Clouds Seen in Regulators’ Crystal Ball for Banks

Five years ago, the financial regulators of the United States — and more broadly the world — didn’t see the storm coming.

Would they if a new one were brewing now?

The answer to that is far from clear. The regulators have more information now, and they have applied the tools they have to measure risk with more vigor.

But a new assessment from a little-known agency created by the Dodd-Frank law argues that the models used by regulators to assess risk need to be fundamentally changed, and that until they are they are likely to be useful during normal times, but not when they matter the most.

“A crisis comes from the unleashing of a dynamic that is not reflected in the day-to-day variations of precrisis time,” wrote Richard Bookstaber, a research principal at the agency, the Office of Financial Research, in a working paper. “The effect of a shock on a vulnerability in the financial system — such as excessive leverage, funding fragility or limited liquidity — creates a radical shift in the markets.”

Mr. Bookstaber argues that conventional ways to measure risk — known as “value at risk” and stress models — fail to take into account interactions and feedback effects that can magnify a crisis and turn it into something that has effects far beyond the original development.