March 31, 2008
Why Bank Risk Models Failed and the Implications for what Policy Makers Have to Do Now
My friend Professor Avinash D. Persaud recently gave a speech to the Committee of European Securities Regulators (CESR) on why bank risk models failed and are bound to fail. It is today’s guest blog. Avinash is a trustee of the Global Association of Risk Professionals, Chairman of Intelligence Capital Limited and Emeritus Professor of Gresham College.
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Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.
The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed at the Rand Corporation by Harry Markovitz and George Dantzig. This was a time of capital controls between countries, the segmentation of domestic financial markets and to get the historical frame right, it was the time of the Morris Minor with its top speed of 59mph.
In today’s flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments and use standard optimization models, which throw up the same portfolios to be favoured and those not to be. Market participants don’t stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite.
When a market participant’s risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs is less to do with the precise financial instruments, but more with the depth of diversity of investor behaviour. Paradoxically, the observation of areas of safety in risk models, creates risks and the observation of risk, creates safety.
Quantum physicists will note a parallel with Heisenberg’s uncertainty principle.
Policy makers cannot claim to be surprised by all of this. The observation that market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner, was going to send the herd off the cliff edge was made soon after the last round of crises*. Many policy officials in charge today, responded then that these warnings were too extreme to be considered realistic.
This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.
My purpose is to explain why the reliance on risk models to protect us from crisis was always foolhardy. In terms of solutions, there is only space to observe that if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse. This is the approach we have stumbled upon. Central bankers now consider mortgage-backed securities as collateral for their loans to banks. But the asymmetry of being a buyer of last resort without also being a seller of last resort during the unsustainable boom will only condemn us to cycles of instability.
The alternative is to try and avoid booms and crashes through regulatory and fiscal mechanisms designed to work against the incentives, fed through risk models, bonus payments and the like, for traders and investors to double up or more into something that the markets currently believe is a sure bet. This sounds fraught and policy makers are not as ambitious as they once were. We no longer walk on the moon. Of course, President Kennedy’s 1961 ambition to get to the moon within the decade was partly driven by a fear of the Soviets getting there first.
Regulatory ambition should be set now, while the fear of the current crisis is fresh and not when the crisis is over and the seat belts are working again.
*Sending the herd off the cliff edge: the disturbing interaction between herding and market-sensitive risk management models, A. Persaud, Jacques de Larosiere Prize Essay, Institute of International Finance, Washington, 2000.
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Posted by: FT.com | Willem Buiter’s Maverecon | The Howling Hole in Treasury Secretary Paulson’s Proposals for Regulatory Reform | March 31st, 2008 at 11:36 pm | Report this commentIt appears an understanding of Nash equilibrium ought to required of every trader!
Another source of structural instability, possibly related to Heisenberg’s principle, is that the addition of new financial instruments (or novel large scale trading strategies) changes the equilibrium configuration of relative prices. Thus, innovations based on exploiting historically robust pricing relationships may fail because their widespread adoption - the ‘herding’ effect - alters the equilibrium configuration. A relevant contemporary example is the failure of risk modeling of the housing market. It is just possible that the historical relative frequency relating borrower credit-worthiness and default was altered when the market became swamped with low credit borrowers. Before, when there were fewer low credit borrowers, the incidence of borrowers who could not pay was low enough that their forced sale did not affect the market price of homes, and therefore most were able to realize enough from sale proceeds to avoid default. Now that the proportion of low credit borrowers has dramatically increased due to the recent proliferation of sub-prime lending, their selling has caused a price collapse which, in turn, has triggered a wave of defaults and a financial crisis.
Finally, Prof. Persaud presents another alternative to the restrictive assumption of ubiquitous model knowledge inherent in the prevailing Rational Expectations paradigm. In addition to the pervasiveness of model uncertainty and model plurality (ala Frydman and Phelps), he paints a compelling sketch of a herd careening in unison from one incorrect model to another.
Posted by: Daniel J Aronoff | March 31st, 2008 at 11:43 pm | Report this commentProfessor Persaud, Well said. Are you familiar with Bookstaber’s “A Demon of Our Own Design”?
Posted by: groucho | April 1st, 2008 at 1:35 am | Report this commentMarket sensitive risk models make large institutions akin to option traders. An option trader who is short gamma will sell as prices fall and buy as they rise. There is no harm as long as he or she is small relative to the market.
Posted by: Otto | April 1st, 2008 at 1:45 pm | Report this commentHowever, we can not all dynamically hedge the same adverse outcome. I refer to Grossman and Zhou for an analysis inspired by the 1987 crash but still valid today: Equilibrium Analysis of Portfolio Insurance, J. OF FINANCE, Vol. 51 No. 4, September 1996.
This sounds fraught WITH policy makers and I’m having difficulty imagining how that is the best way to correct the problem. I agree that models should never be relied upon as a backstop but I don’t believe that we have seen enough price transparency to discount it’s ability to avoid these problems in the future. The policy makers should set an example by making public their valuations of all the illiquid debt they are assuming.
Posted by: simple undergrad | April 2nd, 2008 at 7:47 pm | Report this commentMany good thought here. I go with the comment from Aronoff any day.
I feel this all boils down to what could be frased the lucas critigue. From Wikepedia on that subject “note that Fort Knox has never been robbed. However, this doesn’t mean we can safely eliminate the guards, since the incentive (not) to rob Fort Knox depends on the presence of the guards”.
So perhaps the guards vere not there (or they fell asleep) and Fort Knox was robbed. So should we guard the empty fort now? Well for sure that will work, because there is nothing to rob! In due course it will get filled again and the guards will most likely fall asleep again; especially if we give them too many silly routines. Or if the guards somehow manages to stay awake, someone will think of a way to get around it. The french build the Maginot line to protect France. Hitler just drove by.
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It hard not to agree with the fact that to rely on models that tells us that the future is a function of the past is not smart.
BUT to lay all this out as a model failure is wrong I believe. I think it is more fair to say that in the standardised and globalised world of today risk (and cherry pie) is transferred through multiple processes to the final consumer; no-one in the production feels responsible for quality only for quantity and sure this is how they are paid. As long as it all works it works great, but at a point someone gets too greedy and eventually it fails in a big systemic crash (think mad cow disease) and the herd shy even the good beef. Eventually the appetite comes back and there you go again.
There is nothing new under the sun in this. Its called capitalism, and it works, cycles are seen before and will be seen again.
The “solutions” I think is
(1) live with it and take the pain when it gets too crazy
(2) Go back to a (not so?) rosy world where each farmer eats his own beef
(3) Communism
Of these 3, I’d go with (1). To think the solution is more power to regulaters or to deny the Golman Sachs trader his bonus is foolish. Robert Lucas will find his way around that anyways. And thats the spirit, the future is made of.
Dr. Pangloss does have his moments, Mr Buiter
Posted by: Jacob Peter | April 5th, 2008 at 12:18 am | Report this comment