March 02, 2009
Black Swans and Banking Regulations
Editor's Note: John Nellis was a Senior Manager in the World Bank's Private Sector Development Department. He is now Principal of the consulting/research firm, International Analytics.
On February 24 I attended the first day of a two and half day World Bank conference on Markets and Crises: What Next and How? Two sessions were particularly interesting: the keynote address by Nassim Taleb, author of "The Black Swan: The Impact of the Highly Improbable," and a panel on "What has the financial crisis taught us about risk management?" with Mark Carey from the Federal Reserve Bank of the US, Stijn Claessens from the IMF, Martha Cummings from Banco Santander and Mark Zandi of Moody’s.
First, Mr. Taleb. He is wildly entertaining and delightfully iconoclastic; he left no one in or outside the room uninsulted. All economists are worthless. Certain central bankers are charlatans and fools. French bankers are the worst of all possible bankers. No professor of finance has ever been right about anything (especially those who for years kept rejecting his submissions to finance journals). No one on the staff of the New York Times knows anything about finance or economics or statistics. Regressions are useless; models are worse. "People who use history as a guide do not understand history."
The last is the essence of his central thesis -- the common and fatal error of those working in and around economics is that they generally assume that what happened yesterday is highly likely to occur again today; they see and model the world in terms of "Gaussian" statistics; that is, the normal distribution. But his study (of forty years of data on things that have been priced) leads him to see that in finance and economics "most of the variance is concentrated in a very small number of events." (This is measured by "kurtosis," a term in statistics meaning the extent to which rare extreme deviations from the norm explain more of the variance than frequent smaller movements around the norm. Phew!)
So, convinced that "as risks mount fewer and fewer outsized events are required to bring the whole system down," he some years back predicted doom and started shorting the market, day after day after day, losing money day after day.....etc. Until last year. Bam. With the market gains (and the loot from two million copies of the book sold so far) he is now invited to World Bank seminars to point out with gusto their (our) ignorance and culpability, and everyone else's too. I got the distinct impression that he is happy with the money but much more enthralled by the vindication against all those who called him a kook, a cultist, or worse. He is having a grand time. And he was right about the crash.
When it comes to the question “So what should we do now?” he is not helpful. Questions included, "How should we go about reforming the regulatory system?" Answer: Don't try to reform it; scrap it. "But what should we do?” Answer: Abolish debt. All of the world's great religions agree; there should be no interest. "Did regulators make the crisis worse by their incompetence?" Not an area of interest to him; he is not concerned with minor tinkering with the system. Good-bye.
As I said, rewarding and fun, but of little value to those trying to work their way out of the present mess.
The afternoon seminar was toute autre chose: four earnest, smart, articulate, wonkish insiders admitting some errors and looking hard for practical solutions to an increasingly frightening debacle. But at the end of the session the practical answers were notable by their absence.
Carey, from the US Federal Reserve Bank, argued that bank regulators such as himself had certainly seen signs of problems but thought they were off-white or grayish swans, not black. Small reform would, they hoped and thought, suffice. He stated that this did not derive from a dependence on misguided models, but rather that avoidance of the dramatic is ingrained in financial regulators; that those in central banks must be absolutely sure they are looking at a bubble before trying to use monetary policy to burst it. Knowing in advance that a problem area is a real bubble is not all that simple. And they must also be sure that calling attention to a possible bubble does not create the very situation they are trying most to prevent -- a panic. He concluded that increased
regulation by itself will not solve the problem; what has taken place is "not a technical problem, but rather a governance problem." (The distinction was not made clear.)
Martha Cummings has excellent credentials; as head of Risk Analysis at Banco Santander she advised her board that much of the portfolio was incomprehensible and she recommended getting out of lots of loans whose underlying assets were based on impenetrable securities. Thus, Banco Santander is today not in such a poor position as many other banks. She was tougher than Carey; she says we should have seen it coming. Masses of people were and still are living far beyond their means, in debt up to their eyes and leveraged to the hilt. We did know it was coming; we just didn't know when. We kept thinking we would somehow get 24 hours notice and get out ahead of everyone else---and we were wrong. We knew banks were doing deals to get market share, regardless of
profitability; we depended on ratings agencies and models, not facts and basics. We consistently ignored the signals because "no one wanted to end the party." We ignored a basic fact: "The market can stay irrational far longer than you can remain solvent." Her advice is on the ruthless side: let housing prices fall to where the market wants them to be; let the lenders and the borrowers take the hit. Trying to prop it all up will fail and make things worse. Let it rip (at least she has a clear point of view).
Mark Zandi of Moody's first flagellated himself and then all other supposed supervisors of the system. "Both the architecture and the plumbing of the regulatory system were deeply flawed." No one in the oversight system had responsibility for saying "this is a bad loan." The lender wanted a fee and passed the mortgage to someone else. The investment bank securitized the loans, took a percentage, and forgot about it. Rating agencies are paid by the lender, not the investor, and they "keep the ball rolling." Bank regulators failed to recognize or call attention to the problem. And here we are.
