-heroes and mini-heroes into gods. The Cult of Shareholder Value, perversely enough, extracted large wealth from the value that rightfully belonged to the investors. The Congressional hearings on the Big Three auto giants and their pleas for bail-outs showed cultism at its silliest. The three CEOs turned up in separate corporate jets, with no documents or plans, giving the committee a field day. Would the trio accept a cut in pay to $1 a year? The Ford man reckoned that his massive $22 million was just about right.

The banks sum it all up: overpaid colossally, professionally incompetent, immensely conceited. That’s no way to run a bank, a car company - or the world economy.’

Today we hear only bad news, but is it all bad? It cannot be bad that inefficient, and incompetent leaders who lack vision and act only out of selfish greed are removed from the corporate decision making process. It is not bad that excess productive capacity is trimmed – redirecting scarce world resources to more useful activity.

There is no doubt that we live through a time of painful transition for many people, a transition that could have been eased, less radical, and spread over a longer time period if corporate leaders had had the skills and vision for which they were so handsomely rewarded.

Edward de Bono wrote in his January 2009 Letter to Thinking Managers:

‘Most executives regard thinking as a luxury. It is enough to follow the routines. Continuity is everything. Now and again there is a need to analyse a situation to identify a standard element and then the standard response can be applied.

When things are going well, then this continuity works because you are carried along on the tide of success. Unfortunately, the reverse happens when things are going badly, because the tide is going in the opposite direction.

Better thinking is never a luxury. Better thinking is an absolute necessity in difficult times.

This better thinking includes creativity. There is a need for creativity in order to look at things in a different way.’

Although many businesses will benefit from the state of transition in which we find the world economy; let us hope that new leaders of vision and compassion will emerge to enable the whole world economy to expand and prosper to the benefit of all participants.

Ron Wells

Members can subscribe to the Letter to Thinking Managers at http://www.thinkingmanagers.com