From the Knowledge@Wharton today blog.

In the wake of President Barack Obama’s victory over challenger Mitt Romney in the 2012 presidential election, KnowledgeToday asked Wharton faculty for their perspective on a number of issues that will take center stage in the days and months ahead.

We posed a number of questions, including:

1. What do you think was the biggest reason for Romney’s loss? What should he have done differently?
2. What was the biggest reason for Obama’s victory?
3. An editorial in The Wall Street Journal suggested that Obama got a big boost in the election from two men: Ben Bernanke and his quantitative easing, and John Roberts, who joined four other Supreme Court justices in upholding Obamacare. Do you agree?
4. The election raised interesting demographic questions. Romney appealed to many white males, while Obama appealed to many Hispanics, Asians, women and African Americans. Does this suggest that Republicans need a better strategy to attract these groups going forward?
5. What should Obama’s strategy be for dealing with the key issues of unemployment, the fiscal cliff and the deficit?
6. Is there any reason to think that the Republicans, who control the House of Representatives, will be more willing to work with Obama to get some of these issues resolved? Can the two parties hope to work together?

Here is what we heard:

Peter Cappelli, director of Wharton’s Center for Human Resources:

“Aside from the tactical issues, the fundamental issue in the election was the role of government. The vote was basically split between those who did not think government did much for them economically and those who thought government either did, or should do, something for them. The Democrat/Republican divide always reflects this issue, but it was much starker this time because the Republican position was more extreme, particularly in the proposed cuts for social services.

“The Romney campaign suffered because its proposals seemed to frighten too many voters who feel they need government protection. The Romney ticket also could not shed the baggage from the primaries on social issues – women’s rights and immigration, in particular – that hurt them with those voters.

“The biggest reason for the Obama victory in my mind was that Governor Romney’s various gaffes shifted the contest from being a referendum on President Obama and the poor state of the U.S. economy to being more of a referendum on Governor Romney. Much of the energy on the Democratic side seemed to be [directed] to voting against the Romney ticket.

“There are a hundred things that made a difference to the election. Certainly if Obamacare had been turned down by the Supreme Court, things would have been bad for the President, but then it was bad for the Democrats when the Supreme Court upheld Citizens United. Quantitative easing appears to be helping the economy, but it has been bad news for the President that none of the other treatments before helped much. A lot of other things could have gone differently that would have affected the outcome….

“The big question seems to be how the Republican party, especially in the House of Representatives, will see their effort over the last four years to obstruct anything that would appear to give the President a legislative victory. The goal of that approach was to prevent the President’s reelection. That did not work. So what do they do now?”

Mark V. Pauly, professor of health care management:

On why Romney lost: “The economy recovered enough to take away his main argument for change.”

On The Wall Street Journal editorial: “I do not see that the court decision on health care reform meant more votes for the President. It kept an issue alive — you need to vote Republicans [into office] to get rid of Obamacare — but that was obviously not an important enough issue, nor should it have been since in the short run, relatively few people gain or lose from health care reform.”  

On dealing with the issues of unemployment, the fiscal cliff and the deficit: “Republican control of the House of Representatives will keep us at the same point in discussing these issues as we were before the election.”

On whether the two parties can work together: “Now that the House knows it will have to deal with the President, I expect they will try to get some things resolved that were held hostage to the election. I think the President has used most of the ammunition he has in terms of executive orders and the like, so I expect the House will pull things their way. We will have some tax increase on millionaires and billionaires, but of course we do not have enough [of them], so that will not help the deficit that much. It will just make Democrats feel better.

“I am hoping this will set the stage for bipartisan tax reform along the lines of the Rivlin-Domenici or Bowles-Simpson [debt reduction plans]. Both have big health care parts to them. I think the election gives cover to Republicans to go along a little.”

Kent Smetters, professor of business economics and public policy:

On why Romney lost and Obama won: “Obama had a better ground game — more regional offices, more effort to get out the vote. Romney also focused solely on jobs without painting a broader picture. He should have channeled Reagan a bit more.”

