17. Latent Perils: Stressed VaR, Elicitability, and Systemic Effects

See Sheppard, Chap. 13, supra note 31, at 496.

Compare Dan Bloom, Spell Checkers Developing “Atomic Typo” Capabilities, China Post, Sept. 30, 2012 (describing the development of spell-checkers able to detect typographical mistakes resulting in correctly spelled but unintended words, such as unclear for nuclear, or vice versa) (available at http://​www.​chinapost.​com.​tw/​commentary/​the-china-post/​special-to-the-china-post/​2012/​09/​30/​356026/​Spell-checkers.​htm) with Michael Gorham & Nidhi Singh, Electronic Exchanges: The Global Transformation from Pits to Bits 299 (2009) (describing algorithmic techniques for detecting erroneous trading orders).

See, e.g., Michael C. Macchiarola, Beware of Risk Everywhere: An Important Lesson from the Current Credit Crisis, 5 Hastings Bus. L.J. 267–308, 294–297 (2009).

See Joe Nocera, Risk Mismanagement, N.Y. Times Magazine, Jan. 4, 2009.

See http://​gop.​science.​house.​gov/​Media/​hearings/​oversight09/​sept10/​taleb.​pdf.

David Einhorn, Private Profits and Socialized Risk, GARP Risk Rev., June/July 2008, at 10.

See Basel 2.5, Chap. 13, supra note 11, at 1; Basel Committee on Banking Supervision, Interpretive Issues with Respect to the Revisions to the Market Risk Framework (July 4, 2011) (available at http://​www.​bis.​org/​publ/​bcbs193a.​pdf).

See Basel 2.5, Chap. 13, supra note 11, at 1.

Interpretive Issues, supra note 7, at 2.

See Basel III, Chap. 13, supra note 11, at 1–2.

For a comparison of the elicitability of VaR and expected shortfall, see Chen, Chap. 13, supra note 7, at 197–198; Ziegel, Chap. 13, supra note 45.

See Gneiting, Chap. 14, supra note 58, at 768.

See Ziegel, Chap. 13, supra note 45.

Rama Cont, Romain Deguest & Giacomo Scandolo, Robustness and Sensitivity Analysis of Risk Management Procedures, 10 Quant. Fin. 593–606, 602 (2010).

See Susanne Emmer, Marie Kratz & Dirk Tasche, What Is the Best Risk Measure in Practice? A Comparison of Standard Measures, 18:2 J. Risk 31–60 (Dec. 2015).

Carlo Acerbi & Balázs Székely, Backtesting Expected Shortfall, 27 Risk 76–81 (2014).

Bertrand Russell, The Study of Mathematics, in Mysticism and Logic, and Other Essays 58–73, 60 (1988); accord Jim Chen, Truth and Beauty: A Legal Translation, 41 U. Toledo L. Rev. 261–267, 265 (2010).

Edna St. Vincent Millay, Euclid Alone Has Looked on Beauty Bare, in Selected Poems 52 (J.D. McClatchy ed., 2003).

2 The Norton Anthology of English Literature 2163 (M.H. Abrams, E. Talbot Donaldson, Hallett Smith, Robert M. Adams, Samuel Holt Monk, Lawrence Lipking, George H. Ford & David Daiches eds., 3d ed. 1974). But see Xiros Cooper, T.S. Eliot's Orchestra: Critical Essays on Poetry and Music 302 (2000) (“He wrote poetry of pain and alienation and at least one straightforward love poem …. He wrote plays, monologues, choruses, religious verse, satirical portraits, and cat poems. What more could you want in a poet?”).

Eliot, Burnt Norton, Chap. 12, supra note 1, at 19.

See Fabio Bellini & Valeria Bignozzi, On Elicitable Risk Measures, 15 Quant. Fin. 725–733 (2015); Fabio Bellini, Bernhard Klar, Alfred Müller & Emanuela Rosazza Gianin, Generalized Quantiles as Risk Measures, 54 Ins. Math. & Econ. 41–48 (2014); Freddy Delbaen, Fabio Bellini, Valeria Bignozzi & Johanna F. Ziegel, Risk Measures with the CxLS Property, Fin. & Stochastics (forthcoming 2015) (available at http://link.springer.com/article/10.​1007/​s00780-015-0279-6); Edgars Jakobsons & Steven Vanduffel, Dependence Uncertainty Bounds for the Expectile of a Portfolio, 3 Risks 599–623, 600 (2015); Ziegel, Chap. 13, supra note 45, at 8.

