Risk round-up

It is sobering to consider that the last time the world endured an economic crisis on the scale it is now experiencing — the Wall Street Crash of 1929 — it was followed swiftly by the most destructive war in history.

Thankfully, the interconnectedness of today’s societies should prevent the same sequence of events. But that is not to say that the economic crisis won’t trigger a wave of political upheaval around the world.

The banking crisis of the 1920s ignited discontent with the ruling order in the West. Now, with rising levels of unemployment and inflation in the developing world, the new crisis poses a serious threat to political stability.

From the anti-capitalist G20 protests in London to the wave of demonstrations against rising living costs in countries as diverse as Senegal, Egypt, Myanmar, Belgium, Russia and South Africa, violent risks are marching hand-in-hand with the global slowdown. The greater the economic shocks the greater the likelihood of social unrest and conflict.

All this makes companies uneasy, and likely to reconsider whether to make that investment overseas. The flow of capital into emerging markets is slowing to a trickle. The Institute of International Finance says the total volume of capital entering emerging markets this year is expected to drop to $165bn (£113bn), compared with $466bn in 2008 and the record $929bn in 2007.

By shunning the developing world, companies may be hampering efforts to overcome the crisis as well as creating problems for themselves. The World Bank estimates that the developing world is facing a financing shortfall of up to $700bn this year. Robert Zoellick, the bank’s group president, says: “Preventing an economic catastrophe in developing countries is important for global efforts to overcome this crisis.”

Certain emerging market leaders are actively seeking foreign investment. However, they face a huge challenge of convincing companies that they are a safe place to do business in tough economic times. Political instability, opaque rules and excessive bureaucracy are significant obstacles to success.

Still, faced with the prospect of a deep recession in their home markets, some companies are still looking for pockets of growth elsewhere. Emerging market growth rates remain a strong incentive for international investors.

Risk adviser Maplecroft says Eastern Europe, as well as parts of South America, Africa and the Middle East, are considered the most politically risky.

Charles Mackay, political risk underwriter at Pembroke, thinks political risks are set to intensify. “Even before the onset of the global recession, the general threat of confiscation, expropriation or nationalisation had increased. The global economic outlook looks set to accentuate this trend.”

HOW RISK MODELS FAILED

The trouble with risk models is they cannot predict the future. They can only analyse historical events and make assumptions about what will happen. That’s fine if you are dealing with something as simple as losses on a book of motor insurance business. But over the past couple of decades, the global financial system has become so complicated and inter-related that accurately predicting market gyrations is practically impossible.

Systemic risk, meaning the spread of instability throughout the entire system, is a new feature of the global business environment. Most models incorrectly assumed that risks were not interdependent. This should have been an early warning that models were not keeping pace with developments in the modern world.

Even with perfect models and perfect data, few people could have predicted an economic crisis of the magnitude we are now experiencing. The models simply were not built or tested to withstand such a colossal collapse. They should have been stress-tested to consider the outcome of end-of-the-world scenarios. But the probability was so slim it appeared to be insignificant.

Popular consensus is that models are a good thing. Regulators even encourage financial firms to rely on them to judge how much capital they need to store in reserve. The problem is that to capture the complexity of the financial system, simplifications and assumptions have to be made. The people who make models know that, but how well that is understood by everyone else is up for debate.

One phenomenon that is far too complex to squeeze into a model is human behaviour. Our decisions are rarely rational because they are more likely to be based on emotions – something that a strict formulaic approach cannot account for.

Another assumption is that everyone follows the rules. Not so. Many people engage in activities that are anything but responsible, honest or diligent.

Furthermore, as long as the models suggested the risks were “remote”, businesses ploughed ahead. Risk managers may have suffered from a little myopia and failed to stress the importance of questioning what the models were saying.

With money rolling in and the world lulled by a sustained period of growth and stability, few people – politicians, investors and business leaders included – wanted to restrain financial firms. Short-termism was a major hallmark of the current crisis and may continue to be a characteristic of future crises.

Modelling is not a new thing and it is not likely to go away just because it failed, as everyone else did, to spot the financial crisis in advance. The limitations of models have always been known, but may have been intentionally ignored.

BRIBERY ON THE RISE

Bribery and corruption in business transactions decreases competition, deters investment, and increases the cost of goods and services. And yet it is surprisingly and worryingly common in the world of international business.

The Organisation for Economic Co-operation and Development (OECD), one of the world’s foremost anti-bribery groups, believes the moral responsibility is on the rich world, the “supply side” or bribe payers, to stamp out corruption. But the level of convictions for bribery remains poor.

There are many reasons for this. Offences are difficult to detect because they are, by their nature, secretive. Uncovering them requires a free flow of information across national borders and improved co-operation between businesses, the financial sector, governments and the media. Complicated jurisdictional issues also slow the pace of enquiries. And prosecutors sometimes lack the resources and specialised training to detect, investigate and prosecute bribery properly.

Another big issue is that some jurisdictions do not take their responsibilities to tackle corruption seriously. For example, the OECD is deeply troubled by the UK’s discontinuance of the BAE/al-Yamamah investigation [into two decades of arms dealing with Saudi Arabia], which was silenced in 2006 in the interest of national security, and the lack of progress in rectifying deficiencies in foreign bribery legislation.

Britain has a damning reputation and a long history of failing to tackle corruption. This country achieves far fewer prosecutions for bribery by comparison with the US and Europe. Only between 10 and 12 bribery cases are brought to court each year in Britain, according to Ministry of Justice figures.

But there are promising moves towards improved enforcement worldwide and tough penalties are being handed out for non-compliance. With the prosecution of the insurance group, Aon, at the beginning of this year for failing to prevent $7m (£4.8m) of suspicious payments to overseas firms, the UK could be toughening its stance.

Another big step forward would be tougher laws. Britain is preparing a draft Bribery Bill making it a criminal offence to offer or accept a bribe anywhere in the world. Under the proposals the maximum penalty for such a crime would rise from seven to 10 years, with an unlimited fine.

The bill is also expected to include a new corporate offence of negligence in preventing bribes. Transparency International, a global coalition against corruption, has urged the government to pass the bill before the next election.

The OECD also is pushing to grow its influence in Asia and Africa – two regions where bribery thrives.

Meanwhile, Transparency International has welcomed President Obama’s tough stance on anti-corruption enforcement, evident from his first day in office. The coalition lauded his declaration that “transparency and the rule of law will be the touchstones of this presidency”.

The Siemens bribery case, which revealed widespread corruption in one of the biggest corporations in the world, also demonstrated to companies that they can be hit with tough fines if they break anti-corruption laws. In December 2008, the German engineering giant pleaded guilty to violations of the Foreign Corrupt Practices Act (FCPA) and agreed to pay a record total of $1.3bn to American and European authorities. This was the largest monetary sanction ever imposed in an FCPA case.

The incident, which has done untold damage to Siemens’ corporate reputation, is also indicative of a trend whereby foreign jurisdictions are increasingly co-operating on big cross-border investigations.

But there is a danger that governments and businesses will focus less on corruption in the current economic climate. Governments may be tempted to protect business at all costs. The British government, for example, has begun using emergency powers to remove barriers to export credit agencies, which means exporting companies can circumvent safeguards meant to protect human rights, the environment and sustainable development.

There is also a serious threat that in the fight for business companies will engage in questionable tactics. And there stands to be more and more public contracts for businesses to compete for because of the role played by government in reigniting domestic economies. A large part of the fight against corruption depends on the level of political will to use the tools already in place.

Nathan Skinner is associate editor of Strategic Risk, a sister title to Insurance Times.