SCRAM: A Platform for Securely Measuring Cyber Risk2020
We develop a new cryptographic platform called SCRAM (Secure Cyber Risk Aggregation and Measurement) that allows multiple entities to compute aggregate cyber-risk measures without requiring any entity to disclose its own sensitive data on cyberattacks, penetrations, and losses. Using the SCRAM platform, we present results from two computations in a pilot study with six large private-sector companies: (1) benchmarks of the adoption rates of 171 critical security measures and (2) links between monetary losses from 49 security incidents and the specific sub-control failures implicated in each incident. These results provide insight into problematic cyber-risk-control areas that need additional scrutiny and/or investment, but in a completely anonymized and privacy-preserving way.
Macroeconomic Models for Monetary Policy: A Critical Review from a Finance Perspective2020
We provide a critical review of macroeconomic models used for monetary policy at central banks from a finance perspective. We review the history of monetary policy modeling, survey the core monetary models used by major central banks, and construct an illustrative model for those readers who are unfamiliar with the literature. Within this framework, we highlight several important limitations of current models and methods, including the fact that local-linearization approximations omit important nonlinear dynamics, yielding biased impulse-response analysis and parameter estimates. We also propose new features for the next generation of macrofinancial policy models, including: a substantial role for a financial sector, the government balance sheet and unconventional monetary policies; heterogeneity, reallocation, and redistribution effects; the macroeconomic impact of large nonlinear risk-premium dynamics; time-varying uncertainty; financial sector and systemic risks; imperfect product market and markups; and further advances in solution, estimation, and evaluation methods for dynamic quantitative structural models.
Macro-Finance Models with Nonlinear Dynamics2020
We provide a review of macro-finance models featuring nonlinear dynamics. We survey the models developed recently in the literature, including models with amplification effects of financial constraints, models with households' leverage constraints, and models with financial networks. We also construct an illustrative model for those readers who are unfamiliar with the literature. Within this framework, we highlight several important limitations of local solution methods compared with global solution methods, including the fact that local-linearization approximations omit important nonlinear dynamics, yielding biased impulse-response analysis.
An Empirical Evaluation of Tax-Loss-Harvesting Alpha2020
Advances in financial technology have made tax-loss harvesting more feasible for retail investors than such strategies were in the past. We evaluated the magnitude of this “tax alpha” with the use of historical data from the CRSP monthly database for the 500 securities with the largest market capitalizations from 1926 to 2018. Given long-term and short-term capital gains tax rates of 15% and 35%, respectively, we found that a tax-loss-harvesting strategy yielded a before-transaction-cost tax alpha of 1.08% per year for our sample period. When the strategy was constrained by the “wash sale rule,” the tax alpha decreased from 1.08% per year to 0.82% per year.
If Regulations Don’t Bend, They’ll Break2018
The tenth anniversary of the disastrous weekend that nearly brought down the global financial system is fast approaching. But in many of the jurisdictions that were central to the crisis, financial regulations introduced in the aftermath, aimed at preventing a repeat, are now being rolled back. The pendulum of regulation is now swinging back towards fewer and looser restrictions – and if the past is any guide, a ramp-up in systemic risk exposures will be the result.
Financial Risks Don’t Go on Holiday2018
August is typically when Wall Street goes to the beach, the mountains, or just home to recharge for a week or two. Many Europeans take the entire month off. But financial markets have a cruel knack of ruining holidays. As we lie in our hammocks this August, we might do well to recall a remarkable event that occurred, seemingly without warning, 11 years ago this month in the run-up to the financial crisis.
All the News that’s Fit to Print2018
The information revolution has transformed everyday life for billions of people throughout the world. For example, according to mobile phone research group GSMA Intelligence, there are currently over 5 billion unique mobile phone subscribers, out of an estimated global population of 7.6 billion. This is the equivalent of a mobile phone for every person on the planet between the ages of 15 and 65.
Stop-loss Strategies with Serial Correlation, Regime Switching, and Transaction Costs2017
Stop-loss strategies are commonly used by investors to reduce their holdings in risky assets if prices or total wealth breach certain pre- specified thresholds. We derive closed-form expressions for the impact of stop-loss strategies on asset returns that are serially correlated, regime switching, and subject to transaction costs. When applied to a large sample of individual U.S. stocks, we show that tight stop-loss strategies tend to under-perform the buy-and-hold policy in a mean-variance frame work due to excessive trading costs. Outperformance is possible for stocks with sufficiently high serial correlation in returns. Certain strategies succeed at reducing downside risk, but not substantially.
Moore’s Law vs. Murphy’s Law in the Financial System: Who’s Winning?2017
Breakthroughs in computing hardware, software, telecommunications, and data analytics have transformed the financial industry, enabling a host of new products and services such as automated trading algorithms, crypto-currencies, mobile banking, crowdfunding, and robo-advisors. However, the unintended consequences of technology-leveraged finance include firesales, flash crashes, botched initial public offerings, cybersecurity breaches, catastrophic algorithmic trading errors, and a technological arms race that has created new winners, losers, and systemic risk in the financial ecosystem. These challenges are an unavoidable aspect of the growing importance of finance in an increasingly digital society. Rather than fighting this trend or forswearing technology, the ultimate solution is to develop more robust technology capable of adapting to the foibles in human behavior so users can employ these tools safely, effectively, and effortlessly. Examples of such technology are provided.
