Volume 8 - December 6, 2005 - Expert Contributions

The Role of Risk Models in the Financial Crisis

bridges vol. 19, October 2008 / Pielke's Perspective

By Roger Pielke, Jr.

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pielke_r_new_small.jpgRoger Pielke, Jr. "Our 21st century global economy remains regulated largely by outdated 20th century laws."  This was one of the explanations for the financial crisis given by President George Bush in his address to the nation on September 24, 2008.  While the full reasons for and details of the still-unfolding crisis will certainly be explored in depth, one important aspect of the crisis has yet to receive the attention it deserves:  the notion that regulation of the 21st century economy requires 21st century technologies in the form of highly complex financial risk models.  When the story of the current financial crisis is told in full, I expect that the misuse of risk models will be found to have played an important role.

Risk models can be valuable tools in the financial industry.  But there are two significant problems with their use in financial decision making.  One is that risk models break down in times of crisis.  Jón Daníelsson of the London School of Economics explained this dynamic in a 2000 paper appropriately titled "The Emperor has No Clothes: The Limits to Risk Modelling":  "The basic statistical properties of market data are not the same in crisis as they are during stable periods; therefore, most risk models provide very little guidance during crisis periods."  The same models that make sophisticated financial instruments possible during normal times are virtually useless during times of crisis.

 

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