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.
A well-known American economist, drafted during World War II to work in the US Army meteorological service in England, got a phone call from a general in May 1944 asking for the weather forecast for Normandy in early June. The economist replied that it was impossible to forecast weather that far into the future. The general wholeheartedly agreed but nevertheless needed the number now for planning purposes.
Similar logic lies at the heart of the current crisisStatistical modelling increasingly drives decision-making in the financial system while at the same time significant questions remain about model reliability and whether market participants trust these models. If we ask practitioners, regulators, or academics what they think of the quality of the statistical models underpinning pricing and risk analysis, their response is frequently negative. At the same time, many of these same individuals have no qualms about an ever-increasing use of models, not only for internal risk control but especially for the assessment of systemic risk and therefore the regulation of financial institutions.1 To have numbers seems to be more important than whether the numbers are reliable. This is a paradox. How can we simultaneously mistrust models and advocate their use...MORE