TRC Networks and Systemic Risk2016
The authors introduce a new approach to identifying and monitoring systemic risk that combines network analysis and tail risk contribution (TRC). Network analysis provides great flexibility in representing and exploring linkages between institutions, but it can be overly general in describing the risk exposures of one entity to another. TRC provides a more focused view of key systemic risks and richer financial intuition, but it may miss important linkages between financial institutions. Integrating these two methods can provide information on key relationships between institutions that may become relevant during periods of systemic stress. The authors demonstrate this approach using the exposures of money market funds to major financial institutions during July 2011. The results for their example suggest that TRC networks can highlight both institutions and funds that may become distressed during a financial crisis.
What Is An Index?2016
Technological advances in telecommunications, securities exchanges, and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes but which depart from traditional market-cap-weighted portfolios. I propose broadening the definition of an index using a functional perspective—any portfolio strategy that satisfies three properties should be considered an index: (1) it is completely transparent; (2) it is investable; and (3) it is systematic, i.e., it is entirely rules-based and contains no judgment or unique investment skill. Portfolios satisfying these properties that are not market-cap-weighted are given a new name: “dynamic indexes.” This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and I provide a simple example of how this can be achieved. Dynamic indexes also create new challenges of which the most significant is backtest bias, and I conclude with a proposal for managing this risk.
Risk and Risk Management in the Credit Card Industry2016
Using account level credit-card data from six major commercial banks from January 2009 to December 2013, we apply machine-learning techniques to combined consumer-tradeline, credit-bureau, and macroeconomic variables to predict delinquency. In addition to providing accurate measures of loss probabilities and credit risk, our models can also be used to analyze and compare risk management practices and the drivers of delinquency across the banks. We find substantial heterogeneity in risk factors, sensitivities, and predictability of delinquency across banks, implying that no single model applies to all six institutions. We measure the efficacy of a bank’s risk-management process by the percentage of delinquent accounts that a bank manages effectively, and find that efficacy also varies widely across institutions. These results suggest the need for a more customized approached to the supervision and regulation of financial institutions, in which capital ratios, loss reserves, and other parameters are specified individually for each institution according to its credit-risk model exposures and forecasts.
Opinion: A New Approach to Financial Regulation2015
In this Op-Ed Piece, MIT Sloan Professor Andrew Lo and Princeton Professor Simon Levin write, "We propose that the financial system has crossed a threshold of complexity where the system is evolving faster than regulators and regulations can keep pace. For example, the system is now truly globally connected, but coordination across sovereign jurisdictions is difficult to achieve. This new situation calls for a new perspective, one based on a different paradigm than the ones on which financial regulation is currently based, such as efficient markets, rational expectations, and models patterned after the physical sciences."
Dealing with Femtorisks in International Relations2014
The contemporary global community is increasingly interdependent and confronted with systemic risks posed by the actions and interactions of actors existing beneath the level of formal institutions, often operating outside effective governance structures. Frequently, these actors are human agents, such as rogue traders or aggressive financial innovators, terrorists, groups of dissidents, or unauthorized sources of sensitive or secret information about government or private sector activities. In other instances, influential “actors” take the form of climate change, communications technologies, or socioeconomic globalization. Although these individual forces may be small relative to state governments or international institutions, or may operate on long time scales, the changes they catalyze can pose significant challenges to the analysis and practice of international relations through the operation of complex feedbacks and interactions of individual agents and interconnected systems. We call these challenges “femtorisks,” and emphasize their importance for two reasons. First, in isolation, they may be inconsequential and semiautonomous; but when embedded in complex adaptive systems, characterized by individual agents able to change, learn from experience, and pursue their own agendas, the strategic interaction between actors can propel systems down paths of increasing, even global, instability. Second, because their influence stems from complex interactions at interfaces of multiple systems (e.g., social, financial, political, technological, ecological, etc.), femtorisks challenge standard approaches to risk assessment, as higher-order consequences cascade across the boundaries of socially constructed complex systems. We argue that new approaches to assessing and managing systemic risk in international relations are required, inspired by principles of evolutionary theory and development of resilient ecological systems.
Dynamic Loss Probabilities and Implications for Financial Regulation2014
Much of financial regulation and supervision is devoted to ensuring the safety and soundness of financial institutions. Such micro- and macroprudential policies are almost always formulated as capital requirements, leverage constraints, and other statutory restrictions designed to limit the probability of extreme financial loss to some small but acceptable threshold. However, if the risks of a financial institution's assets vary over time and across circumstances, then the efficacy of financial regulations necessarily varies in lockstep unless the regulations are adaptive. We illustrate this principle with empirical examples drawn from the financial industry, and show how the interaction of certain regulations with dynamic loss probabilities can have the unintended consequence of amplifying financial losses. We propose an ambitious research agenda in which legal scholars and financial economists collaborate to develop optimally adaptive regulations that anticipate the endogeneity of risk-taking behavior.