Working Paper: Risk and Uncertainty in Financial Models - Implications in Asia
Posted on Thursday, April 24, 2014
Over-reliance on mathematical risk models contributed to misreading the risks and uncertainties leading to the global financial crisis.
Overreliance on mathematical risk models, such as Value at Risk (VaR), contributed to misreading the risks and uncertainties leading to the global financial crisis (GFC). These models are built on unrealistic assumptions and are vulnerable to data errors. They also ignored radical uncertainty and are unreliable at best, almost meaningless at worst.
Uncertainty is rooted in dynamic, non-linear feedback behavior between market participants that can lead to unpredictable (by current risk models) and sometimes chaotic outcomes. Radical uncertainty exists because participants cannot predict counterparties’ reactions with precision, even in a simple two-party game. Systems theorists from other disciplines, such as engineering, physics and biology are aware that feedback loops can either be negative, meaning that the system will revert back to stable equilibrium, or positive, meaning that the system could explode and enter into chaos or breakdown.
Dealing with uncertainty requires trust to create mutually predictable outcomes; however, the breakdown of trust creates uncertain behavior at the system level.
True uncertainty cannot be quantified by a probability; hence the risk models failed to predict “black swan” events, such as the ‘London Whale’ incident, in which JP Morgan is reported to have incurred US$6 billion of losses. Panic resulting in loss of trust in counterparties and in the system led to cascading bank runs.
Post-GFC, trustis essential in stabilizing the financial system. In 2008, the U.S. and other governments took sudden and drastic measures to preserve trust and prevent panic from a wholesale bank run. The state restored trust in the system, but only by taking on high debt and other costs, including ‘moral hazard’.
The industry and regulators must adopt new quantitative and qualitative methods to model at the microcosmic level the ‘ebb and flow’ of collective trust in the macro-economy. These models should be embedded in cultural, traditional and ethical contexts to fully understand the financial system.
‘Thinking the unthinkable’ requires us to recognize that the free-market system may not always be able to address its endogenous problems. The state should have a backup plan to step in directly to shore up the financial supply chain to avoid a sudden seize-up of funding, as happened during the GFC. This is important for the non-financial sector, especially SMEs that generate the bulk of jobs, growth and innovation.
The views expressed in this report are those of the author and do not necessarily reflect those of the Fung Global Institute. The author is solely responsible for any errors or omissions.