Kevan Watts: A world of risk

Information technology has transformed how we perceive and deal with specific risks. But, says Kevan Watts, we still need to get better at managing how these risks interact

We live in a world of risk. Everywhere risks are identified, analyzed and managed.

It is not that risk is bad, although one might assume so from much commentary and, certainly, from the rhetoric of many politicians and regulators. The word “risk” derives from the Italian risicare – to dare. And, just as an act of daring may be excitingly bold, risk comes from the uncertainty that makes the world interesting. After all, what chance would Autumn Pearl, my talented filly, have against the legions of racehorses fielded by Godolphin, without the uncertainty and the unpredictability of life? However, while risk makes the world interesting, it also creates winners and losers. So the focus on risk management is partly about ensuring we are the winners and partly about protecting the losers.

Government policies everywhere are heavily affected by the desire to influence who are the winners and losers. It has always been thus, but recently the focus on risk appears to have moved to a different level. For instance, much has been written about doctrine of pre-emption in the development, and justification, of US foreign policy. Very significant interventions have been predicated on eliminating unrealized risks. On a more mundane level, financial regulators have certainly moved the goalposts in terms of their expectations of risk management practices and procedures at financial services firms. Similarly, research analysts now spend time and effort considering the value at risk measures for the major firms active in the capital markets. Importantly, much of this analysis is intended to measure return against risk, and so the analysts tend to remember that risk is what makes the world go round.

A more dangerous world?
So the question arises: is the world today riskier than it was yesterday? This question is impossible to answer persuasively without much more definition. After all, different answers would be given by the same person depending on the point of comparison: riskier than when? I felt extremely vulnerable on the morning of September 11, 2001 as I walked up the West Side of Manhattan having watched a hijacked aircraft hitting the World Trade Center. But then how do we distinguish between the risk and the perception of risk? The world was just as risky on September 10 as on September 11, but I went about my business in New York in sublime ignorance of the unfolding events. For many policy-makers, the perception of risk is the greater reality, the more potent driver of behaviour and votes. Finally, measuring one world of risk is impossible. Which types of risk affecting which people and where in the world?

It’s a different kind of risk
Although the question may be unanswerable, it is arguable that the nature of risk in our world has changed, and some of this change arises from the impact of the revolution in information technology on our world of risk.

First and most obviously, we all know much more about the risks in the world, large and small. This is, in part, a result of more people knowing more, the mass of data at our fingertips and our reaching out to the world through the Internet. This is powerful in itself, but the revolution in information technology also embraces our enhanced ability to manipulate data. Desktop and distributed computing power democratizes scenario planning and enables us to imagine the worst by developing doomsday possibilities at a level of detail far beyond the imagination of historical Cassandras.

Second, this impact of information technology on risk shows us how interconnected the different risks are and tightens the connections by accelerating and correlating our behavioural responses. During my working life, there has been a very significant shift in how financial risk moves between asset classes and around the world. It is no longer good enough to buy on the rumour and sell on the news. You now need to anticipate the next rumour and watch carefully shifts between different asset classes as more and more investors chase new opportunities in pursuit of some non-correlated returns.

Third, the power of our new information technology raises expectations about our ability to manage risk, to position ourselves as winners in this world of uncertainty or to redirect our behaviour away from doomsday. Financial regulators certainly see new opportunities to avoid the failure of individual firms and to reduce systemic risk. Sometimes the possibilities seduce them into forgetting how risk and return are two sides of the same coin; how uncertainty makes life interesting.

The revolution in information technology has raised expectations in many areas, and not simply in terms of our expectations about our ability to manage risk. Critically, it has materially broadened the appreciation of inequalities of wealth and income in the world, and shown the poor how the rich live. It has also enabled the local terrorist to take a global stage. Individuals are more able to reach fellow sympathizers, to organize and communicate, as well as to attract worldwide attention to their demands as well as their sanctions.

The challenge of management
So many things have changed in our world of risk, especially with the dramatic changes in our information technology. But not all of our management mechanisms have stayed current with the technology. Indeed, much of the management of risk is restricted and separated from adjacent risks that we increasingly understand may break down the starting assumptions for complex models of specific types of risk. There are very significant variations between the electoral cycle of political success, and failure and the timescale of environmental risks. Similarly, we know that political geographic divisions are not respected by the major environmental risks to which we are exposed.

One consequence of risk management with a narrow focus is a tendency to redistribute risks from the core to the periphery or from the strong to the weak. For instance, in the capital markets, the extensive use of derivatives to hedge market positions moves exposures with sometimes limited transparency. It appeared that this had happened a year or two back in the transfer of corporate risk from the banks to insurance companies through the credit default swap market. Capital pressures emerged in the insurance sector following the decline in world equity markets as the Internet bubble collapsed. It seemed that these pressures were intensified by insurance companies’ participation in the credit derivative market. It is not that insurance companies are weak and banks are strong, but rather that banks are familiar with corporate risk. So, as financial regulators raise risk management standards among capital market firms, there is a real possibility that the risk moves in unexpected directions.

Our new information technology has changed our world of risk. It has magnified local risk and accelerated interconnections. It is both a catalyst for new uncertainties and critical to more sophisticated risk management techniques. However, we do not yet know how best to use this power to govern and manage our world of risk. Our best managers of risk are very specialist, but our world of risk is making connections across categories very quickly as human behaviour responds ever more rapidly to the burgeoning data about what might happen tomorrow. For the world to prosper, we must reach beyond our specialties and understand the connections between the worlds of risk in which we are engaged professionally and personally. We should connect the specialists and the narrow models, and seek to understand the whole.

Kevan Watts
Kevan Watts is chairman of Merrill Lynch International. Before joining Merrill Lynch, he was an official at HM Treasury, which he joined in 1974 from Oxford University. He is on the Development Committee of the National Gallery, London, and on the Advisory Board of Heart of the City.