(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 Old, conservative bankers and traders have been replaced by keen young mathematical analysts, yet anyone who listened to a grandmother who survived the Depression would have been warned against debt and been better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 …
Well I think you get it just about spot on! I certainly enjoyed wondering through your wee labyrinth. I only ran out of breath a little bit.
Me, I think economics should be ashamed of itself. I mean it can’t even agree on whether we are due a bout of inflation or deflation ferkrisesakes. What would physics be if it couldn’t predict the direction of an apple falling from a tree?
Sheesh.
“Can they (the regulators) be paid enough, and by whom, to do that?”
The problem isn’t only the regulators. It’s the politicians as well. As long as the legalized system of bribery we call campaign contributions are allowed to continue, those who pay the pols will rule the regulators.
Dumbublicans and Replutocrats are only too eager to do the banksters’ bidding: (repeal Glass-Stegall; bar regulation of derivatives; use taxpayer money to bailout firms that deserve to fail.
The insurance industry survived the crisis better than most by doing stress testing, rather than VAR. Kudos to the state insurance regulators, who are smarter than the Feds.
Now, let’s see if the states could do the same for banking. Eliminate federal charters. Let the states regulate banking. THey would be far more conservative than the Feds have been, and it would eliminate too-big-to-fail risk, because the bank holding companies would have to be broken up, a la AT&T.
” … preference to elegant mathematical models that could describe the world using the smallest number of parameters.”
That’s true in the sense that risk models in banks usually have a small number of parameters. In academic papers the models usually have some more parameters. The author seems to suggest that it would be better to have models with even more parameters than the academic ones.
That last opinion is misguided as it would be impossible to calibrate those models. If you have a lot of parameters, you need a lot of past data to calibrate. In many cases you just don’t have that data. For instance, there isn’t a lot of data for CDO tranches related indices. Hence calibration would be next to impossible.
Of course you can just make a choice of parameters. But then a smaller less complicated model with less parameters is usually a better alternative. In the last case you also just make a crude choice, but at least you admit it, and you don’t pretend your model is fancy.
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.
That’s the key issue which renders the position of dissenter-from-within-the-system somewhat incoherent.
Once you continue, in the face of all the historical evidence, to grant the premise that this sector should exist at all, it’s difficult to see why anyone within it should listen to the common sense of Taleb’s grandmother rather than the formula geek who says the coast is clear.
The premise itself already contradicts common sense. And so does the notion, beloved of those cited above, that you can “reform” this sector, with “regulations”, because somehow in the future you’re going to have better regulators.
Even if you had regulatory personnel who never become corrupted (but common sense and all historical evidence says they will), they would not be able to forever fight successfully the lobbying war of attrition which the premise institutionalizes.
Attempter said “The premise itself already contradicts common sense. And so does the notion, beloved of those cited above, that you can “reform” this sector, with “regulations”, because somehow in the future you’re going to have better regulators.”
Agree 100% – I would add we get the regulators we want (Martians did not appoint Greenspan) – Why was the maestro so revered? Pretty much like grandparents who spoil children.
David, do you really believe stress testing helped the insurance industry avoid problems? I am skeptical of this, so it would be very interested to hear more details about your reasoning.
The insurance industry did not walk away unscathed, and it is debatable that insurance regulators have done a better job in the face of crisis. The financial guarantors are a prime example – an area where state insurance departments have failed and continue to fail miserably. Even without the financial products unit blowing up, AIG held plenty of nasty non-agency RMBS. My understanding is that most of this was held by the insurance subsidiaries. Even without SCA, XL had problems with structured finance investments. Hartford experienced commercial real estate problems.
It seems to me that the more important factor helping the insurance industry has been a strong cultural aversion for anything fancy.
Just to be clear, I am not apologizing for the failed measure of whatever (VaR), or the massive failures in federal regulation … just questioning whether stress testing or state regulation really helped that much.
The models did not fail, the models were intentionally rigged with the wrong statistics, ala acquiecense of the rating agencies. Like cattle to the chute, our discussions continue to be misdirected.
The financial industry models have worked just fine. The whole point of the game has been one huge agency problem, a con, whereby the agent enriches herself at the expense of the customers, the taxpayers, and the society. The club, with Paulsen as the Trojan Horse, were betting that Geithner, Greenspan, Bernanke, and the Congress would cover the theft with the bailout. They did.
We are still on the hook.