The logical fallacy at the heart of the intellectual case for Brexit
Half a decade after the Brexit vote, it is clear that the classical liberal intellectual case for Brexit has a fatal flaw.
Half a decade after the Brexit vote, it is clear that the classical liberal intellectual case for Brexit has a fatal flaw.
How far into the future should we be able to execute computer code written today? Next month, next year next decade or next century? My choice of a language depends on the answer to that very question.
A common misconception maintains that different notions of risk capture the same concept: VaR, ES and volatility all measure the same “true” risk”. In the same way as like Celsius, Fahrenheit and Kelvin all tell the same thing, only on a different scale. Not true.
After using Julia successfully in a few new projects, my latest came to a sticky end because of how it saves large data files.
Financial risk management has become ritualised. It is more important to follow the correct procedures than to control essential risks. Why and what does it mean for us?
Do all the talented engineers working on cryptocurrencies ensure crypto success?
There are many measurements of systemic risk and a huge number of papers depend on those measurements. But is that work of any use?
The almost infinite complexity of the financial system is the main reason why it is so hard to keep it under control. And that complexity is due to everybody that works in the financial system having incentives to increase its complexity, including the regulators.
Risk measurements are quite inconsistent. Does that matter, and how to interpret the results?
As the price of bitcoin continues to rise, this column argues that most of us would not want to live in a society where bitcoin succeeds. Fortunately, the internal contradictions and perverse consequences of cryptocurrencies success mean that they are destined for failure. Until then, it might make sense for speculators to ride the cryptocurrency bubble, so long as they get out in time.
There are a million ways to measure financial risk, and if one wants to calculate global risk, it requires a truly heroic set of assumptions. But it’s much easier to calculate global market risk, and that is what I set myself to do below.
As Amazon continues its exponential growth, where will it all end? Growth has to stop, but when and why?
The new Apple M1 processor has gotten excellent reviews for speed. Getting curious, I measured its speed on pure c code, latex and R and compared it to its most recent Intel competitors.
While the direct economic consequences of Covid-19 have been significant, the impact on the financial markets has been more nuanced. This column uses a unique data set on the financial markets’ fears and perceptions of long-run financial risk to identify how Covid-19, and particularly Fed policy responses to Covid-19, affected global market fears. While some Fed interventions had little or no impact on market fear, the most powerful were the US dollar swap lines, which strongly reduced the perceived likelihood of global market losses decades into the future. The results suggest that the Fed’s relative global role has been strengthened, possibly at the cost of increased moral hazard.
Central-bank digital currencies will make the financial system more efficient. But will they make it safer? Maybe, but they could easily end up increasing systemic risk. Depends on the implementation.
As a part of its quest for independence, Britain decided to leave the Erasmus program. We now have Turing, the global version. So, will it lead us to the sunny uplands?
The Brexiteers and Karl Marx have more in common than often thought. Both were guided by ideology, and both refused to tell us how to get to the sunny uplands they promised.
Financial crises and bailouts of financial institutions are inevitable and can’t be prevented without paying too high a price. Diversity is the best way to minimise the frequency and severity of crises and ensure sustainable high economic growth.
Are cryptocurrencies and blockchains the solution to the problem laid bare by the Covid-19 bailout of the financial system? No.
A libertarian sees the Covid-19 bailout of the financial system as a predictable failure of regulations. Much better to have a laissez-faire economy and never, ever bail private firms out. But does the laissez-faire utopia survive contact with reality?
The state just saved the financial system from itself. What is the point of privately owned banks if they need to be bailed out every decade?
The financial authorities have just bailed the financial system out for the second time in a decade. While the authorities are proud of having prevented a financial crisis, are we really better off? No, one cannot judge the policy intervention a success if it is only due to the promise of the intervention that the problem arose in the first place.
The central banks bailed out the financial system in March 2020, the second time they have done so in 12 years. What is the point of privately owned banks if they require a bailout every decade?
The most widely used programming languages for economic research are Julia, Matlab, Python and R. This column uses three criteria to compare the languages: the power of available libraries, the speed and possibilities when handling large datasets, and the speed and ease-of-use for a computationally intensive task. While R is still a good choice, Julia is the language the authors now tend to pick for new projects and generally recommend.
Does it make sense to invest in low vol funds?
I just tried the same code in R’s data.tables and Julia’s DataFrames, and the results are a bit surprising.
It is easy to manipulate risk forecasts. If your regulator or compliance officer sets a risk target you don’t like, just tell them what they want to hear and continue taking the risk you like.
