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The Stagflation Challenge for Next-Generation Risk Managers: A Q&A With Paul Shotton

How would a combination of economic stagnation and inflation impact the risk management landscape, and what specific steps can young risk professionals take to not only comprehend this potential threat but also to help their employers mitigate it? A former quant and current risk advisory CEO offers some practical insights and ideas.

Friday, November 18, 2022

By Tod Ginnis

The threat of stagflation is now causing headaches for financial risk managers. This rare confluence of abnormally high inflation and stagnant growth hasn’t been seen in the U.S. since the oil crisis of the 1970s, but market experts, including many economists, see it as a looming and significant risk.

For aspiring and early-career FRMs hoping to get a leg up on their fellow job-seekers or colleagues, it’s important to understand both the challenges stagflation presents (across, e.g., the credit and liquidity risk disciplines) and the steps one can take to ameliorate this problem.

As an ex-quantitative trader, Paul Shotton – the current chairman and CEO of White Diamond Risk Advisory – knows a fair amount about the conditions that drive economic crises and the effects of these downturns on risk management.

Over the past 35 years, Shotton developed his knowledge of markets and honed his insights in high-level trading and risk management posts at financial institutions in major metropolitan hubs, first in fixed-income trading positions at Goldman Sachs and Deutsche Bank in London, and subsequently, in New York, as the global head of market risk management at Lehman Brothers and the deputy head of group risk control and methodology at UBS.

Paul Shotton, Chairman and CEO, White Diamond Risk Advisory

What’s more, in his current role, Shotton provides risk advisory services to boards of directors and executive management across asset classes in financial services. Recently, he spoke with Risk Intelligence (RI) about the reasons behind stagflation, and the obstacles and opportunities it presents to FRM candidates and early-career practitioners.

RI: Why is stagflation such a tricky problem for risk managers?

Paul Shotton (PS): The inflation part is key. When inflation is uncontrolled, it's volatile, and financial markets are also volatile.

Risk management metrics use historical data for things like risk aggregation, capital determination, default probabilities, and credit risk calculations. That data is often more highly weighted toward recent experience. The high volatility of interest rates, stock prices and commodity prices — which are common when inflation is high — are not well represented in historical time series. It's a shortcoming of statistical approaches to risk measurement.

We assume historical data is a good representation of the distribution from which future events will be drawn. Ordinarily, this is a valid assumption, but markets adapt and change.

George Soros calls this reflexivity. When historical correlations break down, it happens most egregiously at crucial times, when markets are under tremendous stress. That’s when risk management is needed the most, as banks require capital to absorb unexpected losses. And it’s when tools that risk managers use, like value at risk, are weakest.

Inflation normally accompanies a strong economy and helps heavily-indebted governments like the U.S. keep their debts more manageable. Stagflation is more insidious due to the political pressure to get the economy growing. Presidents Johnson and Nixon, for example, pressured their respective Federal Reserve chairs to lower rates when inflation appeared to be ebbing, but their actions were premature. Chairman Powell is determined not to repeat their mistakes.

RI: Do you see any challenges to dealing with the problem of stagflation for less senior risk managers or those planning to enter the field?

PS: A lot of junior people in risk management are coming into their roles straight out of college or business school with quantitative training. That’s great. But what they really miss is the trading background. You can’t replace the experience of having positions at risk and the fear of losing money. They don’t teach that in school. In my experience, some of the best risk managers are former traders.

Markets are examples of complex adaptive systems. The complex piece means that there are deep interconnections between different parts of the system. Complex adaptive systems tend to follow power laws, which means that small uncertainties in the input parameters lead to magnified differences in the outputs.

Analyzing complex systems by breaking them into components and then adding the pieces together, which is a traditional way to measure risk, doesn’t work well. To address extreme risk during stressful periods, the Fed prefers to use scenario analysis and stress testing over historical models.

The flaws in our assumptions due to the complex nature of markets doesn't mean that traditional tools are useless. They should be part of every risk manager's toolbox. But you can't rely upon them completely. Risk management remains as much an art as a science, because of the shortcomings in the assumptions that underlie the quantitative part.

It’s the qualitative part — the art that comes from having direct experience living through these kinds of stressful periods — that completes the risk manager’s toolbox. Young risk managers should pay attention, because we’re living through a stressful period now.

RI: How can early-career and aspiring risk managers prepare to work in an environment of rising inflation and economic stagnation? Since few current risk managers were working during the last period of stagflation, is the playing field relatively level regarding experience?

PS: There might be something to that. I joined the investment industry right before the 1987 stock market crash. I’ve never faced a landscape like today’s.

The key is you never want to stop learning about risk management and markets. Read widely, including the Wall Street Journal, Financial Times, and Bloomberg. I also recommend The Economist and GARP’s publications. Follow well-respected writers, like wealth manager Barry Ritholtz and Bridgewater founder Ray Dalio. 

These days, moreover, we all should be reading about geopolitics. As you read more, you’ll begin to synthesize your own view of the world. Although the future is unknowable, absorbing more history and information will put you in the best position to draw up valid scenarios.

RI: During your presentation at the recent GARP New York chapter meeting, you mentioned it’s difficult to measure inflation accurately, since it’s uncertain and changes over long periods of time. How does this lack of certainty affect risk decisions related to inflation?

PS: Every individual, every family, every business has their own inflation rate, which is the rate of change of prices of the things that they buy. If you're a risk manager, your starting point should be to determine the risks to which your firm is exposed. You can then try to construct metrics or use publicly-available metrics that are closest to the experience that you anticipate or that are most appropriate for the nature of your business.

There’s always a cost to hedging. How close are the hedges to your actual exposures? How much protection are they going to give you? Also, are you appropriately compensated for the cost of establishing those hedges?

RI: What is the best way for up-and-coming risk managers to establish themselves during unprecedented financial circumstances?

PS: It’s time to embrace the art over the science. This is where scenario analysis comes into its own.

Create extreme scenarios and look for the things that would be most damaging to your portfolio. What would really harm the firm, such as Illiquidity concentrations and adverse correlations?

Assets that were previously highly correlated could, for example, suddenly become uncorrelated. Others that are not normally highly correlated may move in lockstep, as people exit multiple markets simultaneously to raise liquidity. Everything tends to fall together.

Liquidity is a fair-weather friend: it’s freely available when you don't need it and disappears immediately as soon as you do, particularly during abnormal market periods. Scenario analysis is limited only by your imagination of what might happen.

 

Tod Ginnis is a content specialist at GARP. He is the author of a GARP blog that is aimed at early-career risk managers and professionals aspiring to earn their Financial Risk Manager (FRM) certification.




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