Scientists and bankers — a new model army

April 12, 2012 | Source: Nature News

Bankers must surrender more information on their activities to scientists to use it to build better system-wide financial models, says John Liechty, director of the Center for the Study of Global Financial Stability and Professor of Marketing and Statistics at Pennsylvania State University in University Park.

Existing financial models failed to predict the crisis of 2008 and the follow-on crisis of 2011–12. They missed the huge system-wide risks that developed as banks promoted an undisciplined supply of mortgages and created an increasingly complex web of relationships through legal contracts that transferred risk throughout the financial markets.

For commercial reasons, banks have historically been reluctant to share this kind of information, but that is changing. Legislation in the United States now allows regulators to collect such data from banks, pension funds, insurance companies and other big players in the financial markets. Regulators in Europe are following suit, and hopefully Asia will as well. As a result, we will soon be able to model and identify potential system-wide risks.

Clearly, regulators have a responsibility to build such models and to use them to monitor for potential crisis. To do this, they will need to leverage expertise among scientists by supporting and encouraging research in universities and labs, and by hosting the more applied work to maintain confidentiality. Bankers should join this effort too, if only to avoid forcing regulators to use crude tools to set prices on these risks — through capital ratios or transaction taxes, for example.

Bankers should work in parallel and form an industry group that collects system-wide data from its members, organizes resources for scientists to develop the necessary models, and creates a secure and confidential infrastructure for members to determine the price of system-wide risks.

Everyone would benefit if bankers were to engage with scientists to build the infrastructure needed to price system-wide risk. Banks could get feedback about common holdings and trading strategies, which would allow them to adjust their behaviour and avoid following the herd. Regulators would have extra market information to help them to determine when to act to ensure stability. And the rest of us could have increased confidence in the financial system.