Call for a new agenda on 'risk' - Emirates24|7

Call for a new agenda on 'risk'

We do not usually expect central bankers to display wit and elegance. Intelligence, certainly – sometimes sparkling but we do not expect them to entertain us.

But I think I have found one: step forward Andrew Haldane, the Bank of England's executive director for financial stability.

Last week in a speech to a specialist City of London audience he delivered what may well go down as a classic text on why, precisely, the financial system got itself into its current mess. It is a must-read for all students of economics and of modern history, in my view.

Here's an extract that caught my eye:

"A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.

"A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities – we understood how difficult these were to capture?

"No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

"All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mismanaging their risks?

"Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue…"

Too right! Haldane is talking here, in candid terms, about the fact that the management of risk within the financial sector at some point became broken.

It has been said many times that the most expensive words in financial markets are: "It's different this time." But that is exactly what was claimed in the area of risk management within financial institutions across the globe.

Applying copious amounts of academic work and fearsome levels of computing power, the world's global financial elite developed in the late 1990s what they believed were a set of risk management tools that could take finance to a new and higher plane. They had somehow made finance "different" – creating a world where superior risk management techniques would in themselves allow financial institutions to take greater risks in a controlled manner, and therefore earn substantially greater returns.

The trouble is, as Haldane eloquently explains, the data used to produce all these new risk management tools only applied to modern – historically stable – times. He has produced a series of charts to show that, when compared with the much longer-term, the assumptions garnered from this so-called "Golden Era" vastly underestimated the real risks involved.

It was not different this time. It was like all times past, but the financial community collectively conspired to ignore this fact. Haldane notes that the risk models failed the Keynes' test, namely that it is better to be roughly right than precisely wrong: "With hindsight, these models were both very precise and very wrong."

The tale of the Emperor's new clothes – that were admired by all, but didn't actually exist – has been used many times during the current troubles, but it remains painfully apt. Instinct and basic intelligence should have told market participants that the models they were relying upon might just be unreliable – or indeed risk was really not being managed at all. No one questioned the models publicly because there was so much money to be made building a financial structure upon them. They offered a "precise" foundation that was assumed to be "precisely right".

Conferences like the one addressed by the Bank of England man last week, became "catwalks for banks and the authorities alike, parading their new garments through the streets in all their finery. Risk modelling became high fashion for the pointy-heads, haute-couture for the anoraks".

Says Haldane: "The past two years have rather changed all that. The sub-prime market has played the role of the child in the fairytale, naively but honestly shifting everyone's perceptions about how threadbare the financial system had become. The madness of crowds, as Charles Mackay so vividly put it, became visible to all. The resulting unravelling of the Golden Decade has been little short of remarkable."

Asset prices collapsed and now the whole idea of risk management – the Emperor's clothes – has to be re-stitched from scratch. As Haldane puts it: "Estimated losses within the financial sector since the start of the crisis lie anywhere between a large number and an unthinkably large one."

"For that reason, 2008 might well be remembered as the year stress-testing failed. Failed those institutions who invested in it in the hope it would transform their management of risk. Failed the authorities who had relied – perhaps over-relied – on the signal it provided about financial firms' risk management capabilities. And, perhaps most important of all, failed the financial system as a whole by contributing, first, to the decade of credit boom and, latterly, the credit bust."

That's a stark conclusion, but also an inevitable one. When tested against real stress in the form of the credit crunch, large parts of the financial system simply seized-up and a number of high-profile banks and other institutions failed.

So now is the time for people like Haldane to be brutally honest about what went wrong. The market failures have to be diagnosed in painful detail and, in particular, there is a need to fix the sort of avoidance of reality epitomised by the Bank of England man's anecdote above. Incentivising risk managers to work for the common good, in this instance, really does come above incentivising greed.

Getting this roughly right rather than precisely wrong is something of a priority.

Andrew Haldane's full essay, drawn from his speech, is available here:

- The writer is an Associate Editor with the Financial Times