Turner’s review dangerously flawed

Last week I met two Edinburgh-based academics who specialise in finance and risk. They told me that, in their view, Lord Turner’s review on the future of financial regulation is flawed.

They said this is largely because the Turner review, published last Wednesday, failed to push for a more integrated approach to risk management at the level of either financial institutions or within national economies.

The review, which was published by the FSA (of which Turner has been chairman since September 2008) has, perhaps optimistically, been pitched as a means of setting the international regulatory agenda ahead of the G20 summit in London next month.

But Dr Gavin Kretzschmar, director of finance and risk at the University of Edinburgh business school, said he is dissappointed at what was left out.

“There was very little on how risks and understanding of risks need to be pulled together within an integrated, institutional risk management framework,” said South African-born Kretzschmar. “The lack of such a framework was arguably one of the main causes of the 2007-9 credit crisis: It could easily have lead to macro-prudential oversight failures by the Treasury — and failures in micro-prudential oversight and supervision of financial institutions by the FSA.”

Kretzschmar went on to say that in using simplistic “basic asset correlations” to calculate their economic capital, UK banks had failed to account of the inter-dependence between asset classes and risk factors, and therefore capital, that occurs at times of stress.

He believes the Turner review is flawed since its fails to address such weaknesses. “Guidance as to risk integration at the institutional level is still completely lacking. To us it is a surprising oversight.”

Alexander McNeil, professor of quantitative risk management at Heriot Watt University who wrote one of the seminal textbooks on financial risk (Quantitative Risk Management: Concepts, Techniques, Tools), said the reason that European banks entered the credit crisis seriously under-capitalised was precisely because they lacked an integrated or “economic capital” approach to assessing the risks to which they are exposed.

He said that the old-fashioned “silo” approach — in which financial risks are computed in silos for different parts of a very large enterprise and then added together in a simplistic way — is “fundamentally flawed”.

“What an institution really ought to have is a model that explains the sources of dependence and tells an economic narrative about what could happen also as a tool for stress-testing in the future,” said McNeil.

McNeil also said that, if a bank the size of RBS lacked a fully integrated understanding of the risks to which it is exposed, it would inevitably encounter “problems”. “To an extent these organisations were rather opaque and there were risk concentrations that they may well have been unaware of.”

Kretzschmar believes that banks’ failure to use integrated risk modelling becomes even more dangerous when they are exposed to multiple economies, as RBS was. “When you are global and you are exposed to multiple asset classes, there’s a heightened need for integrated risk-modelling.”

The Turner Review seeks to blame the near systemic meltdown on the use by banks and other institutions of complex mathematical formulae to calculate their risk . A key passage reads: “Mathematical sophistication ended up not containing risk, but providing false assurance that other indicators of increasing risk could be safely ignored.”

However McNeil disputes this, arguing that mathematics is part of the solution, not part of the problem. He said: “Quantitative modelling can be done better and integration is probably the most important part.”

He says that to blame the crisis on mathematical geniuses who had little understanding of economics — so-called “quants” who put together ‘black box’ valuation tools and complex derivative products — is “scapegoating”.

“To blame the rocket scientists and the people who brought in the fancy maths is a little bit simplistic. You can’t wish it away

“It’s a bit simplistic. You cannot wish the mathematics out of modern finance. What you have to do is raise the skills throughout financial organisations and communicate a better understanding of risks — and indeed mathematical modelling of risk — to people at a higher levels.”

Kretzschmar said: “Mathematical risk models provide a framework for understanding the risks of a wide range of asset classes.”

Both McNeill and Kretzschmar are advisers to the Edinburgh-headquartered global risk management consultancy Barrie & Hibbert, in whose offices we met. Both universities are launching new Mscs in finance and risk this October. The two academics have ambitions to create an inter-disciplinary centre of excellence for finance and risk in Scotland.

Turner’s recommendations represent the first systematic and detailed attempt by a regulator to tackle the whole field of regulatory reform. His review of banking regulation was commissioned by the Treasury in November 2008.

An abbreviated version of this article was published in The Sunday Times on 22 March 2009