It is easy to criticise risk forecasting, but it’s rather pointless unless one can come up with proposals. Here are my five principles for the correct use of riskometers.
Backtesting is the magical technique that tells us how well a forecast model works. Test the model on history, and we have an objective way to evaluate how good the model is. But does it really work in practice?
The way financial risk is measured is by a device I have called the riskometer. It is a fantastic thing, plunge it into the bowels of the City of London and out pops a single accurate measurement of risk. Magical. But does it work in practice?
The way we manage financial risk has a lot in common with the old concept of scientific socialism. The modern-day riskometer is pseudoscientific, and the increased reliance on it leads to disastrous systemic risk.
Epidemics and financial crises are different beasts. But they are eerily similar underneath — The dynamics, the politics, the mistakes and the learning all are the same.
Corona is unprecedented and I am willing to give government’s plenty of latitude. Mistakes will be made. But some are worse than others, and the dumbest economic mistake I have seen comes out of France this week. Friedrich Hayek saw it coming in 1944.
Corona est sans précédent et je suis enclin à permettre aux gouvernements une grande latitude. Des erreurs seront commises. Mais certaines sont pires que d’autres, et l’erreur économique la plus stupide que j’ai vue a été commise par la France cette semaine. Friedrich Hayek l’avait prévu en 1944.
We are bombarded by Corona epidemiology analysis. How it spreads, how to contain it, how to cure it, how it will play out. I am ignoring it all.
Many comparisons have been made between the coronavirus crisis and the global systemic crisis in 2008. This column argues that seen through the lens of exogenous and endogenous risk, these two crises are quite different. Coronavirus is unlikely to cause a global systemic crisis, and the policy response should be different.
Artificial intelligence, such as the Bank of England Bot, is set to take over an increasing number of central bank functions. This column argues that the increased use of AI in central banking will bring significant cost and efficiency benefits, but also raise important concerns that are so far unresolved.
Financial institutions are increasingly outsourcing information technology to the cloud, motivated by efficiency, security, and cost. This column argues that the consequence is likely to be short- and medium-term stability at the cost of the increased likelihood of catastrophic systemic events. Cloud providers are systemically important and should be regulated as such.
The type of risk we most care about is long-term, what happens over years or decades, but we tend to manage that risk over short periods. This column argues that the dissonance of risk is that we measure and manage what we don’t care about and ignore what we do.
As central banks accumulate ever more job functions, their reputation risk increases. This column offers a cautionary tale from Iceland where, after the central bank was put in charge of capital controls, it was subject to severe attacks because of perceived mistakes in how the capital controls were enforced. The accumulation of powers erodes a central bank’s independence and subjects it to regulatory paralysis.
In all the disappointments about Brexit, one stands out for me — the inability of the libertarian Brexiteers to outline a coherent vision of what Brexit will accomplish. They used to see rational economic management as as a virtue, now what matters is culture.
Brexit discussions have degenerated into a culture war.
Imagine the day when BoB — the Bank of England bot — comes to life, the artificial intelligence engine designed to keep us safe from the evils of the financial system.
Apple’s revenues are falling. A tiny, tiny part is thanks to me. Why? I used to buy a new Apple device every six months, but no more.
The financial markets did not have a good 2018 as the media kept on reminding us:
The riskiest year in human history was 1962. The year of the Cuban missile crisis, the closest we ever came to a nuclear war. The mother of all tail events, where all prices go to zero. Volatility that year was average — 16.5%
How can market risk be average when tail risk is at its highest?
Perceived risk is risk predicted by models and actual risk is the fundamental underlying risk. We measure perceived risk and care about actual risk. Unfortunately, those two are negatively correlated.
If private cryptocurrencies were to find widespread economic use the result would be increased financial instability, inequality, and social instability.
Was last month’s stock market crash was as bad as some are making out?
On top is the authority in charge of fiscal policy, followed by those running monetary, microprudential, and finally macroprudential policies. This ranking can cause conflicts in terms of policy effectiveness and legitimacy.
Are cryptocurrencies the future of money, Ponzi schemes, speculators dream, freedom or just a cult?
One of the puzzling things about post-crisis financial policymaking is the dual understanding that we missed the excessive build-up of risk before 2007 in spite of having all the numbers right in front of us and at the same time founding the new world order on numbers and measurements. Have the policymakers fallen for the McNamara fallacy?
Medieval mapmakers noted the risk of an unknown kind by “here be dragons”. Attempts at measuring extreme risk should come with a similar warning. Just like the sailors of yesteryear, financial institutions will go into unknown territories and, just like the map makers of the earlier era, modern risk modellers have little to say.