See generally, e.g., Masanao Ozawa, Universally Valid Reformulation of the Heisenberg Uncertainty Principle on Noise and Disturbance in Measurement, 67 Phys. Rev. A 042105, 1–6 (2003).

See Werner Heisenberg, Über den Anschaulichen Inhalt der Quantentheoretischen Kinematik und Mechanik, 43 Zeitschrift für Physik 172–198 (1927).

See https://​en.​wikipedia.​org/​wiki/​Observer_​effect_​(physics).

W.I. Thomas & D.S. Thomas, The Child in America: Behavior Problems and Programs 571–572 (1928) (“If men define situations as real, they are real in their consequences.”). See generally Robert K. Merton, The Thomas Theorem and The Matthew Effect, 74 Soc. Forces 379–424 (1995). “The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.” Donald T. Campbell, Assessing the Impact of Planned Social Change, 2 Eval. & Program Planning 67–90 (1979); accord Rebecca Boden & Debbie Epstein, Managing the Research Imagination? Globalisation and Research in Higher Education, 4 Globalisation, Societies & Educ. 223–236, 226 (2006).

See John Maynard Keynes, The General Theory of Employment, Interest, and Money 156 (1st ed. 1936) (“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs … so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors.”). See generally Rosemarie Nagel, Unraveling in Guessing Games: An Experimental Study, 85 Am. Econ. Rev. 1313–1326 (1995).

Daníelsson, Chap. 13, supra note 35, at 1293.

Charles Goodhart, Problems of Monetary Management: The U.K. Experience, in Inflation, Depression, and Economic Policy in the West 111–146, 116 (Anthony S. Courakis ed., 1981); accord Charles Albert Eric Goodhart, Monetary Theory and Practice: The United Kingdom Experience 96 (1984); see also Keith Hoskin, The “Awful Idea of Accountability”: Inscribing People into the Measurement of Objects, in Accountability: Power, Ethos and the Technologies of Managing 265–282, 280 (Rolland Munro & Jan Mouritsen eds., 1996) (observing that when a unit of exchange is “publicly defined as money in order to enable monetary control, it will cease to be used as money and [will be] replaced by substitutes [that] will enable evasion of that control”); cf. Robert E. Lucas, Jr., Econometric Policy Evaluation: A Critique, in The Phillips Curve and Labor Markets 19–46, 41 (Karl Brunner & Allan H. Meltzer eds., 1976) (“Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change of policy will systematically alter the structure of econometric models.”).

Marilyn Strathern, “Improving Ratings”: Audit in the British University System, 5 Eur. Rev. 305–321, 308 (1997). Competing variations on the theme of Goodhart’s law abound. One popular version states: “As soon as the government attempts to regulate any set of financial assets, these become unreliable as indicators of economic trends.” Pears’ Cyclopædia G27, G31 (99th ed. 1990–91); accord Jaime Caruana, Financial Reform and the Role of Regulators: Evolving Markets, Evolving Risks, Evolving Regulation 4 (Feb. 24, 2015) (address to the Global Association of Risk Professionals 16th Annual Risk Management Convention by the general manager of the Bank for International Settlements) (available at http://​www.​bis.​org/​speeches/​sp150225.​pdf); https://​en.​wikipedia.​org/​wiki/​Goodhart%27s_​law. See generally Michael Mainelli, Failure Is Not an Option, 10:1 J. Risk Fin. (2009). In chemistry, Le Châtelier’s principle holds that a system at equilibrium, if subjected to a change in concentration, temperature, volume, or pressure, will readjust itself to counteract the change and will establish a new equilibrium. See generally Henri Le Châtelier & Octave Boudouard, Limites d’Inflammabilité des Mélanges Gazeux, 19 Bulletin de la Société Chimique de France 483–488 (1898). Homeostasis describes the same phenomenon in biology. See generally Alison C. Lloyd, The Regulation of Cell Size, 154 Cell 1194–1205 (2013). The Spanish-speaking world celebrates the saying, Hecha la ley, hecha la trampa, which roughly means, “Every law has its loophole.” See Juan Salanova, Diccionario de Dichos y Frases Hechas 44, 233 (2010). This saying, in Spanish and in Catalan, dates as far back as 1803. See Joaquin Esteve, Joseph Belvitges & Antonio Juglà, Diccionario Catalán-Castellano-Latino 53 (1803) (available at http://​books.​google.​com/​books?​id=​lykCkd9Vc2wC). In other words, “the system always kicks back.” John Gall, The Systems Bible: The Beginner’s Guide to Systems Large and Small 25 (3d ed. 2002).

