Risk Analysis and War Games in Banking

In case you’re one of the many people who believe that no one could have foreseen the banking crisis that began in the U.S. last year, the Financial Times reported just days ago that in 2004 the British banking system–specifically, the Financial Services Authority, the Bank of England, and the Treasury–did, in fact, foresee the failure of several British banks.  They used risk simulation to conduct "war games" within the banking system.  These war games were analogous to the recent stress tests to which U.S. banks were subjected, and they were intended to reveal the potential effects of sudden turmoil in the mortgage markets.
By revealing what banking authorities considered unacceptable risk exposure on the part of a few banks, including Northern Rock and HBOS, the 2004 risk analysis tests did fulfill their function, but bank regulators–who themselves were in  did not believe they could force the banks to change their business practices.  In 2007, as wholesale lending markets dried up, Northern Rock failed, and HBOS was rescued in a buyout by Lloyd’s.

The moral of my story is that in banking, as in all other enterprises that require decision making under uncertainty–i.e., most of them–risk simulation and other forms of statistical analysis, dialed up properly, can provide valid forecasting–even if nobody acts on the results.  Evidently the British had tuned up their Monte Carlo software better than the U.S. analysts whose simulations were tweaked to avoid the forecast of bad news. 

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