Causal vs. Non-causal Models

Stork Bringing Baby Casual

In certain northern European countries, parents used to tell their children that storks bring babies.  For many years, I did not understand the actual link of how the old tale arose.  However, I found out that in these countries that after a baby was born, the child’s nursery was frequently placed at the top of the house.  Also, the parents would increase the heat within the house to keep the new born warm throughout the night.  What happened is that the storks would discover these warmer roofs and would exploit this extra heat and would build their nests over the same rooms at the top of the house.  So, the birth of the baby actually brought the storks and not the other way.

Stork on Nest Causal

This amusing analogy can relate to causal vs non-causal models and well as an example with the idea of model dependency.

When constructing ERM models, if you know that situation A impacts situation B which again impacts situation C, you want your ERM model to reflect this causality.   Usually a causal system is one that depends on current or past input only. If the the model depends on future values as well, you have an non-causal (or a-causal) model. Also see https://en.wikipedia.org/wiki/Causality  for a further discussion around this topic.

However, when modeling various risks, initially, you may not be able to determine how different risks are properly interrelated. In these situations, you might use non-causal modeling to set up various statistical models to estimate a specific risk.  Or you may set up a loose correlation model.  In this situation, you know storks and delivery of babies are related so you would have a strong positive correlation.

Non-causal models with correlations were more frequently used before the financial crisis of 2008, primarily, because no one actually knew how to model credit. So, credit derivatives were modeled for several years, by setting up a VaR model and using copulas for the aggregation of risk. However, we saw that the relationship of the high quality bonds issues that were built off of the sub-prime mortgages and additional collateral was actually highly correlated in the extreme scenarios.

Now it is more common to create causal models where you design your scenarios and models to interrelate, which is the best approach.  At least you would model the delivery of babies implying the arrival of storks.

However, in some companies, the non-causal models are still used, especially when that company wants to model a large diversity of risks. Also, if a company has several risks that are modeled separately with differing systems and scenarios, these risks may be segregated into silos. In these situations aggregation of capital may still require non-causal methods to handle the silos.