Cato: The Solution is Legislation!

Edition 38,456….

Kevin Dowd, writing for the Cato Institute, finds fault in the modeling of the Fed and the risks this faulty modeling introduces into the financial sector.

The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.”

Bully for you, Kevin.

The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.

Maybe, or maybe it’s all a PR stunt to pacify the masses while the looting continues.

Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable.

Taken right out of “The Best of Hayek” compendium.  With this introduction, you would think Kevin is ready to hit one out of the park…or…you would remember he is writing for Cato, where hitting one out of the park is not a consideration:

The solution to these problems is legislation…

The solution is congress…congress…. sorry, I interrupted Kevin.  Let’s try again:

The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models.

And just how would the “conservative capital standard for banks based on reliable capital ratios” be determined?  By who?  Based on what factors?  (Hint: it would take a model.)

The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits.

So, just who does have a “credible track record at forecasting” that can therefore “be entrusted with the task of telling banks how to forecast their own financial risks”?

Unless Congress intervenes, the United States is heading for a new systemic banking crisis.

This is Kevin’s solution – congress should develop a model!  Just another version of central planning for money and credit.

I offer a better solution – in fact, the only one:

End the Fed.