Skin in the game – why banks are blowing up

King of the Quants, Paul Wilmott, has a great blog post on his very popular site about the current financial crisis. If you’re wondering how popular a site about quantitative finance can be then consider there’s about a 65,000 subscribers engaging in debate (some heated, some light-hearted & some perhaps ridiculous) on his forum.

Wilmott is the author of the authoritative textbooks on the subjects relating to financial modelling of derivatives. So you’d be thinking “it’s all his fault” and you’d be wrong. In his writings and courses you’d be hard pressed to find a “rocket scientist” more skeptical of the limitations of risk management using financial models. Unless you happened to be Naseem Taleb but that’s another story.

He’s written a blunt wake up call, stating why he believes some derivatives are just too dangerous to be traded (esp. CDO’s) in large quantities due to inadequate models for their behaviour and the misappropriate incentives for risk management inherent in the salaries of quants, traders and salesmen.

As Wilmott says

“Risk managers have no incentive to limit risk. If the traders don’t take risks and make money, the risk managers won’t make money.”

If ever there was a misnomer it’s risk management in investment banks. A major problem is that management conveys the meaning that the “managed” can be confidently and competently controlled, steered on a path. For example, we don’t call lion taming – “Lion Attitudinal Management” but we would if the lions tamed were on Wall St. It’s this mislabeling that makes systems with a propensity towards cascade failure every few years seem safe and predictable.

I think one solution is to ensure that the well remunerated traders and salesmen must keep skin in the game. Personal ownership of the rewards & punishments for the long term performance of their portfolio. So long as they are rewarded today in cold hard cash for trades where the value can’t accurately be determined until a future date then there’s no incentive on the individuals for risk mitigation. Having a greater margin of safety in their transactions, reduces profits and ultimately their bonuses under the current system. It’s economics101 that they’ll respond to this incentive. Banks/funds/etc. will say that they put in place organisation-wide risk management strategies and calculate Value at Risk to say but ethical quants like Wilmott and Emanuel Derman point out the flaws and contradictions both the process and mathematics of this apparent circumspection. Of course the bank doesn’t want to blow up. But a bank is made up of individuals and if those sloshing the most amount of cash around, betting the company’s future, can systematically risk more than is prudent then what’s the point of the oversight? You don’t need rogue traders to screw up a system that’s gone rogue in the 1st place.

The answer to the problem lies in the very Black-Scholes formula that enables banks to issue and hedge these bonds in the first place. The recipe for taking a bit of security A, a smattering of security B and some cash and chucking out the “risk managing” security the customer wants. Pay a sizeable part of bonuses parties in bonds derived as an index of their trades that year and you’ll see a lot more consideration of the risk Wall St has cheerfully exposed Main St. to.  A trader, like a lion, is an animal with a very acute sense of incentives and an eagerness to respond to them at all times 🙂

It might not be a popular initiative in finance houses who use the tagline “creating greater liquidity” to describe so much speculation. The powerful intuitive force of John Maynard Keynes, as in so many assessments, was bang on the money when he said

“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” — JM Keynes, General Theory of Employment, Interest and Money