I can now reveal that is was the OCC…
The nameless regulator I criticized in my blog on calibration, “Bankers Can’t Avoid Risk by Hiding It,” was the Office of the Comptroller of Currency in Washington.
The OCC has had a lot of negative publicity recently for their less-than-rigorous examination of JPMorgan in the run up to that bank’s multi-billion dollar losses.
Just to recap what I said before, the OCC were unintentionally encouraging banks to hide model risk by requiring calibration when the role of the regulator should be to point out the downside of calibration and instead ask about the stability of the calibrated parameters. Certainly the concept of model risk, and the difference between hiding risk and hedging it, seemed beyond them. So it didn’t come as a surprise to me that the difference between hedging and speculation also proved too much for their very theoretical brains.
To add a bit of balance here, my experience of the OCC was not dissimilar to my experiences of many quant teams in banks. By this I mean that they love to talk mathematics but struggle to talk markets. When you’ve had a quant education that’s too academic then all you’ve seen is complete markets and risk neutrality, so it’s almost understandable that you don’t appreciate model risk. It doesn’t exist in complete markets! And of course in the risk-neutral world you pretend as if everything earns the same rate of return and risk has no value!
It’s all beginning to make sense!
Part of the solution is more robust education and better critical thinking.
But the cynic in me thinks that if regulators were better educated in the ‘practice’ of banking then there’d be less trading, smaller bonuses and fewer donations to political parties.