On The Wall Street Journal editorial: “I don’t agree with it. Money injected by [the third round of quantitative easing] is basically just sitting on bank balance sheets. I think that the [Supreme Court decision on health care], if anything, helped mobilize conservatives behind Romney.”

On the demographics question about Obama’s popularity with minorities: “The election raised interesting demographic questions. Romney appealed to many white males, Obama to Hispanics, Asians, women, African Americans and other ‘minorities.’ Does this suggest that Republicans need a better strategy to appeal to these groups going forward? Romney also appealed to married females. But, yes, the Democrats are effective at class war politics. Republicans need to do a better job of explaining how prosperity is better than envy.”

On a strategy for dealing with unemployment, the fiscal cliff and the deficit: “The ‘fiscal cliff’ is a horrible term. Minus five for Bernanke for coming up with it; minus 10 for still being an old school Keynesian. Otherwise, I like him.

“The real cliff is if we keep focusing on the short run without also addressing the huge budget deficit. The problem with the U.S. economy is not the lack of consumption. We have plenty of it. The problem is the lack of investment. We need to address the fiscal cliff by removing some of the uncertainty about future tax rates and returns to investment. Any proposed solution to the fiscal cliff can’t be short-term and [can’t work without] comprehensive reform of the tax code and spending side that improves the long-run situation as well.”

On whether the two parties can work together: ”No, they will continue to play chicken. Hopefully, however, it will lead to a grand compromise, like the 1986 Tax Reform Act where Reagan and the House Democrats hammered out a deal that was tenable to both sides.”

Mark Duggan, professor of business economics and public policy:

On why Romney lost and Obama won: “A key reason for Obama’s victory is that the economy has been gaining more momentum over the last few months, with unemployment falling below 8% and job creation relatively strong. This may have given voters more confidence that his policies, such as his help for the auto industry — an important issue in arguably the most important state of Ohio — were working. His handling of Hurricane Sandy also probably helped to give him just a bit more support so that he pulled out wins in pretty much all of the states that were deemed battlegrounds.

“While Florida has still not been called, the races in states like Ohio, Virginia and Colorado were sufficiently close that even a small boost might have helped lead him to victory. Plus his victory margins in Wisconsin, Iowa, New Hampshire and Nevada were somewhat bigger than expected. On the foreign policy front, I think most people felt he won the third debate; that may have helped to tip the balance for many voters, too.”

On issues like the fiscal cliff, taxes and unemployment: “As for big things that are coming down the pike, the President will be negotiating with Congress on what to do about the upcoming fiscal cliff. Effective January 1, 2013, there are a set of spending cuts and tax increases taking effect that will lower the deficit by about $600 billion, which is close to 4% of GDP. While reducing the deficit is important, many think that a change in government policy of this magnitude could put the economy back into recession. Thus, it will be very important for Obama to work with Congress to make the right tradeoff between starting to tackle the deficit and stimulating economic growth.

“Certain parts of the fiscal cliff, like the payroll tax holiday (a 2 percentage point cut in this tax for all workers on their first $115,000 in earnings), are very unlikely to be renewed, but others — like the spending cuts and increases in income taxes — are likely to be negotiated. Long-term deficit reduction is also hugely important, with changes needed to the tax code and to entitlement programs.

“The fact that Obama will now be a second-term President may make it easier for him to confront these challenges as he does not need to worry about being re-elected. Indeed, that is why many support term limits.”

Tim Harcourt | The Airport Economist

When you are punting on this year’s Melbourne Cup, have a bit of sympathy for Australian export businesses who have to make their big bets on international markets in the Asian region. Like a good punter Australian exporters have to look at the horse, the jockey, the state of the track, and of course, the odds. And it is not just a flutter for them but a major business decision that will affect their livelihood as well as the well being of those whom are dependent on their business as well.

