In the table below, we show the 15 extreme risks and attempt to determine their likelihood and impact. To do so, we assigned each risk to one of three risk categories—low, very low and very, very low—and categorized them by impact from high to low.
As can be seen from the table above, depression, hyperinflation and excessive leverage are the three most extreme risks that bear further consideration.
•Depression: The risk of depression appears to have been reduced through policy action, but remains an extreme risk because it may not be possible for governments to counteract any future drop in demand.
Overconsumption by Western consumers has led businesses to build productive capacity to satisfy demand unlikely to be reached again for a number of years as households increase their savings rate. Spare capacity is likely to mean lower corporate margins, employment, and growth, as well as subdued asset returns. A complicating factor is the level of debt which, on default, may force asset sales (as discussed earlier in the article).
•Hyperinflation: This is very high or out of control inflation (in some countries, it has approached 100% per year). In response, prices increase rapidly as money loses its value. The main cause is a massive and rapid increase in the amount of money, which is not supported by growth in the output of goods and services, and which leads to a loss of confidence in the money, similar to a bank run.
Hyperinflation is often associated with wars or their aftermath, economic depressions, and political or social upheavals. It wipes out the purchasing power of savings, provokes extreme consumption and hoarding of real assets, causes the monetary base to flee the country and results in a cessation of investments. Enactment of legal tender laws and price controls to prevent discounting the value of paper money relative to gold, hard currency and so on, fails to force acceptance of a paper money that lacks intrinsic value.
•Leverage: The use of leverage is helpful for society because it allows capital-constrained entrepreneurs to bring new products to market and contribute to employment and economic growth. However, there is an optimal level and going beyond it implies a social loss. Leverage becomes excessive when the debt can no longer be serviced from income or when no safety margin exists. This will typically occur with speculation, when the intention is to repay the debt when the speculative asset has been sold for a higher price. Falling asset prices will trigger a self-reinforcing cycle, and we have seen that it is not automatically possible to reduce leverage even if desired. Excessive leverage could be considered as a “public bad” and therefore appropriate for governments to regulate. As some public sectors are increasing their leverage (debt-to-GDP ratios), the risk of excessive debt will persist for a number of years.
In addition to standard debt, derivatives are another way the system becomes leveraged— allowing a given amount of economic exposure to be gained with a fraction of the amount of capital. While many derivative contracts have built-in protection mechanisms (exchange traded, collateral requirements, variation margin and so on), not all do.
There has been extensive media coverage of credit default swaps in particular, which are not exchange traded (introducing higher counterparty risk) and are a multiple of the value of the physical bonds they are designed to hedge. Derivatives could be a source of excessive leverage, potentially causing asset sales to satisfy the contracts, and financial markets to stop functioning, thereby triggering a reaction in the real economy similar to the one we have just seen: falling growth, employment and incomes, and the possibility of depression.
Conclusions
It has become increasingly complex to run a pension fund, to determine how to investment the assets, how best to govern the plan and provide the necessary oversight. We don’t believe this is likely to change in the future. Plan fiduciaries need to determine whether they want to structure their assets for the expected outcome, or protect them from a less likely but potentially severe outcome (extreme risk). This has implications for asset allocation and ultimately plan cost.
We have learned the hard way that models cannot replace good judgment and matching investment structure with governance capability is a precondition for success. Enabling a more dynamic decision making framework to deal with extreme events when they occur can help reduce the impact of these “bad” situations. Finding managers who think about these is one way to improve ability to act when things go wrong.
Janet Rabovsky is a senior investment consultant with Towers Watson.
