Interview with Michael Halling, Associate Professor at the Department of Finance and Director of the Sustainable Finance Initiative at Misum, on how key features of dealing with market risk can be related to the COVID-19 crisis – and why it differs from previous downturns.
Risk management is an integral part of finance to provide participants in financial markets with appropriate tools to gauge the returns of certain assets against potential factors that might cause a plunge in their prices.
“When I teach this topic to master students and in the Executive MBA, the focus is first on evaluating how risk management creates value and second on finding the right metrics for risk, and a good balance between simplicity, comprehensiveness and accuracy. We often face correlations between different market risks and at the same time incomplete information, so it is important to combine quantitative approaches with scenario analysis and stress tests”, Michael Halling introduces his field of research. “But one has to differentiate between corporate risk management and the perspective of regulators and public institutions in the covid-19 crisis. What we have now is a macroeconomic issue and the key question is how governments respond. In my opinion, individual companies cannot and could not have accounted for the situation we are in right now.”
JK*: In a recent seminar by the Swedish House of Finance (SHoF) about the economic consequences of the corona crisis and implications for the corporate credit market in Sweden, your colleague Bo Becker compared the current situation with 9/11, in that it was not foreseeable like other major economic crisis, e. g. the one that was caused by the financial crash in 2008. Furthermore, he pointed out that 9/11 resulted in broader set of political measures, not only related to financial institutions and bail-outs, and that we might see something like this happening now as well. Do you agree with this?
MH: I think Bo has a point in that businesses and private actors more generally could not have accounted for this situation. Yet in more general terms, I would not say that the pandemic was unforeseeable. There have been scientific studies pointing this risk out, and in particular that new diseases might be more likely to appear and spread along with environmental degradation and climate change, for example. But the scope of this is far too big for the private sector to internalize in their management decisions. If one thinks about companies offering insurance for a situation like the COVID-19 crisis, for instance, how should this have worked? They would have been bankrupt in less than a few days. The current crisis is really a macro issue that has to be handled by governments, but they have been pretty badly prepared for this. I would have expected that some government institutions are doing scenario planning and contingency plannig for such situations, given that there is this scientific knowledge, including estimations for probabilities and scopes of disasters.
At the same time, it is a very intricate situation of course: A pandemic doesn’t halt at national borders. Thus, a similar cristicism of lack of appropriate risk management can be put forward for supra-national institutions such as the European Union. The crisis has clearly shown that governments don’t coordinate their actions in a sufficient way during such a situation. We see very different strategies, with Sweden standing out in several ways. And we don’t know yet what is the right strategy, there are so many unknowns. That makes it particularly hard to use models for forecasting as it is typically done in risk management. And it makes it particularly hard for economic agents to adjust to the situation or take measures in a forward looking way. So, there are some parallels to 9/11, but overall, I would say that this situation is pretty much unprecedented, especially in scope.
JK: Would you say that the politicians will be able to do appropriate simulations and take according actions once they have enough data? How many variables can you include in such models?
MH: It would have to be different models than the ones typically used in economic analysis. From my perspective, the trickiest thing in this crisis is that it is the progress of medical sciences that determines how long it will last and how severe the outcomes will be, eventually. This is something that economists and financial analysts have no clue about, so it is almost impossible to use our forecasting techniques in this context. It could be that there is an effective treatment or vaccination available tomorrow, and then it is all over rather quickly. Or the crisis can continue for months more and it turns out that countries have lifted lock-downs too early etc. As a consequence of this medical uncertainty, there is substantial political uncertainty and different approaches of governments to respond to the crisis. In principle, modelling the spreading of a virus or the economic consequences of a lock-down is certainly possible, but as you mentioned it depends on the availability, quality and reliability of input data. It seems that in the current crisis the data basis has only built up relatively slowly; in fact, too slowly to appropriately inform policy makers. This implies for the future that efficient mechanisms of sharing and distributing medical data in crisis situations need to be in place in order to ensure that medical studies are run quickly and with sufficient data to generate reliable results.
JK: Could one say then that public risk management is fundamentally different from private risk management in that the objective function for the former is security and well-being for the collective while for the latter it is profit?
