Banking on the unexpected
By Mike Cranna,
The baby has to go out with the bath water. This is according to one of the most influential yet radical thinkers commenting on the current global financial crisis.
He is Nassim Nicholas Taleb, author of the international bestseller The Black Swan. This book is a must-read for anyone who wants to understand the deeper causes of the crisis but doesn’t want to be bogged down in the detail of derivatives, hedge funds and complex financial instruments.
Taleb’s primary concern is in the quantification of financial risk. This is because human affairs—financial affairs included—are vulnerable to the occurrence of ‘black swans’: low probability, high impact events.
Here is a quick illustration of the concept. Imagine a football stadium full of people. If one were to analyse their heights, the distribution would form a bell curve. Human height is determined by biology, and biology does not tend to feature significant exceptions to the rule.
Now imagine the same stadium of people, but this time you are measuring something in the realm of human affairs: wealth. And in that stadium, it just so happens that a super-billionaire is present—Bill Gates, perhaps. So much for the bell curve.
Now take a look at the graph. It shows the daily variations of a derivatives portfolio exposed to UK interest rates between 1988 and 2008. Pretty much in the same way as Gates’ wealth will represent close to 99 percent of the wealth in the stadium, 99 percent of the financial variations over the span of 20 years will be represented in one single day—the day the European Monetary System collapsed.
No known econometric statistical method can capture the probability of the event with any remotely acceptable accuracy (except, of course, in hindsight, and ‘on paper’).
Who would be dumb enough to bet billions against the odds of a Gates-sized billionaire ever walking into the stadium? That’s what banks are doing when they use quantitative methods to calculate their exposure, using a methodology that assumes wealth and height distribute in the same way. In effect, the bankers are calculating the risk as, “What are the chances of someone being 20,000 feet tall?” when in fact the risk they are exposing their clients’ money to is more in the region of, “How often do the super-wealthy attend football matches”? I’m being facetious, but you get the point.
The book is a great read, not only because of its polemic, non-academic style, but also because Taleb has several sacred cows in his sights—most notably economics Nobel Prize winner Myron Scholes and Ben Bernanke, current head of the Federal Reserve. Scholes was one of the chaps who designed the risk model that underpinned the investment profile of the hedge fund Long-Term Capital Management (LTCM). Despite the Nobel Prize and claims that the model was infallible, its failure in predicting the likelihood of debt default in Eastern Europe in 1998–99 led to LTCM almost bringing down the entire global financial system. You would have thought some lessons might have been learned.
Apparently not. Taleb quotes a Princeton economist as making a pronouncement in late 2004 about the “new moderation” in economic life and the financial world becoming more and more stable. That economist? Ben Bernanke.
Taleb is also critical of the Obama administration’s policy of incurring more debt to solve the crisis, what he calls “capitalism for the profits, socialism for the losses”. The bankers get to keep their bonuses, but Joe Public pays for the losses. Taleb’s recent appearance at the US congressional hearings on the subject is quite entertaining, and can be viewed at www.edge.org.
The conclusion he reaches is that there is no incentive to address the cause of the crisis when the perpetrators feel no pain from its effects.
Bertrand Russell once stated the definition of insanity is to make rational conclusions from flawed assumptions. Until the bankers go out with the bathwater, it seems that there will still be some in the financial sector who will continue to confirm that definition.