There is a widely held belief that financial risk is easily measured – that we can stick some sort of riskometer deep into the bowels of the financial system and get an accurate measurement of the risk of complex financial instruments. Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in.
Unfortunately, the lessons have not been learned. Risk sensitivity is expected to play a key role both in the future regulatory system and new areas such as executive compensation.
We can create the most sophisticated financial models, but immediately when they are put to use, the financial system changes. Outcomes in the financial system aggregate intelligent human behaviour. Therefore attempting to forecast prices or risk using past observations is generally impossible.
The inaccuracy of risk modelling does not prevent us from trying to measure risk, and when we have such a measurement, we can create the most amazing structures – CDOs, SIVs, CDSs, and the entire alphabet soup of instruments limited only by our mathematical ability and imagination. Unfortunately, if the underlying foundation is based on sand, the whole structure becomes unstable. What the quants missed was that the underlying assumptions were false.
When complicated models are used to create financial products, the designer looks at historical prices for guidance. If in history prices are generally increasing and risk is apparently low, that will become the prediction for the future. Thus a bubble is created. Increasing prices feed into the models, inflating valuations, inflating prices more. This is how most models work, and this is why models are often so wrong.
In the same way it is so hard to measure risk, it is also easy to manipulate risk measurements. It is a straightforward exercise to manipulate risk measurements to give vastly different outcomes in an entirely plausible and justifiable manner, without affecting the real underlying risk. A financial institution can easily report low risk levels whilst deliberately or otherwise assuming much higher risk. This of course means that risk calculations used for the calculation of capital are inevitably suspect.
The myth of the riskometer is alive and kicking. In spite of a large body of empirical evidence identifying the difficulties in measuring financial risk, policymakers and financial institutions alike continue to promote risk sensitivity.
The reasons may have to do with the fact that risk sensitivity is intuitively attractive, and the counter arguments complex. The crisis, however, shows us the folly of the riskometer. Let us hope that decision makers will rely on other methods.