Just Blame the Mathematicians?

At the core of the financial crisis, there is a cultural question: Thirty years ago, large banks were, with very few exceptions, conservatively managed. They would have never relied on what turned out to be a flawed mathematical algorithm to determine their risk position. In any case, they would have been far less leveraged.

True, mathematicians were brought into the major investment banks in the mid-1980s. True as well that they were seduced by the remuneration available, which was far in excess of what they could conceivably get in academia. No wonder, given these one-sided incentives, that they became slaves to the more strong-willed traders and management of the banks.

Told that their jobs depended on managing risk in such a way as to allow the traders free rein, they devised mathematical models — primarily the Value-at-Risk (VaR) risk management system — that appeared legitimate, and could be presented to inquisitive top management and regulators as such, but in reality were fatally flawed.

The traders also responded to incentives. Told that their bonuses required them to maximize profits while remaining within the risk management parameters produced by the mathematicians, the traders found ways of designing products that satisfied the (highly) fallible models.

Talk about a hermetically closed, self-referential — and indeed self-reverential — mode of operations.

Mathematicians and traders, working hand in hand, found ways, supposedly safe, to take larger risks than their firms’ top management officially contemplated. Credit default swaps (CDS) — the loss on which could be a hundred times the premium paid for them — had “tails” far longer than the VaR models contemplated. (In other words, the maximum possible loss on them was far greater than the models predicted.)

It goes without saying that the risks were also far greater than the models predicted. Collateralized debt obligations (CDOs) — especially the multi-layered “CDO-squared” and CDOs on subprime credits — turned out to be far more internally correlated than the VaR models predicted.

While the “tail” losses on CDOs were of the same order as VaR predicted, the “tails” were much fatter. That is, the probability of those losses occurring was far higher.

Precisely because of the pathological nature of their risk profiles, CDOs and CDS were extremely attractive to traders. They realized that they could generate far more profit from these very risky instruments than was possible from conventional instruments.

In the latter area, financial markets were indeed becoming much more efficient, as the “spreads” — the previous main source of profits — were arbitraged away by fierce competition.

The poison of misguided incentives also extended to the top executive suite, largely by the malign effect of permitting ever higher leverage, supposedly to squeeze sufficient profits out of ever smaller margins on a per-transaction basis.

Traditionally, leverage in banking had been moderate. While long-term interest rates were generally higher than short-term rates, occasional credit crises kept bankers honest, convincing them that it was foolish to leverage up on long-term paper and borrow in the short-term market.

That basic wisdom and core mode of banking operations went out the window over the past two decades. We are all now paying the price for that “oversight.”

If the 2008 crash had been treated with the traditional Walter Bagehot remedy of lending amply, but on good security and at high rates, behavior patterns would have been modified. Caution would have been seen once again to have its virtues.

Instead, what happened was the combination of a bailout that was almost cost-free to the banks and an intensification of the easy money policies by the central banks that had caused the problem in the first place.

This has produced a truly perverse result under the circumstances. We now witness the inevitable behavior of yet more leverage, yet larger trading risks, and all of it suitably hidden by the spurious VaR system.

Banking turned into gambling

One might well ask where the regulators were while all this was going on. While sensible in principle, the abolition of Glass-Steagall restrictions — which prevented commercial banks from acting like investment banks — in 1999 allowed the biggest banks to take massive advantage of easy money conditions.

Banking turned into gambling. Bankers relied on the proceeds of FDIC-insured deposits in the knowledge that they would be bailed out, if necessary.

The worst regulatory dereliction of duty came from the Basel regulators tasked with setting leverage and risk principles for the banking industry. Instead of using a common-sense definition of leverage based on balance-sheet totals, they allowed banks to “weight” their assets, with government debt having a zero risk weighting — thus allowing infinite leverage in that sector.

Instead of applying the strictest supervision to the mushrooming trading desks, where the risks were being incurred, they allowed the banks to devise a spurious risk management metric that hid the most serious risks.

Stupendously, the international regulators then permitted the banks to use this metric to describe themselves as “sophisticated,” thereby allowing them — wouldn’t you know it? — to escape much of the regulation imposed on lesser mortals.

Not only were the Basel regulators “captured” by the industry, they have suffered a “Stockholm syndrome” by which they have adopted the attitudes and practices of their captors. No serious attempt has been made, nearly four years after the 2008 collapse, to replace the discredited VaR system with something that works properly.

What’s more, while the Basel regulators have now — thankfully, but much belatedly — included a “common sense,” un-weighted leverage limit as well as the spurious weighted limits, there is a catch: Their required capital is a pathetically low 3%, allowing yet again a leverage of 33 to 1.

That is a higher ratio than that which led Bear Stearns and Lehman Brothers to their doom.

The only comfort then is the old saying that if something cannot go on forever, it will end. The current rickety edifice of international finance, with reckless monetary policies, excessive leverage, spurious risk management and Stockholm Syndrome regulators, will cause a series of crashes.

Meanwhile, the world had hoped that a serious crisis such as that of 2008 would have brought reform instead of recession. It now appears that it will take half a dozen such crises, each one more expensive than the last, before common sense returns. But return it will!