Abstract
This essay examines lessons from systemic breakdowns, and presents a framework for Adaptive Stress Testing to proactively manage systemic risks. The framework is inspired by evolutionary ecosystems, including ecology, economics, technology, psychology, and sociology. Adaptive Stress Testing harnesses network intelligence to integrate early warning signals. We pre-diagnose systemic fragilities by tapping into the marketplace of ideas, and then identify key metrics to monitor market-based early warning signals. We apply the Technology Adoption Lifecycle model to develop a theory of social diffusion of disruptive information in financial markets. We start by taking a macro view of risk in its hidden potential form, and then focus on phase transition signals as risk becomes visible. This process allows us to better understand key systemic risks, and to more effectively sense and respond to emerging risks.
The future is already here. It’s just not evenly distributed yet.(William Gibson)
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Notes
- 1.
Also noteworthy is that some Black Swans may be Dragon Kings to those with special insight: astronomers might forecast an asteroid impact, security analysts might uncover a high likelihood of a terrorist attack, while safety engineers might have insight about escalating risks of an industrial breakdown.
- 2.
I can’t help but think that we see this same effect in the climate change discussion, with climate scientists as Innovators at the periphery of the public network, struggling to cross the chasm of global adoption.
- 3.
All VaR backtesting is based on the standard RiskMetrics methodology (exponential weighting with 0.94 decay).
- 4.
Deregulation and increased global capital flows were additional systemic warning signals, as noted by Rogoff and Reinhart (2009).
- 5.
CFO.com, “Missing Pieces” by Avital Louria Hahn, March 2008, reported: “Morgan Stanley's fixed-income traders built a $2 billion short position on the sector. As protection, they bought $14, billion worth of triple-A mortgage-backed securities. …Morgan Stanley's hedge collapsed, triggering a $9.6 billion fourth-quarter write-down-nearly triple the $3.7 billion that Colm Kelleher, Morgan Stanley's newly appointed CFO, had forecast a month earlier.
- 6.
As measured by one day standard deviation residual, using dynamic RiskMetrics volatility estimation.
- 7.
Impressively, October 2007 was the bubble peak forecasted by Didier Sornette’s LPPL models.
- 8.
Interestingly implied volatility did spike in THB options prior to the devaluation as an early warning signal, as documented by Malz (2011).
- 9.
This build-up of hidden risk until a dramatic collapse is a common theme with pegged currencies: Argentina experienced a similar.
- 10.
I am reminded of a statement by a HK hedge fund manager about Goldman Sachs, after we discussed their use of VaR outlier signals to exit subprime. “They’re like geologists who make their living right top of all the world’s fault lines line, monitoring every tremor.”
- 11.
See www.er.ertz.ch for updated information.
- 12.
A detailed white paper of HeavyTails is available upon request, and visit HeavyTails.com for more information.
- 13.
Innovator would consider all four quadrants (and more perspectives) in their risk assessment.
- 14.
A famous example is legendary investor George Soros who developed gut instincts about risk. He was known to presciently exit positions by listening to his body’s stress signals.
- 15.
Dr. Atul Gawande’s “Checklist Manifesto” (2009) provides great insights about importance of well designed checklists for managing risk, with case studies from medicine, aviation, investments, and construction.
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Acknowledgments
I’d like to express gratitude to the many minds who have inspired this work. Firstly, to Sergey Ivliev of Prognoz for organizing the unique gathering of Perm Winterschool, and encouraging this paper. Thank you to my colleagues at FNA. Kimmo Soramaki opened my eyes to financial cartography. Sam Cook generated our case study network graphs. And Eugene Nevdov provided valuable feedback. Deep gratitude to the RiskMetrics family. Ethan Berman nurtured the open and creative culture that brought the best out in us. Our credo: “Change the world. Have fun. Make money. In that order.” Allan Malz’s crisis early warning research was seminal. I’ve referenced Chris Finger’s research throughout, and am proud that we have finally realized our idea of a global outlier based systemic risk monitor with FNA HeavyTails. It was great to work with Pete Benson on riskcommons.org and to produce the first generation of StressGrades analytics. Gilles Zumbach’s RiskMetrics 2006 time series research were invaluable. It was an honor to work with Knut Kjaer on next generation risk management, which evolved into the Adaptive Stress Testing framework. It was always a joy to brainstorm with my RiskMetrics labs partner Ron Papanek. Marty Nemeth was also a great sounding board, overflowing with ideas. Alvin Lee was my first mentor at JPMorgan and has always supported new ideas and a path of growth and adventure. And it was great to work with Ken Parker, Tom Stockdale, and the NextThought.com team to produce our online Adaptive Stress Testing course. Thank you to PRMIA for much support. Lori Ramos-Marilla offered constant encouragement and enabled the opportunity to present the work at several conferences. Alex Voicu has been a creative force in enabling this research. He established a bridge to the global risk community by organizing many excellent workshops and producing the Adaptive Stress Testing online course at PRMIA University. I deeply appreciate the insightful conversations with Anne Lalsing of Citibank, who inspired the StressGrades methodology and has provided so much thoughtful feedback. Thank you to my Winhall Consulting partner David Shimko for encouraging early warning research, an area he had pioneered many years ago at JPMorgan. I am grateful to philosopher Ken Wilber who inspired Integral Risk Management, and to the Boulder Integral community (especially Jeff Salzman and Nomali Perera). Thank you to the editors at Springer for their detailed attention and patience. And finally, I hope that Didier Sornette’s foundational Dragon King research will empower the global community to be more proactive in managing systemic risks before irreversible tipping points are crossed.
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Laubsch, A. (2015). Adaptive Stress Testing: Amplifying Network Intelligence by Integrating Outlier Information (Draft 16). In: Bera, A., Ivliev, S., Lillo, F. (eds) Financial Econometrics and Empirical Market Microstructure. Springer, Cham. https://doi.org/10.1007/978-3-319-09946-0_11
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