Transparency in Bank Risk Modeling: A Solution to the Conundrum of Bank Regulation

Abstract

After financial disasters, financial risk models are often blamed for failing to provide adequate warning. The author argues that, in many cases, the models provided accurate warnings but were ignored by market participants who did not like what they said.The financial crisis of 2008–2009 was not the first time this has happened. The author describes similar but smaller debacles in 1994 and 1998 that had their roots in financial innovation that took place a decade earlier. In both cases, risk models warned that volatile securities would become impossible to hedge; but rather than exiting those positions as they should have done, some market participants simply ignored the flashing warning lights.Some current financial risk models have proven to be quite robust. Large commercial banks have mined their internal data to create empirical models of default probability that forecast accurately out of sample. Default models based on contingent claims analysis have been available for years, including some that use continuously‐traded equity and equity options prices. Hybrid models that combine empirical data‐mining and forward‐looking market‐based signals have been shown to provide reliable early warning signals about corporate credit risk.The author recommends making banks' data bases and risk models freely available to regulators, ratings agencies, and independent analysts. When provided with access to the findings of independent efforts to measure the riskiness of bank portfolios, public scrutiny and third‐party analysis would compel bank senior management to improve risk measurement and increase transparency. Banks would benefit by restoring market confidence in the quality of their books.Making risk models transparent could also help break the present impasse between regulators and financial intermediaries. It may be possible for markets to establish a standard for credit risk that is more robust and more trustworthy than the ratings‐based system that fell into disrepute after the 2008 crisis. This would be preferable to the present thrust of bank regulation, which proposes to apply the severest standards to bank ownership of risk, and threatens to dampen economic growth.