Why no one saw it coming?
-------------------------------------------------------------------------------- Probability theories dominated risk measurement in the world of finance. Now they failed to visualise black swan and consequences are disastrous. -------------------------------------------------------------------------------- B. Sambamurthy Bank of England recently reduced the repo rate to 1.5 per cent, which is the lowest in its 315-years history. The rate is the lowest since 1694 - yes, not 1964.The rates are near zero in the US and Japan. This is enough to shatter any illusion of normalcy. The conventional risk measures could not capture or foresee these risks. Shocked by the deluge of bank failures the Queen of England exclaimed, why no one saw it coming! Mathematical principles "Anything in finance that has equations is suspicious," says Nassim Nicholas Taleb, a no nonsense and successful trader and author of Black Swan. He was, in fact, a quant who extensively used mathematical principles in his earlier avatar as trader. He also recommends banning portfolio theory and linear regression. This guru goes on with sage advice that Monte Carlo is more a way of thinking than computational method. Quite surprising indeed coming as it does from an ace mathematical trader. It looks as though new age bankers have become superstitious of mathematics. How philosophical is his thought that mathematics is a tool to meditate rather than compute. Whoever forgot that LTCM had two Noble Laureates on its board and they had extensively used mathematics in finance? Thanks to Math, Moon is within reach but safe banking is far off. A story goes that people believed that all swans were only white, till one day in the 16th century black swans were sighted in Australia. Well, black swan has emerged as a metaphor for the rarest of the rare event and which brings with it huge impact. Besides, it is prospectively unpredictable (that is where mathematics fail bankers). It is said that mathematics is backward looking and as such could not help in predicting the carnage ahead. No amount of loss reporting by the big and mighty surprise any more. Bailout packages for a couple of the US banks rivals India's GDP. We have this spectre in Iceland where the borrowers, lenders and the country are bankrupt. This is a classic example of how far unchecked wrong banking practices could go. There are enough diatribes - greed, excessive leverage, fraud, lax regulations, indulgent monetary policies etc. There were sane voices too before the carnage. Toranto-Domonian, a Canadian Bank, had exited out-of-structured and other derivative products in 2005 itself. The CEO was then pilloried for leaving profit on the table. He said that he made the decision because he could not comprehend those products. This decision kept the bank in the black while many banks who did not exit bled profusely and many could not survive. He said that he is an old school banker. This CEO has a Ph.D. in economics is beside the point. Peter Bernstein, author of Against the Gods, counsels that risk is not danger. It is uncertainty. Something good can happen or something bad too. Risk is not to be abhorred. It is vital for human progress. Tools that are good in a game of chance do not work in real world of finance. We underestimate the role luck in real world of finance but overestimate the role of luck in personal life. Probability theories dominated risk measurement in the world of finance. Now they failed to visualise black swan and consequences are disastrous. We need new skill sets to address uncertainty. Mr Taleb is a professor on this subject of uncertainty. There needs to be a paradigm shift from probability to uncertainty. Black swan events are not confined only to the universe of finance. Only a few months ago there were strident voices of huge talent shortage and how this can spoil India's growth story. Now, the same honchos are throwing out talent as excess baggage. Every upheaval gives birth to new leaders, ideas and institutions. Better banks would no doubt emerge from ashes. What are the lessons for bankers? My guru gives me short interim list to rebuild business models and cajoles that it is not the end of the world. He promised more after the debris is cleared. Lessons for bankers Remember you deal with other people's money. Risk management has to be top down. If the CEO does not understand the risk in any line of business, he/she should not assume that someone down the line would know. Business model that enables and encourages people to live beyond means is not sustainable. It does not matter you have sophisticated operating models to reach out fast to large number of people. Muscular operating model shall not dictate business wisdom. Mathematical models cannot supplant human judgment. They can only supplement. Tail risks can happen in our career times. Risk is not dangerous, but uncertain. Develop skill sets for uncertainty. Don't get overawed by masters of universe. Mere obsession with size, oblivious of strength, would make the bank shaky and not strong. Moderate banks involve with financial markets either for funding or profiteering. At a more fundamental level, the Senior Manager shall be the anchor for any operating model. Lending shall be driven by 'C' - character, capital & capacity We learn a lot from failure. Get failure early before it gets too late? There are large issues as well - socialisation of risk, regulatory arbitrage, excessive leverage Basel framework, market fundamentalism, reliability of economic capital, insane valuations, sustainability of universal banking model etc. Let policy makers, legislators and regulators grapple with these issues. Bankers need not wait for resolution of these larger issues and they can rebuild banks by correcting the business models. Black swan is not a wisecrack. Its philosophy is not to banish risk taking. It is about non-commoditised thinking. Some know what they know. Some know what they do not know. Many do not know what they do not know. There is unknown-unknown. What is relevant is unknown more than known. By the way, had Dr Reddy's RBI sighted black swans a couple of years ago when every one else was clinging to the white swan theory? Otherwise what explains his contra cyclical approach? Which swan you see now, Sir? (The author is Director of IDBRT, an RBI sponsored institution and former CMD of Corporation Bank. [email protected]) http://www.thehindubusinessline.com/2009/01/26/stories/2009012650741200.htm ekamber --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups "Kences1" group. 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