In Conversation with Paul Shotton, founder of White Diamond Risk Advisory and former Group Head of Market Risk and Group Head of Risk Methodology at UBS, and Global Head of Market Risk at Lehman Brothers
H/K: Paul, thank you for taking the time to speak to us in these unusual times. As a highly experienced leader in risk management for major financial institutions, what have you found most interesting about the last few months? What has surprised you?
PS: The most surprising thing for me as the coronavirus pandemic has unfolded has been the disconnect between financial markets and the real economy. The lockdowns which many governments introduced caused economic activity to fall off a cliff, and the ramifications of the pandemic will cause permanent changes in the way people live and work. In many cases, such as the adoption of technology, the coronavirus is simply accelerating trends which were already well under way, so the continued outperformance of the large tech companies is understandable, but the recovery of the stock market more broadly, and the growth of credit, both based on the liquidity which the central banks have pumped into the markets, implies an outlook which in my view is far too benign.
Whilst we all hope for the speedy development of an effective vaccine which will allow things to quickly return to “normal”, I think we have to recognize the possibility that this may never happen, and that ultimately we will just have to get used to living with coronavirus, as we have done with related viruses such as those which cause the common cold and influenza. Such vaccines as have been developed for the latter are only partially effective at best, with many hundreds of thousands of people dying globally each year. Evidence that some people have caught Covid-19 twice, with small genetic variations between the two instances, indicates that herd immunity through either the development of a vaccine, or through widespread infection, may also not be attained.
Until and unless either an effective vaccine is developed or herd immunity is established, a great many business models will be unviable, and ultimately, since temporary financial assistance from governments cannot continue indefinitely, those businesses will fail. At some point, when we have seen enough businesses close their doors, I am afraid to say there will be a reckoning in the credit and equity markets.
How do you think that policymakers have reacted under the circumstances? Have they been helpful or a hindrance?
In the short term, policymakers have been forced to pump liquidity into the financial system to prevent catastrophic failure, but the problem for the longer term is that this is more of the same drug administered after the financial crisis, off which they have been unable to wean markets during normal times. Since the time of Alan Greenspan as Chairman of the Board of Governors of the Federal Reserve during the market crash of October 1987, central banks have established a practice of flooding markets with liquidity whenever stressed market conditions occur, a phenomenon which became known as ‘the Greenspan Put’, and which practice successive Fed governors have continued. The ‘bailing-out’ of markets has engendered the problem of ‘moral hazard’ in the markets, as mentioned by Mervyn King in 2009. It has driven the process which Hyman Minsky described in the 1970s in his ‘Instability Hypothesis’: that long periods of market stability, including periods of volatility smoothing caused by the actions of the central banks, would encourage increased risk-taking and ultimately beget greater instability.
Each of the monetary policy cycles we have seen in recent years have resulted in lower highs and lower lows in interest rates, weaker economic recoveries, weaker productivity growth, and weaker monetary velocity, all accompanied by an explosion in government indebtedness. Lower interest rates have allowed the proliferation of zombie companies, which has been the cause of lower productivity, and the explosion of debt has been and will remain a drag on future economic growth. Whilst policymakers had few other options available to them when each of these crises hit, the cumulative effect of all the monetary stimulus that has been provided is that the world’s major economies are in a very weak position, and it won’t end well.
How does the coronavirus crisis compare to previous crises you have witnessed, such as the GFC in 2008?
The GFC was essentially a financial market crisis which originated in the US mortgage loan market, the fallout of which hit Main Street indirectly but very damagingly due to the liquidity shock, which was exacerbated by Lehman Brothers’ failure. In contrast, the coronavirus pandemic has a direct impact on the real economy and is much worse in terms of global scale and disruptiveness than anything we have witnessed since the Great Depression. The pandemic has completely upended many businesses which will never recover as business models are changed forever, and there will be major credit losses for banks exposed to those businesses – and we are talking about major companies here across a range of sectors.
One common thread is that the pandemic, and policymakers’ actions in response to it, will exacerbate existing trends in place since the GFC, such as that of greater wealth disparity. Just as central bank action in the GFC was seen to be ‘bailing out’ Wall Street whilst Main Street took the hit, the continuation of essentially the same monetary policy prescription has boosted asset values and the wealth of the 1% who are already rich, and those whose jobs allow them to work from home have seen relatively little impact from the crisis. Once more, Main Street is carrying the greater burden and is suffering a much greater impact. I believe the policy failures which led to the GFC and the actions taken in its aftermath have led directly to the rise in political extremism in the US and other industrialized economies, which are being exacerbated by the actions taken in response to the pandemic. Again, I don’t believe it will end well.
These are some fairly alarming predictions you’re hinting at, but it has to be said, there’s a level of general instability / vulnerability out there that is increasingly hard for the average businessperson to ignore. What would you be advising your peers in leadership roles to be focused on at this point?
