Models for financial risk are flawed

In his NY Times column, Floyd Norris looks at Richard Bookstaber's work at the Office of Financial Research on modeling contagion in the financial system and concludes that regulator run bank stress tests are likely to be inadequate for predicting or understanding the path of the next financial crisis.

Regular readers know that your humble blogger thinks that the focus on modeling contagion and regulator run bank stress tests is a destructive distraction that results in a financial system that is much more likely to crash.

This focus on model embraces all the elements of substituting the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

It is well known that the Office of Financial Research is where transparency goes to die.  Mr. Bookstaber's research is a prime example of why transparency dies there and we end up with a financial system dependent on complex rules and regulatory oversight.

His goal is to model the financial system to understand the pathways that contagion could take during the next financial crisis.  To do so, he needs information on the exposures of the various financial market participants.  Information that is only available at the Office of Financial Research.

Clearly, his models are complex.  Equally clearly, since it is only the OFR that has the information, the financial system is dependent on OFR's regulatory oversight as it applies his complex models.

Under the FDR Framework, which is the basis for our financial system, stability is built into the financial system by the combination of the philosophy of disclosure and the principle of caveat emptor (buyer beware).  Transparency is necessary for stability because with transparency market investors can be held responsible for all gains and losses on their exposures.

When market participants know that they can lose money on an investment, they have an incentive to use the data provided by transparency to independently assess the risk of the investment and, most importantly, to limit the size of their investment to what they can afford to lose given the risk.

By limiting their risk to what they can afford to lose, market participants build robustness and stability into the financial system while at the same time eliminating concerns over financial contagion and how a crash might spread.

As regular readers know, we got to our current financial crisis by allowing opacity in vast areas of the financial system.  This includes structured finance securities (whose opacity makes them resemble 'brown paper bags') and banks (whose opacity has them compared by the Bank of England's Andrew Haldane to 'black boxes').

The Office of Financial Research with its monopoly on the information that market participants need to assess risk and adjust their exposures is a barrier to the restoration of stability in the financial system and ending financial contagion.

The best thing for the global economy would be to end the Office of Financial Research.

Please note that Mr. Bookstaber could continue with his research as he, like everyone else, would have access to the necessary information.

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

Full disclosure, it is a matter of public record that your humble blogger saw the storm coming and recommended bringing transparency to opaque structured finance securities.

To make these securities transparent requires that they provide observable event based reporting on all activities like a payment or delinquency that occur with the underlying collateral before the beginning of the next business day.

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....

The combination of complex rules and regulatory oversight has been shown by the current financial crisis not to work.

It doesn't work for a number of reasons.

First, the regulators having a monopoly on all the useful, relevant information prevents market participants from using this information to assess risk and properly gauge how much investment exposure they should have.

Second, the regulators having a monopoly on all the useful, relevant information means that market participants are dependent on the regulators to properly assess this information and communicate the results.  Regulators have shown that they are unwilling to communicate the results (please recall that they lied about the solvency of the large US banks at the beginning of the financial crisis).

Can you imagine the head of OFR getting up, telling the truth and saying the large US banks are insolvent despite five years of massive government support?

“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 agency, the Office of Financial Research, in a working paper. “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 having additional negative effects on capital. “So the first shock leads to a second shock, and you also get the contagion.”...

Actually, if we actually implemented the FDR Framework and brought transparency to all the opaque corners of the financial system, we wouldn't have to worry about contagion.  As explained above, each market participants knows to make sure they don't have more exposure than they can afford to lose.

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.

As I said, OFR is where transparency goes to die.

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.

Who would possibly think that it is a good idea to make the markets dependent on regulators properly assessing what is going on and then taking appropriate steps given the degree to which regulators can be politically influenced and captured by the banking industry?

The basis of the FDR Framework is that market participants are given the incentive to and the information they need to protect themselves.