By taking a naïve view of how to measure risk in an unpredictable market environment, the US Office of Financial Research (OFR) could potentially carry on the negative side effects of the financial crisis, according to epistemologist Nassim Nicholas Taleb, who is most famous for his book on unpredictability The Black Swan. Speaking as a risk practitioner rather than an analyst at last week’s US government organised roundtable on the OFR, Taleb likened the new Treasury agency to “an omniscient Soviet-style central risk manager,” noting that there are limits to being able to predict “black swan” events and “throwing government money” at the problem will exacerbate matters by causing a reliance on “sterile data.”
He highlighted the chequered history of the risk management function and called it the “disastrous translation of risk research into practice,” and one that will be perpetuated by the establishment of the OFR. “Financial risks, particularly those known as black swan events cannot be measured in any possible quantitative and predictive manner; they can only be dealt with non-predictive ways. The system needs to be made robust organically, not through centralised risk management,” he contended.
He went on to warn about the negative side effects of such an endeavour: “The very method of model-based quantitative risk management causes increases in risks, particularly hidden risks. Such risk management techniques as you are proposing have in the past caused iatrogenics —that is, harm done by the healer.” Thus by attempting to measure systemic risk and creating a false sense of security, the OFR may worsen the impact of a crisis that is not predicted ahead of time. Relying on “sterile information,” as he referred to it, will also increase overconfidence and cause a rise in risky behaviour.
Data aggregation would therefore be costly, he added, in terms of both direct costs (gathering the data and reporting system requirements) and indirect costs (causing the industry and regulators to rely on data that does not adequately reflect systemic risk).
Taleb’s alternative proposal is that risks should instead be dealt with by the financial institutions themselves in an “organic way, paying for mistakes as they go.” This pragmatic approach, rather than a theoretical one, is much more effective in holding firms accountable for their mistakes, according to Taleb. He is from the “less is more” school of though in terms of risk management and suggested: “The more complicated the rule, the more likely it is to fail.”
This is obviously the polar opposite attitude to the OFR’s supporters such as Penn State University academic John Liechty and it pokes serious holes in the systemic risk monitoring endeavour that will be the remit of the OFR and the Financial Stability Oversight Council (FSOC). Taleb went on in his speech to explain the reasons why black swan events are not measurable, including the failings of using conventional statistics, the impact of small variations in variables and the unpredictability of the financial markets in general, referring to the failure to measure any of these aspects in the past.