Reliable indicators of future financial crises are important for policymakers and practitioners. While most indicators consider an observation of high volatility as a warning signal, this column argues that such an alarm comes too late, arriving only once a crisis is already under way. A better warning is provided by low volatility, which is a reliable indication of an increased likelihood of a future crisis.
Cryptocurrencies are supposedly a new and superior form of money and investments – the way of the future. The author of this column, however, does not see the point of cryptocurrencies, finding them no better than existing fiat money or good investments.
The stock market had a mini crash yesterday. So how big was that in a historical context?
Artificial intelligence is increasingly used to tackle all sorts of problems facing people and societies. This column considers the potential benefits and risks of employing AI in financial markets. While it may well revolutionise risk management and financial supervision, it also threatens to destabilise markets and increase systemic risk.
European banks and sovereigns are much more closely linked than American banks and their government. The resulting bank-sovereign doom loop has been gathering strength, since the 2008 crisis.
The new postcrisis financial regulations, for example Basel III, have the unfortunate side effect of favouring the largest banks relative to the smaller. This can result in concentration, oligopolies, and even larger SIFI banks. This problem is made worse because of how Europe likes to regulate.
Regulations change behaviour and outcomes. It is seductively attractive to say that someone misbehaves, therefore we need the rule to prevent the misbehaviour. However, human beings, being human, don’t just comply, their behaviour changes. That is why regulating the financial system is infinitely more complex than engineering.
I did a seminar at the University of Iceland. The first half of the presentation was about risk and regulations and the second part is about economic policy in Iceland. The slides can be downloaded from here.
The announcement is here.
The slides are in English but the Icelandic title is:
Stenst uppskriftin í raunverulegum bakstri? Getur þjóðhagsvarúð og peningastefna skilað því sem lofað er - eða aðeins lækka hagvöxt að nauðsynjalausu?
Brexit is likely to cause considerable disruption for financial markets. Some worry that it may also increase systemic risk. This column revisits the debate and argues that an increase in systemic risk is unlikely. While legal ‘plumbing’ and institutional and regulatory equivalence are of concern, systemic risk is more likely to fall due to increased financial fragmentation and caution by market participants in the face of uncertainty.
The Icelandic government announced today it it lifting its capital controls. Private investors, pension funds and the government need to prioritise investing abroad to lower the chance of another crash.
The Icelandic authorities in November 2008 imposed capital controls because they were in a panic over how to react to the crisis. The IMF was an enthusiastic supporter, its representative at the time arguing that it was one half of a belts and suspenders policy, the other being interest rates of 21%.
I have been struggling to make sense of the Brexit debate. Perfectly reasonable, well informed and highly intelligent people reach diametrically opposite conclusions, all impeccably argued. In order to make sense of the debate, I did what any quant might do and made a graph of the competing Brexit visions.
Discretionary macroprudential policies aim to be countercyclical by adjusting risk-taking across the financial cycle. This column argues that the opposite effect may happen in certain cases. Depending on how regulators measure risk and how they react, the eventual outcome may well be procyclical, with serious unintended consequences.
Political risk is a major cause of systemic financial risk. This column argues that both the integrity and the legitimacy of macroprudential policy, or ‘macropru’, depends on political risk being included with other risk factors. Yet it is usually excluded from macropru, and that could be a fatal flaw.
Investor demand for bonds is very high. This column argues that this is surprising because under almost any likely inflation scenario, including central banks merely hitting their target inflation rates, bondholders suffer large losses. The beneficiaries are sovereign and corporate borrowers; the losers are pension funds, insurance companies and some foreign exchange reserve funds. Meanwhile, the systemic risk from a bond crisis is increasing.
Brexit creates new opportunities and new risks for the British and EU financial markets. Both could benefit, but a more likely outcome is a fall in the quality of financial regulations, more inefficiency, more protectionism, and more systemic risk.
The threat to the financial system posed by cyber risk is often claimed to be systemic. This column argues against this, pointing out that almost all cyber risk is microprudential. For a cyber attack to lead to a systemic crisis, it would need to be timed impeccably to coincide with other non-cyber events that undermine confidence in the financial system and the authorities. The only actors with enough resources to affect such an event are large sovereign states, and they could likely create the required uncertainty through simpler, financial means.
At the risk of overgeneralising, Brexiteers have two, rather different world views — 1950s Britain or the hip, modern, perhaps like Hong Kong. One certainly is more likely.
