Tuesday, 24 March 2009
The Socialization of Risk: FSA Report (3)
Turner muses on the subject of whether mathematical modelling of risk – e.g. for determining capital adequacy – is valid.
“it is unclear whether … we need to recognise that we are dealing not with mathematically modellable risk, but with inherent ‘Knightian’ uncertainty. This would further reinforce the need for a macro-prudential approach to regulation." (page 45)
Many will have read Taleb on this subject, Fooled by Randomness being much more measured than the later, more famous and intemperate diatribe The Black Swan. Turner goes on:
“But it would also suggest that no system of regulation could ever guard against all risks / uncertainties, and that there may be extreme circumstances in which the backup of risk socialization (e.g. of the sort of government intervention now being put in place) is the optimal and the only defence against system failure."
Well. Obviously, since it’s happening right now, socialization is indeed the ultimate back-up: it always will be. But ‘optimal’ and ‘only’ are strong words – could the current nonsense be described as optimal by anyone except a successful banker-looter who’s made his escape ?
To argue that planning for this to happen (even in a more orderly fashion) once in every 50 years or so, is optimal, is akin to saying that government should always make every capital investment because it has the lowest cost of capital. Defeatist, statist claptrap. And ‘only’ is strictly for Marxists.
Conventional risk management can do much better than this without recourse to ‘state insurance’ – has Turner never heard of margining, for example ? Of course he has, see pages 83 and 110-3. Only if the state knew what risk margin, or ‘insurance premium’ to levy (or to set aside from general taxation by way of subsidized ‘sinking-fund’), could a true optimisation calculation be made. But if the appropriate margin is known, this can be handled, as with on-Exchange or bilateral margining, within the commercial sphere itself.
And if for a particular deal or player such margining were ‘too expensive’, that is a strong indication the deal in question shouldn’t be transacted at all !
What ‘society’ should demand is not the dubious privilege of socializing ultimate risk, but the proper implementation of conventional risk management between the consenting adults involved.
Posted by Nick Drew