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William J. McKibbin
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Dr William J McKibbin is a risk modeler, decision analyst, and educator specializing in forecasting, simulation, optimization, stochastics, statistics, programming, training, and presentation support. Dr McKibbin has been in professional practice serving companies in various capacities as... More
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  • Too Big to Fail, or Just Too Big
    I just read a discussion paper by Dr James B Thompson of the Research Department of the Federal Reserve Bank of Cleveland (2009, “On Systemically Important Financial Institutions and Progressive Systemic Mitigation”), in which he proposes various criteria for identifying and supervising financial institutions that are “systemically important.” According to Dr Thompson:
    Delineating the factors that might make a financial institution systemically important is the first step towards managing the risk arising from it. Understanding why a firm might be systemically important is necessary to establish measures that reduce the number of such firms and to develop procedures for resolving the insolvency of systemically important firms at the lowest total cost (including the long-run cost) to the economy.
    Dr Thompson further argues that disclosing the identity of firms that may eventually be designated “systemically important” would require “constructive ambiguity” in order to ensure the market is not mislead into believing certain firms retain special dispensations in the form of government guarantees.
    The choice of disclosure regime would seem to be between transparency (publication of the list of firms in each category) and some version of constructive ambiguity, where selected information is released… In the context of central banking and financial markets, the term [constructive ambiguity] refers to a policy of using ambiguous statements to signal intent while retaining policy flexibility. In the context of the federal financial safety net, many have argued for a policy of constructive ambiguity to limit expansion of the federal financial safety net. The notion here is that if market participants are uncertain whether their claim on a financial institution will be guaranteed, they will exert more risk discipline on the firm. In this context, constructive ambiguity is a regulatory tactic for limiting the extent to which de facto government guarantees are extended to the liabilities of the firms that regulators consider systemically important.

    After considering Dr Thompson’s ideas, I am flabbergasted with doubts. My first is with regard to the dogma implied by “systemically important” (i.e., “too big to fail”). What does “systemically important” mean? What makes a company “systemically important?” Dr Thompson sidesteps the “too big to fail” proposition by coining the alternative phraseology, “systemically important,” which is equally lambaste with normative relativism. The entire concept of “systemically important” lacks content validity, both in rhetoric and substance. To say a firm is “systemically important” is just another way of designating the firm as “too big to fail.”

    My second doubt centers on the need for “constructive ambiguity” in disclosing the identity of firms that are designated as “systemically important.” The suggestion that “constructive ambiguity” will somehow protect the markets is preposterous. What the marketplace needs today is greater transparency, not less. The very notion of “constructive ambiguity” is laced with deceit. Ambiguity can only further harm the stature and creditability of our financial markets, especially given the recent collapse of public confidence in the face of the ongoing economic crisis.

    My final comment is to offer a new suggestion for dealing with firms that are either “systemically important” or “too big to fail,” and that is we treat such firms as simply too big to keep around. Firms that are so large as to become “systemically important” or “too big to fail” should be broken up into smaller companies, thus advancing the competitive spirit of the marketplace, while ensuring that no firm becomes so large as to be able to threaten the financial stability of our nation as a consequence of their misfortunes.


    Aug 17 9:29 AM | Link | Comment!
  • In Defense of Financial Theories
    I recently read a ridiculous critique of Value at Risk (VaR) by Pablo Triana in BusinessWeek (“The Risk Mirage at Goldman,” Aug 10, 2009). His review of this advanced financial technique is scathing:
    VaR-based analysis of any firm's riskiness is useless. VaR lies. Big time. As a predictor of risk, it's an impostor. It should be consigned to the dustbin. Firms should stop reporting it. Analysts and regulators should stop using it.
    Mr Triana bases his assertion on the observation that VaR is “a mathematical tool that simply reflects what happened to a portfolio of assets during a certain past period,” and that “the person supplying the data to the model can essentially select any dates.” My response to his argument is simply to ask, “Isn’t that true of any model or theory…?” Mr Triana goes on to argue that:
    VaR models also tend to plug in weird assumptions that typically deliver unrealistically low risk numbers: the assumption, for instance, that markets follow a normal probability distribution, thus ruling out extreme events. Or that diversification in the portfolio will offset risk exposure.
    In essence, Mr Triana seems to be saying that normally distributed results have bounds, and that portfolio diversification does not offset risk. Neither of his assertions are supported by probability theory or the empirical evidence. Yet, Mr Triana goes on to conclude, “it’s time to give up analytics so that real risk can be revealed.”

    Mr Triana does a disservice to the financial services industry and public at large with his dramatic commentary. Yes, the discipline of finance has much to learn from the ongoing economic crisis, and of course, financial theory in general will evolve based on these recent lessons. However, just because one gets a bad meal in one restaurant does not mean that one should quit going to restaurants.

    Financial theories such as VaR stand as state-of-the-art tools in the business of finance and risk management. These techniques are grounded in the same stochastic methodologies that are used by engineers in virtually every industry. To dismiss VaR so completely without considering its utility for supporting effective financial decisions is tantamount to sending financial theory back to the dark ages. Our knowledge of finance needs to advance as a result of what is happening in the economy, not go backwards.

    Aug 17 9:18 AM | Link | 1 Comment
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