December 03, 2017

When being rightly suspicious about making algorithms powerful let us not ignore that powerful humans could be very dangerous too.

Sir, Tim Harford, agreeing with Hayek holds “Market forces remain a more powerful computer than anything made of silicon.” “Algorithms of the world, do not unite!” December 2.

But when regulators decided to replace the risk assessments of thousands of individual and diverse bankers, with those produced by some few human fallible credit rating agencies; and then allowed banks to increase their bets on these ratings being correct, for instance with Basel II allowing banks to leverage a mindboggling 62.5 times if only an AAA or an AA rating was present, we would have benefitted immensely from having some algorithms indicate them this was pure folly.

Because, in the development of such algorithms, it would not been acceptable to look solely at the risks of bank assets as such, but would have required to consider the risk those assets posed for the banks.

And as a result the algorithms would not have allowed banks to leverage more with safe assets than with risky, that because only assets perceived as very safe can lead to the build up of such excessive exposures that they could endanger the whole bank system, were the credit ratings to turn out wrong.

An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: “The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason given for that inexplicable simplification was: “Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

Sir, algorithms are precisely designed to combat such complexities.

Yes, “Facebook and Google have too much power” but so did the regulators; and with their risk weighting of the sovereign with 0% and citizens with 100%, Stalin would have been very proud of them.