MH: Yes and no. I would say that public risk management might have somewhat different, more nuanced goals and might be exposed to different types of risk. Of course, the objective of public decision makers is to save lives and improve health conditions in the COVID-19 crisis, and not to minimize the damage for the public budget. However, in the end states also face cost-benefit problems here, just as companies do: If a crisis like a pandemy occurs, it comes with high costs, but preventing or mitigating it via complete shutdowns might offer some relief in the short-term but is also very costly in the medium- and long-term, as we already see now with exploding unemployment, rising numbers of corporate bankruptcies, and other health issues caused by the measures against the virus. One important difference between public and private risk management is in fact that governments often follow a short-term perspective driven by election cycles. Furthermore, politicians of different parties have different target groups they need to make happy. All of these “constraints” make effective risk management more difficult for public than for private institutions. Firms are not free of such issues, but they seem less prevalent.
JK: Given this particular situation, what measures could governments take that are effective, after all?
MH: Immediate measures would have to be very broad ones, to secure jobs and income for people and liquidity for companies. This is what we see governments and central banks doing at the moment, and there are quite a few economists who say that we need much more government aid for both businesses and employees. David Robinson from Duke University, who also has an affiliation with SHoF, for example proposed considerable lump sum payments to households. His point is that the economic system as a whole is quite fragile, especially in the case of the US that he writes about, but the same applies to most countries in Europe right now, and therefore general liquidity is crucial to avoid chain reactions.
When it comes to bailing out businesses, I think one would ideally be a little bit more selective and not automatically bail out everyone. It is, however, very difficult and controversial how to determine which firms deserve to be rescued and which ones not. But I agree with David’s argument that ‘now the house is on fire and we need to extinguish this fire first, not arguing how we could have built a better house’. On the other hand, it is also important not to overlook that if the house had been built in a better way, the situation would have been easier to handle. Thus, looking forward, it will be important to learn from the current crisis and one important implication, as discussed before, would be to be better prepared for such situations, to actively engage in risk measurement and management for pandemics.
JK: More and more researchers, journalists and activists have postulated a ’green new deal’, where government aid for companies is linked to improving environmental and social performance in the future, instead of general bail-outs. Wouldn’t this be more efficient from a long-term resilience perspective as well?
MK: I consider this to be very unlikely to happen. I think that the next years will be much more about recovery than they will be about brown versus green. But what I could imagine is that both governments and companies will rethink the ways in which they set up their operations in order to get more resilient to such crisis. For example, more local and diversified supply chains could very well be an outcome of this crisis. Similarly, I expect virtual meetings, online teaching, etc. to gain importance and to remain more prominent after the crisis compared to before the crisis.
All of this will most likely lower emissions and benefit the environment, and also could have positive social impacts, e. g. higher labor standards. At the same time such strategies might, of course, increase prices and potentially decrease demand for certain goods and services. This tradeoff – being better prepared for the next pandemic versus lower product prices – highlights precisely the dilemma of risk management. How prominent do you allow risk management to interfere with daily operations at the corporate or the public level? This is a very difficult decision to make and, in my opinion, it is even more difficult at the public, governmental level.
Then again, the current situation could also have a long-lasting impact on market participant’s perception of the importance of having sustainable and resilient systems in place. Some recent research suggests, for example, that sustainable firms’ stock prices dropped less in the crisis. Thus, one could imagine that the crisis in the end boosts the sustainability discussion if more evidence appears that sustainability and resilience against crisis fit well together.
When it comes to costs, related to e. g. investments in the public health system, we need to address the question where the money comes from of course. It might be that private investors, hedge funds etc. can play a role here. Or we’ll see restructuring in public budgets and fiscal policies, with new priorities. I think the willingness of investors and taxpayers to adopt such new strategies will depend a lot on how long this crisis will last. We humans tend to forget exceptional events rather quickly, but if this crisis goes on for months or even longer, the effects on our attitudes and values could be profound and I would assume that at least for a several years many actors in both the public and private sector would be willing to accept higher costs for risk prevention and lower profits in favor of building a more resilient system.
*Interview by Johanna Klatt, Misum research support & project management