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Whodunit? Part III: The Murder

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The two previous installments explained how quantitative tools developed to manage risk were turned into a weapon. Part III tells how that weapon was used to kill the financial system, and what we can expect next.

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Editor's note: This is part three of a three-part series. Click here to read part one and click here to read part two.

MINYANVILLE ORIGINAL The first two installments described the creation of quantitative tools to optimize individual risk taking, and the adoption of those tools by financial regulators to set bank capital standards. To the rocket scientists who invented the methods, "capital" was an intangible used to manage risk of an individual risk taker. To economists and regulators, "capital" was an excess of assets over liabilities that ensured liabilities could be paid even if assets declined in value. It was defined at the level of the entire regulated institution, not individual risk takers.

To make this more concrete, think of the question: How much capital does it take to support a new business idea? Clearly there are a variety of answers. With minimal capital, an innovator might build a prototype by hand in his or her garage on weekends, then use it to get a single customer to order ten units, for which production could be outsourced. Initial growth of the business would be slow, but over time profits from each stage could fund the next stage. Alternatively, a big company or venture fund might pour a large amount of money into the same idea, helping it to grow more quickly. It might build a factory and begin aggressive marketing, spending tens of millions of dollars before the first dollar of revenue is generated.

Now suppose a quant comes in and models the process to determine an optimal schedule to supply capital to this business. Too little capital guarantees failure because at each stage the business must succeed in order to generate capital for the next stage. An unbroken run of successes is virtually impossible, even if you start with a great idea. The business needs to be able to survive setbacks, and possibly to run at a loss for a period, both of which require capital. However some businesses with inadequate capital will have substantial runs of success. These will be flashes in the pan, overnight sensations followed by spectacular busts.

Too much capital can insulate a business from the selection pressure needed to evolve and, in any event, will be wasted. So in principle-and I believe in practice-it is possible for a quant to come up with an optimal schedule for supplying capital to a business venture.

The government has a different perspective on the problem. It doesn't like companies failing and leaving unpaid liabilities. It might decide business ideas must be funded by a minimum amount of capital so that suppliers and employees (not to mention taxes) are paid in full if the idea doesn't work. We could imagine regulators seizing on the calculations done by quants, and insisting businesses have equity capital at least equal to the optimal level.

Before going any farther, note that the government concern is legitimate, although largely self-created. In a free market, potential suppliers and employees will consider the business' prospects and either go elsewhere or demand terms that compensate them for the risks. If a business fails, the losses are allocated among people who took on the risks willingly.

Of course, we don't have a completely free market. The government likes to help voters. So it pays unemployment benefits and takes on liabilities for some pensions. It makes loan guarantees for politically favored businesses. Money for these programs comes from taxes levied on successful businesses.

Regardless of whether you think we have too much or too little of these sorts of things, the fact is that we do have them and they induce moral hazard on the part of the business. If the government is willing to stick successful businesses with some of your losses, you can take risks in which you get the profits while losses are paid by others. This creates the need for the government to limit the amount of risk you take. One simple way to do that is to demand minimum capital levels, and liquidate businesses that fall below the minimum when there are still enough assets to pay all creditors in full.

Notice that the quant and the government are concerned with entirely different kinds of capital. The quant considers what level of capital will drive optimal real business decisions. The regulator wants a pool of unencumbered assets to make sure the venture can cover any losses it incurs. There's no reason to expect these amounts to be the same, or even similar. The regulatory amount must be real money, but it doesn't matter whether the people running the business know it exists (in fact, it's safer for creditors if they don't). The essential thing for quant capital is that the people running the business think it exists, it doesn't matter whether it's real or not.

The biggest difference between quant capital and regulatory capital is that the latter has a diversification benefit. From a quant perspective, you want each individual business to make the right risk decisions. If no individual business has a disaster, the institution will be fine. Businesses will be run the same way whether they are independent or part of large organizations. This situation generally favors smaller companies because you save the layers of management above the day-to-day decisions.

A regulator thinks large companies with many risk-taking businesses need less capital than the same businesses considered as stand-alone entities because the individual business lines are not likely to all fail at the same time. So companies will grow in size in order to use capital more efficiently. But the individual business units will each be undercapitalized, thus they will expand too aggressively after successes and cut back too deeply after failures, and suffer too much volatility drag. Most businesses will fail, even if the underlying ideas are good. A few will get very large before failing. When a very large business unit fails, taking with it the reputations of its managers who have been propelled to high positions in the overall company, there can be the disaster regulators wanted to prevent. The capital set aside to cover losses will be inadequate because most of it will be in the form of business value of the large risk-taking business unit that failed.

The regulators' conception of the problem led them to focus on the overall equity capital of the institution rather than the dynamic behavior of the institution's risk takers. But the overall institution may seem okay while each individual risk taker is pursuing a strategy certain to blow up. Institution-wide constraints do not change individual behavior. While there were attempts to push capital charges to lower organization levels, these were much too crude to induce proper risk-taking behavior.

The result was regulators took tools that had been developed to enforce discipline in individual businesses, and used them to determine how much institution-level capital was needed to pay for the inevitable losses when individual businesses blow up. This institution-level capital was inadequate because, according to the regulatory view, you got a diversification benefit from combining businesses. If you had 25 independent traders, for example, you needed only five times the capital as if you had one trader. This makes sense if you're thinking of standard deviation and the probability of large overall losses. But it's incorrect if you're thinking of variance (standard deviation squared), which is what determines whether blow up is impossible for any unit or inevitable for all units.

The purported benefits of diversification meant that risk takers in a large financial institution could take far more risk per dollar of equity than independent traders. Regulation actually encouraged them to follow strategies that had to lead to ruin. Not all of them did, of course, but regulation made it easier than it otherwise would have been. A consequence of this behavior is that some risk takers have phenomenal runs of success, gaining institutional power in the process, and inflating the institution's reported capital with assets that are real enough at the time, but guaranteed to disappear suddenly. To make matters worse, institutions pursued similar strategies, so they blew up at the same time.

In finance, this was a pervasive misunderstanding. Regulations led to creation of huge risk management bureaucracies in banks, staffed mostly by people with no experience in taking risks. These organizations encouraged undercapitalized risk taking-overreaction to short-term gains and losses. They insisted on an equity cushion for losses that was going to disappear any time it was needed. If there is a quant culprit to the financial crisis, this is the quantitative misunderstanding that killed us.

What about the future? I don't see any fundamental reappraisal of regulatory theory going on either among academics or practicing regulators. On the other hand, many of the specific changes will work in the right direction. Financial institutions will be required to hold more capital (in the regulator's sense of the word), and the largest ones will have to hold extra. One major risk-taking business, proprietary trading, will be severed from US financial institutions. There have been technical adjustments to tools that result in smaller capital reductions for diversification. Depending on the implementation details, these changes may result in better capital allocation (in the quant sense) to individual risk takers. Nothing else will help; you cannot manage risk from the top down. If your line risk takers are running strategies certain to blow up, your institution cannot be saved by top management or regulators.

If the regulatory changes work, or if market forces prevail despite regulations, I predict we will see smaller, simpler financial businesses replace the gigantic global institutions created in the late 1990s, which have never enjoyed two successive years without a major crisis. These institutions will have to manage risk in the quant sense, or they will blow up and disappear from the gene pool. The benefits to the economy of efficient, effective, innovative, honest, and risk-controlled financial institutions are immeasurable.

On the other hand, it seems equally likely to me that the regulatory changes will merely prop up undercapitalized and overcomplex financial institutions until the next crash. In that case, the misunderstanding that nearly killed the financial system in 2008 may complete the job.
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