Sunday, February 15, 2009

Risk Part 7: Some Basic Accounting Problems

Avinash Persaud, chair of Intelligence Capital, describes current financial regulations as like seat belts that stop working when you need them. He says, "If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. ...if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse."

Persaud argues that financial markets follow a sort-of Heisenberg uncertainty principle: since everyone is seeing the same data, using the same statistical tools, and chasing the same investment opportunities, then "under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite. ...Paradoxically, the observation of areas of safety in risk models creates risks, and the observation of risk creates safety." He wrote in 2000 about the problem of market crises being exacerbated by this phenomenon: "market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner... send the herd off the cliff."

Another problem with our current measurement of risk is that it too frequently looks at risk in isolation. In The Case for Collective Risk Reporting, David Shimko, president of Asset Deployment and a trustee at the Global Association of Risk Professionals, provides several examples of times when looking at risk in isolation was inadequate. One horrifying example is that banks do not have collective risk reporting, so can only evaluate the risk of their relationship with a company without knowing how many other banks the company is borrowing from. Another example is trading with an entity when you don't know who else they're trading with, and how vulnerable they are to their other counterparties.

Shimko suggests "a neutral risk report aggregation and disaggregation service, overseen or managed by the Fed, that would report each bank’s risk information on a no-names basis to the peer banks and other stakeholders. In so doing, risk information could be shared while the identity of the bank providing the information could be kept secret."

See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard


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