If a poorly dressed guy grabs your wallet at a knife point in a dark alley we call it robbery. If a group of scary looking people wearing ski masks threatens lives of hundreds of innocent hostages and demands million dollars ransom we call it terrorism. If the team of smiling gentlemen wearing Armani suits threatens lives of millions of people and demands trillion dollar bailout package we call it banking.
How did it come to that?
Since I came to this country in late 80ties as a Physics Professor I have changed several fields: teaching in Princeton, starting an Internet startup, working for public company which acquired this Internet startup and for the last decade working in my own small company specializing in proprietary stock trading based on mathematical algorithms.
We do not take investments in my little company, nor do we take management fees on the money of the owners we manage. We just share profits (or – should we get unlucky, losses) and tell outside investors to go away.
In my view, the management fee is the main reason we came to the financial crisis and are now taken hostage by smiling bankers. This fee is proportional to the amount of money under management, whereas the management work does not grow in that proportion (except those rare occasions when managers are moving banknotes from vault to vault). This fee comes as a windfall on the heads of money managers who logically see their main responsibility in luring money into the bank. But the idiocy of financial traditions goes even further, into wrong rewards for profit.
The first thing you learn in financial industry is that probabilities are money. If someone tells you every day that chances for the market to go up are 55% today, 45% tomorrow and so on, you can make money. This was realized half a century ago by fathers of information theory: Shannon and Kelly. Since then most of financial theory and practice was about inventing smooth and good looking mechanisms to convert probability into money.
The oldest trick in the book is hedging. If you protect yourself against losses you can do crazy things and get away with that. At every level in financial institution, personal risk of traders and managers is hedged by incredibly stupid system of yearly bonuses. Even if your decisions lead to eventual disaster wiping out five years of your profits for the company you are not required to give back your yearly bonuses you were paid for five years of “successes”. This system rewards risk “management” preventing most frequent instead of most dangerous events.
At the level of the whole country, banks are taking unjustified risks for the same reason: once disaster happens every decade or so, they will be bailed out, as the country cannot afford them going down with all savings of the population. Again, they are rewarded for short term success and left unpunished for long term negligence.
Apart from pure dishonesty and greed there is a pseudo scientific reason for this reckless behavior. There is a branch of Science called Financial Mathematics, based on bell curve, used to justify the risk miscalculation. My whole career as a Physicist was dedicated to so-called Critical Phenomena, where bell curve does not work. Critical Phenomena (or fractal probability distributions) exist everywhere in Nature, as it was observed by great Benoit Mandelbrot: shorelines, turbulence, avalanches, ferromagnetism, liquid helium and – most famously – the stock market. Most recently, the fractal behavior of stock market was explained to general public in a fascinating book “Black Swan” by Nassim Taleb.
The most important feature of the bell curve that expected delta value above large threshold will go to zero inversely proportional to this threshold. So, if you believe in bell curve (or random walk), once something big happen, you believe that it will never happen again. With fractals it is just the other way around: expected delta above any threshold is directly proportional to this threshold.
Common sense says that such crazy law: “the more happened the more is yet to come” cannot hold indefinitely: there are, of course, mechanisms which can eventually stop any large move of the market. But these mechanisms must be sought for outside the naïve probability theory. Mathematically, these are so called conditional probabilities, with conditions sometimes obvious, such as Lehman Brothers going out of business – but sometimes – alas – totally unknown.
Like Albert Einstein cannot be responsible for Hiroshima or Chernobyl, the founders of Probability Theory cannot be responsible for its recent abuse. But still, in my opinion, some of our great economists owe an apology to American people for blessing medieval probability theory as a latest word of mathematical science. This happened in the 80ties and 90ties, when Critical Phenomena Theory was already finished, moreover it was awarded Nobel Prize in Physics in 1974, way before the bell curve was pushed to the throat of Financial Mathematics.
Coming back to the analogy with terrorism: it makes sense to negotiate with terrorists when there is no way to arrest them without harming hostages. In our case, however, there are many ways to make bankers responsible and make financial terrorism less attractive business.
Nationalization of banks may be too radical, given the proven inefficiency of US government to manage large agencies. Also, the hedge funds and other investment institutions generate cash needed to sustain free entrepreneurial spirit which we all value in America. Professional investors are supposed to know what they are doing and estimate their risk themselves.
However, banks have to be rewarded for long term profit, not the risky speculations. Their management fees must be capped by government, eliminating direct proportionality to capital under management; moreover there must be some global insurance in place, taking big portion of every bonus of banks managers as a premium. Their past losses must increase this premium, just like the traffic violations increase your car insurance premiums.
This insurance can be used for those clients who lose their jobs and savings as a result of failure of their bank. Clearly, those responsible for that failure will not get the insurance, not to mention the bonuses. There are many more things which the government can impose, like bonus clawbacks.
Above all, the risk management should be done with all the power of modern Theory of Critical Phenomena. There are plenty of real experts, just look into successful Hedge Funds with decades of track records. They know how to analyze the long fat tails and how to use common sense to help probability theory when it should not be applied. Why not form a Committee of Risk Managers working for US Government and helping to avoid risks at the scale of AIG and Lehman Brothers.
Now is the time, before these financial terrorists regain their confidence.