Black swans and global capital markets

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SPECIAL ISSUE

Black Swans and Global Capital
Markets: Preparing for the
unknowable
March 2014

Global Financial Institute

Your entry to in-depth
knowledge in finance

Dr. Paul Kielstra


2 Black Swans and Global Capital Markets

Global Financial Institute

Introduction to “Global Capital Markets in 2030“
Deutsche Asset & Wealth Management’s Global Finan-

component of government debt; and stock markets face

cial Institute asked the Economist Intelligence Unit to

weakening demand in many mature markets.

produce a series of white papers, custom articles, and
info-graphics focused specifically on global capital

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

market trends in 2030.

stocks, bonds, currency and commodity futures) is growing, the pattern of that growth suggests that major shifts

While overall growth has resumed, and the value

lie ahead in the shape of capital markets.

traded on capital markets is astoundingly large (the
world’s financial stock grew to $212 trillion by the end

This series of studies by Global Financial Institute and the

of 2010, according to McKinsey & Company) since

Economist Intelligence Unit aims to offer deep insights

the global financial crisis of 2008, the new growth

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

has been driven mainly by expansion in developing

both secondary and primary research, based on surveys

economies, and by a $4.4 trillion increase in sovereign

and interviews with leading institutional investors, corpo-

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

rate executives, bankers, academics, regulators, and others

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

who will influence the future of capital markets.

many places debt markets are fragile due to the large


3 Black Swans and Global Capital Markets

Global Financial Institute

Introduction to Global Financial Institute
Global Financial Institute was launched in November

are hundreds of years old, the perfect place to go to

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Deutsche Asset & Wealth Management invites you to

geting an audience within the international fund inves-

check the Global Financial Institute website regularly

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are nonetheless highly relevant to anyone who is inter-

from Deutsche Asset & Wealth Management’s Co-Chief

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Investment Officer of Asset Management Dr. Asoka

economic, political, financial, and social issues facing the

Wöhrmann, CIO Office Chief Economist Johannes Mül-

world. To accomplish this mission, Global Financial Insti-

ler, and distinguished professors from institutions like

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the University of Cambridge, the University of California

& Wealth Management’s investment experts with those

Berkeley, the University of Zurich and many more, all

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fessionals like you.

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

has included a variety of pieces covering the financial

ing resource for economic and business research, fore-

services industry including the changing role relation-

casting and analysis. It provides accurate and impartial

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

intelligence for companies, government agencies, finan-

paring for the future bank customer, sanctions compli-

cial institutions and academic organisations around the

ance in the financial services industry, and the future of

globe, inspiring business leaders to act with confidence

insurance. A published historian, Dr. Kielstra has degrees

since 1946. EIU products include its flagship Country

in history from the Universities of Toronto and Oxford,

Reports service, providing political and economic analy-

and a graduate diploma in Economics from the London

sis for 195 countries, and a portfolio of subscription-

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

based data and forecasting services. The company also

demia, and the charitable sector.

undertakes bespoke research and analysis projects on
individual markets and business sectors. The EIU is head-

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

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

Leadership Team. His work has covered a breadth of

cities and a network of some 650 country experts and

business strategy issues across industries ranging from

analysts worldwide. It operates independently as the

energy and information technology to manufacturing

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

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

leading source of analysis on international business and

well as editing, project management and the occasional

world affairs.

speaking role. Prior work included leading investigations into energy systems, governance and regulatory

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

regimes. Before that he consulted for the Committee

Brian Gardner.

on Global Thought and the Joint US-China Collaboration on Clean Energy. He holds a master’s degree from

Dr. Paul Kielstra is a Contributing Editor at the Economist

Columbia University in New York City and a bachelor’s

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

degree from American University in Washington, DC. He

ics, from the implications of political violence for busi-

also contributes to The Economist Group’s management

ness, through the economic costs of diabetes. HIs work

thinking portal.