To help the average race goer understand the nuances of exporting, the following export ‘form guide’ has been produced. 

Horse number one is Great Samurai, representing the Japanese market. It’s a long standing champion, has been written off by some, but still very capable and strong and has helped others develop in the East Asian stable yards through outward investment.

Secondly, there’s New Dynasty, representing China. This dynamic new colt has surprised seasoned punters with his ability to maintain a fast pace, year after year.

Thirdly, Passionate Tradition, representing Korea. This little known but powerful galloper with an industrious approach has revealed new appeal to punters in recent years.

Fourthly, there’s Fragrant Harbour, representing Hong Kong. Known for slipstreaming the colt from China but also an attractive performer in her own right.

Fifthly, there’s Little Dragon, representing Taiwan. She is occasionally overshadowed by her new high profile cousin, New Dynasty, but she’s a tidy performer who has rewarded loyal supporters well over many seasons.

Next is The ASEAN Emissary, representing Vietnam. This is the dark horse of the East Asian field that has put together a string of good seasons in recent years and seems set for even better days ahead.

Next is Taj Mahal, representing India. An up and comer who is twinned sometime unfairly with New Dynasty, but is coming into his own thanks to ongoing reform of stable practices.

Finally there’s Archipelago, representing Indonesia. Had question marks a while ago but had now start challenging the field and becomes am up and coming favourite amongst Aussie punters.

Racegoers should also consider a few newcomers amongst the emerging markets including Arabian Nights from Abu Dhabi in the United Arab Emirates, Samba Fever from Brazil and even a roughy like Genghis Khan from Mongolia, Burmese Days from Myanmar or Boratnomics from Kazakhstan might be good for a place.

So there you have it, your own export form guide for Asia. Fortunately, back in the real world, exporting is clearly not all about luck as much as skill and strategy. It requires good research, innovation, flexibility and good knowledge of your prospective market. And most importantly, the evidence shows that it does pay off. According to economic research, exporters are, on average, faster growing, more profitable and more productive than non-exporters. Exporters also pay better wages; provide better employment conditions and higher quality jobs than non-exporters. In short, exporting is a good bet for both large and small players in the international trade game but you’ve got to be a stayer in the Asian Century.

Tim Harcourt is the JW Nevile Fellow in Economics and an adjunct professor in International Business Strategy, at the Australian School of Business, the University of New South Wales (UNSW) & author of The Airport Economist:  www.theairporteconomist.com.

Associate Professor John Evans

Dr Amandha Ganegoda

The Rumsfeld classification

In the Finsia Journal of Applied Finance in 2008, we used the “Rumsfeld” classification of risks to identify the different types of operational risks and how to best approach each type of risk from a quantification perspective. The Rumsfeld approach characterised risks into:

• known/known (ie, we know the risk exists and we know how to model the outcomes);
• known/unknown (ie, we know the risk exists, but we don’t know how to model it with any reliability); and
• unknown/unknown (ie, we have no idea what risks might exist and, by definition, no idea how to model the risks).

This classification system, in terms of risk management, implies:

• for known/known risks, it is appropriate for the institution to accept these risks and to manage them through economic capital;
• for known/unknown risks, it would be prudent to transfer these risks to another entity; and
• for unknown/unknown risks, these should not be taken on at all, and are best managed by “positive” contract wording that specifies what risks the institution is exposed to.

The Diebold classification

In their 2010 book on risk management, Diebold et al advocated a slightly different classification system consisting of identifying risks as Known (K), Unknown (u) or Unknowable (U), but the implication of this classification system was the same as our Rumsfeld approach.

Both the Rumsfeld and Diebold classification systems are based on the extent of knowledge available as to the occurrence of an event, and how to model the outcome of the event. Under the Diebold system, K refers to situations where there is a broad agreement between experts on the relevant theories and the underlying models, u refers to situations where there is more than one competing theory or a model in which none of them have reached the status of a paradigm, and U refers to situations where there is no theoretical model.

