How to Stress Test Financial Weapons of Mass Destruction

How to Stress Test Financial Weapons of Mass Destruction

In recent decades we have been collectively spared the haunting images and existential anxiety provoked by the sight of detonating nuclear weapons for testing purposes – not to mention the increased levels of radiation in the atmosphere and other side-effects. This achievement is largely thanks to a series of treaties to control nuclear bomb testing that have been signed and enforced by most (unhappily not all) countries worldwide.

What may be less known to readers that do not hold doctorates in nuclear physics is that there is at least one large scale program to perform virtual testing of nuclear weapons. The approach is to use the most sophisticated super-computing facilities and detailed physical modeling of the processes taking place inside these devices to determine how those evolve (e.g., deteriorate) over time and whether they continue to be the deterrent they are supposed to be.

That such an undertaking can even be contemplated as a practical alternative to real tests is a testament to the remarkable progress in both using computer technology for large scale calculations and the successful encoding of physical laws in numerical algorithms.

We should not get too carried away with our ability to simulate complex processes. If we look at the “vision for the future” page of the above mentioned NNSA program we can only smile when we read about the aspiration to “develop the ability to quantify confidence bounds on the uncertainty in our results”. Indeed, there is model risk wherever there is a quantitative model, no matter how many smart and trained nuclear physicists are profitably employed to build it.

Modeling hubris aside, it seems worthwhile to encourage the financial industry to emulate sectors with more demonstrable engineering and safety prowess. One would think actually that there is some merit in the idea of developing

a simulation program for comprehensive, virtual, testing of financial products and instruments before those are unleashed into the unsuspecting public

That is, ex-ante stress testing before a financial product actually gets deployed. After all, its not for nothing that financial products have been called weapons of mass destruction. If the analogy is accurate, overall economic stability might benefit if they were to be treated with a similar degree of caution as their real counterparts…