The Thought Refuse

A Virtual Repository for the Mind

Assessing Risk Management As The Problem To The Economic Downturn

with one comment

The New York Times published an article yesterday detailing how, in 2004, reduced federal regulations for investment firms where in they did not have to back their mortgage backed securities with capitol reserves, and thus allowing them to utilize those reserves in the investment market.  Keep in mind that following the repeal of the Gramm-Leach-Bliley Act, the banking and investment operations of financial entities essentially became a single, connected operation through the allowance the investment arm to leverage the banking arm’s issued mortgages into mortgage backed securities.

In the preceding meeting between the the Securities and Exchange Commission, government officials, and CEOs of the five largest investment firms , only one warning was issued to the potential dangers of the regulation change.

A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake.

He additionally went to cite that

the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.

and referenced a history of risk management model failures.

similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.

One single opponent whose field was specific to the risk management field aired dissent.  I can only deduce that the majority of risk management experts within both the government, SEC, and the investment firms did not warrant the reduction in capitol backing against assets as a substantial risk.  It’s of particular note that he focused on the inadequacies of risk management software models.

The article continues focusing primarily on the SEC role in it’s lack of oversight.  The point of interest for me is the issue of risk management which I have posted about previously.  The fundamental problem is not improper oversight as much as it is the inability of risk management models to qualify risk aversion.  More precisely, the problem is that these models provide a incorrect data.

It is nearly impossible to make an informed decision when supplied with an incomplete knowledge base.  No amount of regulations and oversight will balance out the risk management models shortcomings.  If what I considered the proper operation of a motor vehicle to be that the pedal on the left is the gas, the pedal on the right is the brake, spinning the wheel left turns the vehicle right and vice versa and my conviction in this knowledge was inflappable then the success with which I operated a motor vehicle would be independent of you, who shared the same knowledge base for operating a motor vehicle, were sitting next to me in the passenger seat.

The lack of knowledge problem becomes even more acute when trying to forecast future events.  Any mathematical model requires the input of initial conditions to calculate an end point.  Not having every possible set of initial conditions, therefore restricts us to a limited number of predictable end points.  An analogous example would be the knowledge problem prediciting the future of technology.  For if I could predict future technological advancements, I would necessarily be able to create that technology in the present.


Written by huxbux

October 3, 2008 at 6:24 pm

One Response

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  1. The Cavalcade of Risk is now online, and your post is in it:

    Please let your readers know.


    Cavalcade of Risk

    October 8, 2008 at 9:25 am

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