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Accepting What You Don't Know Is Crucial to Detecting Risk 

October 20, 2016

William W. Lang, American Banker

One remarkable feature of the 2008 financial crisis is that the vast majority of risk experts were caught largely unaware of the extreme fragility of our financial system. Most analysts remained bullish about the housing market in the months leading up to the crisis, and even among those who saw the potential for a slew of foreclosures, very few recognized that mortgage defaults could destabilize the global financial system.

After the financial crisis, Congress passed the Dodd-Frank Act requiring stricter oversight of large financial institutions including stress testing, which uses complex statistical models to assess whether large banks have sufficient capital reserves to survive a hypothetical severe recession. Tighter supervision and improved risk analysis are important, but it is also worth noting that overconfidence in sophisticated statistical models also contributed to the financial meltdown.

To avoid repeating similar mistakes, financial risk professionals should look to incorporate lessons from the physical and behavioral sciences on the study of ignorance. The fundamental message of that body of research for the financial industry is that a strong and dynamic risk detection system requires focusing on the most important blind spots not satisfactorily explained by existing tools, rather than focusing on the "answers" produced by those tools. Read more

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