Whitehead, Chap. 13, supra note 22, at 346.

See, e.g., Martin L. Leibowitz, Anthony Bova & P. Brett Hammond, The Endowment Model of Investing: Return, Risk, and Diversification 235, 265 (2010) (observing that rising correlations in falling markets may imperil portfolios designed to weather variation and confer diversification under normal conditions); Malcolm P. Baker & Jeffrey Wurgler, Comovement and Predictable Relations Between Bonds and the Cross-Section of Stocks, 2 Rev. Asset Pricing Stud. 57–87 (2012); Rob Bauer, Roul Haerden & Roderick Molenaar, Asset allocation in Stable and Unstable Times, 13:3 J. Investing 72–80 (Fall 2004); John Drzik, Richard J. Herring & Francis X. Diebold, The New Role of Risk Management: Rebuilding the Model, Knowledge@Wharton, http://​knowledge.​wharton.​upenn.​edu/​article.​cfm?​articleid=​2268 (June 24, 2009) (“The only thing that rises in falling markets is correlations.”); François Longin & Bruno Solnik, Extreme Correlation of International Equity Markets, 56 J. Fin. 649–676 (2001) (observing that correlation increases in bear markets, but not in bull markets, which implies that holding different asset classes acts may act as a drag on returns in bull markets without providing adequate diversification in bear markets).

See Whitehead, Chap. 13, supra note 22, at 341 & n.85.

See id. at 346–352; see also Ian Ayres & Joshua Mitts, Anti-Herding Regulation, 5 Harv. Bus. L. Rev. 1–46 (2015); Felix B. Chang, The Systemic Risk Paradox: Banks and Clearinghouses Under Regulation, 2014 Colum. Bus. L. Rev. 747–816.

See Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud & Hyun Shin, The Fundamental Principles of Financial Regulation 8 (2009) (Geneva Reports on the World Economy, No. 11); Malcolm P. Baker & Jeffrey Wurgler, Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure and the Low Risk Anomaly, 105 Am. Econ. Rev. 315–320 (2015).

See Malcolm P. Baker, Brendan Bradley & Jeffrey Wurgler, Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly, 67:1 Fin. Analysts J. 40–54 (Jan./Feb. 2011).

See Zeyu Zheng, Boris Podobnik, Ling Feng & Baowen Li, Changes in Cross-Correlations as an Indicator for Systemic Risk, 2 Sci. Reports 888 (2012).

See Brunnermeier, Crocket, Goodhart, Persaud & Shin, supra note 43; cf. Charles Goodhart, Financial Regulation, Credit Risk, and Financial Stability, 192 Nat’l Inst. Econ. Rev. 118–127 (2005) (proposing that regulatory capital adequacy requirements be set on a procyclical basis relative to inflation and other macroeconomic indicators).

Francis X. Diebold & Kamil Yilmaz, On the Network Topology of Variance Decomposition: Measuring the Connectedness of Financial Firms 2 (Sept. 30, 2014) (available at http://​ssrn.​com/​abstract=​1937894); cf. Robert F. Engle & Bryan T. Kelly, Dynamic Equicorrelation (NYU Working Paper No. FIN-38-038; Chicago Booth Research Paper No. 12–07, June 1, 2011) (calculating average correlations across all pairs of financial firms) (available at http://​ssrn.​com/​abstract=​1354525).

See Tobias Adrian & Markus Brunnermeier & Tobias Adrian, CoVaR (Sept. 15, 2011) (Federal Reserve Bank of New York, Staff Report No. 348) (available at http://​www.​princeton.​edu/​~markus/​research/​papers/​CoVaR).

