(R)evolutions in Political Risk Assessment
The 2015 Fletcher Conference on Managing Political Risk got kicked off with a exciting and broad perspective on the industry of "Political Risk" (if that is indeed the right name for it...)
Check out the video and conference notes below to see what self-diagnosis and predictions for the industry's future were provided by our panelists.
Panel 1 – (R)evolutions in Political Risk Assessment
Global expansion of businesses requires an understanding of varied political landscapes and regulatory environments in new markets. Political risk analysis aids business strategy by early identification of threats that may directly impede business performance and obstruct return on investments. Instability of political regimes in the MENA region, acts of terrorism globally, threats of sanctions, and national elections in emerging markets are only some events of this year that have had significant bearing on conducting business internationally. This panel will explore the evolution of political risk analysis and its incorporation within a firm’s broader risk management strategy. In addition, the panelists will share their insights into the existing tools and frameworks to measure political risk and strategies adopted to mitigate it.
Moderated by Professor Jonathan Brookfield, Associate Professor of Strategic Management and International Business
DJ Peterson, Founder, Longview Global Advisors
Eight trends/changes in political risk
- Political risk industry has evolved over time and has recently become more formalized. No one was advising students on careers back in the 90s; this conference could not have happened then. For a career in political risk, you have to be flexible and evolve with the markets
- Regional focus on risk analysis has changed over time. For example, focus shifted away from Russia and the Soviet Union after the collapse the Soviet Union, later China emerged as an important subject of study and now we are witnessing rising interest in Southeast Asia and Africa. In the future, it's Brazil, India, Venezuela, Cuba; Iran may present niche opportunities of study. The United States is a source of political risk for investors, especially after 2008-2009.
- The ubiquity of data is a significant shift in the political risk industry. Emerging markets data, social media, are all creating massive inflows of data. This data needs to be converted into insights for the clients.
- Crowdsourcing has made information and data ubiquitous: multiple sources and views can be extracted.
- The buyers of political risk have changed over time from the CIA, focusing on conflict to Mining and oil companies thinking about expropriation and asset managers or currency traders. But now, consumer retail companies are emerging as customers as well and are focused on brand risk, regulatory risk, license to operate etc. The language used changes depending on the client.
- Client questions have become much more complex. Longview Advisors offers frameworks to clients, rather than data points, through which to understand the world in a sophisticated manner.
- The marriage of political risk and consulting is an interesting filed to watch out for.
- Geopolitics and risk have become very commonplace. However, discussions should be focused on both risks and, importantly, opportunities. You want to empower and enable your client to mitigate the risk.
Sam Wilkin, Senior Advisor, Political Risk, to Oxford Analytica
Political risk in the banking sector
- The big difference between banking and all other sectors is that banks are required by regulation to manage and assess country risks. For example the Sarbanes-Oxley regulation in the United States.
- Country risk exposure, country ratings and monitoring of country conditions are mandatory for banks to watch and therefore critical to the sector.
- In the 1990s country risk reports were fairly commonly released. However, banks became less concerned with country risk and learned not to lend to emerging market borrowers. In turn emerging markets became more prudent and did not borrow as much, especially after the Asian Financial Crisis.
- Political risk in banking has re-intensified in advanced economies as the 2008 crisis witnessed in the United States and the Euro Zone.
- Now, the country risk analysis profession has re-emerged in the banking sector.
- When a banker says political risk, they're talking about political events that may effect economics or drive credit profiles of countries.
- Quality of governance in a country has become a major factor of determining if the country is going to receive a bailout in case of a financial crisis—this important factor creates more concern among bankers regarding country risk. Governance in Greece, for example, represents an important concern for the European Central Banks in determining whether Greece can be bailed out.
- Distinction between models and analysts has evolved: many banks still use political risk models, but analysts are gaining the upper hand. For example, modeling techniques were unable to detect the 2008 financial crisis. In response, analysts are becoming increasingly important for a holistic approach to risk assessment for banks. Mathematical techniques can be supportive of the human assessment – so the country risk analyst uses the model as a tool, but the analyst must make the final decision.
Laura Burns, Senior Vice President, Willis Financial Solutions
Political risk insurance industry
- Willis serves Fortune 500 companies and banks loaning emerging markets. These clients want actionable and prescriptive data.
