In thinking about recent economic events, I keep thinking, along with many others, that “somebody” ought to oversee and regulate the organizations that deal with other people’s assets. That means that financial institutions would be limited in the amount of risk they take. But how can that be done? How is risk measured? And can that be regulated?
There are a couple different definitions of risk that you’ll see in financial discussions. The first is that risk is the probability of something bad happening, and the second is that risk is the volatility associated with a security. The former is used in insurance contexts, and the latter in investments.
The underlying problem with both notions is that you need to have a model for how markets behave in order to assess the risk associated with a position. The most popular risk measure is value at risk, which is based on a model that makes some questionable assumptions. During normal times, it’s a reasonable approximate measure, but in times like last year, when risk measures are very important, it tends to go badly wrong.
The other problem with regulating the amount of risk that banks can hold is that you risk forcing a fire sale in a bear market, which can drive prices through the floor. In fact, similar regulations have been causing all kinds of problems in the current crisis.
You missed one- the probability of something bad happening is only useful information in conjunction with the probability of how bad things will go if something bad happens.
When judging the risk of a portfolio of loans, for example, a highly simplified way of measuring ‘Value at Risk’ is
VAR = Probability of something bad happening * $$ Lost when Bad Thing happens
summed over all of the loans.
A lot of VAR models use a one-tailed 2-sigma event or 3-sigma event for the first term above, and historical averages of recovery for the second.
Problems, of course, can arise when things happen such as what ultrafilter stated above.
Many models sort-of assumed the Probability of Something Bad Happening was largely independent from asset to asset. In other words, the models assumed a default on a loan in Stockton had nothing to do with a default on a loan in Las Vegas. They built that into their models because that’s what the historical data showed. And for 2002-2007, that probably wasn’t a bad assumption.
But recent events highlight how Bad Things Happening can become highly correlated, so that when one thing goes wrong, many things go wrong simultaneously.
To make things worse, the $$ Lost when Bad Thing Happens also rises dramatically - much more than what was expected in the models - in illiquid markets such as today’s markets, which in themselves are correlated to Lots of Bad Things Going Wrong Simultaneously. Yoiks.
In short, the models assumed that every once in while somebody would get up from the movie theater because they didn’t like the movie and go home. And then you would lose $2 in potential popcorn sales.
But when there’s a fire, everybody stampedes for the exits and stomps on each other. Then you lose all of your popcorn sales, your Coke sales, and people demand refunds. Plus your movie theater burns down and you’re out of business. And then the people who got stomped on decide to sue you, to boot.
There are a lot of measures of risk, depending on what you’re worried about. They’re almost always dollar-weighted so that there’s a chance of some outcome with an expected loss due to that outcome. So an investment might have a 10% chance of losing 10% of its value and a 1% chance of losing 100% of its value and you might call it.
Volatility actually has several measures of its own, including Beta and standard deviation. Those measures try to describe the degree of change. A bond’s value varies very little compared to most stocks. Even within stocks, some are more likely to see extreme change.
Ultimately, risk is always based on assumptions, estimates, guesses, etc. A regulator may sometimes spot bad assumptions, but mostly no one knows until something happens. And… just because you know about a risk doesn’t mean you can avoid the consequences. For example, we know there’s some small risk that the world will go through a nuclear war or another Black Death-scale plague. Such an event could wipe out your portfolio for good, even in “no risk” investments like cash or Treasury Notes. You invest anyway because not investing has its own risks/costs and those costs are more likely than the superflu.
I think that’s part of what people need to understand. Even in a perfectly assessed, perfectly regulated, ideal market, there are still disasters, business cycles, bankruptcies and other catastrophes.
So, if VAR models are the simplified version of how risk is assessed, how can something like that be regulated? Particularly in an industry that is growing based on the degree of risks it takes. Could a regulator say that you have to use a minimum probability of something going wrong and no lower? Could they say to a financial institution that they MUST set the probability of defaults on mortgages at, say, 12 %? And then insist that their policies reflect that level of risk?
Banks are regulated regarding their capital reserves and risk levels (see the link below for lots of boring details). As other posters have mentioned, the models to assess risk tend to do well in average situations, but not very well in extreme situations (like now). One of the reasons is that many models assume events occur with a normal (bell-shaped) distribution, and the specifics of this distribution are calibrated based on historical data. This falls apart when things don’t happen as they did in the past (again, like now), and those extreme events in the “tails” of the distribution occur far more frequently than expected (known as “fat tails”).
Keep in mind that the larger the financial institution, the more latitude they are given to construct their own risk models. The assumption is that they are more sophisticated and do not need as much regulator intervention. When you get into various derivatives and exotic financial instruments, it become extremely hard to properly model the risks, even in a stable economic environment.
Generally, the more risky an investment, the more money a financial institution has to keep in reserve to provide protection in the event of bad things happening. Money in reserve is “idle money”, so banks try very hard to justify lower risk levels and thus lower reserves. A good strategy in boom times, but not so good in bust times, as you may have noticed. 
Check out this article from this month’s Wired magazine. It is about a mathematical formula that a lot (or all?) of these investments were based on and really explains its shortcomings.
I found this excerpt to be the most eye-opening for me, with regards to the “confusion” of how to calculate the risk:
A few reactions here. As you will see below, this is a mixture of opinion and fact.
- The US banking system is a fractional-reserve one. What does that mean?
Basically, it means that banks lend out money that they technically do not ‘have’. The bank is counting on the fact that
- It’s losses from bad loans won’t exceed its capital
- Depositors won’t all come in at the same time and cause a run on the bank
For a full explanation, you might enjoy the first few chapters of Murray Rothbard’s ‘The Mystery of Banking’, which is available free online at mises.org. I find Rothbard to be very readable.
