Risk managers take note: Brexit was not a black swan

Protecting yourself against true black swans is the art of the possible, not the probable

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Nassim Nicholas Taleb deserves credit for his contribution to literature and received financial wisdom. His 2007 book, The Black Swan, forced many risk managers and other industry practitioners to think more deeply about the impact of improbable events and how they shape our lives. But the effect of Taleb's teachings has not been wholly benign.

To explain this, it's worth taking a look at the UK's June 23 referendum on its membership of the European Union. The result of that vote – 51.9% in favour of leave versus 48.1% for remain – has been described as a ‘black swan'.

Certainly, the result was unexpected and caught many by surprise. In a recent column for Risk.net, operational risk consultant Ariane Chapelle tells the story of a French financial firm that "prepared nothing except a vague internal note on Brexit – and only then because it was encouraged to do so by the European Banking Authority".

The upshot was the company had absolutely no communication prepared to reassure worried clients when the worst happened on June 24.

Lazily categorising entirely probable events as black swans narrows the range of potential outcomes and avoids the need to think of other, more extreme scenarios

Some risk managers I spoke to in the run-up to the vote told a similar story. For some, it seemed the scale of the challenge that might be thrown up by Brexit had persuaded them to put the possibility of it aside.

But the truth is that Britain's exit from the EU was not a black swan.

Taleb points to several distinguishing features of black swan events. One is that they have an extreme impact. Make of that what you will. Another is that they are "outliers", which lie "outside the realm of regular expectations, because nothing in the past can convincingly point to [their] possibility".

A true black swan event – such as the discovery of the first Australian black swan itself – is something that shatters our previous understanding of a system by giving us new evidence that differs dramatically from what existed before.

On the eve of the UK's referendum, four closely watched opinion polls contained margins of victory for either side of 2% or less, well within the usual margin of error. Two of those polls actually showed leads for the leave side, as other polls had done earlier in the campaign.

More fundamentally, the idea of the EU not being particularly popular in the country that coined the word euroscepticism should not have come as a surprise.

Comfort blanket

In the case of Brexit, the use of the term ‘black swan' is a comfort blanket – a reason why, in retrospect, the failure to prepare was excusable. It is symptomatic of a trend in which the risk managers' feathered friend reappears with alarming frequency. Lazily categorising entirely probable events as black swans narrows the range of potential outcomes and avoids the need to think of other, more extreme scenarios.

Since 2007, I've seen this all too often. During conference sessions with chief risk officers or other senior risk managers, participants are sometimes asked to identify potential black swans that their firm or the wider industry may face. Without ignoring the difficulty of this task, for it is difficult, most of the responses I hear are certainly not real black swans. History shows us there is no shortage of sharp corrections in oil prices, for example.

Good risk management requires more imagination than this. Protecting yourself against true black swans is the art of the possible, not the probable.

Risk managers – particularly operational risk managers – are paid to think about Taleb's outliers. But when reaching for extreme scenarios, too few think of the sort of paradigm-shifting events he had in mind. More rigorous thinking would confer benefits on individual firms and the industry as a whole. It would also make Brexit look like a picnic.

 

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