- The wave of privatizations and emerging market investment means that virtually every industry is interested in political risk.
- Tools for forecasting political risk were not always relevant for decision-making. Willis created an alternate model that could monetize profits and losses.
- Willis launched VAPOR or Value at Political Risk to provide a more valuable risk assessment tool for clients. VAPOR builds on the framework of natural disaster catastrophe modeling while recognizing that political risk events are dynamic. VAPOR covers100 countries (mostly emerging and frontier market), and calculates risk based on: expropriation, currency inconvertibility, political violence, embargo, and exchange risk.
- VAPOR tries to apply this new framework to political risk, infusing qualitative data, and running it through an algorithm to come up with a figure for and annual expected loss number and a maximum loss number to guide conversations regarding insurance.
- As with any model, VAPOR was based on a series of assumptions—it chooses to focus on large catastrophic events like expropriation, large currency convertibility issues, regulatory changes etc.
- The wave of the future is to quantify risk, because that is the only way to mitigate it.
David Glancy, Professor, Institute of World Politics (IWP)
How political risk assessment can be improved
- Political risk has increased significantly past 20 years that created the need to consolidate best practices.
- Three needs should be addressed in the political risk field: improving quality of assessments, and incorporate new technologies into the field and adding economic and financial impacts of risk.
- The quality of assessments varies greatly since there are no core methodologies applied in most firms, frameworks for methodologies are absent, and quality of analysts could vary.
- In contrast, country risk reports have core methodologies but limited in scope.
- Methodologies should be developed based on industry focus or risk exposure. There are no set standards for political risk analysis – academic research could help in building those frameworks.
- More academic programs should develop case studies in political risk – and also offer courses in political risk, providing the connective tissue between law, economics, conflict, security, etc.
- Strategy consulting firms publish more in the field than political risk focused industries now.
- The Good Judgment project for example found that even with minimal training forecasting results can be improved and sustained.
- Academic institutions can drive the research needed to show how political risk assessment tools can concretely affect businesses in terms of profits.
- There is still work to be done in the field – many multinational firms said in a survey that political risk analysis would not be their first course of action to minimizing the risks of their investment. Therefore, the profile of political risk analysis still needs to be raised.
From the moderator, Professor Jon Brookfield:
- What is political risk? In finance, it's volatility – and this incorporates both the downside and the upside. But we don't talk about windfall gains in terms of political risk. Political risk should also focus on the upside.
- We have focused a lot on the role of the analyst, relying on individual insight, the mathematical models, and frameworks. The frameworks appear to be necessary to communicate the information from the expert to the client.
- What are the top risks for 2015?
- Russia and Ukraine will continue to spiral downward
- Iran has a lot of upside and downside
- India is the market to watch right now
- A lot of people are hedging on China, Brazil
- Southeast Asia also has a lot of upside
- Turkey is on the downside and its course is uncertain
- The new era is one of creeping expropriation, not overt nationalization. Could those previous risks reappear?
- Less risk in terms of expropriation, especially now that oil prices are so low
- Sovereign default in Europe is a big risk. It is a risk in emerging countries like Russia, Venezuela because of oil prices
- When was the last time you were surprised by a geopolitical event?
- Laura: Arab Spring in 2011 was caused by unforeseen events. Behavioral economics of understanding the crowd and social media unfolded as an important factor. And the unintended consequences and lesser linkages between countries are hard to predict, for example extremism caused in Mali after the fall of Qaddafi.
- David: There are triggers that can guide assessment—trends, elections, and other factors are essential to monitor.
- DJ: annexation of Crimea was an unexpected event. Wars and revolution are very hard to predict. As Ian Bremmer has said, you can never put together a prediction and a timeline – because then you hold yourself to a very tight standard. The blind spot is often the client: firms need to connect the dots and make the research relevant to the client.
- Sam: the blind spot has been political risk in advanced economies. Regulation still stipulates that in the home country, sovereign debt is risk free, which is obviously not true in places like Italy. That is a major blind spot.
- When will clients take risk analysis in-house instead of using outside agencies?
- Many sophisticated firms want opinions from inside and outside for a third party objective view.
- Firms may have political risk assessments buried in the finance, law or strategy silos—that presents a challenge in gaining leadership support for a dedicated in-house team.