Our extension of the Diebold classification: Ambiguity

In our soon-to-be-published paper in the Australian Journal of Management, we have extended the classification system to include an “Ambiguity” group of risks, as there are situations in which future outcomes are vaguely defined due to ambiguous behaviour of the market participants, but the risks are neither K nor u. In this particular context, we use the term Ambiguity to refer to the uncertainty created by market participants’ ability to respond differently to certain events and circumstances.

Although often ignored, Ambiguity is an important source of indeterminacy, which is difficult to measure and manage like risk, nor can it be reduced by investing in knowledge as for a u-type risk. A primary source of Ambiguity is the ability to understand something more than one way and to respond differently.

Examples of ambiguous situations are surprisingly common. A classic example of how Ambiguity can lead to disastrous outcomes is the highly publicised and controversial credit rating system of asset-backed securities (ABS), which served as a catalyst to the recent subprime mortgage crisis and the consequent global market meltdown. The originate-to-distribute lending model of the banking industry, which has been partly blamed for the subprime mortgage crisis, heavily depended on the ability of the rating agencies to accurately value ABS. Rating agencies used a scale similar to the ones they used to rate bonds to rate the probabilities of default on ABS. It was only later realised that although a BBB tranche of an ABS may have the same expected loss as a BBB corporate bond, the loss distributions of the two are significantly different. Even though the BBB ABS was priced higher than the BBB corporate bond, most market participants failed to notice this due to the Ambiguity created by similarities in the notation of the rating systems. If rating agencies used a different notation from the one they had been using for the bonds, investors might not have made the false interpretation.

Why introduce Ambiguity?

Whereas previously we included Ambiguity risks in the u category, we feel that these risks have significant differences from the u-type risks and that specific attention should be brought to these risks. Our classification would then become:

• K, where we know the risk exists and can be confident of the modelling;
• A, where we know the risk exists, but recognise that there is a range of outcomes, each of which can be modelled, but where we are uncertain as to which outcome will occur due to the difficulty of predicting human actions and counteractions;
• u, where we know the risk exists, but we are not confident of how to model the outcome; and
• U, where we have no idea what risks exist.

Issues remaining

There are still some issues in using this classification system. First, even though we might have a model for a K-type or A-type risk, care needs to be exercised in understanding the model rather than just blindly adopting it, as the assumptions may not be appropriate in all circumstances. Second, in terms of the implications of this classification (as well as the Rumsfeld and Diebold versions), there is a serious problem in that it would inhibit financial product innovation, as most innovation would involve at least u-type and U-type risks. If introduced as part of a prudential regulatory process, it could result in inefficiencies in the capital markets. To some extent, the effect of the introduction of u-type risks could be ascertained by stress testing, but care needs to be exercised in the acceptance of the results as the process is highly dependent on historical experience. Reverse stress testing, where you search for events that would cause insolvency, can also be useful. It may be possible to manage the u-type risk by spreading it across the capital markets so that the impact on any one institution is minimised, but, as the global financial crisis showed, poor information systems may not detect cumulative risks of this type – with disastrous consequences.

There is also another issue with this classification. It may infer that once classified, a risk remains constant, which is not correct, and there is the possibility of misclassifying a risk as a type K when it is in reality a type u. For example, a u-type risk may, with the passing of time, become a K-type or A-type risk, and it is hoped that it will in fact become reclassified and reduce the risk. Also, once a U-type risk occurs, it progresses to become a u-type or A-type risk.

