Frank Elderson: Ensuring resilience in the face of uncertainty

Frank Elderson addressed the recent joint ECB-Bank of England conference, emphasizing the importance of ensuring resilience in an increasingly non-linear world. Risk management has traditionally relied on the assumption that with enough data and historical patterns, banks can estimate losses with a reasonable degree of precision.

However, the modern world is becoming more complex, interconnected, and uncertain due to factors such as geopolitical fragmentation, demographic changes, artificial intelligence, and climate and nature (C&N) crises.

The conference aimed to explore the challenge of addressing non-linearities and understanding uncertainty, distinct from risk. The speaker introduced a simple framework to tackle this issue, distinguishing between known knowns, known unknowns, and unknown unknowns. While progress has been made in identifying, quantifying, and managing C&N risks, many of these risks are forward-looking, and their timing, magnitude, or probabilities remain uncertain.

The known unknowns include risks that we know exist but whose impacts are difficult to predict. Examples include the potential approaching of tipping points in the Earth system, such as the dieback of the Amazon rainforest and the collapse of the Atlantic Meridional Overturning Circulation. Additionally, the speaker highlighted the complexity of compound events and their potential to amplify impacts.

For instance, a severe drought could occur alongside other adverse events, making it challenging to forecast and assess their combined effects on financial risks faced by banks.