Simple indicators of systemic importance are a fast track to unintended consequences
Michael Zerbs, president and COO of Algorithmics, feels that macro-prudential regulators need to keep in mind the predictable unpredictability that makes their reliance on simple indicators so dangerous. May 26, 2011 | Michael Zerbs“In the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.” - Friedrich August von Hayek (1974): The Pretence of Knowledge, Nobel Prize Lecture The recent financial crisis has clearly shown the consequences of relying on one-dimensional indicators when managing financial risks. As risk managers and micro-prudential regulators alike used metrics such as VaR, external ratings or regulatory capital ratios without probing the underlying assumptions in depth, the potential for unknown tail risks was often forgotten. Industry and regulators are now applying the lessons learnt as they relate to risk management and micro-prudential supervision. However, the same cannot yet be said for macro-prudential supervision and policy. Recently, simple and readily available indicators of systemic importance such as bank size, a bank’s interbank lending and interbank borrowing, have been proposed (BIS Quarterly Review, March 2011), and Dodd-Frank automatically designates all banks with $50 billion in assets or more as systemically relevant. For example, Dodd-Frank automatically designates all banks with $50 billion in assets or more as systemically relevant. However, the reduction of systemic risk to a handful of basic indicators is a perilous fast track to unintended consequences in at least three ways: First, it is likely that we assume away much of what makes systemic risk so insidious. For example, studies that demonstrate the explanatory power of simple indicators of systemic relevance tend to focus on interbank borrowing and lending, exclude derivatives, and assume equal distribution of interbank assets and liabilities among the group of banks analysed. Hence they would not consider AIG’s near default, the massive build-up of CDS... Please login to read the complete article. If you already have an account, you can login now or subscribe/register.
Categories: Regulation, Risk and Regulationriskregulation,Risk and Regulation, Regulation,Risk and Regulation, Keywords:Dodd Frank, Systemic Risk Dodd Frank, systemic risk
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