One often hears from Brexit supporters that too many regulations come from Brussels, that it would be much better if we could regulate ourselves. At least when it comes to finance, that argument just does not hold water.
I just spotted an interview with the IMF representatives to Iceland about their policy prescriptions, and it did make for an interesting reading.
Macroprudential policy has become increasingly popular in the aftermath of the Global Crisis, but it remains controversial. This column argues that vigorous disagreement is both inevitable and healthy, reflecting differing fundamental views of how the financial system really works. By embracing the divergence of views instead of seeing it as problematic, macroprudential policymaking will be made easier and more effective. åÊ
Suppose one cares about tail risk, what is the best way to estimate it? There are two, not mutually exclusive, ways; statistical and structural. Which is right?
There a lot of evidence that models are less than perfectly reliable. Why then do we rely so much on models in decision-making, and especially financial regulations? Because there are three types of people: Believers in true model, skeptics who accept model risk and nihilistic rejectionists.
When designing models, the underlying assumption is often that the model captures the true data generating process. Does a true model exist? To me, the question is completely irrelevant.
Much of the analysis of the recent market turmoil is amusing. Take the Wall Street Journal, Why the Fed Is the Root of Much Market Turmoil: Fed is a key reason markets have plunged and risk of recession rising . Here is a quote:
There has always been conflict between macro- and microeconomic regulation. Microeconomic policy reigns supreme during good times, and macro during bad. This column explains that while the macro and micro objectives have always been present in regulatory design, their relative importance has varied according to the changing requirements of economic, financial and political cycles. The conflict between the two seems set to deepen and so, regardless of which wins, policymakers must not undermine the central bank’s execution of monetary policy.
Last January I looked at how the Swiss FX shock affected the most popular risk measures. Events of the past week give us another interesting test. My daily risk forecast shows the various risk measures for a number of assets, but focus on the SP-500, and the following picture taken from the site today:
The Greek and the Icelandic crisis have much in common, not the least the heavy pressure from foreign countries and the hectoring from their public officials. In Iceland and in Greece this was counterproductive, hardening the opposition to any settlement. The will to reform needs to come from within, and the sooner the Troika realizes this, the easier it will be to deal with the Greek situation.
The long-running Greek crisis and China’s recent stock market crash are the latest threats to the stability of the global financial system. But as this column explains, systemic risk is an inevitable part of any market-based economy. While we won’t eliminate systemic risk entirely, the agenda for researchers and policymakers should be to create a more resilient financial system that is less prone to disastrous crises and that still delivers benefits for the economy and for society.
Some financial authorities have proposed designating asset managers as systemically important financial institutions (SIFIs). This column argues that this would be premature and probably ill conceived. The motivation for such a step comes from an inappropriate application of macroprudential thought from banking, rather than the underlying externalities that might cause asset managers to contribute to systemic risk. Further, policy authorities are silent on the question of what SIFI designation should mean in practice, despite the inherent link between identification and remedy.
I have been in a conference for the past few days, and have seen a few presentations on macropru type regulations.
I got to be on the radio show Sprengisandur, if you understand Icelandic. After discussing Greece, got asked about Iceland. The Icelandic authorities could have made some of the same mistakes as the Greek government did in its crisis, but overall, the three governments since then, have done a decent job. All, in their own way, paving the way for prosperity.
Iceland has just announced it is getting rid of its capital controls. This column argues that the government’s plan is a credible, efficient and fair plan to lift the costly and misguided controls.
May 14, 2015
Bloomberg today had an interesting piece, called Market Moves That Are Supposed to Happen Every Half-Decade Keep Happening. Here is their self-described “terribly simplistic list”
So, does ES capture tail risk, but VaR not? Therefore the Basel committee is correct, and we all should use ES. Is that true?
Regulators and financial institutions increasingly depend on statistical risk forecasting. This column argues that most risk modelling approaches are highly inaccurate and confidence intervals should be provided along with point estimates. Two major approaches, value-at-risk and expected shortfall are compared, and while the former is found to be superior in practice, it is also easier to be manipulated by forecasters.åÊ
This column introduces a new Vox eBook collecting some of the best Vox columns on financial regulations, starting with the fundamentals of financial regulations, moving on to bank capital and the Basel regulations, and finishing with the wider considerations of the regulatory agenda and the political dimension. Collecting columns from over the past six years, this eBook maps the evolution of leading thought on banking regulation.
Just looked again at the what I did on the Swiss FX shock, looking at how the various risk measures performed in the days after the event, and also looking at the risk of the inverse FX.
