Financial markets have a very safe way of predicting the future.

George Soros is interviewed in Der Spiegel and says all sorts of entertainingly outrageous things, but my favorite line is about whether the U.S. will have a recession.

 

"The indebtedness of the U.S. is not all that high, but if a double-dip recession  was in doubt a few weeks ago, it is less in doubt now, because financial markets have a very safe way of predicting the future. They cause it. And the markets have decided that America is going to see a recession, particularly after the recent downgrade of the U.S. by the rating agency Standard & Poor's," Soros says.

 

That's the shortest version of the concept of reflexivity I've ever come across.

 

In that interview, Soros also pins the European financial crisis squarely on the back of German Chancellor Angela Merkel.

 

SPIEGEL: Is the current crisis even worse than the one in 2008?

Soros: This crisis is still the continuation of the same crisis. In 2008, the financial system collapsed and it had to be put on artificial life support. The authorities managed to save the system.

But the imbalances that caused the crisis have not been removed.

 

SPIEGEL: What do you mean?

 

Soros: The method the authorities rightly chose three years ago was to substitute the credit of the state for the credit in the financial system that collapsed. After the failure of Lehman Brothers, the European financial ministers issued a declaration that no other systemically important financial institutions would be allowed to fail. That was the artificial life support; it was exactly the right decision. But then Chancellor Merkel stated that such support would only be granted by each EU member state individually, and not by the European Union.

 

SPIEGEL: That undermined the concept of a strong European response to the crisis. Has that been the biggest mistake so far?

 

Soros: That Merkel statement was the origin of the euro crisis. It shattered the vision that the EU will protect the euro in a joint effort.

Oh, and he also hints that China is propping up the euro because it wants an effective alternative to the U.S. dollar.

 

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Euro crisis 'poses severe risk' to UK

Wednesday, August 17, 2011

By Alex Brummer, Daily Mail, London

Aug. 17--Sir Mervyn King has warned the Chancellor that the eurozone crisis is a major risk to Britain and that he is prepared to ease monetary policy further despite the latest rise in inflation.

The Bank of England governor's comments are contained in a letter to George Osborne which was published after the government released the latest inflation figures showing that consumer prices rose to 4.4pc in July after falling back slightly in June.

In the letter, the governor acknowledges that the Bank expects inflation to rise to 5pc later this year before falling back in 2012.

King's letter contains the strongest words to date on the danger to Britain's economic recovery from the problems in the 17-country eurozone.

"There is a risk that this could lead to further severe stress and dislocation in financial markets and, were this risk to crystalise, it would have a significant impact on the British economy," the governor says.

The caution of the Bank of England suggests that the official bank rate, currently pegged at 0.5pc, could remain at that low level for the foreseeable future.

King also makes it clear that if necessary the Monetary Policy Committee, which sets interest rates, would be ready to engage in further asset purchases -- quantitative easing -- to try and boost output. But he admits that there is a "limit to what monetary policy can do when large real adjustments are required."

The low interest rate message will come as a relief to households with mortgages who have been able to use lower repayments to offset the higher prices cascading through the economy.

But it will be another blow to savers, particularly those in retirement, who must watch inflation denude their nest eggs. They will find it almost impossible to obtain real returns -- those above inflation -- on their deposits with banks and building societies.

The Office for National Statistics reported that the higher prices in July were the result of prices being restored to normal in the shops after heavy discounting and sales in June.

The public will be enraged to learn that another factor was higher charges imposed by the banking sector. Inflation can be expected to surge ahead next month when the latest round of gas and electricity prices -- ranging from 11pc to 19pc -- start to feed through to domestic utility bills.

The Bank of England is, however, hopeful that inflation will ease later in the year as lower oil and commodity prices, which are falling because of a softening world economy, cool the upward pressure.

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Re-levering Beta

When assessing the value of a company’s operations the free cash flows need to be discounted using the weighted average cost of capital (WACC). The weighted average cost of capital is calculated using the cost of equity and cost of debt weighting them by their respective proportions within the optimal or target capital structure of the company, i.e.


WACC = E/(D+E)*Cost of Equity + D/(D+E) * Cost of Debt, where E is the market value of equity, D is the market value of Debt.


