Analysis of quantified news holds great promise for the purpose of managing risks within financial institutions, and broadly across the financial system. By facilitating rapid responses to flows of information that reveal risky circumstances, such systems will meaningfully contribute to a lessening of the potential for financial crises. Monitoring flows of information on markets and securities and the sentiment of their content is an excellent indicator for potential dispersion of beliefs among investors, and hence the potential for changes in the prices of assets.
However, the ability to respond quickly to information also increases the requirement that the response be the right one. Responding instantly, but in the wrong fashion, can foster disaster, just as driving a racing car requires greater precision than driving a golf cart. As such, we must frame the general principles of our risk management effort in a thoughtful and thorough fashion.
The first thing to focus on is the difference between risk management in a commercial or investment banking setting, and risk management in an asset management setting. Hedge funds are often in the middle on this spectrum, but we should at least understand the issues. This is the biggest mistake people make. Banks are investing firm capital and are highly leveraged with liabilities at call (a run on the bank). They are worried about bankruptcy and regulatory ...