Black Swans and global capital markets

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Black Swans and Global Capital Markets: Preparing for the unknowableMarch 2014 Dr. Paul Kielstra

Deutsche Asset & Wealth Management

S2 SPECIAL ISSUE

Black Swans and Global Capital Markets2

Deutsche Asset & Wealth Management’s Global Finan-

cial Institute asked the Economist Intelligence Unit to

produce a series of white papers, custom articles, and

info-graphics focused specifically on global capital

market trends in 2030.

While overall growth has resumed, and the value

traded on capital markets is astoundingly large (the

world’s financial stock grew to $212 trillion by the end

of 2010, according to McKinsey & Company) since

the global financial crisis of 2008, the new growth

has been driven mainly by expansion in developing

economies, and by a $4.4 trillion increase in sovereign

debt in 2010. The trends are clear: Emerging mar-

kets, particularly in Asia, are driving capital-raising; in

many places debt markets are fragile due to the large


Introduction to “Global Capital Markets in 2030“

component of government debt; and stock markets face

weakening demand in many mature markets.

In short, while the world’s stock of financial assets (e.g.

stocks, bonds, currency and commodity futures) is grow-

ing, the pattern of that growth suggests that major shifts

lie ahead in the shape of capital markets.

This series of studies by Global Financial Institute and the

Economist Intelligence Unit aims to offer deep insights

into the long term future of capital markets. It will employ

both secondary and primary research, based on surveys

and interviews with leading institutional investors, corpo-

rate executives, bankers, academics, regulators, and others

who will influence the future of capital markets.

Black Swans and Global Capital Markets3

About the Economist Intelligence Unit

The Economist Intelligence Unit (EIU) is the world’s lead-

ing resource for economic and business research, fore-

casting and analysis. It provides accurate and impartial

intelligence for companies, government agencies, finan-

cial institutions and academic organisations around the

globe, inspiring business leaders to act with confidence

since 1946. EIU products include its flagship Country

Reports service, providing political and economic analy-

sis for 195 countries, and a portfolio of subscription-

based data and forecasting services. The company also

undertakes bespoke research and analysis projects on

individual markets and business sectors. The EIU is head-

quartered in London, UK, with offices in more than 40

cities and a network of some 650 country experts and

analysts worldwide. It operates independently as the

business-to-business arm of The Economist Group, the

leading source of analysis on international business and

world affairs.

This article was written by Dr. Paul Kielstra and edited by

Brian Gardner.

Dr. Paul Kielstra is a Contributing Editor at the Economist

Intelligence Unit. He has written on a wide range of top-

ics, from the implications of political violence for busi-

ness, through the economic costs of diabetes. HIs work

has included a variety of pieces covering the financial

services industry including the changing role relation-

ship between the risk and finance function in banks, pre-

paring for the future bank customer, sanctions compli-

ance in the financial services industry, and the future of

insurance. A published historian, Dr. Kielstra has degrees

in history from the Universities of Toronto and Oxford,

and a graduate diploma in Economics from the London

School of Economics. He has worked in business, aca-

demia, and the charitable sector.

Brian Gardner is a Senior Editor with the EIU’s Thought

Leadership Team. His work has covered a breadth of

business strategy issues across industries ranging from

energy and information technology to manufacturing

and financial services. In this role, he provides analysis as

well as editing, project management and the occasional

speaking role. Prior work included leading investiga-

tions into energy systems, governance and regulatory

regimes. Before that he consulted for the Committee

on Global Thought and the Joint US-China Collabora-

tion on Clean Energy. He holds a master’s degree from

Columbia University in New York City and a bachelor’s

degree from American University in Washington, DC. He

also contributes to The Economist Group’s management

thinking portal.


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4

Black swans: A phrase goes viral

In September 2008, a financial malaise growing for over a

year came to a head. Lehman Brothers’ bankruptcy – the

largest in US history – rocked markets. Existing unease

about possible contagion rapidly transformed into

pervasive fear. Equity markets dropped precipitously;

leading financial institutions in major developed countries

required rapid government intervention to remain

solvent; capital markets, already constricting under

the weight of devaluing sub-prime mortgage backed

instruments, seized up further, thereby threatening

the global economy. Indeed, the latter phenomenon

provided the original name for what was happening: the

credit crunch.