The target or optimal capital structure of the company is one where the WACC is minimized which would result in the maximization of shareholders’ wealth.


 The cost of debt can be observed from bond market yields. However the cost of equity may be estimated using the Capital Asset Pricing Model (CAPM) formula, specifically


Cost of Equity = Risk free Rate + Beta * Market Risk Premium


Beta in the formula above is equity or levered beta which reflects the capital structure of the company. The levered beta has two components of risk, business risk and financial risk. Business risk represents the uncertainty in the projection of the company’s cash flows which leads to uncertainty in its operating profit and subsequently uncertainty in its capital investment requirements. Financial risk represents the additional risk placed on the common shareholders as a result of the company’s decision to use debt, i.e. financial leverage. This is because with the addition of more debt to the structure the residual claim of the shareholders becomes less certain and hence more risky.


If the capital structure comprised of 100% equity then the beta would only reflect business risk. This beta would be unlevered as there is no debt in the capital structure. It may also be known as the asset beta.


To obtain the equity beta of a particular company, we start of first with the portfolio of assets of that company or alternatively a sample of publicly traded firms with a similar systematic risk. We will first derive the betas of these individual assets or firms from market prices. The derived betas are levered betas as they would reflect the capital structure of the respective firms. They would need to be unlevered so as to only reflect their business risk components. From the unlevered betas a weighted average unlevered beta will be obtained using as weights the proportions of the assets in the company’s asset portfolio or an average across all comparable firms will be derived. The weighted unlevered beta thus obtained would now be re-levered based on the capital structure of the company in order to determine the equity or levered beta for the company, a beta that reflects not only the business risk but also the financial risk of the company.


Un-levering and re-levering beta may be done in a number of ways. A method employed by practitioners gives the relationship between un-levered and re-levered beta as follows:
Levered Beta = Unlevered Beta * (1+D/E), where D/E = Debt-to-Equity Ratio of the company.


The practitioner’s method makes an assumption that the corporate debt is risk free. If corporate debt is considered risky then another possible formulation is:


Levered Beta = Asset Beta + (Asset Beta – Debt Beta) * (D/E) where Debt Beta is estimated from the risk free rate, bond yields and market risk premium.


The above formulations do not incorporate the impact of corporate taxation, i.e. the fact that debt returns tend to be tax deductible. In order to consider the impact of taxation the following adjustments will be made in the relationships given above:


Under the practitioner’s method:


Levered Beta = Unlevered Beta * (1+D*(1-T)/E) where T is the tax rate.


Under the risky-debt formulation:


Levered Beta = Asset Beta + (Asset Beta – Debt Beta) * (D/E)*(1-T).


And WACC would be equal to E/(D+E)*Cost of Equity + D*(1-T)/(D+E) * Cost of Debt.


A simple example of un-levering and re-levering beta is given below:


NewCorp is a corporation of personal hygiene and medical subsidiaries. We are estimating its levered beta for the purpose of determining its cost of equity. The personal hygiene subsidiary is worth USD 20 million while the medical subsidiary is worth USD 30 million. The firm has a debt-to-equity ratio of 1. The tax rate for all firms is assumed to be 30%. The risk free rate is 7% and the market risk premium is 6%. The following information has been obtained of firms with comparable systematic risk:

Comparable Firms	Average Beta	Average D/E Ratio
Personal Hygiene	0.9	20%
Medical	1.2	60%

Note that the average betas above denote the average of the levered or equity betas of these firms.


In the first step we will calculated the unlevered betas for each group of firms using the practitioner’s method:


Unlevered Beta for the personal hygiene business = 0.9 / (1+ 0.2*(1-0.3)) = 0.79


Unlevered Beta for the medical business = 1.2 / (1+ 0.6*(1-0.3)) = 0.85


We will then calculate the unlevered beta for NewCorp. This will be the weighted average of unlevered betas where the weights are taken in proportion to the subsidiaries value in the firm, i.e.


Unlevered Beta for NewCorp = 0.79*20m/50m+0.85*30m/50m = 0.82


Levered Beta for NewCorp = 0.82*(1+1*(1-0.3)) = 1.40


Cost of Equity = 7%+1.40*6% = 15.39%.

