Friday, June 8, 2012

Andrew Haldane strikes again: Tails of the unexpected

The Bank of England's Andrew Haldane co-authored an interesting article called Tails of the unexpected. In it, he looks at the failure of risk models to properly price catastrophic risk and suggests that risk models must be torn up and a whole new way of thinking about risk implemented.

He proposes a number of solutions including as the Telegraph put it

If taxpayers are to be protected in future, financial regulators must put “in place robust fail-safes to stop chaos emerging”, such as UK plans to ringfence banks’ retail operations or US proposals to ban casino-like proprietary trading. 
Such “structural safeguards on worst-case outcomes” need to be accompanied by a massive increase in the “array of financial data available to regulators” provided by banks, he added. The extra information would allow regulators to build a “systemic risk map” not unlike a weather forecast that could “provide early warnings to enable defensive actions to be taken”. 
“In a complex, uncertain environment, the only fail-safe way of protecting against systemic collapse is to act on the structure of the overall system, rather than the behaviour of each individual within it,” he said. “Until then, normal service is unlikely to resume.”
Please re-read the highlighted text as Mr. Haldane is summarizing where the leading edge of regulators' and economists' thinking is.

And what they are thinking about on this issue is completely and utterly depressing as it shows zero understanding of how a transparency based financial system works.

We most certainly do need structural safeguards.  The first structural safeguard is to protect us from dependence on financial regulators.  It is well known that any system with a single point of failure is highly, highly, highly likely to fail catastrophically.

A quick look back to August 9, 2007 and the beginning of our current financial crisis confirms that financial regulators are perfectly capable of failing catastrophically.

Your humble blogger has been calling for a massive increase in the financial data available to market participants including the regulators.  If the data is only for the regulators, they have an information monopoly and hence they are a single point of failure.

While I think Mr. Haldane is brilliant, even he is capable of having a bad day and missing in his capacity as Executive Director Financial Stability at the Bank of England a tornado that could destroy a wide swath of the financial system and the real economy with it.

I happen to agree with his observation that the only fail-safe way of protecting against systemic collapse is to act on the structure of the overall system.  That is why I have said we need to shine the bright light of transparency into all of the opaque corners of the financial system.

It is only with access to all the useful, relevant information in an appropriate, timely manner that market participants can independently assess this information and adjust their exposures based on this risk assessment.

Under the FDR Framework, which is the transparency based financial system we currently have, market participants know they are responsible for all gains and losses on their exposures.  As a result, they adjust their exposure to higher risk investments to what they can afford to lose.

What brought about our financial crisis was the catastrophic failure of our regulators who loudly proclaimed that the risk in the financial system had been reduced due to financial innovation.  Since the regulators had a monopoly on all the useful, relevant information, market participants trusted them.  This led to massive mis-pricing of risk.

It also led to moral hazard as there is an obligation placed on the government to bailout investors who relied on representations made by the government when making an investment.

One of the primary reasons for requiring transparency is that it ends the government's information monopoly and reliance on the government's assessment of this information.  This delivers two benefits to the financial system:  ends the single point of failure and ends moral hazard.

Finally, I know one of the individuals who spearheaded the fight to create the Office of Financial Research (the US version of Mr. Haldane's financial weather service).  Once it had been created, he called me to apologize.  He realized that OFR and similar financial weather services for regulators are where transparency goes to die.

What he understood after the fact is that the weather service is not there to only use the data itself, but to share the data with anyone who wants it.

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