The only objective test of the accuracy of the model is how well the theoretical value matches market prices for traded instruments. And in a calibrated model it does that perfectly, but only at that one instant in time. Next week, or even tomorrow, or just an hour later, theory and practice will inevitably diverge. But if you are forever recalibrating, you never see this. Recalibration means that risk managers remain in blissful ignorance of the errors in their model and hence the risk. If anything ever gave a false sense of security, this is it. All that risk management has done is to hide the risk, making it harder to spot, to estimate and to hedge.We live in a complex world. It changes every day, sometimes drastically, and it is inter-causal, especially when the lion's share of an industry are all buttressing a practice that inherently increases risk like say, reducing mortgage requirements.
Bankers Can’t Avoid Risk by Hiding It - Bloomberg
Fri, 12 Aug 2011 16:25:24 UTC
And there is another issue that finance models have not adequately addressed; the structural exposure caused by the warren of incestuous wholesale relationships between the large banks. The model might treat the risk as arm's length, but when the whole industry becomes shaky, we find you didn't diversify your risk really at all.
Canadian banks did not need bail-outs. The principal reason may have been that they avoided mortgage back securities. But the best predictor of their health was their proportion of retail deposits; a regulative requirement. The large American banks, not so much.