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How Banks Can Confront the Unknown

Financial services firms well understand that they operate in an environment of risk and uncertainty. In recent years, however, a new breed of risk -- more ominous than what banks have historically faced -- has appeared. It can take the form of risks without historical precedent (such as the September 11, 2001, terrorist attacks) or those that exceed commonly anticipated "worst case" scenarios (such as $200-a-barrel oil).


By their nature, emerging risks are not well understood, are linked to other risks, cross multiple geographies and tend to be outside the scope of any organization. Their systemic nature and severe potential impact can, unfortunately, be devastating to financial institutions.


Accenture recommends integrating emerging risks into a firm's existing enterprise risk management framework and embedding emerging risks into an organization's business planning, execution and evaluation process.


While financial firms are usually not in a position to prevent geopolitical disturbances, global resource shortages and worldwide demographic shifts, they can -- and should -- seek to minimize the effects of such developments. Indeed, institutions that anticipate and effectively manage emerging risks may even discover business opportunities.


The potential competitive advantages are not limited to avoiding the devastating effects of the next major event. Rather, leading companies are making gains by moving quickly on opportunities presented when emerging risks have materialized.


A major North American bank, for instance, was able to make a key strategic acquisition during the turmoil following the collapse of the subprime mortgage market and the subsequent credit crisis. The bank did so at a time when other banks were folding or divesting portions of their business as a result of the liquidity freeze.


Similarly, in the early 2000s when the U.S. economy soured, an airline made significant gains in market share -- becoming the domestic market leader -- due to its low-cost business model and the success of its fuel hedging program.


The Rise of Unforeseen Events


It is surprising, if not shocking, to look back a little over 30 years and see the difference between what experts thought would happen and what actually happened -- in society, politics and economics around the world. Some problems -- such as rising oil prices -- were with us then and still remain. But there are so many that few could or would have anticipated: the fall of communism in the Soviet Union and the break-up of that country into smaller republics; the rise of the Internet, mobile telephony, social media and a host of other communications and information technologies; the bursting of the dot-com bubble; a tsunami that killed almost 640,000 people in Asia and Africa; the emergence of pandemics such as AIDS, mad cow disease and avian flu; the near-collapse of the world economy in 2008 and multiple crises for the financial services industry, automobile industry and governments; and the Japanese earthquake, tsunami and nuclear crisis of early 2011.


In almost every case, the increase in relationships and dependencies among countries amplified and extended the reach of these events and trends. Inexpensive air travel, for instance, fostered the spread of diseases. The role of the Internet and social media in encouraging and coordinating political activism is well documented. Mobile telephony has brought modern communications to countries that previously lacked land-line infrastructure.


It seems clear that emerging risks will grow in impact and frequency over the next decade because of several intersecting trends:




Climate change will continue to produce abnormal weather patterns, resulting in more natural disasters. In addition, population and economic growth creates regions that are more heavily affected by such disasters.


Dependence on technology will continue to grow as emerging markets become more mature, as mature markets are further saturated, and as more and more commercial and business activity moves online.


Economic, societal, environmental and political pressures will increase over the next 10 years as the world becomes more interconnected. The impact of friction or major disruptions will be more significant.


The global distribution network will become more complex as suppliers and manufacturers of goods become more interdependent, with greater opportunity for risks to manifest themselves.


Global population growth will place ever greater demand on natural resources.






Identifying New Risks




Traditionally, banks have tended to focus on risks that are financial in nature, more easily measured, and with historical precedents. They evaluate unemployment statistics, interest rates, asset valuation, foreign exchange rates, volatility in energy and commodity prices and other factors to develop scenarios that might unfold. The vast majority of the measured risks have occurred in the past; for others, some consensus develops around the idea that they might occur.




Banks are less proficient at measuring emerging risks and therefore must find better ways to predict their impact, particularly with respect to credit and market risk exposure.




