Models and regulations and the political leadership

February 27, 2016

Why do the regulatory authorities seemingly fall into the category of model believers, if not quite to the view that there must be one true model? Well, it is sort of inevitable the way the regulatory process works.

Why do the regulatory authorities seemingly fall into the category of model believers, if not quite to the view that there must be one true model? Well, it is sort of inevitable the way the regulatory process works.

There are a few reasons for that, ranging from philosophical to political to technical to ...

Let's discuss one of the political reasons, leaving the rest for later.

Take macro pru. We had a huge crisis from 2007, and the political leadership decided that something has to be done about finance. Suppose the President/Prime Minister calls the Governor of the Central Bank saying:

"Do something about finance. I am giving you billions of dollars and plenty of political capital to do so."

Perhaps, this is the beginning and end of the mandate. OK, it is fairly obvious that risk-taking in the financial sector got out of hand. So what is the Central Bank to do?

The obvious way is to hire a large number of people and tell them to come up with something, quickly. They can focus on perceived risk or actual risk ( to be discussed later). Actual risk is hard to do, and risks delaying the program too long. Much easier to focus on perceived risk. Just take off the shelf modeling technologies and use them to identify the risk in the financial system.

Does accuracy matter? Surely, but it is more important to keep the program going:

Expediency trumps reliability

And that means we end up with all the perceived risk models, regardless of how reliable they are.

One thing to keep in mind, given the fact that the typical OECD country enters into a systemic crisis once every 42 years, everybody associated with the process will be retired — in expectation — by the time the next crisis comes around.

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