Analysing past behaviour is no longer the only way to assess risk.
Managing risk is currently as much about data and rules as it is about unpredictable behaviour. But the limitations and obvious failures of existing approaches to managing systemic risk are beginning to lead policy-makers and risk managers into new territories. Typically, historical data and individual banks’ risk profiles were in the frame. Newer approaches look at the actions of those specific banks within the dynamic system they inhabit.
Past events are not necessarily an indicator of the future, but this has been the overriding principle so far. The problem has found a potential solution in agent-based models, which look at how agents (people and organisations) interact with each other in ways that keep their environment stable or inadvertently pull a thread that makes it unravel.
Research into experimental risk methods such as agent-based modelling, a technique inspired by natural science, is new. The US Treasury’s office of financial research tasked not-for-profit organisation Mitre, which undertakes federally funded research, with creating a tool to help assess systemic risk back in 2013 after the shock of the financial crisis. This led to an agent-based modelling application. But Mitre and the US Treasury are among few pioneers in this field.
The Bank of England is also looking into agent-based models, as well as the use of big data, machine learning and semantic algorithms. However, the bank’s chief economist, Andy Haldane, says: “Banking supervision is an area of research that is relatively under-explored by academics and central banks.”
Simulation, big data and new techniques are only tools, not silver bullets: they have limitations, just as existing risk management tools do, and are worthless if used within a culture of weak governance. Since the financial crisis, efforts have gone into enforcing better conduct within the banking system to encourage more prudent behaviour. Research into how that system evolves and reacts to shocks, big or small, should also be encouraged, by policy-makers and individual banks. All need the system they operate in to maintain balance.
