Managing Interdependence

1. Managing Interdependence The New Scenarios for Financial Risks and Uncertainty Paolo Garonna 22 May 2019

2. The Context: From the Financial Crisis to the Great Uncertainty • Growing uncertainty: Knightian, structural (more than methodological or parametric), black swans and Plinian eruptions • Multiple conundrums generated by uncertainty have put risk scenarios at the heart of decision-making. Risks perceived to be on the rise. • Example 1 (policy): Should we maintain and extend overexpansionary monetary and fiscal policies, or accelerate the «normalisation»? Deleveraging? What deleveraging? Global private and public debt are all-time high ($184 trillion, 225% of GDP, 22,5 times the average income per capita, 2017). This constitutes «a potential fault line» (IMF). See graph • Example 2 (business): Markets affected by increased volatility, reflecting the building up of unresolved vulnerabilities (trade wars, political instability, downside risks to the housing market, etc.). Investors caught between two fears: fomo (fear of missing out) and folm (fear of losing money). Cyclothymic investors: bouts of risk aversion and investment euphoria. Deployment of macro-prudential tools and repair of public and private balance sheets are still lagging behind.

3. Deleveraging? Whatdeleveraging?

4. Shifting Risk Scenarios: a Challenge to Conventional Risk Management (RM) • Financial institutions and regulatorshaveimprovedconsiderablytheircapacity to managetraditional risk types, suchas market, credit and liquidity risk (modelling, analytics, data, IT, etc.). • But, the importance of other (non-financial) risks hasgrown, challenging RM effectiveness: operational, misconduct (reputation), third-party, business interruption (due to conflicts or disasters), etc. Such risks are oftenhard to quantify, non-insurableor onlypartiallyinsurable (uncertainty), and increasinglyunpredictable to prepare for and mitigate (seenextTable). • Moreover, risk rankings and perceptionsvaryacross markets and regions and changerapidly. 1/3 of the top 15 risks werefound to be new entries, several risks gained or lostrelevance, often in connection with events or viral news headlines. • New risks haveemerged, suchasmacroeconomicconditions, cybersecurity, social and politicalstability, climatechange and disasters, geopoliticalconflicts, regulatory and legislative changes, disruptive technologies and skill shortages. Managingsuch risks require a holisticapproachand a verybroad set of expertise, analysis, data, which are notgenerallyleveraged by conventional RM environment. • The consequenceis a growing gap in RM effectivenessand a widespreadperception of insufficient risk readiness. The paradoxisthat the more one invests in enhancing RM capacity, the more one becomesaware of unmanageable risks. Risk readinessisestimated to be nowatits lowestlevel over the last 12 years ( ).

5. Insurable and Non-Insurable Risks Source: Aon, Global Risk Management Survey 2019

6. Aon Survey: How Ready Do WePerceiveOurselves vis-à-vis the Top 10 Risks?

7. The MostThreatening Risks: Assessments and Rankings • Risk scenarios are nowregularlyreleased from national and international agencies. Methods, modalities, degree of accuracy, and outcomesvary. Thereis no consensus scenario, as with economic forecasts or rating agencies. A few trends however emerge. • The main sources of anxietylie in environmental, economic and geopoliticalfactors (see WEF Table 1) • The shifts over the last 10 yearshavebeensignificant. Whilebefore the dominantfactorswereeconomic and societal, now the top positions in terms of likelihood are held by naturalcatastrophesand other events linked to climatechange and environmentaldegradation, and technological disruptions suchascyberattacks and data fraud or theft. In terms of impact, the top ranking istaken by geo-politicaltensionslinked to trade disputes or conflicts (e.g. Libia, Venezuela, US-China or US-Russia power relations), environmental and social (polarization) factors. (WEF, Table 2) • The mostseriousthreats come from tail risks, unknownunknowns or black swansthat are impossible to predict, mitigate or prepare for. Black swans do exist!, and whentheyappearhavecatastrophicconsequences. Ex-ante risk analysis in that case isrelativelypowerless. The lessonwehavelearned from the last crisisisthat an inherentcharacteristic of such risks isthattheytend to be sistemic, i.e. associated with risk interdependence.

8. WEF: The Global Risk Landscape 2019

9. WEF: The Evolving Risk Landscape

10. Risk Interdependence and Systemic Risks • Variousdefinitions and dimensionsof systemic risks. «The risk of widespread disruption to the provision of financial services thatiscaused by an impairment of all or parts of the financial system, and which can cause serious negative consequences for the real economy» (IMF). Time dimension: vulnerabilitiesrelated to the built up of risks over time, and control of pro-cyclicalit. Structural cross-sectionaldimension: vulnerabilities from interconnectedness, mostlyrelated to SIFIs. • Key features: contagion, endogenous risks, cascadingeffects, amplificationmechanisms, strong and simultaneous impacts. • Need of broaderdefinitions: risk-trends interconnectionsamongseveral and different triggers (economic, environmental, geopolitical, etc.). See WEF Table • Considering the scope and scale of the problem, standard RM tools, both micro- and macro-prudential, appear by-and-large unable to cope with managing risk interdependence and uncertainty

