Financial Stability Report Reads Like a Bad Hollywood Script

(Bloomberg Opinion) -- Hollywood likes to serve up big-budget disaster movies in early summer or the last few weeks of the year. The year the Financial Stability Oversight Council has joined the fun with its 2021 Annual Report to Congress. This report leads with huge, dramatic, eye-catching dangers: climate change, pandemics and cyberattacks. Each has spawned disaster movies, television shows and novels. Each is of intense political interest, which can be handy when asking for bigger budgets and more power. But planning for Hollywood disaster movies leads to poor risk management.

Climate change, for example, could threaten financial stability in many ways. It could cause a natural disaster that knocks out many key financial institutions—like Superstorm Sandy but bigger and global. Rising sea levels could erode the value of real estate that was supposed to be uncorrelated and cause unexpectedly large losses in securities. Government regulations to reduce CO2 emissions could harm the value of fossil fuel reserves, oil companies, car manufacturers and others, perhaps leading to corporate and government defaults and bank failures. It’s easy to come up with dozens of others.

The problem is that thinking about climate change requires relying on models forecasting future decades, not just climate but reactions of people, and dealing with many different implications at once. A more tractable task is to prepare for natural disasters. For one thing, you must do it whether or not you’re worried about climate change. For another, you have thousands of historical examples and solid scientific understanding.

Of course, you also have to consider other things that might happen as a result of climate change, a process that causes large swaths of real estate to change value at the same time, changes in government regulation and so forth. But each of these is best analyzed on its own, without worrying about what caused it.

The Hollywood approach results in overinvestment in highly specific mitigants. Not only are these inconvenient and expensive, they rarely work because things never develop exactly as predicted. Effective and cost-effective risk management relies on simple and robust mitigants that are not designed under any specialized assumptions. Making every airline passenger remove their footwear because one person hid a bomb in their shoe and more than a dozen movies were made about shoe bombers, while letting people wear things that could just as easily hide explosives, is an example of Hollywood thinking.

Even “natural disaster” is too broad a category for useful analysis. There are an infinite number of things that might happen, but a manageably small number of ways they can cause financial crises. An institution might not have necessary cash to pay its bills. There might be physical destruction of buildings or essential records. An institution might become insolvent due to a decline in value of its assets or an increase in value of its liabilities, or it might be prevented from doing business for regulatory reasons such as lack of capital. Key employees might be killed, incapacitated or act perversely. Essential communication links might be severed. Public trust might evaporate, as in a bank run. Massive fraud or error or security breaches might be discovered. Government actions, up to and including war, could trigger crisis.

Risk managers think about each of these possibilities without worrying to much about why they came about. You need a contingency plan if you lose access to your servers whether it’s due to physical destruction, loss of communication links, cyberattack, employee malfeasance or technical glitch, and whether the root cause was climate change or something else.

The FSOC is in a different position from private sector risk managers. All the risks above are frequent occurrences and rarely trigger systemic problems. FSOC has to worry about any of them happening at an unexpectedly large scale, or in unexpected combination. Headline issues like climate change, pandemics and cyberattacks are exactly the wrong way to go about this, not just because they’re too big, uncertain and ill-defined for useful analysis, but because they are well known. Lots of people in and out of the government are worrying about climate change, pandemic and cyberattacks. Lots of Hollywood screenwriters are imagining every more exotic disasters. FSOC should stick to its mandate.

More From Other Writers at Bloomberg Opinion:

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• The Everything Crackdown Reaches Private Equity: Paul J. Davies
• Fed Ignores Key Bubble Risk for Stock Market: Brian Chappatta

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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