Central Banking Journal Vol 18 No 3. , 27th February 2008
A review of Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently by Riccardo Rebonato [published by Princeton University Press].
Bank depositors need to be able to access their funds at short notice, but those who borrow from banks cannot sensibly promise to repay on demand. Bridging the gap is the risky business of “maturity transformation” – borrowing short and lending long. While the explosive growth of financial complexity is a reasonable cause for concern, among its benefits has been improved liquidity arising from the increased ease of maturity transformation. If this process becomes clogged, it can create serious problems. While the financial system adapts readily to small shocks, the benefits from improved liquidity come at the expense of systemic risks from large shocks. Bad trouble in finance is contagious and often affects the real economy.
Misunderstanding risk can thus lead to problems for the economy as a whole as well as for individual institutions. Excessive risk taking by banks will lead to failures and it is the role of bank supervisors to try to prevent them. When, despite their efforts, banks do collapse, central banks, which may also be the supervisory authorities, must seek to prevent the problems becoming systemic. Rebonato quotes Alan Greenspan as saying that “The management of systemic risk is properly the job of central banks.”
Central banks and tax payers would like these shocks to be less frequent than they have been. It is therefore important that we should have a good understanding of financial risk and that the increasingly complex statistical techniques which have become the standard approach to their assessment should be soundly based. Riccardo Rebonato argues convincingly that they are not. After commenting that “overconfident extrapolation from early, impressive successes of a new method has become the current feature in modern thought” the author claims that this fault is common in finance today.
Full article: Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently