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Inconsistent Risk Assessment by Banks Isn't That Bad

Jon Danielsson, the director of the Systemic Risk Centre at the London School of Economics, has a post up at Vox EU arguing that we should applaud recent revelations about banks using very different risk models to assess their assets.

You'll recall that in January, the Bank for International Settlements produced a paper decrying inconsistent risk weighting of various European banks. The paper showed that the most aggressive banks rated assets as just one-eighth as risky as their more conservative competitors. The next month pretty much the same thing came out of the European Banking Authority.

Bank regulators view this inconsistency as a problem that needs to be addressed. Certainly, they argue, everyone should be using pretty much the same models. If different models are producing different risk assessments, then someone must be wrong.

Alex Potemkin | E+ | Getty Images

Where this idea goes wrong is in assuming that a unified view of risk would be the would view. We know from history that this hasn't been true in the past. Regulators viewed mortgage securities as far less risky than many of them turned out to be, with the result that the entire banking sector was entirely undercapitalized and overexposed to mortgage risk.

Danielsson explains that we have good reason to expect that any unified model will be wrong. In the first place, a model imposed by regulation cannot easily be adjusted to account for new information. Second, monopolisitic control of the model by regulators will tend to undermine its accuracy. Competition among banks to produce better models will be more effective.

Here's Danielsson:

If the authorities pick one modelling approach over another, they may just as easily be backing the wrong horse, a model that is less accurate, affording financial institutions and the financial system less protection in the future.

For this reason, it is generally better for financial institutions to develop their own models internally. This is more likely to lead to a healthy competition in model design and more protection for the financial system, because model quality will improve over time. A supervisory-mandated model is much more likely to stagnate and become ossified, leading to less model development, and ultimately less protection.

If the authorities end up backing the wrong horse, and some years down the road when the next crisis happens, analysts may find that a key contributor to the crisis was the wrong model promoted by the authorities. This means that responsibility has been transferred to the governments, making a stronger case for bailouts. Regulatory involvement in models design directly affects the probability of bailouts and increases moral hazard.

This means that it is better to leave model development to the financial institutions, let them take responsibility, whilst encouraging innovations in modelling.

Danielsson also points out that unified models undermine financial stability by encouraging banks to adopt herd behavior.

Moving towards model homogeneity leads to procyclicality. If each bank develops its own models, and models are different across the industry, when the next shock arises some banks may view it positively and buy the underlying asset, whilst other banks take the opposite view and sell. In aggregate their actions cancel out, resulting in stable markets where extreme movements are unlikely.

If however the banks are forced to have the same models, they will all analyse the shock in the same way, and react in the same way, amplifying price movements. All buying or all selling. In a worst-case scenario it causes extreme price movements. It also undermines market integrity because it encourages predatory behaviour by other market participants not bound by the models. It doesn't really matter how accurate the models are. Even if the supervisor 'lucks out' and picks the best model, it will still harmonise bank reactions. Model homogeneity is procyclical and undermines market integrity.

One point that Danielsson doesn't raise deserves attention here. The crowding into positions that are viewed by an official model as less risky has an additional risk-enhancing feature. It tends to drive up the price of the favored assets, which in turn encourages the over-production of those assets. The entire financial system can wind up unbalanced because of this capital regulation driven distortion.

Danielsson's arguments are not completely novel. I've been making similar critiques for years, ever since I encountered them in the groundbreaking work of Jeff Friedman and Wladimir Kraus. But it's definitely good news that we critics of capital regulation have an ally at the LSE's Systemic Risk Centre.

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