Via Baseline Scenario:
One thing that seems clear is that risk models that are designed to function in normal market conditions should not be relied upon to predict outcomes in times of crisis. On this account, VaR doesn’t kill banks; executives who don’t recognize the limits of VaR kill banks. As Bookstaber put it, “one has to look beyond VaR, to culprits such as sheer stupidity or collective management failure: The risk managers missed the growing inventory [of risky assets], or did not have the courage of their conviction to insist on its reduction, or the senior management was not willing to heed their demands. Whichever the reason, VaR was not central to this crisis.”
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, which we discussed here), 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.
Read the full post here
This is a great follow up to my previous post. Simon Johnson and Peter Boone discuss the Wall Street-Washington connection, or as Tyler Cowen termed it, the politicization of the economy.
The real problem with our financial system is that our economic and political system work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse. In 1998, a much smaller Lehman Brothers was placed in financial peril by the aftermath of the Asian financial crisis and failure of Long Term Capital Management, a major hedge fund. The Federal Reserve responded by lowering interest rates and other central banks followed suit. This reduced the cost of obtaining funds, effectively bailing out Lehman and other institutions in trouble.
As markets have grown to recognize how quick the Federal Reserve is to bail out institutions (and executives) in trouble, they naturally respond. In the 1990s, people talked about the “Greenspan Put” a term which derisively suggests that it is always safe to invest in risky assets, because the Federal Reserve is ready to bail out investors (a put is effectively a promise to buy an asset at a fixed price if you are unable to sell it to someone else at a higher price – this is a way to lock-in profits or limit losses on investments). However, in months following the collapse of Lehman, we learned that the “Bernanke Put” is even more valuable since Chairman Bernanke, alongside the Bank of England, the European Central Bank, and central banks in much of the rest of the world, is prepared to take drastic measures to prevent asset prices from falling when there are risks of global collapse.
This policy of responding to the aftermath of bubbles, rather than addressing them before they get going, through tighter regulation, has become the mantra of most central banks. It is usually combined with fiscal policy stimulus and other measures to support the economy. Each time banks fail, by bailing the system out again, we teach our finance sector a lesson: you can safely take too much risk because, when you lose, the taxpayer will pick up the bill. We also send a simple message to creditors: it is safe to lend to Goldman Sachs, or Barclays Bank, because taxpayers and our nations’ savers are standing by to cover your losses. Rational bank executives and creditors respond as any person would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits. Such a system is destined to fail, but the party can run for a long time.
A government implicit (now explicit) guarantee absolutely encourages excessive risk taking. FDIC and government implicit guarantees helped lead to the financial crisis by encouraging reckless risk taking, and then the government bailed out the companies. I’m not sure how much of a free market proponent Simon Johnson is, but for the record, what I just described is not how the free market operates. It’s also not capitalism, but once again, the mixed economy at work.
Felix Salmon comments on the Simon Johnson and James Kwak article, “Before the Next Meltdown”. He has some valid issues with it, which he addresses below:
Simon Johnson and James Kwak have an important article on financial innovation in the latest issue of Democracy. The broad thrust of the article I agree with — as you might expect, given that after listening to my last debate on the subject, James Kwak came to the conclusion that “obviously I agree most with Salmon”. (Thanks, James!)
That said, there are significant chunks of the Johnson and Kwak article that I disagree with, and I feel that it’s probably long past time that the “financial innovation: good or bad?” debate allow itself to make some nicer distinctions than have generally been made until now. So with the clear proviso that I’m on the “financial innovation: bad” side of the broader debate, here’s where I take issue with Johnson and Kwak.
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From Democracy Journal
An interesting article by Simon Johnson and James Kwak:
If innovation must be good, then financial innovation should be good, too. If finance is the lifeblood of our economy, then figuring out new ways to pump blood through the economy should foster investment, entrepreneurialism, and progress. Right? This, in any case, has been the mantra throughout three decades of deregulation and expansion of the financial sector.
And yet today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. The very innovations that were celebrated by former Federal Reserve Chairman Alan Greenspan—negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, and credit default swaps, among countless others—either amplified or caused the crisis, depending on your viewpoint. The journalist Michael Lewis recently argued that the credit default swaps sold by A.I.G. brought down the entire global financial system—and found that the A.I.G. traders he talked to completely agreed.
Recent financial innovation is not without its defenders, of course. As current Fed Chairman Ben Bernanke said in a speech in May:
We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.
Intellectual conservatives and bankers have mounted an even more fervent defense of financial innovation. Niall Ferguson has claimed, “We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street.” Bernanke and Ferguson are being too generous. For the past 30 years, financial innovation has increased costs and risks for both individual consumers and the global economy. To take the most obvious example, consumers bought houses they could not otherwise have bought using new mortgages they had no hope of repaying, creating a housing bubble, while new derivatives helped hide the risk of those mortgages, creating a securities bubble. The collapse of those bubbles has shaken the world for the last year. Today’s challenge is to rethink financial innovation and learn how to separate the good from the bad.
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models | Graham | 
Saturday, October 3, 2009 5:01 pm | 
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