The Chicago Fed today put out a rather unusual paper discussing the art and science of risk management. It concludes that too much focus was put on the science of risk management, rather than the art.
More and more, the ‘art’ of using informed intuition to navigate complicated risk landscapes was giving way to the ‘science’ of statistical models.
Risk management must combine art and science. While strongly informed by math and models, effective risk management ultimately relies on good judgment. Firms and their supervisors should seek to stress the importance of combining these perspectives.
The paper makes much of the unprecedented collapse in the housing market, but nothing about the unprecedented run-up in prices that preceded it. Surely, a sophisticated model would have the capacity to identify risks of a bubble when standard ratios (in the case of housing, prices-to-rent) get way out of whack. Yes, models assume that the future resembles the past in normal times, but if they make no allowances when the present ceases to resemble the past, is the fault not with the “art” of model design?
The paper also seems to undercut its argument that too little latitude was given to the risk managers judgment by point out that judgment is often skewed in good times.
The behavioural economics and finance literature suggests that when making decisions, people tend to underestimate risk and ignore signals of danger during boom periods.
Hmm…maybe managers and supervisors should work on getting the science right. After all, even if they had had the judgment to see the danger signs, would it have done any good?
Maybe not.
A paper released today written by a former resident scholar at the NY Fed says that financial firms risk managers “were often replaced when they did not understand the Brave New World” of post-subprime safety.
