Lessons from Turner

To the sound of stable doors being bolted long after the horses had fled, the UK’s Financial Services Authority (FSA) has published the Turner review – a regulatory response to the global banking crisis. Its analysis of the causes of the global financial sector meltdown is concise and clear, but its suggestions about what to do next are disappointingly predictable: regulation will be ‘more intrusive; more systemic’, and there will be more of it.

It is a moot point as to whether more intrusive regulation could have forestalled the present crisis, and it is arguable that it will not be able to stave off the next one. As the Greek sage Heraclitus remarked, ‘You never step into the same river twice.’ Regulations designed to cope with this year’s crisis may be powerless to prevent the next.

The Turner report has much to say about failure, and it is here that it is most valuable. For the failures it describes graphically illustrate what happens when risk management becomes complacent and begins to believe too readily in comfortable theories. For this reason alone, it should be required reading – and not just for those working in the financial sector.

In the analysis of where theory failed in practice, Turner picks five fashionable assumptions from the past decade, which he believes are open to challenge ‘on both theoretical and empirical grounds’. They are:

i) Market prices are good indicators of rationally evaluated economic value.

ii) The development of securitised credit, since based on the creation of new and more liquid markets, has improved both allocative efficiency and financial stability.

iii) The risk characteristics of financial markets can be inferred from mathematical analysis, delivering robust quantitative measures of trading risk.

iv) Market discipline can be used as an effective tool in constraining harmful risk taking.

v) Financial innovation can be assumed to be beneficial since market competition would winnow out any innovations which did not deliver value added.

These assumptions have not been confined to the financial sector. The deep trouble in European property and construction sectors has arisen as a direct result of assumptions about ‘rationally evaluated economic value’. That risk can be quantified ‘robustly’ by sophisticated mathematics is also a belief that has been – and still is – prevalent in organisations far removed from the banks. The belief that ‘market discipline’ can act as a curb on excessive risk taking – that it can prevent risk appetite turning to risk gluttony – has led to the collapse of venerable institutions which should have known better.

Beyond these, however, lies the most dangerous assumption of all – that diversified transfer of risk is ‘safe’ and allows the organisation to take on more risk. The factor that led directly to the freezing of wholesale money markets in the wake of the collapse of Lehmann brothers was the appalled realisation that risk had neither been transferred nor diversified, but had merely been circulating within the system like some toxic chemical that its users falsely believed had been rendered harmless.

The abiding lesson for risk management is firstly that the complexities of globalised business have created risks which it may be impossible to foresee at all, and which are certainly impossible to quantify by extrapolating from historical data. Secondly, that globalisation also implies that the consequences of a seemingly minor risk materialising in some far-flung corner of the world may be unpredictable, destructive, and extremely rapid. Over-reliance on models in such contexts can lead to trouble.

As Turner puts it: ‘Price movements during the crisis have often been of a size whose probability was calculated by models to be almost infinitesimally small. This suggests that the models systematically underestimated the chances of small probability high impact events. Models frequently assume that the full distribution of possible events, from which the observed price movements are assumed to be a random sample, is normal in shape. But there is no clearly robust justification for this assumption ... VAR models need to be buttressed by the application of stress test techniques which consider the impact of extreme movements beyond those which the model suggests are at all probable. Deciding just how stressed the stress test should be, is however inherently difficult, and not clearly susceptible to any mathematical determination.’ The sting lies in the last sentence.

James Watt, inventor of the modern steam engine, also invented the governor – a simple mechanical self-regulator to control potentially dangerous positive feedback, operating outside human control and reacting to the speed of the engine. Perhaps risk management needs to find the equivalent.