Beware Unknown Unknowns: The Sibylline Books and How to Prevent Financial Crises

Article excerpt

Referring to the sovereign debt crisis in Europe, Poland's Minister of Finance, Jacek Rostowski, said that the negotiations reminded him of the story of the purchase of the Sibylline Books in ancient Rome. Those books contained prophecies which did not exactly forecast future events, but had to be understood as an aid to finding measures to prevent and manage a devastating disaster.

The last king of ancient Rome, the legendary Tarquinius Superbus, was eager to acquire the nine Sibylline Books. But the price that Sibyl, the prophetess, demanded struck him as too high, and the king declined to buy them. Either offended or shrewd, Sibyl burned three of the nine books and offered him the remaining six books for the same price as before. But Tarquinius again turned down the offer. So the prophetess burned three more books, again offering the remaining three books for the original price. This time, Tarquinius accepted the terms, and the books found their way into the Temple of Jupiter.

The books were lost in more recent times. But the questions remain: What advice would the books have had for modem policymakers? What kind of systemic analysis is presented there?

FIRST SIBYLLINE BOOK: REDUCING COMPLEXITY

Modern systemic risk analysis consists of many tools that are applied by central banks and supervisory authorities as well as macroprudential supervisory bodies at the national and international level such as the European Systemic Risk Board and the Financial Supervision Board. Such tools start by collecting and describing a wide set of indicators, most of which give coincident signals with regard to financial stability. In a further step, an attempt is made to isolate those indicators with predictive power, which is fairly difficult, conceptually as well as statistically. Other tools are designed to condense the information into risk dashboards, color coded systems, or web diagrams to present an overview of the highly complex picture. More sophisticated methods include stress tests to study the effects of different scenarios and specified econometric models capturing potentially destabilizing feedback loops and systemic effects.

[ILLUSTRATION OMITTED]

Clearly, these tools are important and helpful in preventing and managing systemic risks. But the question is whether they are sufficient. This seems doubtful given the high level of complexity in globally integrated financial markets. This complexity leads to non-linear dynamics in the system, which are very difficult to handle both for financial institutions in their risk management and for supervisors.

The complexity is also characterized by a phenomenon known as "Knightian uncertainty," named after the famous Chicago economist Frank Knight. Knight argued: "There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns--the ones we don't know we don't know."

Illustrating this theory leads us to the heart of the financial crisis. Prior to the financial crisis, a shadow banking system had emerged which found itself at the center of the crisis a few years later. This shadow banking system has aspects of "known unknowns" and "unknown unknowns." As a consequence, risks stemming from this system were widely ignored or underestimated. International macroprudential bodies such as the ESRB and the FSB are trying to fill this gap with knowledge, but a lack of data means that progress in this area is being made at a snail's pace.

Even if the authorities are eventually successful, they cannot be sure to have identified all relevant risks, because "unknown unknowns," which cannot be observed, could also exist in other areas of the financial system. Therefore, complexity reduction might be an effective instrument for preventing systemic crises. It is conceivable that the lost Sibylline Books could have contained advice such as this. …