Misdiagnosing Risk: A Defense of the ‘Taxi Fable’

By Charles Goodhart

There has been a recent, important, paper by Bulow and Klemperer, entitled ‘Misdiagnosing Bank Capital Problems’.[1] They argue (p.1) that “the regulatory system’s emphasis has been on more insurance rather than more capital”. Consequently, they note (p.3) that “Regulatory forbearance creates especially low capital requirements for the toxic assets that are the riskiest, encouraging insured banks to retain loans that would otherwise be sold and then, for ‘debt overhang’ reasons reject good new loans”. In their long theoretical paper, they make many other valid and useful points, for example about the drawbacks of using book value accounting for regulatory purposes. It is a rich paper and readers of this note are recommended to read it.

That said, however, the model on which their own paper is based is unrealistic in certain key respects. In particular, their model is based on an assumption that “All collateral is affected multiplicatively, and identically, by two random shocks… [these random variables] are distributed independently and identically…”. The paper does not state, but I assume that these probability distributions are supposedly common knowledge.

There are two main difficulties in maintaining this assumption. First, whether one chooses to treat future outcomes as uncertain, or alternatively to regard subjective probability distributions as differing significantly from the real underlying probability distribution, it is clear that in many crises the various participants had not realised forthcoming dangers. Let me give a number of examples. 

First, in 1914, when the war broke out, the City of London had been engaging in normal financial transactions with countries that were to become belligerent enemies almost up to the date of the declaration of war. Given earlier incidents, such as Agadir, one might have thought that financiers would have incorporated the risk of war into the premia charged, but there is virtually no evidence of that.

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