The Fat Tail – a tall tale
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Andy Haldane, the Bank of England’s executive director for financial stability, tipped as a successor to the governor Sir Mervyn King, is also a member of the Bank of England’s financial policy committee which has been tasked with identifying and taking action to reduce systemic risks in the UK’s financial system.said last month’s $2 billion (£1.3bn) trading loss at JPMorgan highlights that current risk management tools are flawed, and regulators need to beef up their “early warning systems” to prevent similar shocks happening again.
In a speech at the University of Edinburgh Business School, Haldane said that catastrophic events that are usually considered rare – “fat tails” in economic parlance – are actually a common feature in complex systems such as modern, finance-driven economies.
He said: “As the world becomes increasingly integrated – financially, economically, socially – interactions among the moving parts may make for fatter tails. Catastrophic risk may be on the rise. If public policy treats economic and financial systems as though they behave like a lottery – random, normal – then public policy risks itself becoming a lottery. Preventing public policy catastrophe requires that we better understand and plot the contours of systemic risk.”
The trading loss at JPMorgan was evidence that traditional models can lead to the mis-pricing of risk, Haldane said, adding that the rules used to set regulatory capital requirements need to be rewritten.
” That was a key faultline during the crisis and, as recent experience attests, remains a key faultline today”.
He also said attempts to “fine tune” risk control may actually add to the probability of catastrophes because if pressures “are constrained and accumulate beneath the surface, they risk an eventual volcanic eruption”.
The Vickers proposals in the UK, which propose ring-fencing banks’ investment activities from their retail arms and the Volcker rule in the US, which is aimed at preventing deposit-taking banks from engaging in risky trading be used a “firebreak-type” approach similar to those used to prevent forest fires burning out of control.
Rules and regulations will stop fat tails, what a tall tale that is.
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