4 Black Swans and Global Capital Markets

Global Financial Institute

Black Swans and Global Capital
Markets

Written by

A collaboration between Deutsche Asset & Wealth Managment‘s
Global Financial Institute and Economist Intelligence Unit
March 2014

Black swans: A phrase goes viral

Steven Culp – managing director of Accenture Manage-

In September 2008, a financial malaise growing for over a

ment Consultancy’s Risk Management Group – recalls that

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

in 2008 some used such thinking as a partial excuse and

largest in US history – rocked markets. Existing unease

as a way to reassure the world that what was happening

about possible contagion rapidly transformed into

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

pervasive fear. Equity markets dropped precipitously;

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

leading financial institutions in major developed countries

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

required rapid government intervention to remain

applied incorrectly to any extreme event. Using the term

solvent; capital markets, already constricting under

this way, however, represents a misunderstanding of what

the weight of devaluing sub-prime mortgage backed

Black Swans are, as well as the ongoing challenge which

instruments, seized up further, thereby threatening

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

the global economy. Indeed, the latter phenomenon

ready for them.

provided the original name for what was happening: the
credit crunch.

The Nature of the Problem
In Taleb’s analysis, a Black Swan event has three specific

Although the world had seen regional economic meltdowns 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 philosopher. 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.

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

1 

characteristics. First, it is an unexpected outlier because
“nothing in the past can convincingly point to its possibility.” Second, it has an extreme impact. Third, in spite of it
being an outlier, “human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.” 1
This definition seems to restrict severely what could be a
Black Swan and, therefore, the ultimate utility of the concept. For example, the numerous historical financial crises
before 2008 pointed to the realistic possibility that serious
trouble would eventually recur. Indeed, at the time various 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


5 Black Swans and Global Capital Markets

Global Financial Institute

clearly acknowledged the possibility of extensive losses

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

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

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

sure alone, the subsequent crisis would have been a poor

markets. More recently, confidence in the inevitability of

candidate for the label of “Black Swan”.

ever greater European integration did much to blind policy makers on that continent to the dangers which weak

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

economies like Greece posed for the common currency –

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

difficulties which Euro-sceptics of various stripes found it

risk tended to under-estimate its magnitude. According to

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

Taleb, the hallmark of Black Swan events is that human

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

mental maps restrict people from assessing their risks. As

aging Director at the Institute for International Finance,

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

a global association of financial institutions – notes that

individual epistemic limitations (or distortions), mostly

major, unexpected crises tend to occur when almost all

confidence in knowledge; it is not an objective phenom-

actors in the marketplace suddenly change their thinking

enon. The most severe mistake made in the interpreta-

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

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

or framework of thinking that crystallises tail risks.”

Swan’ that would be invariant in the eyes of all observers.”
A major terrorist attack by a relatively unheard of group,

Thus, Black Swans do not provide a fatalistic justification

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

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

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

failing to see that which was impossible to predict anyway.

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

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

sible for anyone to predict but because the pervasive risk

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

models of the time so discounted the possibility of trouble

other inputs which shape how we see the world help or

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

inhibit the discovery and analysis of significant, heretofore

market, as well as to ratings agencies and regulators.

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

2

best models it is impossible to foresee many novel chalThis was partly because extreme events are sufficiently rare

lenges accurately, how can companies, and markets as a

that modelling them is nearly impossible anyway. It is also

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

because so many placed excessive reliance on models that

inevitable, unexpected storms.

proved to be highly inappropriate and which should have
been seen to be so at the time. David Viniar, then CFO of

Are companies better placed to cope?

