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Risky Business: Paul Wilmott on the financial sector and the economic crisis [Oct. 27th, 2009|04:03 pm]
Battle of Ideas
Dr Paul Wilmott is interviewed by Stuart Simpson. Paul is in conversation with Stuart this weekend at the Battle of Ideas festival 2009, where they will discuss ‘Risky Business: does financial engineering add up’ on Sunday 1 November at 9.45pm. The Battle of Ideas 2009 takes place on 31 October and 1 November 2009 at the Royal College of Art, Kensington Gore, London, SW7 2EU. For more details go to www.battleofideas.org.uk

Stuart Simpson: As the banks return to profitability large bonuses are returning. Does this mean that the financial sector has turned a corner? Should we celebrate this or are you worried that the lessons of the crisis have not been learned?

Paul Wilmott: No, we haven't turned a corner. And, yes, we should still be worried. The Duke of York said recently that the bonuses are minute in the scale of things, but that misses the point. It's not the size of the bonuses that matters it's the behaviour of the bankers that results from these bonuses. The problem is the way that incentives are still lined up with risk taking with other people's money. Take risks with your own money and maybe make a fortune, that's fine. But risk what is called "OPM" and make a fortune without the possibility of any downside for yourself? That's not right. Even the talk of paying people in company shares has me worried. I can imagine right now that bank lawyers and accountant and quants are devising cunning ways around this.

No one can deny the failures of the financial sector. But are you not worried that bankers are being made the scapegoats in a simple morality tale, where greed and excess lead to failure? If we focus on the behaviour of bankers do we not miss more serious systemic problems that are yet to be addressed?

First of all I've started to explain this as envy rather than greed. I'm trying to promote greed, in moderation, as healthy, a la Gordon Gecko, with obvious evolutionary benefits. And envy, although also of obvious evolutionary benefits, as being its evil, or rather plain nasty, twin. I spoke about this at a conference recently and someone told me this nice Russian tale: "A genie visits a farmer and tells him he will grant him any wish, but with the proviso that his neighbour will get double whatever he asks for. So the farmer wishes to have one eye plucked out." Unpleasant, but it sums up an aspect of human nature that we all recognise. The trick is to set up a banking system, and indeed a political system, that acknowledges the greedy/envious side of human nature and uses it for the good of society as a whole. And as for systemic problems generally, yes there are bucket loads of them waiting in the wings. The world has shrunk dramatically in just the last two or three decades, expect a lot of unpleasantness in the not-too-distant future. Maybe we should treat the banking crisis as a test case for future catastrophes.

If you are not worried about greed and excess per se, what is it exactly about the way in which bankers have behaved that concerns you? After all, a short definition of banking as a practice might be 'taking risks with other people's money.'

They do not make it clear what risks they are taking. They don't know their clients personally anymore, they suffer no downside when things go pear shaped, why should they even care? When lecturing about risk I sometimes ask my audience, usually bankers, whether they will take more risk with OPM than with their own, less risk, or the same. This usually gets a laugh. Some people proudly say they will be more responsible with OPM, some boast that they take more risk with OPM. I've only ever had the correct answer once, and that's "I would take as much risk as I said I would." That's assuming they even have the ability to measure risk, a big assumption and another story entirely.

Isn't that other story key? The popular perception of the City is of a vast casino, where traders gamble other people's money as you say. But a cornerstone of modern finance is the mathematics of risk management. Far from recklessly taking risks bankers have congratulated themselves on their ability to better manage risk. Has the crash of 2008 falsified the assumptions of quantitative finance? Are we not able to measure risk as well as we thought?

Who is 'we'? There are plenty of good risk-management tools out there. But again there's no incentive to use them. The more you know about risk the less you trade and the smaller your bonus.

An important incentive that may be lacking is bankruptcy. Do you agree with Mervyn King that banks should be broken up into safe retail banks and risky investment banks that may then be allowed to fail?

I am happy that Lehman was allowed to fail. But on the other hand saving AIG was the right thing to do. Bankruptcy is a nice incentive, but it hurts shareholders first. Do they know this can happen, and how quickly it can happen? The employees, the traders, the managers, etc. will be temporarily unemployed before moving on to the next lucrative casino. So first there needs to be more transparency, we must know exactly what our banks are getting up to, and, yes, I'd like to see some very safe retail banks that are really, really boring. And second I'd like to see the risk takers, the 'investment' banks, having less power and control over the world economy. As someone who trains more people in risk management and derivatives than almost anyone else on the planet, I'm saying there are too many derivatives around, they are not necessary in the current numbers and are dangerous. That type of bank should be allowed to fail, provided that investors know that this can happen and that such a failure will not bring down innocent parties.

From: cgwb
2009-10-27 07:28 pm (UTC)

Regulatory stupidity versus supervisory wisdom

The problem is that banks have money and money attracts people who will push matters as far as they are able. The government's/FSA’s approach was catastrophically stupid and assumed that ticking boxes is enough to avoid misbehaviour.
What is required is market supervision which assumes that everyone in the market is likely to go off the rails at any time, and to watch for the signs of this, acting rapidly, decisively and without recourse to lawyers, appeals or other fundamentally harmful procedures. The market supervisors should be paid well, but should be banned from moving across to the practitioner side of the market. It used to be the case that older, senior members of firms and banks, who knew all of the tricks, would, in effect become market supervisors and would become, in effect, agents of the real market supervisor, the Bank of England. The reward was some kind of gong and status in ‘the great and good’ of the City, and would normally come at the end of a cut-throat career when the participant was sufficiently well-off as not to need the large bonuses but could recognise every dirty trick in the book.
We now have the worst of all worlds. Stupid heads of regulatory bodies churning out pointless and repressive demands for useless data (does anyone really think the FSA is going to spot financial instability before the research teams of Barclays Capital, Morgan Stanley or Goldmans?), minimal market supervision (Peter Green, formerly of the Bank, put it brilliantly when he said that they were trying to fight the wars of 2008 with the weapons of 1995 – I’d have said 1989, but it matters little) and a regime in which regulation by box ticking has been substituted for intelligent oversight and the regular transfer of staff between regulator and bank.
Similarly, we can see that the OTC market is in fact massively more problematic than the exchange-traded side, one half of Lehmans was folded away neatly the day after the collapse, the other may take 10 years to sort out. The fact is, trades on the commodities markets may be intrinsically risky, but they are enormously less dangerous to the economy than OTC credit derivatives.
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