Risk Models

The problem wasn’t so much with the models themselves, but with how they were utilized. Rather than being used to discipline individual traders and trading desks, they were used to justify bigger and bigger speculative positions, and more and more leverage.

1. The risk models that were commonly used on Wall Street failed abysmally. Not only did they fail to protect their users from a bad outcome, they made such an outcome far more likely. In short, the risk models added to systemic risk.

2. In part, this was a failure of statistical modelling. The techniques that the risk modelers used weren’t up to the task they set for themselves. But it was also a problem of how the models were used. Rather than looking on them as a useful but limited tool, banks and other institutions used them as a substitute for proper risk management, and as a justification for taking on more leverage and more risk. This explains how the risk models made the entire system more risky.

3. At it’s root, the problem is conceptual. The financial market isn’t a deterministic system underpinned by laws of nature, and attempts to treat it like one—such as contemporary risk-management techniques—are destined to backfire.

John Cassidy on Whats wrong with Risk Models