Although the world had seen regional economic melt-

downs in recent times – the Latin American debt crisis and

Asian monetary crisis of the 1980s and 1990s being the

most prominent – when the global financial crisis struck,

its sheer scope seemed unprecedented. At a minimum, the

scope and impact of the latest global crisis had similarities

only to the Great Depression of the 1930s and, perhaps, to

the interlinked, international debt crises of the 1890s. To

such an unusual set of circumstances, it was tempting to

assign a unique cause.

Conveniently, a way to do so seemed to be at hand. The

Black Swan – an unpredictable, high impact event – was a

concept that had recently been popularised by the books

of Nassim Nicholas Taleb, a financial trader turned philoso-

pher. Writing the crisis off as a Black Swan held a certain

emotional appeal: by definition, it would be highly unlikely

to recur. Moreover, if the crisis were truly unpredictable,

and then those involved in capital markets could hardly be

blamed for the losses and damage that resulted.

Steven Culp – managing director of Accenture Manage-

ment Consultancy’s Risk Management Group – recalls that

in 2008 some used such thinking as a partial excuse and

as a way to reassure the world that what was happening

was a one-off, unforeseeable problem. Nonetheless, the

phrase continues to be used too often as a handy justifica-

tion for poor risk management. Indeed, the term is often

applied incorrectly to any extreme event. Using the term

this way, however, represents a misunderstanding of what

Black Swans are, as well as the ongoing challenge which

they present to global capital markets, and how best to be

ready for them.

The Nature of the Problem

In Taleb’s analysis, a Black Swan event has three specific

characteristics. First, it is an unexpected outlier because

“nothing in the past can convincingly point to its possibil-

ity.” Second, it has an extreme impact. Third, in spite of it

being an outlier, “human nature makes us concoct expla-

nations for its occurrence after the fact, making it explain-

able and predictable.” 1

This definition seems to restrict severely what could be a

Black Swan and, therefore, the ultimate utility of the con-

cept. For example, the numerous historical financial crises

before 2008 pointed to the realistic possibility that serious

trouble would eventually recur. Indeed, at the time vari-

ous commentators issued warnings ahead of the event,

for example Taleb himself, who said in 2007 that Fannie

Mae was “sitting on a barrel of dynamite.” More generally,

even the flawed risk models in use at the time included the

possibility of extreme market losses but estimated their

probability as very small, or under the tail of the normal

distribution curve (Accordingly, “tail risk” became another

gift from the crisis to the general vocabulary). Even if

the probability were very poorly appreciated, the models

Black Swans and Global Capital MarketsA collaboration between Deutsche Asset & Wealth Managment‘s Global Financial Institute and Economist Intelligence UnitMarch 2014

Black Swans and Global Capital Markets Global Financial Institute

1 Nicholas Taleb, The Black Swan, (2010 paperback edition), page xxii.

Written by

5 Black Swans and Global Capital Markets

clearly acknowledged the possibility of extensive losses

and therefore of future turmoil in the markets. By this mea-

sure alone, the subsequent crisis would have been a poor

candidate for the label of “Black Swan”.

In another sense, though, the financial crisis was indeed a

Black Swan event, in that even those who were aware of the

risk tended to under-estimate its magnitude. According to

Taleb, the hallmark of Black Swan events is that human

mental maps restrict people from assessing their risks. As

he puts it, “The Black Swan is the result of collective and

individual epistemic limitations (or distortions), mostly

confidence in knowledge; it is not an objective phenom-

enon. The most severe mistake made in the interpreta-

tion of my Black Swan is to try to define an ‘objective Black

Swan’ that would be invariant in the eyes of all observers.”

A major terrorist attack by a relatively unheard of group,

for example, might be a Black Swan for most, but certainly

not for the terrorists themselves.2 In this sense, the global

financial crisis was a Black Swan not because it was impos-

sible for anyone to predict but because the pervasive risk

models of the time so discounted the possibility of trouble

on such a scale as to make it inconceivable to many in the

market, as well as to ratings agencies and regulators.

