Read Taleb’s Black
Swan?....twice?…..so now what?*
* The Black Swan – The
Impact of the Highly Improbable, Nassim Nicholas Taleb 2007, Penguin Books
The Black Swan is an enthralling and instructive
read for anyone concerned about future risk; such as any Credit Risk
Executive or Chief Financial Officer.
A thorough study of this work and its predecessor Fooled by
Randomness is highly recommended. Nassim
Nicholas Taleb (NNT) draws together a large number of references and
anecdotes to illustrate his points. He
repeatedly attacks the received wisdom of those who model the future and
who, being lulled into a false sense of security by the elegant
mathematics of their models, are repeatedly surprised when the future does
not adhere to their script.
In essence NNT persuades the reader that the most
impactful social and technological changes – the changes that will
drastically alter the course of future history - cannot be predicted since
they are ‘unknown unknowns’. Such
events – which he calls Black Swans – will happen for the first time
so cannot be imagined in advance, and cannot be predicted by models that
extrapolate forward the past. The
past cannot be a basis on which to predict the future; ask any turkey just
before the butcher’s cleaver falls if he thought his today would be any
different from the preceding 1000 days when he ate heartily and potted
around a garden or dozed in the sunshine….
With such thoughts in mind, NNT is particularly
critical of the use of past trends and volatility statistics to model
future risk probabilities. The
omnipresent use of Value at Risk (VaR) and Credit Value at Risk (CVaR)
calculations to ‘predict’ future losses, with 95% or 99% confidence,
NNT shows to be particularly dangerous; as has proved to be the case time
and again. Yet the majority of
academics and the decision makers they train persist in the use of VaR and
CVaR - by inference bowing at the Alter of the ‘bell curve’ –
because ‘The demand for certainty is one which is natural to man…’
(Bertrand Russell) even if that certainty is built on mathematical models
that cannot predict pivotal events. Thus
building on sand, trusting in false predictors, all of the unconverted –
those who chose to ignore Benoît Mandelbrot’s theories as expounded by
NNT in The Black Swan – created the instruments and conditions that
caused the global financial firestorm (Credit Crunch) that followed the
collapse of US house prices and the bankruptcy of Lehman Brothers.
NNT refers to the ‘bell curve’ as ‘that great
This is all very interesting however the burning
question after reading this seminal work is; what does it mean for someone
in the business of Credit (Performance and Payment) Risk Management?
The Black Swan reaches its conclusion in Chapter 13
– six chapters before the end – where NNT offers advice for dealing
with Black Swans first in respect of ‘small matters’ and second in
respect of ‘large and important decisions’.
In this respect the advice is to go with your
instinct in, for example, planning a picnic next Sunday, or relying on
your train to be on time on Monday, depend on your DNA programming and
accept the risk of being fooled by the future.
If you take any other approach you will find it impossible to make
even the smallest decision; a condition that has been referred to as
It is true that no one can know the future – since
it is evident that the future has not yet occurred – but for the most
part we have to ‘take a risk’ and plan regardless; we must count on
our ability to adapt to minor unexpected inflections should they occur.
Decisions such as; whether to agree to a fixed price
commodity swap maturing in monthly tranches over two years, commencing one
year in the future. Similarly
decisions like; whether to deliver a cargo of commodity FOB (Free on
Board) against the buyer’s promise to pay 30 days after transfer of
title, call for a different approach.
Here it is useful to quote NNT directly:
‘Knowing you cannot predict does not mean that you
cannot benefit from unpredictability.
The bottom line: be prepared! Narrow-minded
prediction has an analgesic or therapeutic effect.
Be aware of the numbing effect of magic numbers.
Be prepared for all relevant eventualities.’ (The Black Swan, NNT
2007, Penguin Books, page 203)
Black Swans can be positive as well as negative,
depending on your circumstances; Black Swans are also ‘scalable’,
meaning the consequences positive or negative, have unknown limits.
Prior to the earthquake that struck
in 1995 the Japanese authorities channelled most resources into efforts to
predict when and where earthquakes would strike.
proved that predicting every quake is an impossible task.
The city was devastated by an unheralded quake, many buildings and
an elevated expressway collapsed, and firestorms raged. As
a result the authorities switched resources to focus on preparation for
dealing with earthquakes when they occur, wherever they strike.
This has led to a two prong approach, firstly to stepping up
efforts to ensure that built structures are able to withstand sever
quakes, without suffering structural damage, and secondly to improving the
ability of local authorities and emergency services to deal with the
aftermath of a quake.
Beyond preparation, NNT suggests what he calls the
‘barbell strategy’. This
is a strategy which in one aspect is extremely risk averse and yet at the
other end wildly risky; thus opening one up to all of the possible upside
if a Black Swan event occurs, while simultaneously protecting against
suffering unbearable losses.
Thus in 1976 when Dame Anita Roddick was struggling
to establish her then somewhat eccentric Body Shop business, her friend
Ian McGlinn invested £10,000. McGlinn
probably mentally wrote off that amount as an amount he was prepared to
lose; at the same time he opened himself up to the possibility that
Roddick might succeed. As it
happened Roddick succeeded beyond anyone’s wildest dreams, and
McGlinn’s investment turned into many millions of pounds when L’Oreal
bought the Body Shop for £652 million in 2006.
In short, NNT suggests that one should;
‘learn to distinguish between those
human undertakings in which the lack of predictability can be (or has
been) extremely beneficial and those where failure to understand the
future caused harm’;
‘invest in preparedness, not in
prediction’. Chance favours
the prepared but do not prepare for something precise, Black Swans cannot
be predicted; and
‘seize any opportunity, or anything
that looks like an opportunity’ because opportunities are rare, very
rare (pages 206-209).
Enough background already…..so what does all this
mean for Credit Risk Managers?
Credit Risk and the Black Swan
Credit Risk Managers need first to examine their own
business to establish if and to what extent it is vulnerable to a negative
Black Swan event. Remembering
that one of the two prime objectives of the credit management activity is
to protect the company from failure, this first step is essential for the
determination of the risk appetite of the company.
That is the type of risks and quantum of risks the company could
bear to carry, without failing, should a negative Black Swan event occur.
This would indicate the exposure levels above which
third party collateral or credit insurance would have to be obtained in
order to secure additional profitable business; the latter being the
second prime objective.
Standard or traditional counterparty analysis should
be preceded by careful consideration as to the counterparty’s
vulnerability to negative Black Swans and its exposure to positive Black
This should lead to an analysis of the
counterparty’s business model, and its market environment, to enable an
assessment as to its ability to cope with the impact of any negative Black
Swan; that is its ability to ‘roll with the punches’ and survive.
Multiple scenarios – future stories – should
then be developed around each particular counterparty (or each portfolio
of like structured counterparties) to establish possible extreme
downsides. This does not
involve the calculation of a VaR, or ‘bell curve’ based potential
future exposure (PFE) built on historical statistics resulting in a
number-of-little-value; rather it requires the imagination of possible
futures given the occurrence of an unknown ‘extreme impact’ negative
event in each case.
Against worst case scenarios it is then necessary to
imagine how particular counterparties may cope; how might they adapt, what
resources would they be in a position to access to ensure survival, would
they be in a position to perform under their contracts in such
The performance of these analytical steps, and the
answers to the questions posed, should provide a Credit Risk Manager with
a useful guide as to how much counterparty exposure to carry unsecured and
how much to decline or transfer to a third party.
refer to articles found at the following addresses for more discussion on
the need for and plausible use of scenario planning:
Copyright 2009 R K Wells