In this world of regulated safety it is still possible to push the envelope and put yourself in a life or death situation where only instinct honed by skill and experience plus a little bit of luck will get you out of trouble. And you thought I might have been describing paragliding…
Over the summer I headed off for a week with my paraglider and ultralight camping gear (still a total of 16kg), to Nice with the aim of reaching Geneva 300km to the north by flying, hiking and hitching, courtesy of travel arrangements by MThree Consulting.
During that week I put myself in a number of situations, which to the uninformed would have looked hazardous at best, sheer stupidity at a minimum. I was travelling alone, carrying several times the amount of gear I would normally have had on me, launching from precarious spots in the mountains, occasionally in borderline weather conditions. However before every single attempt I had performed a mental risk assessment (a mini stress test), weighed up all the available information, and sometimes not flown.
As I also consult in the financial risk management space it got me thinking about the corollaries to the banking system and, as my opening statement makes clear, there are a lot of comparisons that can be made (including that to the uninformed some of the decisions look hazardous at best, sheer stupidity at a minimum). So I’m going to walk through some of the risks faced whilst flying and try to explain to my banking friends how paraglider pilots derisk the flight (and to my paragliding friends provide a little insight to how banks manage their risk).
So start by thinking of the market as being equivalent to the weather system. It’s difficult to forecast accurately, it can be subject to severe shocks, and modeling it requires thousands of variables.
The board of a bank has to make daily decisions based on the risk appetite of that bank to help them navigate the market, and they will use a variety of risk reports and possibly a dashboard to support these decisions. Just like a paraglider pilot has to use their judgment to determine if the conditions are flyable, and use a vario and GPS whilst in the air to monitor the flight. Watching weather forecasts a few days ahead is one thing, but only the weather on the hill at the time you want to fly is relevant to how much risk you will actually be taking that day. Once you are airborne a sudden change in weather conditions can have a huge negative impact on your altitude (think of this as your capital) and even put you on the ground (make you bankrupt). Effectively this is the equivalent of Market riskwhere changes in financial market prices and rates will reduce the banks capital position. Basis risk is one type of market risk where there is a breakdown in the relationship between a product marketed by the bank and an instrument used to hedge its risk. For a pilot this is where the weather has deteriorated compared to the expected forecast.
So if the pilot is the board, and the weather is the market, what is the paraglider? Initially I thought of it as the bank itself, but actually it is more like the counterparties that a bank is exposed to. Credit risk faced by a bank is the risk that the credit quality of a counterparty (somebody that the bank has invested in) will be downgraded by a ratings agency or by the banks own credit assessment processes, and therefore devalue the banks position (you are worth all the money you have lent everybody, if the chance of them repaying you is reduced then you are only worth what you are likely to be able to recover). If you are flying in a fairly unstable air mass you will experience some bumpy moments, and get the odd small asymmetric collapses of your canopy. Handle these poorly and you’ll make the situation worse. Deal with them in a confident but sensitive fashion and you’ll continue on your path. Hmm – I seem to have digressed to customer management?
Small blips by counterparties won’t have an overall effect on the bank, but a major collapse of an institution (think Lehmans) can have a catastrophic effect requiring the use of a fiscal reserve parachute, equivalent to a full stall with twisted lines, also requiring the use of a reserve parachute.
Paragliders have to top up their height (capital) constantly by looking for thermals and following them up to cloudbase from where it might be a while to the next thermal, or by following a ridge and getting frequent top-ups from the dynamic lift. In a similar fashion banks face Funding liquidity risk, which is their ability to raise cash at regular intervals to roll over debt, or meet cash, margin and collateral requirements of counterparties.
Trading-related liquidity risk is the risk that an institution can not execute a transaction at the prevailing market price because there is no appetite for a deal on the other side of the market. For a pilot the same happens when you reach cloudbase and you are looking around for your next climb. You need to invest some of that altitude in a glide to the next thermal trigger (think heat spots, brown fields, combine harvesters). However if that investment doesn’t get a return from the market you’ll find yourself on the ground again.
Paragliding is often compared to three-dimensional chess and as a result small issues can have large impacts. This might be due to pilot input (fat fingers), flat instrument batteries (inadequate systems), contravening restricted airspace (management failure), line breakage (faulty controls as pre-flight checks might have spotted it). Incorrect input during recovery from a small issue can exaggerate the effects or even transition to a full cascade from which recovery may only be affected by use of the parachute. All of this describes theOperational risk faced by a bank that can have devastating effects on the business (remember Nick Leeson and Barings where there were faulty controls and no segregation of duties in place).
Banks have a regulatory requirement to report their current exposure to risk on a monthly or quarterly basis (depending on the regulator). This is the same as a pilot reviewing their GPS flight logs to see where they have been. Sensible pilots will annually participate in an SIV (Simulation d'Incident en Vol) course where they practice recovery from various collapse scenarios. Again depending on the applicable regulators a bank will be required to perform one of more annual stress tests measuring their capital (altitude) under a number of defined artificial scenarios.
So there we have it. To the uninformed observer it would look like unnecessary risk was needlessly being taken, whether by a paraglider pilot or the board of a bank. However probe a little deeper and instead it would seem that a significant amount of risk assessment precedes every investment decision, whether that be a financial transaction, or to take that step off the hillside.