Uncertainty and Risk Management after the Great Moderation: The Role of Risk (Mis)Management by Financial Institutions

Abstract:     
Since the early eighties volatility of GDP and inflation has been declining steadily in many countries. Financial innovation has been identified as one of the key factors driving this ‘Great Moderation’. Financial innovation was considered to have improved significantly the allocation and sharing of financial risks, both from a macro and micro perspective. In particular, the prevailing opinion was that great progress has been made in developing models and other quantitative methods for measuring and managing risk. However, the global financial crisis that started in the summer of 2007 revealed important failures in risk management by financial institutions. Over-optimism prevailed and risks were underpriced, caused by problems of both a conceptual and technical nature. This paper analyses these two angles from the viewpoint of financial institutions. Conceptually, we will show that risk management degenerated into a ‘pseudo’ quantitative science. This in turn gave a false sense of security to financial institutions and their supervisors. Prior to the crisis, supervisory and regulatory regimes assumed that for the financial sector as a whole, risk management had been improved and that, as a result, financial stability was enhanced. The fact that many financial activities were carried out in a rapidly changing landscape – i.e. key decisions had to be taken in situations with uncertainty - was largely ignored. At a very fundamental level it was mistakenly assumed that all uncertainty can be measured in a reliable fashion using a probability distribution – i.e. all uncertainty can be treated as ‘risk’. This attitude had also adverse consequences for the way risk management and decision making were organised in financial institutions. There was too much focus on quantitative models and measurement and too little on the qualitative dimension of risk management, involving such issues as information flows, people and their motives and incentives. In addition, even from a narrow, technical perspective risk management techniques proved to be insufficiently sophisticated. The second part of the paper focuses on the lessons to be learned from the past episode of inadequate risk management at the level of financial institutions. Apart from technical improvements there is a need for a greater emphasis on handling fundamental uncertainty. More specifically, it will be shown that qualitative risk management is particularly important to deal with the latter uncertainty. However, even with better risk management the future remains uncertain and human nature will remain largely unchanged. Finding better ways of dealing with fundamental uncertainty remains therefore a continuous challenge.

Keywords: risk management, great moderation, credit crisis, mispricing, regulations

JEL Classifications: G01, G12, G18, G21, G32

Working Paper Series