Matching the correct tools to each classification

While the proposed classification system will highlight the differences between risks, it is then important to develop tools for assessing these risk types. History is littered with misunderstandings of what is an appropriate tool for measuring a particular risk. A classic example is that the models based on the assumption of daily market returns are Normally distributed. Using daily returns of the Dow Jones Average, Estrada pointed out that the lowest of the best 10 daily returns during the period of 1900 to 2006 was 8.6 standard deviations above the mean. If we assume that the life of planet Earth is around 4.5 billion years, under the Normal assumption one return of this magnitude or larger should occur every 223,014 lives of our planet; and yet 10 such returns have been observed during the period of 107 years. The degree of the error is enormous, yet the Normal assumption is widely used in the pricing of derivatives, as well as in economic capital calculations. Furthermore, Estrada showed that for an investment made between 1900 and 2006, by not being invested in the best 10 days of the market, the terminal wealth would decrease by 65%, whereas by avoiding the worst 10 days of the market, the terminal wealth would increase by 206% relative to a passive investment strategy. The aggregate outcome – in this particular example, the long-term performance of the investment – is largely determined by just a few extreme observations, and demonstrates the disproportionate impact of the extreme events on the aggregate outcome and the importance of properly accounting for those extreme events. In other words, in contrast to light-tailed risks, the uncertainty of risk measure for a heavy-tailed risk would be largely determined by the ability to accurately estimate the probabilities of the extreme events. The mean and standard deviation hardly provide any useful information.

In dealing with A-type risks, the analysis must be very different from that for K-type and u-type risks. Cognitive psychologists have studied behavioural traits of humans, including herding, framing, mental accounting, loss aversion, overconfidence, conservatism and anchoring. These behavioural traits can often assist to explain (and maybe even to predict) market anomalies and events, such as bubble formations, erratic trading activities, and overreactions to information. A risk manager who pays attention to the cognitive behaviour of market participants will have a better chance of understanding financial markets and their future direction. The findings of behavioural economics show that financial markets and their participants may not always behave rationally. Hence, it is always a good idea to perform a scenario analysis by relaxing the “rational” assumption of traditional finance theory to see what can happen when market participants behave irrationally.

Finally, when dealing with U-type risk, we believe that the focus should be on proactive crisis management. Even though a solid risk management framework will aid in containing risk, unforeseen events would still occur simply because we are unable to predict all possible future states.

Taleb famously defines such events as black swan events. Even though black swan events are almost impossible to pre-identify, this does not necessarily mean that we cannot prepare for an unforeseen crisis. Diebold et al point out that although crisis events may have unique and unanticipated causes, most of the time the required post-crisis responses are often quite similar. Thus, readiness for a known possible crisis can become useful in responding to a surprise crisis situation. For example, several experts have pointed out that the system redundancies developed in New York city in anticipation of the Y2K bug (which never materialised) became indispensable for the fast recovery of the city’s transportation and telecommunication systems after the 9/11 attacks.

The lesson here is that even if one cannot anticipate the nature of a possible black swan event, it is still possible to have some sort of contingent plan in place to assist in a crisis situation. The ability to steer through a crisis depends more on the decisions made before the crisis than on the decisions made in the midst of it.

We identify four important traits a company should have in order to successfully steer through a crisis. First, it is important to have an established process to monitor near-miss events. Monitoring near-miss events can provide early detection of problems, as well as avoid possible future crises. Second, a corporate culture that encourages the reporting of problems rather than the habit of hiding them is vital for early detection of a problem and appropriate response. Third, flexibility of organisational structure is important, since – similar to the evolution of species – only the organisations with flexibility to adapt and innovate will survive while the others will become extinct. Last, but not least, firms need to maintain good public relations and collaborate with relevant parties. Unless firms develop cooperative relationships with their partners, they will not get preferential assistance during either a crisis or an opportunity.

The message

The message is clear: in developing a risk management strategy, it is critical to classify risks according to their characteristics in order to better understand possible outcomes, and then to build models that are appropriate for ascertaining those outcomes. “Shoehorning” inappropriate models into a situation to save costs will lead to disasters, as we saw in the global financial crisis.

John Evans is an Associate Professor and Head of Risk & Actuarial Studies at the Australian School of Business. Dr Amandha Ganegoda is a Research Assistant at the Australian School of Business. This article first appeared in Risk Management Today.