Banks and regulators should not depend too much on risk models, but overruling them altogether can be illogical and economically damaging.

Risk is uncertainty of outcomes, and the essence of risk management is managing that uncertainty. There are two fundamental ways to manage risk: first, by quantifying the uncertainty of outcomes and incorporating it in making decisions; and second, by strengthening defences against losses from adverse outcomes.

Take the case of an investor wanting to invest in a property. All else being equal, London is preferable over Dublin as house prices in London have historically been much less volatile than in Dublin: a way to quantify the uncertainty of future house price change. And for regulators, a 30% investor deposit is safer than 10%. Even if the house price falls by 20%, the investor will still own an asset worth more than the loan, and is less likely to default.

It is obvious that quantifying risk and strengthening defences are complementary, not mutually exclusive. Unfortunately, this self-evident truth has been lost on authorities who regulate banks worldwide.

Before the financial crisis, too much trust was placed in risk models by banks and regulators, to the extent that it bordered on absurdity. Subprime mortgage securities were mathematically modelled to be as safe as US government debt. In August 2007, the chief financial officer of Goldman Sachs saw 25-standard deviation market moves, several days in a row. To put those moves in context, a 7.26-standard deviation event would be expected to occur once every 13.7 billion years, roughly the age of our universe. Regulators relied on banks’ own quantification of risk to establish banks’ defences in terms of capital and liquidity they hold. 'Light-touch regulation' was the norm of the day.

Pendulum swing

Since the financial crisis, however, risk quantification has fallen from grace; risk models are viewed as suspicious at best and downright fraudulent at worst. The mood is best captured by a question asked by Andrew Tyrie, chairman of the UK parliament’s Treasury Committee: “Have you ever turned to a risk modeller as a risk matures and said to him ‘well spotted, well done – if we didn't have that model we wouldn't have identified that’?”

After the financial crisis, a focus on rules to enhance the safety and soundness of financial system was needed. Before 2007, some banks had such a thin loss-absorbing cushion that a mere 2% fall in the value of their assets put them out of business. Most banks are now better capitalised and safer than they were before the crisis. But the pendulum, it seems, has swung too far away from risk quantification, and in favour of rule-based defences against uncertainty.

Business decisions are increasingly influenced by regulatory requirements rather than the needs of the economy or risk management. Europe’s 16 largest banks increased their exposure to sovereign debt by 26%, while reducing their exposure to corporates by 9% from 2011 to 2012. That is because the latest Basel capital rules incentivise banks to invest in sovereign bonds while making corporate lending costlier.

In response to regulations that have made it increasingly expensive for banks to hold riskier corporate bonds, dealer inventories of non-government debt are down 80% since 2007, even as the corporate bond market has grown by 50%. Furthermore, recent regulations have made it more difficult and expensive for banks and large securities dealers to act as market makers, reducing liquidity. Illiquid markets are volatile and can exacerbate financial crises. Not only that, but reduced liquidity has implications for the wider economy as it increases the cost of borrowing and affects investment returns.

What can be done?

First and foremost, banks need to understand that models are useful tools but not a substitute for human judgement, and definitely not a justification for taking on more leverage, as happened in the run-up to the financial crisis. The behaviour of financial markets is not based on immutable laws of nature, and any attempt to model them that way is sure to backfire.

Equally important is for regulators to correct their recency bias – the belief that recent events and trends will continue in the future. Financial crises are a bit like Tolstoy’s unhappy families; each is unhappy in its own way. Just because incorrect risk quantification contributed to the recent one does not mean the next crisis will be the same. Regulators should not focus too closely on their rear-view mirror, lest they completely miss the hazards on the road ahead.

The ability to quantify and manage risk has been at the heart of human progress in fields as diverse as agriculture, construction, space exploration and public health. For the financial sector to move away from risk models will be regressive and unfortunate. The way forward is not rules over models, but rather designing regulations to ensure that they complement each other.

Amit Tyagi is head of group credit risk analytics at National Bank of Abu Dhabi. The views expressed are his own and not his employer’s.

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