There is an interesting article on the NY Times blog about bankers being seduced by models. Not the leggy kind, but the electronic. The author questions the utility of VaR and similar models that give measures of risk in portfolios, and reports on a hearing of the US Subcommittee on Oversight and Investigations of the House Science and Technology Committee into the subject.
Many of the speakers told the committee that models don't work because they don't examine extreme events.
The author speculates that senior bankers didn't understand the models or their limitations. My suspicion is that they understood their limitations very well, not least because traditional banking (lending) is all about catastrophic extreme events (defaults/ bankruptcy), and it is only traders that worry about market price movements, volatility and embedded options.
What would have convinced the senior bankers that the models were kosher would have been the fact that the traders to persuaded the bank regulators of the utility of risk based metrics in the calculation of risk assets, and once that was done, the directors had to follow suit or risk losing business and thus losing their jobs.
But as an inspired writer wrote in February in response to Lloyd Blankfein's analysis of the financial crisis:
One area that he misses completely is the "we never saw it coming" line that is coming from so many mouths today. What they are really saying is "yeah, we knew about it but we shut it out of our minds". The bankers of today's modern finance rely heavily on trading and securitisation, and by and large they have the trader's mentality. An asset is a risk until it is hedged or sold (albeit that there might be some ongoing risk in the asset). A liquidity exposure is a risk until some funding is put in place, although the risk doesn't go away completely. It all happens on an item by item basis and the "market" is often assumed to be almost infinite, or at least to the extent that putting another trade into the market doesn't absorb all liquidity.
When risk assessments were made in banks the one question that was not asked was "What happens if X market goes away?" because the likely answer was "it ain't gonna happen, but if it does we all go to hell in handcart, you, me, the Governor of the Bank of England and the whole economy".
Read the whole post here. Boy, I am good. Take it away, Satchmo.