Sunday, 15 February 2009

Financial meltdown blamed on risk models

The following is an extract from a useful article from the Financial Times

By Norma Cohen, Economics Correspondent

Published: February 14 2009 02:00

The failure of banks to count, manage and hedge their risks over the past decade is responsible both for the fantastic growth before 2007 and the crash that followed, according to the Bank of England's director for financial stability.....

The meltdown in money markets that followed the credit squeeze was an event that banks' risk models showed could happen only once in the lifetime of the universe - once every 13.7bn years - Mr Haldane said. Referring to economist John Maynard Keynes' rule of thumb that it is better to be roughly right than precisely wrong, he added: "With hindsight, those models were both very precise and very wrong."

Banking losses now "lie anywhere between a very large number and an unthinkable one", he said.

In pinpointing reasons why the systems banks use to gauge how big their losses could be under worst-case scenarios were so wrong, Mr Haldane noted that most are based on a very short-term view of the past. Mathematical models were based on economic events in a very narrow window of time, as short as 10 years, he said.

A further look back into history would have shown fluctuations in UK gross domestic product four times greater than that of the past 10 years, that of unemployment five times greater, that of inflation seven times greater and that of earnings 12 times greater.

Bankers also forgot to assume "network externalities" - the possibility that adverse events in, say, the mortgage market, might trigger a similar move in others. These effects would probably be multiplied across the entire financial system.

One comment that comes to mind is that the phrase "network externalities" sounds like it means something but I would suggest that it is not even as useful as "Acts of God" which lawyers have managed to insert in contractual law.

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