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Systemic risk models: issues and
prospects
Discussion by:
Kostas Tsatsaronis
Bank for International Settlements
FMG / CCBS conference
Macroprudential policy: issues and challenges
London, 2 November 2010
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Disclaimer
I am speaking for myself.
The views expressed are not necessarily those of the Bank
for International Settlements or of the Basel Committee on
Banking Supervision
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Overview of paper
 A pragmatic approach to dealing with systemic risk
 Observation:
• Risk measurement technology is not yet up to speed in
capturing the complexities of financial system
behaviour
 Conclusion:
• We cannot play “god engineer” with micro-prudential
tools and actively protect institutions from shocks
• We should pay more attention to prevention and to
reducing the systemic/economic costs given a shock
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My take …
 I very much agree with the observation
• I would even strengthen some of the messages
 I would qualify the conclusion
 Things are moving to the right direction
 The tougher part would be to change mindsets of private
sector as well as supervisors
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Complex nature of financial system risk
 The financial system is not a collection of introvert
individuals
 Interactions are complex and “non-linear”
 The whole is larger (more complex) than the sum of the
parts
• Individual institutions think of themselves as price
takers when they are really shaping the environment
they live in
• Some more than others…
 Risk assessment is very tricky business
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Systemic risk measurement is problematic
 We do not yet have robust, manageable models of
interactions that can be used for analysis of macrofinancial risk
 How can we calibrate the instruments of policy?
• ex ante engineering is tricky
 How can we assess policymakers’ success ex post?
• Political economy , governance
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The pitfalls of relying on market prices
 Prices are particularly unreliable indicators of risk because
they are part of the problem
 Large shocks are by definition not embedded in prices: if
they were we would not have crises
• True meaning of the “efficient markets” proposition
 They can almost be seen as contrarian indicators
 I am very sceptical about any model/measure that relies
exclusively on prices
• Especially those with short horizons because it claims
that the past is not the best description of the future
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So what we do?
 Multi-pronged approach:
• Active protection: try to make institutions more robust
to shocks
• Prevention: try to reduce the likely size of the shocks
so to reduce the stress on institutions
• Passive protection: make sure to contain damage
once hit by a shock
 Do not obsess with the first (limits to effectiveness) and
develop the second and third
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What do we do?
 Hard to disagree
• Diversification usually helps in the presence of risk and
uncertainty.
• Consistent with what macroprudential perspective
implies
• Some of it already happening
 I would add:
• Rules of thumb
• Changing mind frames
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Rules of thumb
 There are empirical regularities in systemic episodes that
can be exploited
• Credit and asset price booms precede busts
• Pretty decent track record in detecting forthcoming
problems
• Important: adopt a longer horizon and forget about
timing
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Credit, asset prices and the financial cycle
1.5
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1
Credit/GDP (rhs)
Property prices (rhs)1
Charge-off rate (lhs)2
1.0
20
0.5
10
0.0
0
–0.5
–10
–1.0
–20
80
85
90
95
00
05
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Rules of thumb
 There are empirical regularities in systemic risk that can be
exploited
• Credit and asset price booms precede busts
• Can be detected with good track record once we
adopt a longer horizon and forget about timing
• Asset price mean reversion literature
• How did Warren Buffet make his money?
 Understanding the financial cycle by following macro-
economists’ example
• Model-free analysis / NBER approach
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Changing mindsets
 That’s a tough one
 Private sector needs incentives to break away from group-
think mode, broaden the horizon for its analysis and its
understanding of macro-type risks
 Policymakers have to make the same transition in
perspective and develop a healthier appetite for acting on
contrarian instincts
• After all they are “overweight” the bad side of the
distribution
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Practical example: Basel III countercyclical buffers
 Simple system of increasing (micro) capital requirements
in boom times and allowing them to be consumed in bad
times
 Authorities use judgment in calling the boom and bust
phases (flexibility)…
 …but there is a simple guide (credit-to-GDP gap)
deviations from which need to be publicly explained
(discipline)
 Main objective to protect the banks form the system
 Side effect: contribute to dampening of procyclicality
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Novel features
 Use of buffers (not minima)
 Link to a macro variable (not the internal models, spreads
or ratings)
• Simple, relatively robust indicator
 Blending of rules with discretion
 Public communication:
• “Comply or explain publicly”
• Force supervisor to take a stance on the state of the
financial cycle
 Potential for contributing to the change of mindsets
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THANK YOU !
[email protected]
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