11. The Blueprint for Systemic Risk

12. The Risk-Trends InterconnectionsMap 2019

13. The Risks of RM Failures • RM hasbecome a source of uncertainty. There are risks, and economicconsequences, associated to RM gaps and inefficiencies. I willdiscuss a fewexamples. • Forecasting errors. Bruegel (2018): «ECB huge forecasting errorsunderminecredibility of current forecasts» (seeGraph). Core inflationremainedbroadlystableat 1% despite the stubbornlypredictedincrease, while the unemployment rate fellfasterthanpredicted. The ECB is one of the best forecasters. Others (central banks, international organisations, private agencies) made evenworsepredictions. • Forecasting errors (e.g. IMF overoptimism in economicprojections) can lead to uncertainty shocks with «sharpsignificant output drops asfirmspostpone investment decisions» (Ball 2009). Uncertainty shocks produce largerdecline in real activity followed by weaker recovery in emerging market economies (IMF 2016).

14. ECB MacroeconomicProjections for the Euro-Area • Core Inflation • Unemployment

15. Navigating with a MacroeconomicCompassPointing to ShiftingDirections! • ThisishowJ.Powell, the Governor of the Fed, decribed «navigation» in monetary policy, as a verychallengingendeavour. He spoke of «shifting stars duringnormalisation»: «According to the conventional thinking, policy-makers should navigate by the stars». Thisrefers to the importance of «starred» variables (the natural rate of unemployment, the neutralinterest rate and the target rate of inflation) in guidingmacroeconomic policy manoeuvring. • Butassessments of the value of the «stars» are often imprecise volatile and subject to significantrevisions. Thereforemonetaryauthorities end up navigatingperilously: between «the shoals of overheating and the premature tightening». • In practise, policy decision makers must haverecourse to euristics or use opportunistically a broad range of indicators and plausiblescenarios. They are increasinglyexposed to the risk of mis-perception and mood swings. Theytend to be overcautious and slow-reacting.

16. Lont-Term Investment: the Vicious Circle of RM- and Policy-Failures • Growinguncertaintyhasfavored a shift towards short term low risk low yield investment. Thishashadseriousconsequences, asunderinvestment, particularly on SME and infrastructure, isat the root of stagnatingproductivity and sluggishgrowth (seeTable) • Long Term Investment (LTI) isparticularlyweak in Europe, hereitisstillbelowpre-crisislevels, eventoughrequirements are risingfacing the greater challenges in risk scenarios (aging, climatechange, migration and geopoliticalthreats, growthpotential, etc.). • Have policy responsesbeenforthcoming, and adequate? A recent report (De la Martinière 2018) hassharplycriticisedit, sayingthattheywereeven counter-productive. Austerity induced public investment cuts, deleveragingaffecting corporate investment, accomodative monetary policies flattening the interestrates curve and slashingilliquiditypremiums, macroeconomicuncertaintieslinked to geo-politicalslippages, etc.: the environment for LTI deterioratedsignificantly, causingincreased risk aversion, low R&D expenditures, feeble equity markets and slim venture capital.

17. Gross Fixed Capital Formation (growthrates)

18. Financial StabilityRegulationFeedingUncertainty • More specifically, measures in support of financialstabilityhaveultimatelyundermined LTI: e.g. accounting standards (mark-to-market), solvency capital requirementsthatconsiderliquidity the mainprotectionagainst risk, penalization of equity, securitization and infrastructure investment, penalisation of research (under Mifid 2 the cost of financialanalysisissubject to the provisionsapplicable to management fees), etc. • The outcome of thisunfavourable LTI environmentisconsequencial: LT investors (insurers and pension funds) havewithdrawn from the securitization market and from equity investment (the equity portfolio of insurersdropped from over 20% of assets to 10% in 10 years), R&D and social infrastructureswent down, shareholdingamong Eurozone residentsfellbetween 2000 and 2017 by more than 10 pp of GDP, cross-border financing hasgone down (fragmentation). • J.DeLarosièreconcludes: «Thisiswhy, in spite of unprecedentedstrengthening of financial institutions’ prudentialconstraints, confidence continues to be lackingamonginvestors and supervisory authorities – whoseconstantaddition of supplementaryregulatorymechanisms (loss-absorbingcapacity, stress testing, continuity plans, …) demonstratethat the economy isstillat risk». • The paradoxisthat the response to uncertainty by policy and regulationcontributed to increaseuncertainty (vitiouscircle). RM failurecompounded with regulatory and policy failuresbecamea source of uncertainty.

