Thoughts Online Magazine
Collected Articles on Culture & Politics
Banks and Risk 
1st-Jun-2011 06:40 pm
Inspiration
An article making the rounds among those who take the risk that financiers pose seriously is this one, "Bankers Can't Avoid Risk by Hiding It." It's excellent, short, and goes right to the heart of why those cute models that bankers are relying on are stupidly unreliable, not scientific (even if they do look like math). It uses an analogy to high-school physics to make the point (Hooke's Law, about springs), but you don't have to follow that very closely to get the idea.

You should read all of it. But the moral of the story is this:

The only objective test of the accuracy of the model is how well the theoretical value matches market prices for traded instruments. And in a calibrated model it does that perfectly, but only at that one instant in time. Next week, or even tomorrow, or just an hour later, theory and practice will inevitably diverge. But if you are forever recalibrating, you never see this. Recalibration means that risk managers remain in blissful ignorance of the errors in their model and hence the risk. If anything ever gave a false sense of security, this is it. All that risk management has done is to hide the risk, making it harder to spot, to estimate and to hedge.

In other words, instead of helping you estimate risk, your model is helping you ignore it. Not very comforting. And, sadly, one of those situations where I'm sure that some government bureaucrat, mesmerized by all the numbers and blinking lights, will say, "Sounds reasonable to me." rather than actively exploring to what extent large banks are, ONCE AGAIN, failing to manage the risks they entail.
Comments 
6th-Jun-2011 06:44 am (UTC)
Banks represent the bankers and governments at the end of the day, as far as I'm concerned. If banks go south, governments go south, and that can't be allowed to happen by either, both of whom have everything to lose in the bargain. It's been a house of cards for a long time, and if it continues as it has, which I believe it will, it's going to be way more than Hell to pay for everyone involved -- and maybe even the bankers.
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