High & Low Finance: Models for Financial Risk Are Still Seen as Flawed

Five years ago, the financial regulators of the United States — and more broadly the world — didn’t see the storm coming.

Would they if a new one were brewing now?

The answer to that is far from clear. The regulators have more information now, and they have applied the tools they have to measure risk with more vigor.

But a new assessment from a little-known agency created by the Dodd-Frank law argues that the models used by regulators to assess risk need to be fundamentally changed, and that until they are they are likely to be useful during normal times, but not when they matter the most.

“A crisis comes from the unleashing of a dynamic that is not reflected in the day-to-day variations of precrisis time,” wrote Richard Bookstaber, a research principal at the Office of Financial Research, in a working paper released by the agency. “The effect of a shock on a vulnerability in the financial system — such as excessive leverage, funding fragility or limited liquidity — creates a radical shift in the markets.”

Mr. Bookstaber argues that conventional ways to measure risk — known as “value at risk” and stress models — fail to take into account interactions and feedback effects that can magnify a crisis and turn it into something that has effects far beyond the original development.

“What happens now when people do stress tests,” he said in an interview, “is they look at each bank and say, ‘Tell me what will happen to your capital if interest rates go up by one percentage point.’ The bank says that will mean a loss of $1 billion. That is static. That is it.”

But, he added, “What you want to know is what happens next.” Perhaps the banks will reduce loans to hedge funds, which might start selling some assets, causing prices to drop and perhaps have additional negative effects on capital. “So the first shock leads to a second shock, and you also get the contagion.”

The working paper explains why the Office of Financial Research, which is part of the Treasury Department, has begun research into what is called “agent-based modeling,” which tries to analyze what each agent — in this case each bank or hedge fund — will do as a situation develops and worsens. That effort is being run by Mr. Bookstaber, a former hedge fund manager and Wall Street risk manager and the author of an influential 2008 book, “A Demon of Our Own Design,” that warned of the problems being created on Wall Street.

He said the first work, being done with the help of Mitre, a research organization that came out of the Massachusetts Institute of Technology, on the interactions between banks and leveraged asset managers, with particular attention on how so-called fire sales develop as asset values plunge. Additional work is being done by central banks in Europe, including the Bank of England.

“Agent-based modeling” has been used in a variety of nonfinancial areas, including traffic congestion and crowd dynamics (it turns out that putting a post in front of an emergency exit can actually improve the flow of people fleeing an emergency and thus save lives). But the modeling has received little attention from economists.

Richard Berner, the director of the Office of Financial Research, said in an interview that his agency was trying to gather information in many areas, understanding that “all three of those things — the origination, the transmission and the amplification of a threat — are important.” The agency is supposed to provide information that regulators can use.

Mr. Bookstaber said that he hoped that information from such models, coupled with the additional detailed data the government is now collecting on markets and trading positions, could help regulators spot potential trouble before it happens, as leverage builds up in a particular part of the markets. Perhaps regulators could then take steps to raise the cost of borrowing in that particular area, rather than use the blunt tool of raising rates throughout the market.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2013/01/11/business/economy/models-for-financial-risk-are-still-seen-as-flawed.html?partner=rss&emc=rss