Risk Management and the Americas Cup

Of all the global sporting contests, few parallel investment banking as well as the America’s Cup regatta. The latest round of the world’s oldest sporting competition kicks off in San Francisco this month and provides a timely, unique comparison to the evolution of risk management in the global financial services industry.

In 1851, an American schooner raced with the Royal Yacht Squadron around the Isle of Wight off the southern coast of Great Britain,  winning a surprising victory and setting into motion a series of no less than 25 successful American defenses of the America’s Cup. To this day, no British team has ever won the cup, and non US teams have only prevailed five times in total.

The sleek schooners used at the competition’s inception in the 1850s were inevitably very different to the futuristic multi-hulled crafts we see today. The first-ever race was completed at an average speed of just under 7 knots—approximately 8 mph, compared to the AC72 class catamarans that can race the bay course at close to 40 knots, or 46 mph. The multiple masts of the wooden racing boats have been replaced by wing sailed carbon fiber cats, often referred to as “Formula One cars on water.”

The 1850s also saw the first truly global financial crisis, featuring the failure of large insurance firm, the Ohio Life Insurance and Trust Company. This led to the spiraling and free-falling of real estate prices, risk taking based on monetary expansion, and finally, government intervention.

The following 160 years have seen the U.S. precede the U.K. as the world’s central investment banking power, and have also seen an exponential growth in complexity of financial instruments routinely traded by Wall Street banks.  

The recipe for successful sailboat racing consists of a well-trained crew achieving the best position to take full advantage of prevailing conditions, while maintaining the necessary safety of the boat and crew. In short, racing yachts are funded and raced by those who understand and are willing to take on significant risks in order to be competitive. Investment banking is much the same — providing strategic funding to “Main Street” while profiting from prevailing conditions in the financial markets and economies.

A comparative example is the fixed sail of the current America’s Cup catamarans. A sail is essentially a wing that, at its fastest point of sail, slits the wind driving against it, sending wind over the top of the sail. This creates a small vacuum, pulling the boat forward while simultaneously sending the rest of the wind behind the sail, pushing the boat forward. This levered effect is exactly what enables a vessel to not only move into the wind, but to move at a higher speed than the wind itself.  The eventual speed is largely dependent on the dynamic tension of the sail and the shape that it is able to hold. In a traditional cloth sail design, accelerating and slowing down can be easily accomplished by simply collapsing this shape. When a fixed sail is used, its shape is established and cannot be easily collapsed. The tension is built into the sail so the boat will hold faster speeds longer and be far more difficult to slow down.  This has always seemed to me to be the perfect physical comparison to a financial derivative, where the design is such that the potential gains can outstrip the underlying market on which they are based. Complex derivatives can be made to profit in falling, rising or volatile markets, and once in motion, can be very difficult to slow down. It may be the case that economic conditions are being taken advantage of, but the pace at which a position can become detrimental and accelerate towards calamity is greater now with modern financial engineering than ever before.

The capacity for unrestrained risk taking in both the sailing and the investment banking world has not gone unnoticed by regulators. The America’s Cup is a unique sporting event, because it does not follow an annual schedule, relying on a challenger to come forward, lodging collateral and working through the rules that will govern the next event with the defending cup holder. This setup means that rules are modified to suit the latest sailing designs and trends for every contest. In turn, this means that in addition to the defender and challenger, anyone else who wants to content must abide by the rules as agreed upon by those two teams and the organizing committee. As well as being the oldest active trophy in international sport, the America’s Cup can lay claim to being the sporting event with consistently the most rule changes per event in the world. This again offers a comparison to the banking world where innovation, competitive advantage (for countries, as well as individual firms) and risk restraint are balanced by a constant rule review process. This is designed to curtail the wilder excesses of uncontrolled risk taking while encouraging profit generation from financial engineering.

In the end though, the regulations can be in place, the engineers can work their magic, and the crew can all know the boat and their responsibilities inside out. Once the race starts, the boat’s skipper is responsible for winning, losing, safety and disaster preparation, and understanding how close to the edge and the absolute risk tolerance the boat needs to run to have the best chance of success. This is where the CRO needs to see himself in an investment bank, or any financial institution, to be competitive, successful and to fulfill his firm’s stated intent in the market. But what does this take?

The answer consists of the following:

• Data – What is available and how reliable is it?
• Technical Understanding – What systems and hardware is available and what are its capabilities?
• Staff – How competent are staff members and how well do they understand the underlying strategy?

Once these are established and understood, it should be possible for a CRO to overlay the strategic goals and risk appetite of the firm onto the most likely market situation, along with tolerances for unknowns, and to stress test the framework. This is no different to the race planning and set up of an America’s Cup skipper.

In reality, conditions and plans rarely happen as expected; therefore, the ability to understand unexpected market impacts is critical to benchmarking the firm’s risk tolerance and appetite, and how tactical choices affect this positioning, which is similar to the challenges faced by the America’s Cup skipper. It’s important to note that while the high-level goals are generally clear, there are often lower-level goals that impact risk tolerance and tactical choices. Stakeholders for a regatta include sponsors who may value “being in the game” more than “winning at all costs,” which means that the racing risk tolerance becomes lower. Likewise, a bank may want to be an active market participant, but not a leader.

To summarize, in a well-run risk department, once the systems and correct levels of automation are in place, the staff understand the mission statement and the available data has been analyzed, the horn can sound and the hulls can fly! Let’s go racing!