Yet more risky testimony

September 11, 2009 in Finance,Risk

Nassim Taleb and Chris Whalen also participated in Wednesday's House hearing on risk management. The full text of their remarks are available here (Taleb) and here (Whalen).

Taleb's thoughts are familiar, consisting largely of his well-known opinions on VaR and financial regulation. Whalen, however, provides an excellent quote:

The problem is not with models themselves. The trouble happens when they are (a) improperly constructed and then (b) deliberately misapplied by individuals working in the financial markets.

Yes, models are just the tool! Unfortunately, Whalen followed it up with this misstep:

We take a different view. We don’t actually believe there is such a thing a a “Black Swan.” Our observations tell us that a more likely explanation is that leaders in finance and politics simply made the mistake of, again, believing in what were in fact flawed models and blinded themselves to what should have been plainly calculable innovation risks destined to be unsustainable.

...

If financial markets and the models used to describe them are limited to those instruments that can be verified objectively, then we no longer need to fear from the ravages of Black Swans or systemic risk. The source of systemic risk in the financial markets is fear born from the complexity of opaque securities for which there is no underlying basis.

...

If we accept that the sudden change in market conditions or the “Black Swan” event that Taleb and other theorists have so elegantly described arises from a breakdown in prudential regulation and basic common sense, and not from some unknowable market mechanism, then we no longer need to fear surprises or systemic risk. We need to simply ensure that all of the financial instruments in our marketplace have an objective basis, including a visible, cash basis market that is visible to all market participants. If investors cannot price a security without reference to subjective models, then the security should be banned from the US markets as a matter of law and regulation.

What a frightening belief! This notion of "objectivity" simply doesn't exist. In a strict sense, it would mean that all market participants agree on a security's value. This comes in two varieties: first, the value of the security is known at all future points. This is a failure because no one would ever speculate on such a product.

Second, a standardized model could be used, in which everyone agrees on the level of uncertainty in the market and that it is the right description of reality. Obviously this is impossible because agreeing that a model is right does not make it so - the emperor is still naked. Moreover, to suggest that all we need to do to avoid crash risk is come up with a "correct" model is naive, as we don't have a universally accepted "correct" model for anything!

Claiming that Black Swans only exist because the prior model didn't encompass them is all very nice; it is however tautological and unhelpful. In fact, I find it especially interesting that this is part of Whalen's testimony, because Bookstaber's testimony at the same hearing includes a near-perfect rebuttal in its appendix, in which he declares that blaming "fat tails" is a straw man argument:

We are not, after all, talking about physics, about timeless and universal laws of the universe when we deal with securities. Weird stuff happens. And the place where the imperfection is most telling is in risk management.

When the risk manager misses the equivalent of a force five hurricane, we ask what is wrong with his methods. By definition, what he missed was a ten or twenty standard deviation event, so we tell him he ignored fat tails. There you have it, you failed because you did not incorporate fat tails. This is tautological. If I miss a large risk – which will occur on occasion even if I am fully competent; that is why they are called risks – I will have failed to account for a fat tailed event. I can tell you that ahead of time. I can tell you now – as can everyone in risk management – that I will miss something. If after the fact you want to castigate me for not incorporating sufficiently fat tailed events, let the flogging begin.

Leave a Comment

Previous post:

Next post: