Wednesday, July 10, 2013

Financial Regulation, Part Three: The Known, the Unknown and the Unknowable

Dick Herring, Neil Doherty and I recently worked on an eye-opening research project that resulted in our book, The Known, the Unknown and the Unknowable in Financial Risk Management. I always liked the cover art (thanks to Princeton University Press, which did its usual fine job throughout).  I feel bad for the poor guy in the necktie, in the maze. But that's life in financial markets.


Poor Little Guy

We abbreviate the known, the unknown and the unknowable by K, u and U, respectively. Roughly, K is risk (known outcomes, known probabilities), u is uncertainty (known outcomes, unknown probabilities), and U is ignorance (unknown outcomes, unknown probabilities).

The book blurb on my web page reads as follows:

"On the successes and failures of various parts of modern financial risk management, emphasizing the known (K), the unknown (u) and the unknowable (U). We illustrate a KuU-based perspective for conceptualizing financial risks and designing effective risk management strategies. Sometimes we focus on K, and sometimes on U, but most often our concerns blend aspects of K and u and U. Indeed K and U are extremes of a smooth spectrum, with many of the most interesting and relevant situations interior."

The blurb continues:

"Statistical issues emerge as central to risk measurement, and we push toward additional progress. But economic issues of incentives and strategic behavior emerge as central for risk management, as we illustrate in a variety of contexts."

The book's table of contents reveals the breadth of that insight, from risk management, asset allocation, and asset pricing, to insurance, crisis management, real estate, corporate governance, monetary policy, and private investing:


Chapter 1: Introduction by Francis X. Diebold, Neil A. Doherty, and Richard J. Herring 1

Chapter 2: Risk: A Decision Maker's Perspective by Sir Clive W. J. Granger 31

Chapter 3: Mild vs. Wild Randomness: Focusing on Those Risks That Matter by Benoit B. Mandelbrot and Nassim Nicholas Taleb 47

Chapter 4: The Term Structure of Risk, the Role of Known and Unknown Risks, and Nonstationary Distributions by Riccardo Colacito and Robert F. Engle 59

Chapter 5: Crisis and Non-crisis Risk in Financial Markets: A Unified Approach to Risk Management by Robert H. Litzenberger and David M. Modest 74

Chapter 6: What We Know, Don't Know, and Can't Know about Bank Risk: A View from the Trenches by Andrew Kuritzkes and Til Schuermann 103

Chapter 7: Real Estate through the Ages: The Known, the Unknown, and the Unknowable by Ashok Bardhan and Robert H. Edelstein 145

Chapter 8: Reflections on Decision-making under Uncertainty by Paul R. Kleindorfer 164

Chapter 9: On the Role of Insurance Brokers in Resolving the Known, the Unknown, and the Unknowable by Neil A. Doherty and Alexander Muermann 194

Chapter 10: Insuring against Catastrophes by Howard Kunreuther and Mark V. Pauly 210

Chapter 11: Managing Increased Capital Markets Intensity: The Chief Financial Officer's Role in Navigating the Known, the Unknown, and the Unknowable by Charles N. Bralver and Daniel Borge 239

Chapter 12: The Role of Corporate Governance in Coping with Risk and Unknowns by Kenneth E. Scott 277

Chapter 13: Domestic Banking Problems by Charles A. E. Goodhart 286

Chapter 14: Crisis Management: The Known, The Unknown, and the Unknowable by Donald L. Kohn 296

Chapter 15: Investing in the Unknown and Unknowable by Richard J. Zeckhauser 304

I say that the project was "eye opening" (for me) because I went into it thinking about econometrics, but I came out of it thinking about economics.  Econometrics is invaluable for risk measurement, systemic aspects of which are embodied for example in the Diebold-Yilmaz network connectedness framework, or in parts of Rob Engle's V-Lab. But risk management, in particular risk prevention, is equally (or more) about creating incentives to guide strategic behavior, particularly in situations of u and U.

The real question, then, is how to write contracts (design organizations, design policies, design
rules) that incent firms to "do the right thing," whatever that might mean, in myriad situations, many of which may be inconceivable at present -- that is, across the KuU spectrum.

How to do it?

To be continued...