Risky Business

In a special report, "The Gods Strike Back," The Economist confirms what those of us who had anticipated the meltdown of recent years already knew: financial risk got [way] ahead of the world's ability to manage it:

“THE revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” So wrote Peter Bernstein in his seminal history of risk, “Against the Gods”, published in 1996. And so it seemed, to all but a few Cassandras, for much of the decade that followed. Finance enjoyed a golden period, with low interest rates, low volatility and high returns. Risk seemed to have been reduced to a permanently lower level.

This purported new paradigm hinged, in large part, on three closely linked developments: the huge growth of derivatives; the decomposition and distribution of credit risk through securitisation; and the formidable combination of mathematics and computing power in risk management that had its roots in academic work of the mid-20th century. It blossomed in the 1990s at firms such as Bankers Trust and JPMorgan, which developed “value-at-risk” (VAR), a way for banks to calculate how much they could expect to lose when things got really rough.

Suddenly it seemed possible for any financial risk to be measured to five decimal places, and for expected returns to be adjusted accordingly. Banks hired hordes of PhD-wielding “quants” to fine-tune ever more complex risk models. The belief took hold that, even as profits were being boosted by larger balance sheets and greater leverage (borrowing), risk was being capped by a technological shift.

There was something self-serving about this. The more that risk could be calibrated, the greater the opportunity to turn debt into securities that could be sold or held in trading books, with lower capital charges than regular loans. Regulators accepted this, arguing that the “great moderation” had subdued macroeconomic dangers and that securitisation had chopped up individual firms’ risks into manageable lumps. This faith in the new, technology-driven order was reflected in the Basel 2 bank-capital rules, which relied heavily on the banks’ internal models.

There were bumps along the way, such as the near-collapse of Long-Term Capital Management (LTCM), a hedge fund, and the dotcom bust, but each time markets recovered relatively quickly. Banks grew cocky. But that sense of security was destroyed by the meltdown of 2007-09, which as much as anything was a crisis of modern metrics-based risk management. The idea that markets can be left to police themselves turned out to be the world’s most expensive mistake, requiring $15 trillion in capital injections and other forms of support. “It has cost a lot to learn how little we really knew,” says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable.

For now, the hubris of spurious precision has given way to humility. It turns out that in financial markets “black swans”, or extreme events, occur much more often than the usual probability models suggest. Worse, finance is becoming more fragile: these days blow-ups are twice as frequent as they were before the first world war, according to Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University. Benoit Mandelbrot, the father of fractal theory and a pioneer in the study of market swings, argues that finance is prone to a “wild” randomness not usually seen in nature. In markets, “rare big changes can be more significant than the sum of many small changes,” he says. If financial markets followed the normal bell-shaped distribution curve, in which meltdowns are very rare, the stockmarket crash of 1987, the interest-rate turmoil of 1992 and the 2008 crash would each be expected only once in the lifetime of the universe.

This is changing the way many financial firms think about risk, says Greg Case, chief executive of Aon, an insurance broker. Before the crisis they were looking at things like pandemics, cyber-security and terrorism as possible causes of black swans. Now they are turning to risks from within the system, and how they can become amplified in combination.

To go along with the report, the magazine has posted a helpful videographic explaining the concept of "fat tails in risk distributions":

As it happens, Economist.com features an extensive collection of audio and video reports on a variety of topics, which can be viewed by clicking here.

Comments

[dearieme]

FT alphaville has this nice chart from RBC, about sovereign defualt risk.
http://av.r.ftdata.co.uk/files/2010/02/heatmapbig.jpg

[fred]

"The idea that markets can be left to police themselves turned out to be the world’s most expensive mistake"

The above comment confirms that "The Economist" (in accordance with their long term political leanings) has not learned the right lesson yet. Markets can police themselves, until governments introduce distortions that destroy the market function. We've been doing just that for 70 years. The breakdown was long overdue, and it's about to get a lot worse.

[roger]

The sum of many small changes is the mother of big changes;

[roger]

Free market? please define free market,if free markets police themselves why do we
have the military? for self defense or for economic domination,perhaps for both.
Is not Government an agent of the super rich? and if not why are they so intent
on controlling it?Free is a dam big word meaning many different things to different people,Free to own slaves,free to dominate other country's,
free to accumulate unlimited power,free to displace millions of laborers, and drive out of business the small entrepreneur.
Nice to dream of a perfect world but is does not exist.
The Von misses philosophy is the dumbest in the world unless it represents
the Ideology of a past Austrian Oligarchy.

[Al Fin]

Libertarian laissez faire is the dumbest philosophy in the world -- except for every other philosophy in the world! Idiots who fall back on Marxist or sociolist ideologies will always demand power "in the name of the people." Social Justice -- that great oxymoron for morons -- is a fetish of fools.

Don't be a fool, R-man.