Flawed model-based approaches to risk management were a major contributor to the global financial crisis, according to the Reserve Bank of Australia

Risk “mis-assessments” played a significant role in the advent of the global financial crisis, according to Guy Debelle, assistant governor of the Reserve Bank of Australia.

These mis-assessments stem from an overreliance on model-based approaches to risk management, which Debelle believes focus too much on measurable risk without taking enough account of unmeasurable uncertainty.

“Risk was mis-assessed by financial institutions, risk managers, investors and regulators,” said Debelle, who was speaking at the recent Risk Australia Conference in Sydney.

“There was a false comfort taken from a misplaced belief that risk was being accurately and appropriately measured. To some extent, the technology provided risk managers with a false sense of security.”

Risk measurement based on historical models cannot be fully effective, according to Debelle, who said that judgment must play an important role in assessing risks.

“At least a focus on ordinal as well as cardinal probabilities, in part by stress testing with scenarios that fall outside the model’s history, would surely be beneficial.

“But stress testing and the assessment of uncertainty is still constrained by the difficult decision as to what is the relevant set of stresses that the framework should be subjected and what is the relevant history. A healthy dose of judgment needs to be brought to bear on these decisions,” he said.

Debelle pointed to value-at-risk (VaR) models as an example, and said that such models draw observations from a defined period of time which is generally not all that long. “If the short time period used to estimate the model is an unrepresentative guide to what is about to unfold, then VaR has a serious problem,” he said.

Similar arguments can be brought to bear on stress tests, Debelle said, which can be used to assess the robustness of a model, or a risk management regime, to a set of outcomes that lie outside the data history of the model.

“Stress testing can go beyond out-of-sample forecasting in that one can conceive of a scenario which is not completely model-consistent. Nevertheless, a similar question can be asked: what is the universe of events that should be considered?” he asked.

“In the US, financial institutions, credit rating agencies and investors stress tested their mortgage portfolios and mortgage-backed securities. However, the stress test was derived from the history of house prices in the US”, which suggested that cities in the US had their own price cycles and that the correlations across markets were not particularly strong.

Using the right models is a primary step in making the system more robust, according to Debelle, who said that using a number of models at the same time may also be helpful.

“The light-touch regulatory approach applied in some jurisdictions (although not in Australia) also unfortunately assumed that the models were doing an adequate job,” he said.

“At this point, the Efficient Markets Hypothesis (EMH) is generally dragged out and beaten. But I think that is somewhat of a straw man. The main message I take from the EMH is that there are no gains left on the table, not that (financial) economics had reached a bliss point where the world could be fully encapsulated by a utility-maximising representative-agent model.”

The goal of making the financial system more robust to uncertainty is one of the key motivations behind the reforms being finalised in Basel at the moment, said Debelle, who noted that the Basel reforms are primarily focussed at the institutional level.

While these measures work to increase the robustness at an institutional level, a different set of considerations come into play with events such as the recent global financial crisis – which ultimately require a response from the public sector, including the central bank, he said.

“It is in the interests of society to ensure that the public sector provides a backstop in such circumstances to mitigate the externality caused by the individually rational risk-aversion of financial sector participants,” he concluded.