Banks should draw upon multiple resources to identify emerging risks and develop responses. Within their organizations, banks can identify enterprise risk leaders and thought leaders, incorporate perspectives from economists and research analysts, expand the monitored and measured scenarios and factors used for sensitivity analysis and stress testing, and conduct scans of media and other indicators of potential risk. Externally, banks should partner with think tanks and consultants, attend conferences and establish networks in support of risk management efforts.




The key question regarding emerging risk is, of course, how to measure and manage events that have never occurred before. Several organizational, process and technology challenges must first be addressed. 






Organizational challenges include creating a mindset that is comfortable with measuring and monitoring the unlikely, given that most risk management efforts today focus on risks with historical precedents or with a high degree of probability. This requires identifying resources with the capabilities to watch for and flag emerging risks; determining responsibility for emerging risk; balancing resources among emerging, strategic, operational, financial and compliance risk management; and establishing incentives to support the management of risks that may not materialize for many years, if ever.




Process challenges include determining the reliability of information to predict the probability of a specific event, especially in the absence of a historical precedent; deciding when action is needed to mitigate emerging risks; communicating emerging risks through the business units; understanding the interconnectedness of risks to current portfolios, strategies and activities; and allocating capital to address the possible impact of emerging risks.




Technology challenges include maintaining the agility needed to measure a wide variety of scenarios and the flexibility to adjust scenarios that are already monitored; limiting the manual effort involved in conducting stress tests, in part to increase the ability to conduct these tests under time-sensitive conditions; and managing an expanding list of risks and setting priorities for monitoring and measuring these risks.




Managing Emerging Risks




Emerging risks should be integrated into the existing enterprise risk management framework and incorporated into the organization's business planning, execution and evaluation processes.




Getting the emerging risks right involves assessing whether existing and emerging risks are a potential barrier to growth. Key considerations include: how to incorporate emerging risks into corporate strategy; how to identify what the firm doesn't know; and how to better understand the complexity and interdependency of risks.




To incorporate emerging risks into the ERM structure, they should be considered as part of the strategic planning process, with a direct link to top-down risk appetite. To accomplish this, firms can initiate brainstorming sessions to gather input from both senior management and associates closer to day-to-day activities. Once the input is captured, it should be thoroughly scanned and analyzed for relevant risk factors.




To identify risks that do not have a historical precedent, financial organizations should consult such additional resources as academics, industry groups and economists. Once the risks have been identified and analyzed, a bank should develop a risk taxonomy, categorizing emerging risks according to a classification system. Finally, financial institutions should look outside their own industry to challenge the norm and ensure that insights from other industries are incorporated into the new model. Risk tolerances can then be set at either the key risk or at the risk category level.




Assessment Methodology




To incorporate emerging risk assessment and response into the ERM framework, decision makers have several tools at their disposal. For example, periodically conducting scenario analysis workshops will help define risks and determine their likelihood, severity and impact, especially if the workshops apply a consistent risk taxonomy. Additional analysis, and exploration of economic, social, political, and technological risks, can help assess the risks' significance, relationships with other risks and implications to the business and its stakeholders.




A decision whether to respond to the risk should be based on its expected impact and probability, in relation to the organization's risk appetite and tolerance for deviation from stated strategic goals. Since many emerging risks will be unprecedented and require a quick response, a predetermined and preapproved action plan can help to mitigate them. Being purely reactive is not sufficient. Finally, based on the identified risks and the response strategies, the firm should establish a buffer by allocating capital against key risks.




Banks must take several steps to incorporate emerging risks into their business planning, execution and evaluation processes. These can be undertaken using the existing risk management framework:




Objective setting. During quarterly strategic planning, the group responsible for risk management identifies high-level goals related to emerging risk. The group also reviews the current list of emerging risks to set or revise tolerance levels.
Event identification. Brainstorming sessions are held with senior management and with risk managers from the lines of business to review the current list of emerging risks and update as required. Risk managers also list risks identified by individuals in the lines of business and review publications and other external sources to supplement the list of identified risks.
Risk assessment. Scenario analysis workshops and event simulations are conducted with experts to discuss identified risks and assess impact and severity. Interconnections with other emerging risks, and with risks in the existing risk library, are determined.
Risk response control. Risks are assessed either at the risk or risk-category level, and appropriate responses are determined. For risks that should be avoided or controlled, a high-level response is predetermined and submitted for executive approval. Risk management by collaboration is also considered.
Information and communication. Periodic communication of the top emerging risks, monitoring strategies and planned response strategy is provided to management and lines-of-business leads to increase awareness.
Monitoring. Previous events are assessed to ensure an accurate picture of the risk landscape. Allocation of resources is reviewed to ensure that adequate resources (people and technology) are dedicated to managing these risks. Additionally, key emerging risks are quantified by connecting them to known risks or by identifying proxy metrics.


