Subcommittee Examines the Role of Risk Modeling
(Washington, DC) – Today, the House Committee on Science and Technology’s Subcommittee on Investigations and Oversight held the first Congressional hearing to investigate the role risk modeling played in the global financial meltdown. Specifically, the Subcommittee examined the Value-at-Risk (VaR), a method of risk measurement, which is widely viewed as a key factor in the extreme risk-taking of financial institutions which lead to the loss of hundreds of billions of dollars causing the economic meltdown in 2008.
“Economics has not been known in the past for mathematical precision. The supposedly immutable ‘laws’ underlying the quantitative analyst models didn’t work, and the complex models turn out to have hidden risks rather than protected against them, all at a terrible cost. Those risks—concealed and maybe even encouraged by the models—have led to hundreds of billions of dollars in losses to investors and the taxpayers, to a global recession imposing trillions of dollars in losses to the world economy and immeasurable monetary and human costs. People around the world are losing their jobs, their homes, their dignity and their hope,” stated Subcommittee Chairman Brad Miller (D-NC).
The advancements in economic and statistical methods in social sciences over the past fifty years have lead to the creation of the risk assessment models that financial institutions have come to rely heavily upon. In the 1980s, J.P. Morgan used these techniques to develop the VaR model to measure the risk of loss to its traders’ portfolios. VaR captures the probability of outcomes distributed along a curve, usually a bell curve, to predict a portfolio’s possible losses.
Many financial institutions – Merrill Lynch, Lehman Brothers, Bear Stearns – used the VaR model to reflect the level of risk they were taking on and assured regulators that a low VaR justified a lower reserve requirement. Critics believe the demise of these financial institutions is due to the inadequacy of the VaR model to capture extreme risks because of their small probability.
“Taxpayers here and around the world are shouldering the burden arising from financial firms' miscalculation of risk, poor judgment, excessive bonuses and profligate behavior. The ‘Value at Risk’ model, or ‘VaR’ stands squarely at the center of this intersection as the most prominent risk model used by major financial institutions,” said Miller. “As a map to day-to-day behavior, the VaR is probably pretty accurate for normal times, just as teams favored by odds makers usually win. But just as long shots sometimes come home, asset bubbles or other ‘non-normal’ market conditions also occur, and the VaR is unlikely to capture the risks and dangers.”
This is the second hearing in a series on how economic modeling and theory have influenced policymaking both inside and outside of government. The first hearing, The Science of Insolvency, was held on May 19, 2009.
National Science Foundation (NSF), an agency under the Committee’s jurisdiction, is the key federal funding source for economic research.
For more information, visit the Committee’s website.
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