Goldman Sachs, reported in August 2007 that during a

Preparing for Black Swan events begins, perhaps ironically,

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

by recognising that they cannot be a leading focus of risk

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

management. Theoretically, Mr Tran notes, if a company

theless he believed that the company’s quantitative strate-

recognises and correctly assesses an unexpected risk, by

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

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

certain specific situations.3 He differed from most others

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

only in having made a memorable quote. The widespread

only thing your organisation is focussed on preventing,

adoption of David Li’s Gaussian Copula function, despite

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

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

Financial institutions today are rightly focussing more of

risk associated with collateralised debt obligations – fre-

their energy on things closer to home than on long tail

quently made up of bundled mortgages –created wide-

events.”

spread belief in the underlying stability of asset prices, and
ultimately of financial markets, that was unjustified for any

Instead, Mr Culp argues, a correctly configured approach

number of reasons.

to risk management, while not a guarantee of safety,

2

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

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6 Black Swans and Global Capital Markets

Global Financial Institute

improves the ability to cope with low probability, high

Mr Culp also sees hopeful signs but remains cautious.

impact events. “Effective risk management is an everyday

Driven by both regulatory change and business necessity,

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

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

the business and investing in the culture are critical and

dramatically changed at both board and senior leadership

will help to provide early indications of where problems

levels. They are much more informed and asking better

may be. Through normal, effective risk management, and

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

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

Unlike in previous eras, where elevated concern about risk

ter insights earlier and can course correct to limit exposure

often dropped during periods of economic growth, Mr

to bigger challenges.”

Culp also hopes that the structural changes of recent years
– such as the greater number of Chief Risk Officers on at

At least three broad elements of effective risk manage-

the leadership table – will give some permanence to this

ment are central in developing and maintaining this men-

appreciation of risk as a critical function.

tality. One is taking risk seriously. This on its own can help
tremendously in dealing with unexpected upheavals. An

Companies also seem to be taking steps toward a more

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

holistic understanding of risk and have a healthier appreci-

with independent risk management functions and strong

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

internal risk controls suffered less during the peak years

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

of the global financial crisis in part because they were

ment] remains around complexity.” Better data gathering

less likely to invest in mortgage-backed securities and off

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

balance-sheet derivatives. They also did better financially

to turn these mountains of information into insight is an

during the preceding boom. 

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

4 

nitely moving in the right direction. In terms of levels of
Another element is the need to go beyond box-checking

capital, investments in talent, connectivity with regulators,

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

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

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

ity is, though, that the broader economic situation does

companies need to maintain humility about the extent of

remain fragile and the regulations are still forming. We are

their understanding of the risks they face. Mr Culp recalls

early into this process.”

that before the crisis “people often acted as if the models
were reality and gained excessive confidence as a result.”

Regulating for robustness

What about capital markets as a whole? Although the

Since the Financial Crisis, capital market firms have

Global Financial Crisis revealed any number of weaknesses,

invested substantially in risk management. Adjusting to

two issues of these could most exacerbate the impact of a

new regulation alone – probably the leading focus of this

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

activity – has required a massive shift and the changes are

nectedness of the national markets than in the past, and

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

the growth of a variety of private companies into strategi-

nying shifts made companies better prepared for rapidly

cally important financial institutions whose failure would

emerging risks and the completely unexpected?

have potentially catastrophic consequences.

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

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

crisis have been busy engaging in all kinds of analysis

nificant issues remain. He observes that the Dodd-Frank

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

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

for unexpected events is quite a bit smaller. Having said

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

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

fail institutions that get in trouble. European Union propos-

change what we thought.”

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

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

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7 Black Swans and Global Capital Markets

Global Financial Institute

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

Ultimately, because of they are impossible to predict, the

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

ability of capital markets to withstand the next Black Swan

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

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

inter-connectedness of global markets, greater levels of

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

transparency and disclosure – to provide enhanced under-

or later.

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 regulatory reform has put similar risk-based capital requirements on non-bank institutions and inadvertently reduced
the diversity of different institutions. This may risk producing 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 decidedly mixed. Improvements have occurred since 2008.
Although the undoubted improvement in risk management 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 awareness when good economic times return. Similarly, regulators 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.”


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