“There are known knowns… there are known unknowns… and there are unknown unknowns…” Donald Rumsfeld
In this age of uncertainty over the regulatory impact on the banking industry we turn to former Secretary of Defense, Don Rumsfeld[1] for some guidance on how to think about managing counterparty risk. Let’s break down this quote and see where it leads us.
KNOWN KNOWNS. This is the easy part… some of the time. This is what we know we know about our financing counterparties. This includes information that is pushed to us through the media and from our counterparties directly. It also includes our beliefs based on our interactions with our counterparties, things we believe to be true. How do we weave these things we know into something we can prepare for and create a series of action steps? This is where scenario planning can be useful, discussion sessions of probabilities and possible outcomes to evaluate your preparedness. There is another potential danger lurking in this category, the UNKNOWN KNOWNS. These are things you thought you knew that it turns out you did not.
KNOWN UNKNOWNS. These are the things we know that we don’t know or for which we don’t have current information. We need to find out or update this information and then feed it back into the KNOWN KNOWNS. This is where an annual review process across a broad range of topics (see tmphedgefundservices.com) can help update the things we do not know and it may also root out the UNKNOWN KNOWNS (see above).
UNKNOWN UNKNOWNS. This is the tricky one and possibly where the root of the next financial crisis lies. These are the things we crash into while looking in the rear view mirror at the last war. What are we not thinking about, or placing a very low (or no) probability of occurring? Sometimes this is an unwillingness to consider less probable outcomes. This is what Rumsfeld referred to as a lack of imagination in thinking about future possibilities. Nassim Taleb talks about this in his book “The Black Swan”. An event that is deemed improbable yet results in massive consequences. This can be a combination of bad assumptions (e.g., housing prices never go down) along with mixed signals and inefficient sharing of information (e.g., 9/11). Byron Wien, now of Blackstone and formerly of Morgan Stanley, tries to root out the UNKNOWN UNKNOWNS with his annual top ten surprises. These are possible events in the coming year to which he applies a less than 30% probability. So how do we deal with what we don’t know we don’t know when it comes to our financing counterparties? Again it may be useful to consider conducting a scenario session a couple of times each year. On the agenda for that session should be the possible events to which you may not be giving a high enough probability, events that could have outsized consequences if they occur.
At the end of the day no one wants to say, “I should have known.”
[1]There is a very good documentary on Rumsfeld, “The Unknown Known”, that is available on Netflix.