I don’t want to take full credit for coining the term “Magoo Finance”, because others have already attached the name to the person of former Fed Chairman Alan Greenspan well before I did (see earlier). But I wonder if it might now serve as a useful shorthand for my colleagues in Big Media to characterise the kind of blind or short-sighted risk-taking that has been a feature of the past several years.

I thought it was noteworthy that the expression Value at Risk yields no useful information when punched into the BBC news archive, The [London] Times, or Daily Telegraph. The Guardian, Independent and New York Times all make mention of it, but in no systematic way, normally simply in relation to bank earnings. (The NYT yields a review of Taleb’s second book Fooled by Randomness, that is less than complementary.)

VaR is used by the banks to determine how much the bank would lose in a given day on its assets under management given a certain fall in the markets. Banks use it to calibrate their risk management. It is a pillar of the modern banking regulatory regime.

Here is what Chris Whalen of Lord, Whalen says on his blog at the Professional Risk Manager’s International Association (PRMIA) site:-

The trouble with VAR models is that the methodology says nothing about specific risks regarding specific transactions, yet provides risk practitioners with the false impression that the particular risk has been measured. So widespread is the delusion that VAR is effective to measure risks of particular exposures that federal regulators are about to adopt it as the central method for measuring bank capital adequacy under Basel II.

By providing a technical framework for estimating market risk that, on the surface at least, has credibility, the Sell Side and the major rating agencies have evolved VAR into a powerful mechanism for increasing both transaction throughput and leverage. Simply stated, if the overall risk calculated in the VAR model appears to be low, then additional risk may be taken.

Since the Greenspan Effect [the effect of low interest rates] pushed actual default rates on loans and bonds to near zero, particularly for mortgage collateral, VAR models became the Sell Side’s best friend. By relying on assumptions of normality in the distribution of possible future events and using recent historical data, VAR models effectively minimize the true financial risk taken and thus are a key enabler of the vast expansion of leverage on Wall Street.

In simple language, the risk models create a fool’s financial paradise, making Magoos of us all.

One of the defences of what has happened to Northern Rock comes from pundits, politicians and the business leaders that these events are unprecedented in their professional careers. As if the custody of other people’s life savings can be defined by their personal experience. Another emerging cliche is to attribute the mess to a local difficulty in the US subprime market, when the problems seem more generic to finance as a whole.

Here is a Taleb critique of the fundamentals of risk management along with Avital Pilpel, for the London School of Economics. With particular reference to the above data requirement to measure the real frequency of a catastrophic events, the paper says this:-

Now, say that you estimate that an event happens every 1,000 days. You will need a lot more data than 1,000 days to ascertain its frequency, say 3,000 days. Now, what if the event happens once every 5,000 days? The estimation of this probability requires some larger number, 15,000 or more. The smaller the probability, the more observations you need, and the greater the estimation error for a set number of observations. Therefore, to estimate a rare event you need a sample that is larger and larger in inverse proportion to the occurrence of the event.

This reminds me of comedian Steve Coogan’s pool supervisor sketch:-

DVD can be purchased here.

BBC reportage yesterday (and increasing today) implied there was finger-pointing at the Bank of England governor emerging from the major UK banks. The gist was that he was wrong to break ranks and not add liquidity in the same way as the other central banks did in August. This behaviour on the part of the banks, amplified by this kind of reporting, does not bode well.

For the average punter, it is much easier to understand that an individual — Mervyn King — made an error of judgment in dealing with an “unforeseen” crisis than to think the collective judgments of the banking community were at fault. It’s a case of fundamental attribution error. This is the challenge for press coverage going forward. Mervyn King as the visible, flawed official has salience;VaR and institutional self-deception/visceral competitiveness are much harder to grasp. Media prefer a political story to a technical one. VaR produces no pictures (until the queues appear outside the banks).

Specifically, King has been a critic of the mis-pricing of risk. He’s been more hawkish on interest rates before now, and he broke ranks with other central bankers, fearing the continued moral hazard that bailing out overly-aggressive financial institutions would entail.

Big Media also needs to stop interviewing people who say things like “the underlying UK economy is sound”, and that there should be nothing to worry about. Confidence comes from knowing that the system is resilient to shocks, and for that we need to be reassured that the approach to risk is sound, and that officials and business leaders recognize the power of the rare event. We can’t avoid the increasing complexity of our world, so it is inevitable that more such events will be produced.

If we know that the system is getting better at resisting shocks then I’ll buy the idea that the economy is sound. It looks like VaR is not helping that, and other approaches need to be considered. That might entail a readiness on the part of the public and politicians to accept failure early on rather than play an ongoing game of doubling up.

Related posts:

1. magoo finance
2. magoo finance iv
3. magoo finance II
4. a northern rock and a hard place
5. stopping time