Predictability of Financial Crises – The Challenge Is The Tool, Build Them And You Can Model Crises

Predictability of Financial Crises – The Challenge Is The Tool, Build Them And You Can Model Crises

We live in an era of financial crises: from the Argentine currency crises of old to the Greek debt crises. We have become so accustomed to financial crises that we may think that financial crises are random and cannot be predicted.  It is like Solomon of the Bible who thinks that there is time for everything: ‘ time to sow, time to harvest’. So, there is time for gloom, time for boom and time for burst.

 

Hell, No! Tekeida is very confident that there is no unpredictability to financial crises. The unpredictability has to do with lack of capability to look at data and make sense of it by regulators, governments and analysts. A curious look into the numbers that were coming out for years before the 2008 crash would have shown what was on the horizon. Unfortunately, people ignored them. Why? We are now a nation of Companies, and not Country. People think what is good for their bottom lines before what is good for the nation, in most cases.

 

Doubt me? Show me an analyst that remembers America when making a call on a stock or bond before he remembers his bonus? It is rare people of Earth because we live in the age of Wall Street. They always win because on good days, they enjoy the parachute and when their fail, we bail them out.  Privatize success; socialize failures. Amerigeddon!

 

In October 2006, I was shocked on the number of credit card offers I received one afternoon after coming back from school. I wondered if it was that easy, can this be sustained? It was a bubble as banks were giving credits with ease. I sent an email to friends that I was skeptical on how these banks were giving credits to people. They told me the same thing; they were getting as much offers.

 

People went on loose spending. Thank Heavens, I have been a banker and never spend on emotions. And there is nothing innovative spending what you do not have or cannot afford. But in this generation, people do it and the world was set on fire.

 

Around the same time, banks in Nigeria were involved in endless public offers. Nigerians abroad helped oversubscribed those shares because credit was too loose. In a city in Arkansas, students were buying houses and renting them while living on stipends. In Maryland, a friend bought a house on the first three months of his graduate program with the very little they were paying him as stipends.

 

The world was in a state of total lack of human capacity to call risk and access it. It was a fantasy world because the risk model was flawed as we knew it. We always get the small risk profiles right, and usually miss the very non-stochastic and big ones.  The latter comes rarely, but when they hit, it is always like a financial tsunami. You could model a loan default of 0.75%; what happens when it is 10%? If the risk model has been well developed, it is very possible that man can live without gloom, boom and burst. Yes, we can predict financial crises if the people doing this try to make it engineering. In other words, if we create the future, we can predict it as Peter Drucker noted. If the models are ahead of the risks, we can see the risks and contain them before they burst in our families.

 

As engineers, Tekedia has this understanding that the models of predictive risks used by banks are overly simplistic. The limitation of the models is the human limitation of understanding reality. Right now, how can the models understand the policy change that will affect Washington which is most likely going to be extremely Right or Left based on those that are winning in the primaries? I do not know, but I do know that America is undergoing a paradigm shift from the centre that made this nation so exciting that all humans want to come here.

 

The best risk officer is man and it is the best that can plan for risk mitigation. Models cannot do that. The simple reason is that there are many events that cannot be captured in models. Relying on them without common sense is asking for calamity.

 

The collapse of Lehman Brothers is not an ordinary event. A potential default of one EU nation will not be an ordinary event. How do you model them? What is the solution to real estate bubble in China? What happens to predictive models if North Korea wages full war with South Korea? If US or Israel attacks Iran, where is your computer model going to converge? This shows the obsolete and primitive nature of model in the financial sector. It works for the small things, but for the main and big things, it will fail flat.

 

Let the world finance do one thing: stop the over reliance on financial models, but rather have more human systems that tract events and make sense out of them in real time. Models could help them, but those models must not give us a peace of mind when the humans cannot assure us that peace. In statistics, we say that the models and human systems are mutually inclusive with the former a subset of the latter.

 

In conclusion, we recommend that all banks must have Chief De-Risk Officer (CDO). This officer will lead a team of people that will constantly attack the financial risk model to see how it behaves in real time. It will be a battle between the Chief Risk Officer (CKO) and the CDO.

 

The idea is that CDO will help discover problems before they hit the world by constantly kicking the models based on present and future events (economics, world trends, business risk exposures, etc).  As he tries to crush them, he gets more data and the CKO will use that knowledge to update the model. By doing this, we keep the failures out of families and leave them only in computers.

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