Physical Risk: The New Frontier

At the start of the 2008 global financial crisis, I was at a hedge fund. By its end, I was at the U.S. Treasury. I worked with kids only a few years out of college at both. The drama of 2008 was all they knew about markets. “Remember what is happening — you’ll never see anything like this again,” I told them.

I was wrong.

These financial shocks, even the most severe, pale to those of the potential risks that are to come. Climate, demographics and geopolitics are ushering in an era of risks that are long-lived, without precedent, and possibly existential. Ones we don't have the means today to fully understand nor measure. Ones we don't have the means to control.  

Now, I’ve worked as a chief risk officer for three decades at both banks and hedge funds. No matter where, the job boils down to three questions: Do we see what can go wrong, and how it will impact our organization? If it does, can we fix it? And can we fix it before it causes too much damage?

For all the financial violence wrought by 2008, there were three things we had going for us: We'd seen this sort of thing before. Banking crises occur in every country, in every decade. And we had the tools to address it. The Fed could inject liquidity, the Treasury could recapitalize banks and Congress could pass emergency measures, which they did through the Troubled Asset Relief Program, or TARP, which funneled hundreds of billions of dollars into banks, insurers, automakers and housing programs. The same in 2020 — markets plunged 30%, but then breakneck, aggressive action by the Fed and Treasury pulled them back from the brink.

And we were able to address the situation in short order. Financial markets are malleable and operate on a short timescale, so the tools can take hold quickly. In 2008, Lehman Brothers failed on a Monday and with aggressive action by the Fed and Treasury — along with a few new tools added to their utility belt — things were back in order by Friday. Within a few months it was as if nothing had happened.

That’s not to say, however, that nothing happened. The S&P 500 fell by 57% from peak to trough, home prices dropped by around 30% nationwide and household net worth collapsed by over USD 13 trillion. Millions lost their jobs, their homes and large portions of their retirement savings.

Going forward, and for the next generations, we will need to pose the same three questions I mentioned above to physical risks. They are risks that run through our supply chains and propagate and cascade to affect governments and societies. Compared to these, a rise in credit spreads or a tumble in the stock market seems downright quaint.

Unlike financial crises, which work their way through the system and dissipate, physical risks can go on and on and get worse and worse. Going from the most immediate to the longer term, as well as from existential to inexorable, the physical risks we face boil down to geopolitics, climate and demographics.

The impacts of geopolitical shifts are already visible and will intensify. Resource competition — over water, energy and arable land — is likely to rise, as are territorial disputes and pressure on borders. The effects of climate will accelerate. The answers will involve huge changes in the physical location of assets and plants and in their relocation, which will likely take years. The sea change of demographics is generational. For much of the developed world, the ratio of the aged population to workers will continue to rise, putting a strain on the social fabric. Labor will be in short supply, forcing a solution through immigration — which will also pose social strains — or a shuttering of factories and a refocus of production.

For physical risk, we can't rely on history — and we might not even recognize the risks given that we have not seen them before. We haven't seen rising sea levels or mass migration due to unsustainable geography. We haven't experienced the economic fractures or social upheaval due to demographic shifts. We can anticipate some implications these might have for our geopolitical landscape; for example, a fight for control of the arctic or for water as the glaciers in the Himalayas melt away, but we can't anticipate them all.

And, we don't have the tools to deal with it. The tools for financial risk work because the markets have a touch of consistency and there is so much data to use. But worse than not having the tools, the profession still has scant focus on physical risks. You can go through all the finance and economic journals over the past four decades and see very little on physical risks. And the term “supply chain” has only recently made it into the lexicon. I've rustled through many gyrations and flavors for financial risk methods — value at risk, marginal risk, factor models — we have those all well covered, and have done so for thirty years. Only now, long into my career, have I begun to touch on physical risk. 

There is one tool we can dust off, however. One that was at the forefront of addressing physical risk in the face of the German threat during World War II — input-output analysis. This was used to identify critical vulnerabilities in the German war machine, to see if there was one central node that could be targeted that would bring production to a halt. It turned out there was — ball bearings. The allies launched heroic missions to destroy the ball-bearing factories. Although success was short-lived because factories could be rebuilt and the output widely distributed, the utility of this tool still holds. Now, eighty years later, in peacetime, it can still be applied once more.

The real economy, with its supply chains, production centers and economic relationships, each linked by thousands more inputs and outputs, moves with the ponderous weight of a supertanker. And the economies make up just one layer in a multi-layer network that also includes governments and societies, all interacting. A course correction isn’t a matter of keystrokes and overnight wires, it is years-long restructuring. In other words, there’s no weekend bail out for a shuttered plant.

Financial risk has been front and center in risk management since the 1990s. Only now is the right amount of attention being placed on physical risk. We still don’t fully grasp it, but we need to get up to speed quickly because financial risk can cascade from one asset to another, but physical risk can change the world.