In the HBR, Amar Bhide notes that models have replaced discretion in many areas of finance, particularly in banks' mortgage lending decisions: "Over the past several decades, centralized, mechanistic finance elbowed aside the traditional model....Mortgages are granted or denied (and new mortgage products like option ARMs are designed) using complex models that are conjured up by a small number of faraway rocket scientists and take little heed of the specific facts on the ground." For the most part, the description of the damage done by "robotic finance" is accurate but the article ignores why this mechanisation came about. It is easy to assume that the dominance of models over discretion may have been a grand error by the banking industry. But in reality, the "excessive" dependence on models was an entirely rational and logical evolution of the banking industry given the incentives and the environment that bankers faced.

An over-reliance on models over discretion cripples the adaptive capabilities of the firm: "No contract can anticipate all contingencies. But securitized financing makes ongoing adaptations infeasible; because of the great difficulty of renegotiating terms, borrowers and lenders must adhere to the deal that was struck at the outset. Securitized mortgages are more likely than mortgages retained by banks to be foreclosed if borrowers fall behind on their payments, as recent research shows." But why would firms choose such rigid and inflexible solutions? There are many answers to this question but all of them depend on the obvious fact that adaptable solutions entail a higher cost than rigid solutions. It is far less expensive to analyse the creditworthiness of mortgages with standardised models than with people on the ground.

This increased efficiency comes at the cost of catastrophic losses in a crisis but long periods of stability inevitably select for efficient and rigid solutions rather than adaptable and flexible solutions. This may be a consequence of moral hazard or principal-agent problems as I have analysed many times on this blog but it does not depend on either. A preference for rigid routines may be an entirely rational response to a long period of stability under uncertainty - both from an individual's perspective and an organisation's perspective. Probably the best exposition of this problem was given by Brian Loasby in his book "Equilibrium and Evolution" (pages 56-7): "Success has its opportunity costs. People who know how to solve their problems can get to work at once, without considering whether some other method might be more effective; they thereby become increasingly efficient, but also increasingly likely to encounter problems which are totally unexpected and which are not amenable to their efficient routines...The patterns which people impose on phenomena have necessarily a limited range of application, and the very success with which they exploit that range tends to make them increasingly careless about its limits. This danger is likely to be exacerbated by formal information systems, which are typically designed to cope with past problems, and which therefore may be worse than useless in signalling new problems. If any warning messages do arrive, they are likely to be ignored, or force-fitted into familiar categories; and if a crisis breaks, the information needed to deal with it may be impossible to obtain."

Now it is obvious why banks stuck with such rigid models during the "Great Moderation" but it is less obvious why banks don't discard them voluntarily post the "Minsky Moment". The answer lies in the difficulty that organisations and other social systems face in making dramatic systemic U-turns even when the logic for doing so is clear, thus the importance of mitigating the TBTF problem and enabling entry of new firms. As I have asserted before: "A crony capitalist economic system that protects the incumbent firms hampers the ability of the system to innovate and adapt to novelty. It is obvious how the implicit subsidy granted to our largest financial institutions via the Too-Big-To-Fail doctrine represents a transfer of wealth from the taxpayer to the financial sector. It is also obvious how the subsidy encourages a levered, homogenous and therefore fragile financial sector that is susceptible to collapse. What is less obvious is the paralysis that it induces in the financial sector and by extension the macroeconomy long after the bailouts and the Minsky moment have passed."

Comments

nick gogerty

nice post. The faith in models which usually justify "diversification" and bundling via low correlations and co-variance usually aggregate holdings at the expense of understanding those holdings. A single number or letters (ratings) becomes a proxy for truly knowing the assets. On this risk side, capital requirements etc. and VaR risk models become fixed obstacles and the adaptation and innovation is in how the can be end run. a la lehman etc. When model myopia ends, we will have a short less efficient, but long term more stable and efficient capital market. I for one don't see this happening. As the saying goes, "it is harder to let go of an old truth than learn and accept a new one."

Ashwin

Nick - you said "I for one don’t see this happening." Unfortunately I agree with you.

John

Forgive me for being frivolous. You've probably seen this already, but if not, it's worth a look: "Bailout" by "Merle Hazard". He has other videos, too.

Ashwin

John - Thanks, that's hilarious!

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