Failed performativity in Iceland
September 25, 2010
(Many thanks to a friend of the blog, who shell remain anonymous, for pointing out the initial story)
A new documentary film, Inside Job, describes the financial crisis and discusses, among other things, the role that academics played in setting the scene for the crisis. Fredric Mishkin, a finance professor from Columbia business school is interviewed in the film, where he is asked about a May 2006 report he wrote (with Tryggvi Thor Herbertsson), titled “Financial Stability in Iceland”. The report was funded by the Icelandic Chamber of Commerce, who also paid Mishkin $124,000, a fact that Mishkin did not disclose in the report itself. The film focuses on the possible biases in the report and makes a general argument that financial economists were part of a broad network that facilitated the motivations and the market devices that brought about the 2008 crisis.
An SSF look at the report, however, produces a more nuanced insight, I believe. Mishkin and Herbertsson try to measure the likelihood of a banking crisis in Iceland by using the spread on Credit Default Swaps (CDS). The CDS spread of Icelandic banks is used to arrive at the probability of a financial crisis. The methodology in the report refers to a Barclays Bank report from April 2006 where the analysts present possible future scenarios of Icelandic banks and where they pose a CDS spread of 500 basis points as a ball park figure that would present a financial catastrophe: “In the worst case, a financial crisis could potentially lead to banks widening to an average of 500 bp, say.” Based on the hypothetical figure of 500 where there is a 100% probability of a crisis (because an actual crisis would cause such widening of spreads), the analysts look back at the current spread of 67 basis points and calculate a probability of 7% for a crisis.
Mishkin and Herbertsson use the figure of 500 basis points as upper limit for a linear relation they assume exists between CDS spreads and the probability of a crisis (see figure 20 in their report). The validity of this exercise relies on how well the CDS market translates default risks to prices. The report, however, does not only present these model-based findings, but also tries to affect the reality in the Icelandic financial markets. After all, the Icelandic Chamber of Commerce funded the research to show that the markets there were stable and sooth investors. In other words, Mishkin and Herbertsson were involved in a performativity attempt: presenting a model-based projection in the hope that market participants would react to the projection in way that will materialise it in the market.
This attempt, as we all know, failed. The question why it failed is intriguing. Finding potential explanations for the failure can shed new light on the conditions in financial markets before the crisis and on the behaviour of financial markets in general. For example, it could be that the CDS-implied probability performativity attempt failed because it ‘came from above’? That is, there were not enough users and market devices that depended on the model when acting in the market to support increasing similarity between the model and the market. Such a process, of co-institution of markets and models (where both gain validity and viability) did not evolve sufficiently in the case of CDS, again, for obvious reasons.
So, the story of the Icelandic report, a candidate for a failed performativity attempt (note: this is different from counter-performativity), is an intriguing way to look at the crisis and its potential causes.