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Thursday, August 01, 2013

The Dog and the Frisbee



"Wheaten terrier catching frisbee" returns zero results.

Mr. Haldane is speaking to the fact that although our economic problems may seem complex on the surface, the underlying solutions should employ more of the K.I.S.S. principle.

The example he uses is The Dog and the Frisbee. He makes the case that regulatory and oversight complexity may have caused signals to be missed that could have prevented the crisis from occurring. 

Something to think about and it does have applications to other areas of interest across the spectrum of your life activities.

This article demonstrates the always priceless wisdom passed down from Mom's and Dad's across the land:

"Sometimes you can be too smart for your own good".


The Dog and the Frisbee - Andy Haldane
 ** Haldane actually says "For studies have shown that the frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant," and I cannot stop myself imagining the dog reasoning that out with a few simple diagrams and an HP-12C.
The world's greatest living public intellectual, Yogi Berra, once, it is said, said;  "In theory there is no difference between theory and practice.   But in practice there is."  (Also attributed to Jan L. A. van de Snepscheut.) If Andy Haldane represents the new class of leading public servants — empirical, based in practical outcomes rather than on rather dubious theories — the world economy well may prove to be poised on the verge of a new golden age.

Ben Bernanke Got To Hear About Adorable, Though Hypothetical, Dogs At Jackson Hole
December 9, 2012

Ben Bernanke gave another Augustinian give-us-QEn-but-not-yet* speech at Jackson Hole today and you could go read it but honestly why would you, you know what it says, which is "everything is bad, but not as bad as it could be, and we want to make it a bit better, but only once it's gotten a bit worse." Moving right along.
To Andrew Haldane's speech, which is a treat! It is here and its title is "The dog and the frisbee," so obviously he had Dealbreaker on his side right there. Haldane, the Bank of England's financial-stability guy, basically argues that while the financial system is complex, it should be regulated simply – "As you do not fight fire with fire, you do not fight complexity with complexity" – just as a dog uses only elementary trigonometry and differential calculus to solve the complex and multivariate problem of catching a frisbee.**
Haldane's main example of overcomplexity in regulation is risk-based capital regulation, in which the Basel accords have moved from simple leverage tests – common equity divided by total assets – to complicated tests where the numerator is made up of different tiers of capital and the denominator uses risk-weights that are largely driven by the bank's own models of riskiness. One thing you could do is compare the performance of those measures in the recent crisis, so he did. 
* That reference in this context feels like it is not original to me but I don't know who got it first. The Economist has used it with austerity. The original is of course.

** Haldane actually says "For studies have shown that the frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant," and I cannot stop myself imagining the dog reasoning that out with a few simple diagrams and an HP-12C.

*** This is a good thing to ponder:
To give some sense of scale, consider model-based estimates of portfolio Value at Risk (VaR), a commonly-used technique for measuring risk and regulatory capital in the trading book. A large firm would typically have several thousand risk factors in its VaR model. Estimating the covariance matrix for all of the risk factors means estimating several million individual risk parameters. Multiple pricing models are then typically used to map from these risk factors to the valuation of individual instruments, each with several estimated pricing parameters.

Taking all of this together, the parameter space of a large bank's banking and trading books could easily run to several millions. These parameters are typically estimated from limited past samples. For example, a typical credit risk model might comprise 20-30 years of sample data – barely a crisis cycle. A market risk model might comprise less than five years of data – far less than a crisis cycle.
**** I mean, not really, but everyone had to have adequate Basel capital, and wanted to minimize capital subject to that requirement. Note that that chart has a narrower range than the total leverage chart. So you shouldn't really expect differences in adequate Basel capital levels to distinguish failed and non-failed banks.














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