The original analysis just looked at the risk of the Franc appreciating, but why not look at the risk of the euro appreciating.
The proposed EU capital markets union aims to revitalise Europe’s economy by creating efficient funding channels between providers of loanable funds and firms best placed to use them. This column argues that a successful union would deliver investment, innovation, and growth, but it depends on overcoming difficult regulatory challenges. A successful union would also change the nature of systemic risk in Europe.
The Swiss central bank last week abandoned its euro exchange rate ceiling. This column argues that the fallout from the decision demonstrates the inherent weaknesses of the regulator-approved standard risk models used in financial institutions. These models under-forecast risk before the announcement and over-forecast risk after the announcement, getting it wrong in all states of the world.
Risk forecasting is central to financial regulations, risk management, and macroprudential policy. This column raises concerns about the reliance on risk forecasting, since risk forecast models have high levels of model risk - especially when the models are needed the most, during crises. Policymakers should be wary of relying solely on such models. Formal model-risk analysis should be a part of the regulatory design process.
Basel III is coming into focus. The fundamental logic of the regulatory changes seems sensible, but the devil is in the detail - empirical implementation. This column discusses a detailed quantitative study, incorporating analytical calculations, Monte Carlo simulations and results from observed data. It concludes that the Basel Committee has taken three and a half steps backwards and half a step forward. If implemented, the framework is likely to lead to less robust risk forecasts than current methodologies.
Europe is set to finally approve new insurance regulation, Solvency II. This column argues that the final text should respect three fundamental principles to ensure solvency.
Central banks frequently lead the macroprudential policy implementation. The hope is that their credibility in conquering inflation might rub off on macroprudential policy. This column argues the opposite. The fuzziness of the macroprudential agenda and the interplay of political pressures may undermine monetary policy.
Icelandic voters recently ejected its post-Crisis government - a government that successfully avoided economic collapse when the odds were stacked against it. The new government comprises the same parties that were originally responsible for the Crisis. What’s going on? This column argues that this switch is, in fact, logical given the outgoing government’s mishandling of the economy and their deference towards foreign creditors.
Cyprus has imposed temporary capital controls. This column sheds light on how temporary and how damaging they are likely to be, based on Iceland’s experience. The longer controls exist, the harder they are to abolish. Icelandic capital controls, which have been Û÷temporary’ for half a decade, deeply damage the economy by discouraging investment. We can only hope the authorities that created the chaos in the first place realise that temporary really needs to mean temporary.
Is the fact that different banks have different risk models problematic? Contrary to the Basel Committee and the European Banking Authority, this column argues that heterogeneity is a good thing. It leads to countercyclicality, and thereby reduces instances of procyclical price movements. Both the Basel Committee and the European Banking Authority have indicated that they are troubled by heterogeneity and are seeking to rectify the problem. Their conclusion is plainly wrong.
The current EZ crisis is not Europe’s first sovereign-debt crisis. This column shows parallels can be drawn from an all-but-forgotten episode, i.e. the 1990 Faroese crisis. Just like Greece, the Faroes got into difficulty because of excess borrowing facilitated by a currency union with an AAA-rated partner undeterred as the sovereign debt spiralled upwards. In the Faroese case, the crisis was eventually resolved when political necessities outweighed the cost of the bailout.
October 2011 saw the latest draft of Solvency II, the European Union’s code for regulation of the insurance industry. This column argues that the latest proposals need to be drafted again, urgently.
October 2011 saw the latest draft of Solvency II, the European Union’s code for regulation of the insurance industry. This column argues that the latest proposals need to be drafted again, urgently.
The IMF has emerged from the global crisis bigger and more powerful. But this column argues that the capital controls it required Iceland to adopt in 2008 are not of the soft and cuddly modern type that slow hot money flows. Instead they are akin to the draconian controls common in the 1950s. They violate the civil rights of Icelanders and significantly hamper economic growth.
According to the IMF, Iceland has graduated from its Fund-supported programme with unqualified success. This column begs to differ.
Much of macroeconomic policymaking is trial and error. This column discusses calamitous error on the part of Iceland’s policymakers, in the hope that others can at least try something else.
A debate is raging on capital adequacy requirements for banks. The UK wants to be allowed to be on ÛÏtop upÛ the agreed levels, i.e. to impose stricter capital standards than the EU minimum. This column argues the UK is right, and that the German and French opposition might be motivated by weaknesses in their banking systems.
