Why Basel III matters

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Numbers Don’t Lie

Some years back, I came upon an article in the San Francisco Chronicle comparing major airlines’ on-time performance (1).  This comparison was based on data published by the US Department of Transportation on a monthly basis. The article listed the airlines having the best and poorest performance but without any explanation of why that might be. In particular, they ranked Alaska Airlines at the bottom of the list.  As I read the article I realized that the readers would make the erroneous conclusion that Alaska Airlines was doing a very poor job.  Why did I think this conclusion was erroneous?  Because Alaska Airlines flies out of cities prone to extreme weather conditions and these conditions would naturally cause delays.

Confounding Variables

In Statistics, confounding (i.e., lurking) variables are extraneous variables that correlate to the dependent or independent variable.  Failing to recognize these usually leads to erroneous causal conclusions.  In the case of the airlines’ on-time performance article, the article failed to mention that Alaska Airlines flies out of foggy airports.  Therefore, it is highly possible that it is not the airline contributing to the delay but, rather, the airport the airline is flying out of.  I wrote a letter to the editor explaining this (2).

Bottom line: watch out for those lurking variables. People can lie with numbers but numbers don’t lie!

(1) The San Francisco Chronicle article can be found here: http://articles.sfgate.com/2003-02-04/business/17476492_1_on-time-performance-american-airlines-flights
(2) The letter I published can be found here: http://www.sfgate.com/cgi-bin/article.cgi?f=/Chronicle/a/2003/02/23/BU164666.DTL

The Heroes of the Risk Quantification Process

What makes for a successful risk quantification process?  Prior to joining the firm I thought it was all about analytics (my own specialty).   I’ve come to realize that a happy marriage between data, analytics, and reporting needs to take place.  Each component brings a necessary piece to the risk puzzle of a portfolio.

But it goes beyond just that.  After working in all three areas I realized that the talented people who specialized in a particular domain were, in a sense, heroes.

The Unsung Hero

These are the people working with the data.  They are also, I believe, the lynchpin to the entire process.   The individuals who work in this area go through much effort (and frustration) to ensure the data being piped down the line is clean, coherent, relevant, and current.  This involves cool stuff like using data models and fancy acronyms like ETL.

What shocks me the most?  Few people truly recognize the importance of these individuals.  Especially if the data is clean and correct.  If it is dirty and incorrect, you know it in a hurry.

The Superhero

These are the people using statistics/mathematics to assess risk.  Much like superheroes with their utility belts or powers, people in this group have their own special tools.  These individuals use a host of nifty items to get a sense of the risk in the portfolio.  Value-at-Risk, regression models, time series analysis, copulas and other intimidating sounding, but extremely useful, tools are employed.

The Epic Hero

These are the people who take the data and analytics and build reports.  In literature, an epic hero is a person favored by the gods.  In this case, the “gods” can be one’s boss or upper management.  Individuals who do this well get praise upon praise upon praise.  The reason why: done correctly, nothing tells a better story than a picture…with pretty colors and nicely formatted numbers.

In Summary

There are three core pieces required to establish a solid risk quantification process.  And, if you are lucky enough to be working with heroes, then all sorts of insight about the risk in one’s portfolio can be obtained.

A parting suggestion: next time you want to praise the person who created your awesome report, do so.  Then follow the thumping sound – that will be the data person banging his head off the nearest wall.  Make sure you thank him too.

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