VoxEU Column Financial Markets

Why bank risk models failed

Financial supervision arguably failed to prevent today’s turmoil because it relied upon the very price-sensitive risk models that produced the crisis. This column calls for an ambitious departure from trends in modern financial regulation to correct the problem.

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 the 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 optimisation 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 or she 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 as vertical price falls, prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs has less to do with the precise financial instruments and 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, were going to send the herd off the cliff edge was made soon after the last round of crises.1 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.

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 upon which we have stumbled. 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 to 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.




1 Avinash Persaud (2000). “Sending the herd off the cliff edge: the disturbing interaction between herding and market-sensitive risk management models,” Jacques de Larosiere Prize Essay, Institute of International Finance, Washington.



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