Financial risk models have been widely criticised for both theoretical and practical failures, especially during the recent financial crisis. In the second of two columns, the authors outline why the shortcomings of risk models matter before making suggestions for how the financial industry and supervisors should use models in practice.
Risk models are at the heart of the financial sector’s self-monitoring as well as supervision by regulators. This column, the first of two, addresses the question of how risk models are misused in practice by practitioners and supervisors alike. This misuse causes risk management to fail when it is most needed.
Icelanders have voted against providing a government guarantee for claims made by the UK and the Dutch governments against Iceland’s deposit insurance fund. This column argues that the heated debates surrounding the referendum may provide a glimpse into the challenges that lie ahead for European policymakers as they attempt to allocate losses suffered by banks between the taxpayers of different countries.
A delicate regulatory question is under consideration on the capital (reserve) requirements at the heart of Solvency II (the insurance industry equivalent of Basel III), which is scheduled to come into effect by 2013. This decision will have implications for both regulation of insurers and for macroprudential stability. The six authors of this article were invited to discuss the issues and concluded that more public scrutiny over this important question is urgently needed.
In crises, insurance companies’ asset values may fall significantly without a corresponding drop in their liabilities. European insurers have argued that their liabilities should be discounted by a higher rate during crises, lest regulations force them to raise more capital at exactly the wrong time. This column argues that that would be the wrong approach to the problem.
Financial models are widely blamed for underestimating and thus mispricing risk prior to the crisis. This column analyses how the models failed and questions their prominent use in the post-crisis reform process. It argues that over-relying on market data and statistical forecasting models has the potential to further destabilise the financial system and increase systemic risk.
Icelanders may well reject the terms of the financial deal with Britain and the Dutch in a March referendum. This column introduces a new CEPR Policy Insight arguing that responsibility for Icesave losses falls jointly on Iceland, Britain and the Netherlands. Regardless of the vote, the three governments should come to a more reasonable agreement that enables Iceland to pay its obligations without tipping the economy into the abyss.
The Icelandic parliament has decided to apply for EU membership. This column warns that domestic opposition and outstanding disputes with EU member countries on Icesave may derail the agreement.
Bank bonuses have been blamed for contributing to the crisis, and regulators and politicians are now demanding changes in compensation arrangements. Most of these calls are based on a misconception of the nature of financial risk, an inflated view of the efficacy of risk models, and an incorrect view of the incentive issues facing financial institutions. This column proposes reforms that would discipline senior managers by exposing them to the dangers of junior managers’ risk taking.
Many are calling for significant new financial regulations. This column says that if the regulate everything that moves crowd has its way, we will repeat past mistakes and impose significant costs on the economy, to little or no benefit. The next crisis is years away, we have time to do bank regulation right.
By incorporating endogenous risk into a standard asset-pricing model, this column shows how banks’ capacity to bear risk seemingly evaporates in the face of market turmoil, pushing the financial system further into a tailspin. It suggests that risk-sensitive prudential regulation, in the spirit of Basel II, makes systemic financial crises sharper, larger, and more costly.
Much of today’s financial regulation assumes that risk can be accurately measured so that financial engineers, like civil engineers, can design safe products with sophisticated maths informed by historical estimates. But, as the crisis has shown, the laws of finance react to financial engineers’ creations, rendering risk calculations invalid. Regulators should rely on simpler methods.
Some view Iceland’s crisis as holding lessons for any country with an outsized financial sector, e.g. the UK. This column disagrees, arguing that Iceland’s downfall is explained by the way its unique history, inappropriate policy responses, and weaknesses in EU banking regulations created a perfect storm, unlikely to happen elsewhere.
Iceland’s banking system is ruined. GDP is down 65% in euro terms. Many companies face bankruptcy; others think of moving abroad. A third of the population is considering emigration. The British and Dutch governments demand compensation, amounting to over 100% of Icelandic GDP, for their citizens who held high-interest deposits in local branches of Icelandic banks. Europe’s leaders urgently need to take step to prevent similar things from happening to small nations with big banking sectors.
Complex financial models and intricate assets structures meant extraordinary profits before the crisis. Markets for structured products became overly inflated as even the banks did not have a clear view of the state of their investments. Given complexity’s role in today’s mess, future regulation should focus on variables that are easy to measure and hard to manipulate (e.g. leverage ratios).
In response to financial turmoil, supervisors are demanding more risk calculations. But model-driven mispricing produced the crisis, and risk models don’t perform during crisis conditions. The belief that a really complicated statistical model must be right is merely foolish sophistication.