The way we are structured today, even if the second thing happens above (the ‘run’) the gubmint guarantees most demand-deposit funds. The gubmint is allowing a bank to operate as technically bankrupt at all times, with a backstop for depositors. The government allows no other type of business to operate this way.
See Rothbard for some anecdotes about the exact points in history when courts ruled that it was illegal for other businesses to operate this way (e.g. grain elevators) but legal for banks to operate this way. It makes for very interesting reading and Rothbard pinpoints moments when the courts seemingly became confused about this very issue, but ruled on it nonetheless.
- If a bank wasn’t a fractional reserve bank, the losses from systemic bad lending procedures could be far more contained. It is also probable that they would never have been made in the first place.
For example, I could lend a bank money and demand 5% interest. The bank would promise to pay me back in 1 year. Sort of like a CD. In the interim, it lends out my money at 12% to others, and through it’s banking expertise, earns
12% - 5% - operating costs - losses from bad loans.
Then it pays me back my principal + 5% at the end of 1 year. If it screws up and loses a lot more due to bad loans, then I’m out some of my money and stand in line like other creditors. But the loss is contained to me. It largely stops there. And since the gubmint didn’t guarantee it, you’re not on the hook as a taxpayer. That is not what happens today.
- Once you’ve made the move away from the gold standard and towards fiat money and fractional-reserve banking, the cat is largely out of the bag. This is my personal opinion, of course. I’ve done a lot of thinking about what could be done to ‘put the cat back in the bag’, or if it’s even possible.
I’ve even tried to spark some debate on that subject on this Board, but it usually only gets about 2-3 posts along the way before someone brings up how George Bush was responsible for the Black Death in Mideval Europe. But I digress.
- Some thoughts on ways forward, at very high levels:
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Raising capital requirements. Just moving along the spectrum from where we are today, towards more fully-reserved banking. Instead of x% reserves, use x+y%
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Separate commercial banking from investment banking, as was the case before GLB. Fairly crude and simple. If you’re going to guarantee depositors’ funds as we do today, you need to make sure the asset-side of the balance sheet is boring and sound. But if not, you could…
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Loosen up the granting of charters for banks that take demand-deposits. Banking could use a lot more innovation and there are companies willing to do it.
Don’t guarantee customers deposits. Don’t have any regulation at all. This is a bit ‘out there’, I realize. But I think you’d be surprised at what might happen. There are little niches like prepaid cards that are already sprouting up as banking alternatives that could flourish, if they aren’t bludgeoned to death by regulators.
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Tie the currency back into a commodity standard like gold. This has been championed by many, but I don’t think everyone has thought through exactly how it would work, how the transition would happen, etc. I’m still noodling through it myself. What a gold standard does is put a natural constraint on how much money can be printed, and how much money can be lent out to customers. As soon as people start to lose confidence in the currency, they demand gold. That should provide a natural check-and-balance on those who would debase the currency. In theory, of course. More on this below.
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Require originators of loans to hold some portion of the risk, perhaps as a first-loss or other primary-loss position. This prevents a bank or mortgage originator from turning into a fee-generating ‘front end’ with no incentive to manage the risk of underwriting the loan.
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There are other ideas beyond the ones above. Read the WSJ or other banking blogs and you’ll get ideas by the dozen. Most of them boil down to some version of the ones described above.
- Now for a little personal commentary…
The business of underwriting loans and managing credit risk has to be a dry, dispassionate affair for it to be successful. The government has to get out of the business of disbursement of credit. When it gets involved, it becomes a giant political football with disastrous consequences. Ref: Freddie and Fannie. Ref: Sallie Mae.
First the government pushes for more loans because they think that’s a ‘good thing’, then those loans go bad, then the government searches for villians who recklessly extended too much credit, then credit contracts, then government beats on bankers to extend more credit. Rinse, lather, repeat. Fannie and Freddie should not exist, period. We’re up to $200+ billion on that bailout and the ticker is still spinning.
Negative real interest rates by the Fed (that fiat money thing, again) poured gasoline on the fire. Hard core libertarians would argue that would have not been possible with a gold standard. I happen to believe that the government would have just found an excuse to go off the gold standard when it became inconvenient, sort-of like it did during the Civil War, following WWI, and in 1971.
Finally, my personal opinion is that relying on government employees to build a recipe for a perfect regulatory framework is wishful thinking. First off, regulation is always a rearward-looking thing. You always try and fix the problems that have already happened.
Secondly, I’ve dealt with these people. They’re nice. They’re serious, thoughtful people. But they aren’t rocket scientists. If they were, they would be working in the private sector for 5x what they make in the gubmint. They are career bureaucrats who work 9 to 5 and follow the rules. Asking them to opine on joint probabilities and the proper form of statistical models is like asking your kindergarten teacher to explain the theory of relativity.
The system needs to be simpler, not more complex, if it is to be regulated. That’s why the commercial/investment banking split may be the best option if we must stay on a system of fiat money and fractional-reserve banking. Otherwise, I would argue for a return to the commodity standard for currency and less regulation.
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The largest weakness in assessing risk is that risk measures assume that large positions can be liquidated at the current market price, or in other words, that a market has infinite liquidity. Embedded within this assumption is that market liquidity itself will remain the same. During any time of uncertainty in general and during a liquidity crisis in particular, liquidity dries up making it more difficult to get a good price on highly standardized assets and difficult to get any price at all on more exotic assets.
Indeed. And one of the major weaknesses of using the Black-Scholes model during major market disruptions. Described nicely in ‘When Genius Failed’. Although that was written about LTCM in the late 90s, you could cut-and-paste entire passages of that book and merely change a few names and dates, and it would provide up-to-date commentary on today’s crisis as well.