(I was going to take a week off, but Yves suggested I post this.)
By George Washington of Washington’s Blog.
We have to change our risk models, and not just defer to the big banks’ inaccurate models which got us into this mess.
Says who?
I have been fighting risk models both as a Wall Street trader and as a professor and my worst nightmares were the results of regulators. It was they who promoted the reliance on ratings by credit agencies. The “value-at-risk” models regulators promoted made us take more risks…We replaced the heuristics of the elders with arrogant (and incompetent) beliefs, breaking, in the name of science, the chain of knowledge. Old, conservative bankers and traders have been replaced by keen young mathematical analysts, yet anyone who listened to a grandmother who survived the Depression would have been warned against debt and been better prepared than Ben Bernanke and Alan Greenspan, respectively chairman and former chairman of America’s Federal Reserve.
[And see this]
- Economist Robert Kuttner
- And many others
Today, Simon Johnson summarized the whole modeling issue very well:
Given that everyone is agreeing sophisticated risk models are worthless in crises, it seems particularly remarkable that regulators allowed some banks to use their in-house models in determining their own capital requirements – since one of the purposes of capital requirements is precisely to provide a cushion that protects banks (and their creditors, and taxpayers) in the event of a crisis. The obvious solution is that regulators should rely on cruder constraints, such as an absolute limit on leverage that banks cannot arbitrage around (one of the recommendations of Treasury’s recent white paper on capital requirements …), or periodic stress tests that estimate how bank asset portfolios will perform in a real crisis.
But there is a more interesting question to ask as well: why did VaR become so popular? It’s important to remember that competition among models is shaped by the human beings who create and use them, and those human beings have their own incentives.
David Colander made this point about economic models: the sociology of the economics profession gave preference to elegant mathematical models that could describe the world using the smallest number of parameters. “Common sense does not advance one very far within the economics profession,” he says.
A similar point can be made about VaR models. Sure, maybe all the financial professionals who design and work with VaR know about its shortcomings, both mathematical and practical. But nevertheless, using VaR brought concrete benefits to specific actors in the banking world. If common sense would lead a risk manager to crack down on a trader taking large, risky bets, then the trader is better off if the risk manager uses VaR instead.
Not only that, but imagine the situation of the chief risk manager of a bank in, say, 2004. As Andrew Lo has argued, if he attempted to reduce his bank’s exposure to structured securities such as CDOs, he would be out of a job; VaR gave him a handy tool to rationalize a situation that defied common sense but that made his bosses only too happy. And at the top levels, CEOs and directors who probably did not understand the shortcomings of VaR were biased in its favor because it told them a story they wanted to hear.
In other words, models succeed because they meet the needs of real human beings, and VaR was just what they needed during the boom. And we should assume that a profit-seeking financial sector will continue to invent models that further the objectives of the individuals and institutions that use them. The implication is that regulators need to resist the group think of large financial institutions. If everyone involved is using the same roadmap of risks, we will all drive off the cliff again together.
We ignore Johnson’s warnings at our own peril.
For background, see this, this, this and this.
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“The implication is that regulators need to resist the group think of large financial institutions.”
Can they (the regulators) be paid enough, and by whom, to do that?
Sometimes, all this reminds me of the acid that lasts too long – the first peak is exhilarating, the second is enjoyable, the third is nostalgic, and the fourth one comes with that sourness in the middle of the gut and the metallic taste in the back of the throat …
Over and over the issues are: How often can a flow of promised funds be repackaged and sold again, as a promise, to someone else? How many people along the way must be designated as expendable – the equity holders, the stake holders, the people with “skin in the game”? Whose side bets create value, and whose side bets are those of carrion feeders? (Right, even they have their niche, an ecological purpose. Right.) How much, and for how long, can central banks (I read the World Bank news today) take promises of future funds onto their books in exchange for spendable funds now, how fast must or can any economies even grow to generate the profits to purchase those back from the central banks, and what happens if those future funds never get collected by the central banks,(and there are analogical questions re GSEs) AND by the way, how much government debt can those central banks hold or is that relative to how fast the a) the real economy or b) inflation generates (real? nominal?) tax revenue to pay off that government debt;(uh oh, Greenspan once said that paying off government debt is inflationary… debt, and the retirement of debt, is bad …) and might all of this have been avoided and can it be fixed if only some commodity were designated as the value numeraire, setting aside any questions whether handing the money supply over to private parties (or corrupt producer states, whatever) is probably no more reasonable than fiat currency in bad faith…since nobody can agree whether private banks create money by making debt which the central banks follow, or who causes what, and so what about ending fractional reserve entirely and let’s just see if everything grinds to a stop, or not?
After all, the only model sufficiently complex to test the policy hypothesis IS the real economy … (No, I don’t want to try that.)
I need an Arthur Jensen surrogate to fully express my exasperation. Maybe I just don’t get it – but then I’ve never been one accused of having much common sense …