While the task of coming to grips with the full range of emerging risks may seem overwhelming, banks can improve their emerging risk management capability by initiating three, small, manageable steps:


Develop consensus that emerging risk is a critical area to understand, monitor, measure and mitigate.
Determine who is accountable for overseeing and managing emerging risk.
Assess whether current risk management practices account for emerging risk topics, and evaluate the maturity of emerging risk management within the organization.


Several initiatives may follow from these first steps, including emerging-risk gap assessment, operating model changes to enable emerging risk management, reengineering of existing ERM processes to accommodate emerging risk, and identifying metrics, management reports and dashboards to assist in future evaluation. Organizations that take action now will be better prepared for whatever risks emerge in a highly unpredictable world.


Steve Culpis global managing director of Accenture Finance and Risk Services.Chris Thompsonis Accenture's North America lead for risk management.

1. Climate change will continue to produce abnormal weather patterns, resulting in more natural disasters. In addition, population and economic growth creates regions that are more heavily affected by such disasters.


2. 
   


3. Dependence on technology will continue to grow as emerging markets become more mature, as mature markets are further saturated, and as more and more commercial and business activity moves online.


4. 
   


5. Economic, societal, environmental and political pressures will increase over the next 10 years as the world becomes more interconnected. The impact of friction or major disruptions will be more significant.


6. 
   


7. The global distribution network will become more complex as suppliers and manufacturers of goods become more interdependent, with greater opportunity for risks to manifest themselves.


8. 
   


9. Global population growth will place ever greater demand on natural resources.

Identifying New Risks


Traditionally, banks have tended to focus on risks that are financial in nature, more easily measured, and with historical precedents. They evaluate unemployment statistics, interest rates, asset valuation, foreign exchange rates, volatility in energy and commodity prices and other factors to develop scenarios that might unfold. The vast majority of the measured risks have occurred in the past; for others, some consensus develops around the idea that they might occur.


Banks are less proficient at measuring emerging risks and therefore must find better ways to predict their impact, particularly with respect to credit and market risk exposure.


Banks should draw upon multiple resources to identify emerging risks and develop responses. Within their organizations, banks can identify enterprise risk leaders and thought leaders, incorporate perspectives from economists and research analysts, expand the monitored and measured scenarios and factors used for sensitivity analysis and stress testing, and conduct scans of media and other indicators of potential risk. Externally, banks should partner with think tanks and consultants, attend conferences and establish networks in support of risk management efforts.


The key question regarding emerging risk is, of course, how to measure and manage events that have never occurred before. Several organizational, process and technology challenges must first be addressed. 



Organizational challenges include creating a mindset that is comfortable with measuring and monitoring the unlikely, given that most risk management efforts today focus on risks with historical precedents or with a high degree of probability. This requires identifying resources with the capabilities to watch for and flag emerging risks; determining responsibility for emerging risk; balancing resources among emerging, strategic, operational, financial and compliance risk management; and establishing incentives to support the management of risks that may not materialize for many years, if ever.


Process challenges include determining the reliability of information to predict the probability of a specific event, especially in the absence of a historical precedent; deciding when action is needed to mitigate emerging risks; communicating emerging risks through the business units; understanding the interconnectedness of risks to current portfolios, strategies and activities; and allocating capital to address the possible impact of emerging risks.


Technology challenges include maintaining the agility needed to measure a wide variety of scenarios and the flexibility to adjust scenarios that are already monitored; limiting the manual effort involved in conducting stress tests, in part to increase the ability to conduct these tests under time-sensitive conditions; and managing an expanding list of risks and setting priorities for monitoring and measuring these risks.