See Viral V. Acharya, Christian Brownlees, Robert Engle, Farhang Farazmand & Matthew Richardson, Measuring Systemic Risk, in Regulating Wall Street: The Dodd-Frank Act and the new Architecture of Global Finance 87 (Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson & Ingo Walter eds., 2011); Viral V. Acharya, Lasse H. Pedersen, Thomas Phillippon & Matthew Richardson, Measuring Systemic Risk 1 (May 2010) (available at http://​pages.​stern.​nyu.​edu/​~lpederse/​papers/​MeasuringSystemi​cRisk.​pdf); Viral V. Acharya, Lasse Pederson, Thomas Phillippon & Matthew Richardson, Taxing Systemic Risk, in Regulating Wall Street, supra, at 121; Christian T. Brownlees & Robert F. Engle, SRISK: A Conditional Capital Shortfall Index for Systemic Risk Measurement (Jan. 1, 2015) (available at http://​ssrn.​com/​abstract=​1611229); Robert F. Engle, Eric Jondeau & Michael Rockinger, Systemic Risk in Europe, Rev. Fin. (forthcoming 2014) (available at http://​ssrn.​com/​abstract=​2192536). See generally Viral V. Acharya, Robert F. Engle & Matthew P. Richardson, Capital Shortfall: A New Approach to Ranking and Regulating Systemic Risks, 102 Am. Econ. Rev. 59–64 (2012).

See, e.g., Basel III, Chap. 13, supra note 11, at 34; 12 C.F.R. § 217.205(a) (Federal Reserve); 12 C.F.R. § 324.205(a) (FDIC).

See Aaron Brown, On Stressing the Right Size, GARP Risk Rev., Nov./Dec. 2007, at 36.

Cf. William Blake, The Marriage of Heaven and Hell 7 (1793) (“The road of excess leads to the palace of wisdom.”) (transcript available at https://​en.​wikisource.​org/​wiki/​The_​Marriage_​of_​Heaven_​and_​Hell).

One million divided by 252, the number of trading days in a year, is just under 4000.

Farber, Uncertainty, Chap. 12, supra note 28, at 927.

See William D. Nordhaus, The Economics of Tail Events with an Application to Climate Change, 5 Rev. Envtl. Econ. & Pol’y 240–257, 242–243 (2011).

See generally Linda O. Smiddy & Lawrence A. Cunningham, Corporations and Other Business Organizations: Cases, Materials, Problems 228–231 (7th ed. 2010) (describing the passage in the 1890s of enabling corporate statutes by New Jersey and Delaware).

See Xiong & Idzorek, Chap. 14, supra note 9, at 29 (Table 6) and 31 (Fig. 2) (reporting excess kurtosis of 9.50 in global high-yield bonds).

See Salazar & Lambert, Chap. 14, supra note 31, at 64.

See Nordhaus, supra note 56, at 243.

Peter Conti-Brown, Commentary, A Proposed Fat-Tail Risk Metric: Disclosures, Derivatives, and the Measurement of Financial Risk, 87 Wash. U. L. Rev. 1461–1474, 1465 (2010).

See Nordhaus, supra note 56, at 253–254.

See Charles E. Lindblom, The Science of “Muddling Through,” 19 Pub. Admin. Rev. 79 (1959); Charles E. Lindblom, Still Muddling, Not Yet Through, 39 Pub. Admin. Rev. 517 (1979).

See, e.g., Andreas Schmittner, Nathan M. Urban, Jeremy D. Shakun, Natalie M. Mahowald, Peter U. Clark, Patrick J. Bartlein, Alan C. Mix & Antoni Rosell-Melé, Climate Sensitivity Estimated from Temperature Reconstructions of the Last Glacial Maximum, 334 Science 1385–1388 (2011).

See Clark R. Chapman & David Morrison, Impacts on the Earth by Asteroids and Comets: Assessing the Hazard, 367 Nature 33–40 (1994) (estimating that the risk of a collision with an interplanetary bolide of at least 10 kilometers in diameter is approximately 1 × 10⁻⁸).

See Martin L. Weitzman, On Modeling and Interpreting the Economics of Catastrophic Climate Change, 91 Rev. Econ. & Stat. 1–19, 1 (2009).

See, e.g., George Greenstein & Arthur Zajonc, The Quantum Challenge: Modern Research on the Foundations of Quantum Mechanics 215 (2d ed. 2006) (describing the inevitably probabilistic nature of quantum mechanics).

Abrams v. United States, 250 U.S. 616, 630 (1919) (Holmes, J., dissenting).