19. LTI in the Euro-zone • Gross Fixed Capital Formation (2008=100) • Shareholding among Eurozone Residents (in % of GDP)

20. Inadequate Policy Responses and UnmanagedUncertainty, Fear and Anger • Policy responsesto the new risks scenarios (interdependence) havebeen by-and-large inadequate – notonly in Europe. They can be grouped and summed up as follows: - micro-prudential; - macro-prudential; crisis management (resolution, deposit insurance, etc.); - structuralconstraints (separation of proprietary trading, commercial versus investment banking); SIFIs (too big to fail); - organisational (monitoring, analysis, early warning, etc.); - capital flows management measures; - cross-border (G-20, IMF annual report, coordination –see BIS) • Mostcommentators support a holisticapproach(banks, capital markets, realestates, etc.). But in general itisnotholisticenough. • Mainmissing links are: 1. thosebetween the financialsector, the real economy and societal stress/vulnerabilities (economic and social policies); 2. thosebetweenindividual institutions, local-national - and international/global dimensions. • Severalmeasuresaddressinterdependence with a backward-looking, avoidant, almostdenyingperspective; ie. by reducinginterdependence. The intentionis to regain control, pursueindependence, go alone, etc. For instance: retrenchingwithin national jurisdictions, limits to capital flows, building operational firewalls, sand-boxing innovation, breaking global value chains, evenprotectionism. But the potentialcollateraldamageisgreat, and often tools miss the point. • Ultimately the outcomeisgreateruncertainty. • Unmanageduncertaintiesis –in myview- one of the root causes of emotional/irrationaleconomicdecisions, populism and the failures of liberal democracies.

21. A Comprehensive Response to UncertaintyRequiresFocusing on Economic and Social Policies • J.DeLarosièreclearly points out the direction to follow: «In order to exit the viciouscircle…, the overridingpriorityshould be to structurallyreformoureconomies. Thisnotablymeansreducing budget deficits, excessivelevels of indebtness and balance of payments imbalances, the primarythreatsfacing LTI. …public policy must enhance the growthpotentialof Europeaneconomies … stimulateinnovation … developproactiveeducation and training programmes …reduce inequalities…» (op.cit.). Thisbroadconclusion in a technical report devoted to obstacles to LTI created by accounting and prudential frameworks shouldnot be consideredsurprising. • Managinguncertainty in factmeansgoverninginterdependence. Itisthereforedifferent, muchbroader and more complexthanmanaging risk (remember F. Knight). The role of public policy and the governance aspects are key to this task that calls intoquestion the responsibility of both private and public players, and their partnership.

22. The Public Policy Task of Dealing with Uncertainty • A credibleresponse to uncertaintyrequires a robustinfrastructure of public policy for severalreasons (seealso Keynes -Treatise on Probability-): - There are significantspillover and externalities, both positive and negative. Costs of uncertainty are oftenborn by people notdirectlyinvolved or by society as a whole. Idem for benefits. – changesneed long gestation to mature; - trasformations are so deep and wide thatonlypubblicefforts can sustainit (energy or demographictransitions, low carbon and circular economy, peace building or constitutionalreforms, etc.); - strong ethicalfoundations are required; - consistency with structuralreforms and socio-economic policy adjustments. • The market alone isunable to face up to those challenges. Weneed incentives, tax/subsidy tools, safety nets, education and public information, a change of culture (resilience), social capital (trust). Eg. compulsory insurance • Butalso the market has an importantrole. Weneed a new public-private partnership approach, to build a multipillar system of interdependentprotection or risk sharing mechanisms: public welfare, private insurance –financing, self-protection (market discipline). The case of pensions, health, disasters, long-term care, securitisation, impact investment, green bonds, etc.

23. Best Practise: the EuropeanEconomic and Monetary Union & the Capital Markets Union • The EU has put LTI financing (InvestEU) and the development of integrated capital markets (CMU) at the center of its strategy for economicgrowth and stability (EMU). • CMU has the objective of providingadditional sources of funding to the real economy, particularly SME and infrastructure. The related action plan foresaw 33 action points, with a focus on fintech, sustainablefinance, personal pension products, securitisation, a review of the institutionalarchitecture of regulation and supervision, and an ambitiousstandardisationprogramme, includigncontroversialareassuchas corporate taxation and insolvency). • To succeed, this project needsleapforward in fiscal union (ESM, SRF, EDIS, stabilisationfunction, etc.), transfer of prerogatives to the Europeanlevel, European «safe assets», etc., i.e. economic and institutionalreformsthat can promotegrowth and stability. • Thisdevelopmentisencountering –asexpected- considerableresistance and delays. Butitis the rightapproach to deal with interdependence and the root causes of uncertainty.

24. Actuariesas Risk Interdependence Managers and Stakeholders of Socio-Economic Policies • The new contextcreatesgreat challenges (e.g. growingfrustration and customers’ dissatisfaction), butalsogreatopportunities: new centrality of risk professions and tools, greater policy relevance and visibility, more strategicmanagerial and innovative tasks, greaterrecognition and credibility. • Actuaries are engaging in a muchwider and complex agenda of resilience and risk frameworks affectingnorms, tools and skills, wellbeyond the traditionalboundaries of risk management, and reaching out to social and economic policies. • Thisopens up new horizons for actuaries, in relation to skills, partnerships with other scientists and professionals, interplay with private and public decision makers, engagement in public policy (e.g. financialinclusion, sustainability and education). • Itrequires strong foundations and insights notonly in hard science butalso in social science, openness to innovation, technology and research, a sense of public purpose, leadership and commitment to democracy and the public good. • Itrequiresbridging the gap between science and society, management and politics, promises and achievements, demands and responsibilities, the world of risk management and the wide-spread aspiration to security and protection.