Risk managers are a bit like goalkeepers, in the sense that they are a backstop against failure by front-line team members. A period of market crisis brings to light whether the risk manager did a good job by putting in place robust risk control frameworks during more benign times. During stressful times, it is easy to convince management of the need for strong risk controls and good risk managers can easily demonstrate their worth. As Rahm Emmanuel famously said: “Never let a serious crisis go to waste!”
Paradoxically, it is during more benign times when risk managers may be challenged over the costs of their operations and the tight reins they may be trying to exercise over the business, which is another an example of Minsky’s Instability Hypothesis. As Chuck Prince, then CEO of Citi, said, just as the Global Financial Crisis was erupting: “As long as the music is playing, you’ve got to get up and dance!”
Businesspeople need to carry on doing business, or attempting to, but there are more shoes to drop at this point in terms of the economy and the markets, so commercial leaders such as CEOs and their revenue-generating management team members should maintain a healthy awareness of this and a decent level of respect for the risk’s team’s ability to avoid pitfalls, both obvious and concealed. Market liquidity can disappear in an instant, and fresh capital can suddenly become unobtainable except at usurious rates, so at this point I would advise risk managers to keep limits tight and exposures close to home. As they say, revenues are vanity, profits are sanity, but cashflow is reality, and whilst a simplification to use such a word in terms of the capital movements across and among the components of the global economy, cashflow is potentially where the real challenges might arise over the months to come from one business to another.
What black swan events might we see over the coming 12-24 months as the world returns to a semblance of normality?
The future is fundamentally unknowable, but it remains to be seen if the ‘old’ normality ever returns. Coronavirus has given rise to what are probably permanent changes in behaviour and the acceleration of pre-existing trends, as a result of which, many existing businesses are no longer viable. Central banks’ liquidity provisions and government handouts may simply postpone the reckoning and delay the Schumpeterian ‘creative destruction’ which is necessary for a healthy free-market capitalist economy. Then again, is that what we will have in future? Perhaps not.
In an article published in 2010, Carmen Reinhart and Kenneth Rogoff argued that in advanced economies, once the government debt to GDP ratio reached a level of ~90%, the accumulation of more debt would provide an extreme constraint on economic growth. As a result of the pandemic, the debt to GDP ratio now exceeds 90% in the US and several other industrialized economies, including the UK, and it remains to be seen how this debt overhang may be dealt with. Historically, such levels of indebtedness resulted in inflation (which central banks are desperately trying to create, so far without success), outright default in the case of countries like Argentina, or some kind of managed repudiation, such as a ‘Debt Jubilee’. Excessive debt has disappeared from the political dialogue in the US, though, particularly with a specialist in debt management occupying the position of Commander-in-Chief since 2016, so it wouldn’t be a surprise to me if something in this area led to a major ‘black swan’ event in the coming years.
What changes in risk management practices do you foresee as a consequence of the coronavirus pandemic?
Good risk management has always been about ensuring that risks are identified, measured, monitored and controlled within the risk appetite of a given organization. In recent years there has been ever-greater focus on quantitative models and leveraging the techniques of artificial intelligence to forecast markets and as the basis of risk models, and the trading and risk management disciplines have seen an influx of people with quantitative training in statistics and computing. However, economies and markets are examples of Complex Adaptive Systems which obey power laws and cannot properly be treated as combinations of linear components, which are the basis for many of the models the industry uses.
The use of statistical models is based on the assumption that historical data may be used as a proxy for the distribution of events from which future market action may be drawn, but the fact that markets are adaptive and change over time means that this assumption is inherently invalid. For these reasons, despite the recent focus on quantitative methodologies, it is my belief that risk management will forever remain as much an art as it is a science, which is why experienced market practitioners make the best risk managers. Extreme stress events, such as those we have seen in the markets as a result of the pandemic and like those during the GFC, may help to drive this message home.
Will these changes be accompanied by a period of prosperity for markets and the financial industry in general, or do you think conditions will generally be more difficult than they have been?
It has become a cliché that in crisis there is opportunity, but indeed crises such as the pandemic will always create and accelerate new market opportunities, just as they kill and accelerate the destruction of established businesses.
For many years, financial markets have ridden a wave of liquidity, as the excesses of inflation resulting from the oil shocks of the 1970s were wrung out of the system. The financial industry has benefited enormously from the bull markets in equities and credit which resulted from this. Now however, for the reasons of excessive indebtedness which I have explained, this period of prosperity is coming to an end. Ray Dalio of Bridgewater Associates writes of the debt super-cycle; other authors refer to the ‘Fourth Turning’, or the ‘Great Reset’. More information on this can be found here: https://www.weforum.org/great-reset/. In time, these periods too, will pass, and the good news is that beyond the immediate and fairly significant period of discomfort that we collectively face ahead, I posit that longer-term, technology developments promise a great future!