Clashing models risk management are responsible for the credit crisis, according to a commentary released today by the C.D. Howe Institute.

In his commentary, Frank Milne, an economist at Queen’s University and newly appointed Special Advisor to the Bank of Canada, examines the roots of the credit crisis that began in mid-2007. Milne identifies two competing models of risk management. According to the first view, securitization in liquid credit markets was making obsolete, or at least reducing, traditional banking concerns about asymmetric information, uncertainty and illiquid markets. The second model saw increasing securitization as merely obscuring traditional banking problems, which remained important.

To the degree that the first model prevailed, risk managers made false assumptions about the liquidity and transparency of a new generation of credit instruments. The result was the creation of a shadow credit-banking system. Milne argues that the current crisis reflects not a liquidity problem, but a massive de-levering of that shadow system as the credit market model underlying it has been shown to be inadequate. There has been what amounts to a massive run on an insolvent shadow banking system, whose reverberations are far from over.

Milne’s paper outlines possible policy reforms for risk management systems and their regulation. However, the author cautions that, at this stage, regulators should be cautious in adopting specific and major policy changes pending further analysis of what has been a complex systemic failure.