Managing Emerging Risks


Emerging risks should be integrated into the existing enterprise risk management framework and incorporated into the organization's business planning, execution and evaluation processes.


Getting the emerging risks right involves assessing whether existing and emerging risks are a potential barrier to growth. Key considerations include: how to incorporate emerging risks into corporate strategy; how to identify what the firm doesn't know; and how to better understand the complexity and interdependency of risks.


To incorporate emerging risks into the ERM structure, they should be considered as part of the strategic planning process, with a direct link to top-down risk appetite. To accomplish this, firms can initiate brainstorming sessions to gather input from both senior management and associates closer to day-to-day activities. Once the input is captured, it should be thoroughly scanned and analyzed for relevant risk factors.


To identify risks that do not have a historical precedent, financial organizations should consult such additional resources as academics, industry groups and economists. Once the risks have been identified and analyzed, a bank should develop a risk taxonomy, categorizing emerging risks according to a classification system. Finally, financial institutions should look outside their own industry to challenge the norm and ensure that insights from other industries are incorporated into the new model. Risk tolerances can then be set at either the key risk or at the risk category level.


Assessment Methodology


To incorporate emerging risk assessment and response into the ERM framework, decision makers have several tools at their disposal. For example, periodically conducting scenario analysis workshops will help define risks and determine their likelihood, severity and impact, especially if the workshops apply a consistent risk taxonomy. Additional analysis, and exploration of economic, social, political, and technological risks, can help assess the risks' significance, relationships with other risks and implications to the business and its stakeholders.


A decision whether to respond to the risk should be based on its expected impact and probability, in relation to the organization's risk appetite and tolerance for deviation from stated strategic goals. Since many emerging risks will be unprecedented and require a quick response, a predetermined and preapproved action plan can help to mitigate them. Being purely reactive is not sufficient. Finally, based on the identified risks and the response strategies, the firm should establish a buffer by allocating capital against key risks.


Banks must take several steps to incorporate emerging risks into their business planning, execution and evaluation processes. These can be undertaken using the existing risk management framework:

1. Objective setting. During quarterly strategic planning, the group responsible for risk management identifies high-level goals related to emerging risk. The group also reviews the current list of emerging risks to set or revise tolerance levels.


2. Event identification. Brainstorming sessions are held with senior management and with risk managers from the lines of business to review the current list of emerging risks and update as required. Risk managers also list risks identified by individuals in the lines of business and review publications and other external sources to supplement the list of identified risks.


3. Risk assessment. Scenario analysis workshops and event simulations are conducted with experts to discuss identified risks and assess impact and severity. Interconnections with other emerging risks, and with risks in the existing risk library, are determined.


4. Risk response control. Risks are assessed either at the risk or risk-category level, and appropriate responses are determined. For risks that should be avoided or controlled, a high-level response is predetermined and submitted for executive approval. Risk management by collaboration is also considered.


5. Information and communication. Periodic communication of the top emerging risks, monitoring strategies and planned response strategy is provided to management and lines-of-business leads to increase awareness.


6. Monitoring. Previous events are assessed to ensure an accurate picture of the risk landscape. Allocation of resources is reviewed to ensure that adequate resources (people and technology) are dedicated to managing these risks. Additionally, key emerging risks are quantified by connecting them to known risks or by identifying proxy metrics.

While the task of coming to grips with the full range of emerging risks may seem overwhelming, banks can improve their emerging risk management capability by initiating three, small, manageable steps:

• Develop consensus that emerging risk is a critical area to understand, monitor, measure and mitigate.


• Determine who is accountable for overseeing and managing emerging risk.


• Assess whether current risk management practices account for emerging risk topics, and evaluate the maturity of emerging risk management within the organization.

Several initiatives may follow from these first steps, including emerging-risk gap assessment, operating model changes to enable emerging risk management, reengineering of existing ERM processes to accommodate emerging risk, and identifying metrics, management reports and dashboards to assist in future evaluation. Organizations that take action now will be better prepared for whatever risks emerge in a highly unpredictable world.



Steve Culpis global managing director of Accenture Finance and Risk Services.Chris Thompsonis Accenture's North America lead for risk management.

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