Unquantifiable risk and financial stability

8 Feb, 2020 at 15:58 | Posted in Economics | 3 Comments

Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent …

uncertainty-uncertainty-everywhereUnwarranted faith in the odds of rare events can set the stage for far worse outcomes. No matter how hard we try, we cannot accurately quantify the chances of rare events. The reasons can be summed up in two parts: can’t know and don’t know.

Putting odds on future events is inherently difficult. It’s obvious that we can’t know what will happen — nobody can predict the future. But we can’t even know everything that might happen. All we can be sure of is that there are things that will happen in the future that we cannot even conceive of today. And since there are possible future events that we can’t even list out, we can’t assign probabilities to them. This simple fact also means our estimates of the chances of events we can list out are likely to be wrong: a person who has never experienced snow will overestimate the chances of rain on a very cold day …

Things don’t immediately go wrong when people estimate the odds of unlikely events. They go wrong when people place unwarranted faith — or undue emphasis — on those estimates.

Policymakers should learn as much as they can from past events and do the best they can to assess the risk environment with the available historical data. But there are limits to how reliably they can estimate the chances of an extreme event. Nobody can know all the possible future events that policymakers should be concerned about. Even with a narrow focus on the things that can be measured, there isn’t much data with which to estimate the tails of the distribution – the unlikely but potentially disastrous events that macroprudential authorities are supposed to deal with.

Adam Codd & Andrew Gimber / Bank of England

3 Comments

  1. If a black swan event occurs, why can’t the Fed act as insurer of last resort and print money to end the irrational liquidity hoarding which just makes panics worse so that they spill over into the real economy?
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    If the Fed had bailed out Lehman’s in 2008 would the panic have been stopped?
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    Also, what if the black swan is that there is no black swan? Today’s market keeps punishing the permabears …

    • seems like a better solution is to not have corporations so big that they can take down the economy with their bets made assuming that the Fed will bail them out

      • Regulations inevitably cause more problems than they purport to solve, because regulators have no clue what is really going on. Misguided capital surcharge and liquidity coverage ratio regulations designed to increase solvency recently resulted in a liquidity shortage in repo funding markets; so the Fed stepped in by supplying some $400 billion from its vertical reserve supply curve. And the Fed has separately resumed buying Treasury bills, also to address the regulatory-caused reserve hoarding.
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        The uncertainty associated with regulatory reform is greater than just relying on the Fed put, and lessening regulations.
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        A much saner solution is for the Fed to sell upfront panic insurance, instead of waiting for a panic to supply the money we all knew they would. By selling panic insurance upfront, the Fed can give banks the ability to hedge against irrational spreading psychological trader-caused crises.


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