Poor risk appraisal key factor in crisis, says expert

Photo / Supplied

RBA official says boom years led to false sense of security pre economic collapse

Poor risk assessment was a key element of the financial crisis, a senior Reserve Bank of Australia official says.

RBA assistant governor (financial markets) Guy Debelle said an over-reliance on a model-based approach to risk management contributed to mis-assessment.

"In the period prior to the onset of the crisis, hubris developed in parts of the financial sector, and in the investor community more generally, that everything could be precisely measured and priced."

Dr Debelle said the boom economic years of the 1990s and 2000s created a false sense of security.

"The decline in volatility led many to conclude that a new, more stable regime had been established.

"In the good times, not being able to quantify the risk of the unknowable downside, or take into account the uncertainties, is not that important while the good times last."

He said while model-based risk assessment was useful, judgement needs to be used on whether the right model is being used, especially when events unfold that are no longer consistent with the history used to develop those models.

Dr Debelle used the example of how US financial institutions stress-tested their mortgage portfolios using the history of house prices.

"That history suggested that cities in the US had their own price cycles and that the correlations across markets were not particularly strong.

"Periods of large house price decline were confined to a few idiosyncratic events in a few cities."

He said institutions could assume some moderate nationwide declines in house price but prior to 2007 using a model that factored in a 20 per cent fall in house prices may not have been plausible.

He uses Bear Stearns as an example.

"With the benefit of hindsight, it would seem sensible that Bear should have stress-tested their funding resilience to a significant reduction in funding from the repo market.

"But how significant a reduction should have been stressed? A 10 per cent reduction, a 50 per cent reduction or a complete closure of the repo market?"

Dr Debelle said to make the system more robust, the right model or perhaps a number of models would be helpful.

"A healthy dose of judgement needs to be added to the model-based analysis. Taking account of uncertainty is not easy, after all, it is uncertain ..."

- AAP