This was partly because extreme events are sufficiently rare

that modelling them is nearly impossible anyway. It is also

because so many placed excessive reliance on models that

proved to be highly inappropriate and which should have

been seen to be so at the time. David Viniar, then CFO of

Goldman Sachs, reported in August 2007 that during a

week of turbulence “[w]e were seeing...25-standard devia-

tion moves [from the norm], several days in a row.” Never-

theless he believed that the company’s quantitative strate-

gies were sound, if in need of adjustments to account for

certain specific situations.3 He differed from most others

only in having made a memorable quote. The widespread

adoption of David Li’s Gaussian Copula function, despite

its creators own public misgiving, as a way to measure the

risk associated with collateralised debt obligations – fre-

quently made up of bundled mortgages –created wide-

spread belief in the underlying stability of asset prices, and

ultimately of financial markets, that was unjustified for any

number of reasons.

Sadly, what may appear in retrospect as large-scale, self-

induced myopia is far from a one-off occurrence in capital

markets. More recently, confidence in the inevitability of

ever greater European integration did much to blind pol-

icy makers on that continent to the dangers which weak

economies like Greece posed for the common currency –

difficulties which Euro-sceptics of various stripes found it

much easier to perceive, and to warn of at the inception of

the project. More generally, Hung Tran – Executive Man-

aging Director at the Institute for International Finance,

a global association of financial institutions – notes that

major, unexpected crises tend to occur when almost all

actors in the marketplace suddenly change their thinking

on a particular issue. “It is change of mentality or paradigm

or framework of thinking that crystallises tail risks.”

Thus, Black Swans do not provide a fatalistic justification

for those involved in the capital markets, or anybody else,

failing to see that which was impossible to predict anyway.

Rather, they raise at least two crucial, forward-looking

questions. The first is the extent to which the models and

other inputs which shape how we see the world help or

inhibit the discovery and analysis of significant, heretofore

unperceived risks. The second is, given that even with the

best models it is impossible to foresee many novel chal-

lenges accurately, how can companies, and markets as a

whole, be made more robust so that they can weather the

inevitable, unexpected storms.

Are companies better placed to cope?

Preparing for Black Swan events begins, perhaps ironically,

by recognising that they cannot be a leading focus of risk

management. Theoretically, Mr Tran notes, if a company

recognises and correctly assesses an unexpected risk, by

definition that event ceases to be a Black Swan. On the

practical side, Mr Culp adds that “If Black Swans are the

only thing your organisation is focussed on preventing,

a lot of other challenges will trip you up in the interim.

Financial institutions today are rightly focussing more of

their energy on things closer to home than on long tail

events.”

Instead, Mr Culp argues, a correctly configured approach

to risk management, while not a guarantee of safety,

2 Page xxiii.3 “Goldman pays the price of being big”, Financial Times, 13 August 2007.



improves the ability to cope with low probability, high

impact events. “Effective risk management is an everyday

activity,” adds Mr Culp, “maintaining the connectivity with

the business and investing in the culture are critical and

will help to provide early indications of where problems

may be. Through normal, effective risk management, and

the mentality of getting the little things right, you get bet-

ter insights earlier and can course correct to limit exposure

to bigger challenges.”

At least three broad elements of effective risk manage-

ment are central in developing and maintaining this men-

tality. One is taking risk seriously. This on its own can help

tremendously in dealing with unexpected upheavals. An

academic study of US banks, for example, found that those

with independent risk management functions and strong

internal risk controls suffered less during the peak years

of the global financial crisis in part because they were

less likely to invest in mortgage-backed securities and off

balance-sheet derivatives. They also did better financially

during the preceding boom.4

Another element is the need to go beyond box-checking

to operate in the spirit of the law which, says Mr Culp, “gives

a broader understanding of risk in a holistic way.” Finally,

companies need to maintain humility about the extent of

their understanding of the risks they face. Mr Culp recalls

that before the crisis “people often acted as if the models

were reality and gained excessive confidence as a result.”

Since the Financial Crisis, capital market firms have

invested substantially in risk management. Adjusting to

new regulation alone – probably the leading focus of this

activity – has required a massive shift and the changes are

still very much a work in progress. But have the accompa-

nying shifts made companies better prepared for rapidly

emerging risks and the completely unexpected?

Mr Tran sees a mixed situation: “Risk managers since the

crisis have been busy engaging in all kinds of analysis

informed by what went wrong. To that extent, the room

for unexpected events is quite a bit smaller. Having said

that, we can still be surprised by things that can completely

change what we thought.”