All agree: "We forgot the basics. We took a crisis and made it a panic." And all agree that while more and more dense regulation is now inevitable, they doubt it will really change the essentials. The Basel regulations had little or nothing to do with the crisis, either in terms of abetting or hindering it. Carey said that his many years of experience fitted him to sense, within minutes, a bad bank, but he had long ago been promoted out of bank examination. And if they sent him back to it he would quit; Bank examination is a lousy job, now handled, worldwide, by very young and inexperienced people. The panel agreed that if corporate boards had members who fully understood risk models they might demand sufficient information, examine it carefully, and instruct
management on how to act. An unlikely prospect. They all are, to a varying extent, concerned that a new thicket of regulation will slow or halt a quick recovery, but Zandi (of Moody's) went on record as saying that the Federal Reserve has the capability and responsibility of forecasting bubbles and being much more aggressive on informing the public of their prognostications.
All this was much more depressing than Mr. Black Swan.
Black swan theory
From Wikipedia, the free encyclopedia
A
black swan, a member of the species,
Cygnus atratus, which remained undocumented until the eighteenth century
The
Black Swan Theory is used by
Nassim Nicholas Taleb to explain the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations. Unlike the philosophical "
black swan problem", the "Black Swan Theory"
(capitalized) refers only to unexpected events of large magnitude and consequence and their dominant role in history. Such events are considered extreme
outliers.
It is noteworthy that in his writings, Taleb never uses the term "Black Swan Theory"; instead, he refers to "Black Swan Events" (capitalized).
[edit] Background
Use of the term a
black swan (not capitalized) derives from the 17th-century European presumption that 'all
swans must be
white', because all historical records of swans reported that they had white feathers. In that context, a
black swan was something that was impossible, and could not exist. After
the discovery of black swans in
Western Australia [1] during the 18th century, the term metamorphosed to connote that a perceived impossibility may later be found to exist. Taleb notes that, writing in the 19th century,
John Stuart Mill used the
black swan logical fallacy as a new term to identify
falsification.
Writing in the
New York Times, Taleb asserted,
"What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives." [2][edit] Coping with Black Swan Events
The main idea in Taleb's book is not to attempt to predict Black Swan Events, but to build robustness into negative ones that occur and being able to exploit positive ones. Taleb contends that banks and trading firms are very vulnerable to hazardous Black Swan Events and are exposed to losses beyond that predicted by their defective models.
Taleb states that a Black Swan Event depends on the observer—using a simple example, what may be a Black Swan surprise for a turkey is not a Black Swan surprise for its butcher—hence the objective should be to "avoid being the turkey" by identifying areas of vulnerability in order to "turn the Black Swans white".
[edit] Identifying a Black Swan Event
Based on the author's criteria:
- The event is a surprise (to the observer).
- The event has a major impact.
- After the fact, the event is rationalized by hindsight, as if it had been expected.
Taleb's black swan is different from the earlier philosophical versions of the problem, as it concerns a phenomenon with specific empirical and statistical properties which he calls, "the fourth quadrant".
[3] Before Taleb, those who dealt with the notion of the improbable, such as
Hume,
Mill, and
Popper focused on the
problem of induction in
logic, specifically, that of drawing general conclusions from specific observations. Taleb's Black Swan Event has a central and unique attribute,
high impact. His claim is that
almost all consequential events in history come from the unexpected—yet humans later convince themselves that these events are explainable in
hindsight (bias).
One problem, labeled the
ludic fallacy by Taleb, is the belief that the unstructured randomness found in life resembles the structured randomness found in games. This stems from the assumption that the
unexpected may be predicted by extrapolating from variations in statistics based on past observations, especially when these statistics are presumed to represent samples from a
bell-shaped curve. These concerns often are highly relevant in financial markets, where major players use
value at risk models, which imply normal
distributions, although market returns typically have
fat tail distributions.
More generally,
decision theory, based on a fixed universe or a model of possible outcomes, ignores and minimizes the effect of events that are "outside model". For instance, a simple model of daily stock market returns may include extreme moves such as
Black Monday (1987), but might not model the breakdown of markets following the September 11 attacks of 2001. A fixed model considers the "known unknowns", but ignores the "
unknown unknowns".
Taleb notes that other distributions are not usable with precision, but often are more descriptive, such as the
fractal,
power law, or scalable distributions and that awareness of these might help to temper expectations.
[4]Beyond this, he emphasizes that many events simply are without precedent, undercutting the basis of this type of reasoning altogether.
[edit] Taleb's Ten Principles for a Black Swan Robust World
1) What is fragile should break early while it is still small. Nothing should ever become too big to fail. 2) No socialisation of losses and privatisation of gains. 3) People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. 4) Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. 5) Counter-balance complexity with simplicity. 6) Do not give children sticks of dynamite, even if they come with a warning. 7) Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. 8) Do not give an addict more drugs if he has withdrawal pains. 9) Citizens should not depend on financial assets or fallible “expert” advice for their retirement. 10. Make an omelette with the broken eggs.
[7][edit] See also
[edit] Books by Taleb
[edit] References
- ^ Black Swan Unique to Western Australia
- ^ http://www.nytimes.com/2007/04/22/books/chapters/0422-1st-tale.html
- ^ The Fourth Quadrant and The Limits of Statistics
- ^ Andrew Gelman, Columbia University, "Statistical Modeling, Causal Inference, and Social Science"
- ^ Nassim Nicholas Taleb, New York Times, "The Black Swan: The Impact of the Highly Improbable" (First Chapter)
- ^ ANALYSIS: Mispriced risk tests market faith in a prized formula by Anuj Gangahar (New York), Financial Times. 16 April 2008
- ^ www.fooledbyrandomness.com/tenprinciples.pdf
[edit] External links
