Financial Risk Models in the Light of the Banking Crisis 2007–2008

Abstract

The financial crisis that began in the US real-estate market in 2007 and culminated in a global economic slump showed bluntly how wrong financial risk models can be. This state of affairs has triggered a number of reactions and observations at the level of the specification and use of models and at a more conceptual/fundamental level. This article focuses on the epistemic features of such models – namely the nature, source, conditions of validity, structure and limits of the knowledge that ‘well-specified’ models generate – so as to (i) assess models in a balanced way, giving due weight to the fundamental determinants of their output and warning against overestimation of their possibilities; (ii) clarify the conditions under which models can be validly applied to economic and social relationships; (iii) render intelligible why the degree of accuracy that successful models would require is intrinsically unattainable; (iv) better understand models’ failure as evidenced by the crisis; and (v) comment on the policy steps being undertaken to prevent similar financial crisis in the future. The analysis applies the principal tenets of critical realism to the daily preoccupations of risk management professionals and financial regulators alike. It is not intended as an intervention into critical realism. It draws on the works of Tony Lawson and Roy Bhaskar, and revisits relevant aspects of John Maynard Keynes’s work, connecting dots amongst them and marrying economic and philosophical analysis with day-to-day financial risk management and regulatory issues.