Mr Culp also sees hopeful signs but remains cautious.

Driven by both regulatory change and business necessity,

he says, “the understanding of risk and its importance have

dramatically changed at both board and senior leadership

levels. They are much more informed and asking better

questions than pre-crisis. Risk awareness is heightened.”

Unlike in previous eras, where elevated concern about risk

often dropped during periods of economic growth, Mr

Culp also hopes that the structural changes of recent years

– such as the greater number of Chief Risk Officers on at

the leadership table – will give some permanence to this

appreciation of risk as a critical function.

Companies also seem to be taking steps toward a more

holistic understanding of risk and have a healthier appreci-

ation that models are not the same as reality. Nevertheless,

says Mr Culp, “the core of the weakness [in risk manage-

ment] remains around complexity.” Better data gathering

and the elimination of data silos is occurring, but how best

to turn these mountains of information into insight is an

ongoing challenge. Overall, he believes that “We are defi-

nitely moving in the right direction. In terms of levels of

capital, investments in talent, connectivity with regulators,

sharing of information, we are in a better place. The real-

ity is, though, that the broader economic situation does

remain fragile and the regulations are still forming. We are

early into this process.”

Regulating for robustness

What about capital markets as a whole? Although the

Global Financial Crisis revealed any number of weaknesses,

two issues of these could most exacerbate the impact of a

Black Swan event: the greater degree of global inter-con-

nectedness of the national markets than in the past, and

the growth of a variety of private companies into strategi-

cally important financial institutions whose failure would

have potentially catastrophic consequences.

Here again, Mr Tran sees some progress but notes that sig-

nificant issues remain. He observes that the Dodd-Frank

Act has at least put in place a legal framework for a resolu-

tion authority in the United States to manage too-big-to-

fail institutions that get in trouble. European Union propos-

als for a similar body are also progressing. “What is lacking,”

4 Andrew Ellul and Vijay Yerramilli, “Stronger Risk Controls, Lower Risk: Evidence From US Bank Holding Companies”, National Bureau of Economic Research, Working Paper 16178, July 2010.



Mr Tran believes, “is a cross border framework to deal with

global firms.” Failures of the latter would presumably pres-

ent the biggest systemic risks. Similarly, in dealing with the

inter-connectedness of global markets, greater levels of

transparency and disclosure – to provide enhanced under-

standing of how given institutions might be exposed to

any emergent, or other, risk – remains desirable.

Even sensible regulation, though, might unintentionally

bring new dangers. Mr Tran notes that “the thrust of regu-

latory reform has put similar risk-based capital require-

ments on non-bank institutions and inadvertently reduced

the diversity of different institutions. This may risk produc-

ing a more uniform reaction to market developments and

these tend to produce a bigger risk, because if everyone

buying or selling at the same time, you get extreme market

movements.”

Are we better prepared for the next Black Swan?

Companies and regulators have made substantial efforts

to improve risk management. This certainly reduces the

probability of a repeat of a chain of events similar to that

of 2008. The bigger question, however, is how well these

changes will reinforce the system against future Black

Swan events.

At the corporate and market level, the news is decid-

edly mixed. Improvements have occurred since 2008.

Although the undoubted improvement in risk manage-

ment by companies is not designed specifically with Black

Swan events in mind, more businesses should be in better

shape to cope with them once the current wave of change

has taken place. If nothing else, they are more alert to risk

and may even be able to maintain this heightened aware-

ness when good economic times return. Similarly, regu-

lators are at least addressing the “too big to fail” problem,

which can create a disincentive for large organisations to

manage their risks vigilantly. In both cases, progress is

only partial and still has far to go: perfection is never truly

possible in a world where unintended consequences are

common. As one senior banking executive predicted to

the Economist Intelligence Unit in 2011, while lessons can

be learned from the past, “We will mess up in a different

fashion the next time.”

Ultimately, because of they are impossible to predict, the

ability of capital markets to withstand the next Black Swan

will only be apparent once it appears. Given the history of

finance, the safest bet is that one will come along sooner

or later.


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Black Swans and global capital markets

Economy & Finance

Transcript of Black Swans and global capital markets