Liechty in Nature Magazine: Scientists, Bankers Must Unite to Prevent Financial Crises

In the April 12 issue of Nature, John Liechty, professor of marketing and statistics at the Penn State Smeal College of Business and Director of the Center for the Study of Global Financial Stability, calls on scientists and bankers to collaborate to help forestall future financial crises.

Liechty, writing in Nature's World View column, says that new federal legislation, which he helped write, forces banks, pension funds, insurance companies, and other major financial players to turn over data to federal regulators. Using this new data, scientists can work with regulators and bankers to create new financial models that have the potential to identify system-wide risks.

To illustrate the complexity of creating these models, Liechty compares the global financial system to a fictitious shopping mall that charges customers to enter and exit.

"To model the movement of shoppers, we could build a purely statistical model of the door traffic, and in most situations this would be sufficient," he writes. "However, in extreme situations, such as a fire, the system would change dramatically. Shoppers would rush for the nearest exits and ticket-takers would get overwhelmed and close their doors. Then shoppers would rush to the next set of doors. In such cases, a statistical model would get it horribly wrong.

"… To fully understand and predict the dynamics of a market in crisis, we have to understand the capacity of the market-makers (the ticket-takers at the door of the shopping mall) and the demand for assets when prices lurch significantly away from present levels (the number of shoppers trying to get out versus the number trying to get in). The new data will allow models to do this for the first time."

Liechty says that the federal government should invest in such research at universities and labs around the country and host the more sensitive work itself to ensure confidentiality. Banks should collaborate, too, while analyzing their own industry data to monitor industry-wide risk.

"Market forces function only if all risks are fairly priced," Liechty writes. "Everyone would benefit if bankers were to engage with scientists to build the infrastructure needed to price system-wide risk. Banks could get feedback about common holdings and trading strategies, which would allow them to adjust their behaviour and avoid following the herd. Regulators would have extra market information to help them to determine when to act to ensure stability. And the rest of us could have increased confidence in the financial system."

To read Liechty's complete column, "Scientists and bankers -- a new model army," visit www.nature.com/news/scientists-and-bankers-a-new-model-army-1.10399.