By Eugene A. Ludwig, 27th Comptroller of the Currency and CEO, Ludwig Advisors
Humans are all too often ensnared by the “normalcy bias”, a cognitive trap that leads us to underestimate the likelihood of disasters and to believe that life will proceed as usual, even when confronted with significant threats. While this bias may serve as a coping mechanism for everyday stresses, it’s imperative that our most sophisticated financial institutions and their overseeing regulators resist its allure. They must adopt a perspective that views risk in the harshest, most realistic light.
The financial community often justifies its limited attention to tail risks—extremely unlikely but potentially catastrophic events—by arguing that these risks are so remote and the costs to mitigate them so exorbitant that it is economically irrational to prioritize them. However, properly adjusting for normalcy bias reveals the inherent risks in this thinking. Events once dismissed as highly unlikely—such as the significant economic impact of climate change, the global pandemic that halted all global and local travel, or the near collapse of the global financial system due to a crisis in the mortgage market in the United States—now serve as stark reminders of the reality and critical importance of tail risks.
From a risk-reward perspective, many segments of the financial-services supervisory mechanism allocate excessive time and resources to the center of the risk distribution curve (RDC) and, increasingly, to the nuances of day-to-day management. Understanding which aspects of tail risk are influenced by normalcy bias and devoting significantly more time, attention and funding to these areas is a critical endeavor.
This is particularly true in this increasingly volatile age, marked by active wars involving allies in sensitive regions and the evident impacts of climate change not only on the financial system, especially the insurance sector, but also on the daily lives of citizens living in affected areas. Rapid and transformative technological advancements further complicate the landscape. We have already witnessed instances of tail-risk events that could have caused international havoc, such as the crypto space’s near collapse and last year’s social-media-induced bank run. Indeed, the swift pace of technological change and globalization suggests that events we currently label as “tail risks” will become more frequent in the coming years.
When considering how best to handle tail risks, it’s important to focus on both macro- and micro-events. Macro-events, often the objects of the greatest attention and the triggers of global disruption, include examples such as the financial crisis of 2007. However, micro-events can also be highly disruptive, if not lethal, for individual financial institutions. As we saw with the failure of Silicon Valley Bank (SVB) and the subsequent panic runs, these micro-events can spread to a broader segment of the financial-services sector.
So, what should be done about tail risk?
Some national and multilateral organizations are grappling with the complexities of tail risk, whether or not they use this precise term. The Bank of England (BoE) is a leader in discussing these important issues. Sam Woods, deputy governor for prudential regulation of the BoE and chief executive officer of the Prudential Regulation Authority (PRA), delivered an important speech on financial stability and regulation that reflects one viewpoint on these issues. He raised the important issue of achieving the proper balance between mitigating less common but serious risks and fostering innovation and economic growth.
To supplement the existing discussion, I propose the following approaches as a baseline for all participants in the financial-services sector—including individual companies, national supervisors and central banks, and multilateral organizations. First, each of these entities should establish a dedicated tail-risk unit if one doesn’t already exist. This unit should be led by a designated chief tail-risk officer (CTRO). The unit should report to both senior management and the board and should meet with both at least quarterly. If necessary, more frequent meetings should be scheduled at the discretion or request of the CTRO or any member of senior management or the board.
Second, the CTRO and his or her team should prioritize tail risks for each group meeting. Tail risks often fatten rapidly, so staying up to date with changing circumstances is essential. The unit should explore possible tail-risk events in individual business units, the business as a whole, the sector and the global economy generally. For example, even an equity-trading firm or loan business could face significant tail risks—a risk-mitigating swap with a counterparty or multiple counterparties could turn upside down due to unusual circumstances, or an entire loan book in the commercial real estate (CRE) market, for instance, could become distressed, leading not only to counterparty losses but also to customer and environmental liabilities.
More global tail risks that could implicate the entire enterprise and sector are not difficult to imagine: a pandemic, a war with supply-chain disruptions and other shocks to goods and services, or a global shock in the price of any critical commodity. The list of potential tail risks is extensive.
The key, of course, is not just identifying the tail-risk event but also being able to act with vigor to cut off or mitigate risks as the “tails” fatten. My experience has shown that while taking quick action to address an emerging tail risk can be expensive and painful, it is almost always critically important for alleviating the risk. Whether it was the Allied Irish Banks (AIB)/Allfirst trading scandal of the early 2000s or the global mortgage crisis from 2007 to 2010, companies that acted quickly to mitigate risks were often disproportionately rewarded.
Mitigating tail risk can be costly, but the investment can be worthwhile if the risk materializes. If the tail risk fattens significantly, the mitigation efforts will have been well worth it. Conversely, if the risk remains dormant, the mitigation will have been a bad bet and money lost.
I recall a specific instance at Bankers Trust in the late 1990s when we purchased insurance to protect against delays in our transaction to sell the bank to Deutsche Bank. Delays were not anticipated, and the insurance policy only paid out if the delay was unprecedented. In fact, the closing was delayed much longer than expected, and Bankers Trust benefited greatly from the insurance coverage. Without the coverage, much of the value of the transaction would have been lost—or worse.
Fortunately, creating a tail-risk list and then monitoring and measuring it can be enhanced by today’s technology and is likely to be further enhanced in the near future. The advent of artificial intelligence (AI) has made this even more robust. However, excessive reliance on mechanical processes can be dangerous. Tail risk is perhaps less amenable to precise mathematical calculations and is analytically aided by imagination, intuition and experience. Therefore, the tail-risk team, the financial-services company’s dedicated unit led by the CTRO, is critical to tail-risk identification and mitigation.
Another aspect of managing tail risk that bears discussion is the tendency for management to be slow to act for various reasons, including direct costs, indirect costs through reputation and the recognition that a full identification and evaluation of the risk can lead to regulatory, shareholder and other complications. However, based on my experience, it’s always preferable to identify and address tail risks early and decisively.
The pervasive normalcy bias often blinds us to the very real dangers posed by tail-risk events. To effectively manage these risks, financial institutions must adopt a proactive approach that departs from the comforting illusion of normalcy. By diligently identifying and addressing potential threats, even those that may seem unlikely, these institutions can mitigate the devastating consequences that tail risks can inflict. This proactive approach, while demanding and challenging, is indispensable for ensuring the financial system’s long-term stability and resilience.