Have we arrived at a financial singularity?

| June 12, 2012 | 23 Comments

A couple of things have happened recently that beg the question: do we truly understand the risks that our largest banks are taking? (And this matters because, 4 years on from the financial crisis, taxpayers on both sides of the Atlantic are still being asked to stand behind the banks. See recent events in Spain.)

Professor Henry Hu, from the University of Texas School of Law, believes that we don’t understand these risks. And that’s because the banks, themselves, don’t either. In fact, they couldn’t even if they wanted to. Gillian Tett of the Financial Times brings Hu and his research to our attention:

Eighty years ago, companies might have been able to offer equity investors real transparency on their results; today even JPMorgan struggles to understand what on earth is going on inside its derivatives book.

Thus, even if JPMorgan wanted to “come clean” about its controversial positions in CDX IG 9 say, [CDX IG 9 is the financial index on which JPMorgan placed a huge bet and has so far lost $2 billion], this is becoming increasingly tough. As Prof Hu says, the 21st century financial system is simply becoming “too complex to depict”.

Sounds a bit like a science fiction novel; are the financial algorithms, models and computers taking over from their human creators? Have we reached a financial singularity? Is this what a world created by the demonic love child of Gordon Gekko and Bill Gates would look like? This would be an amusing thought if it had not leapt from our collective Kindle screens and into our real world economy. But as Eric B. and Rakim might say, this ain’t no joke.

Have we reached the point where our financial markets are so complex that we no longer understand how they really work? And if so, how can we manage what we don’t understand? And I say “we” because the world’s largest, most complex finance houses now have the explicit political support of the G20, and thus the de facto political support of 2/3 of all the world’s citizens.

Unfortunately some of finance’s leading lights don’t quite see it like this. Witness some of the comments made to Bloomberg in defense of JPMorgan Chase and its boss Jamie Dimon in regards to Fail Whale.

“Occasional losses are inevitable,” said Blackstone Group LP’s Stephen A. Schwarzman, 65, CEO of the largest private- equity firm.

Or they do get it but don’t understand what the rest of us are so worried about.

“I kind of shrug,” said Bill Archer, 58, a former co- chairman of Goldman Sachs Group Inc. (GS)’s capital markets committee and now a partner at buyout firm Veronis Suhler Stevenson LLC in New York. “That’s just the way the world is.”

Yeah, Bill, but it didn’t used to be. And that’s kinda the point. Remember the wise words of Satyajit Das that I’ve quoted before:

People like me read the Brady report [from President Reagan's taskforce on the 1987 Black Monday crash] with great care, trying to work out what they knew. And we got very, very skeptical. But at the same time what we found is the academics went the other way. They basically said, “Oh no, it was just a faulty model and we can develop more elaborate models. And the problem, that I kept saying to these people, is: the more elaborate the model, the more the assumptions, the more the problems, the more the breakdowns and the more fragile it is.

So as early as 1987 there was already some indication that developments in finance meant it might start running ahead of our ability to understand it. Oh, and that was before financial models had to be scaled up in breadth, complexity and usage to account for this:

So what can we do? There seem to only be two sensible answers.
1. Call the whole thing off. Gillian Tett again:

[...I]f some banks today are “too complex to depict”, then perhaps it is time to recognise that they are also “too complex to exist,” as Prof Hu says.

or

2. Have the hive mind step in to guide the computers in doing what mere mortals can’t. I’ll quote (for the second time, now, because it is so awesome) wisdom earlier received from Paul Saffo in Foreign Policy

Imagine [...] an institution with the analytic resources of Wall Street players, the reach of Google, and the openness of Wikipedia. Such an observatory would leverage the capacities of cyberspace to become a global (and cost-effective) clearinghouse for economic information. Its scope would extend far beyond the data collected by established entities today, for example probing deep into the world’s illicit economies and exploring the market implications of rapidly spreading social media. And unlike those institutions, it would serve a purely informational role with no policy responsibilities.

Above all, this economic observatory would be open and independent, inviting the participation of crowds and encouraging the broadest possible research access to its data in the service of rethinking our global economic architecture. Funding is less of a hurdle than one might think. Such an observatory could be operated on a fraction of the 342 million-euro annual budget of the Organization for Economic Cooperation and Development. Moreover, its smaller budget would provide the flexibility required to preserve both the appearance and actuality of independence. It might even be possible to crowdsource the bulk of its budget over the Internet.

I know, I know. Crazily ambitious. But  – since it looks like politicians have taken option #1 off the table — do you have any other suggestions?

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Category: Banking

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  • Chris Cook

    Rather than simplifying the institution, maybe we could simplify the instrument.

    Perhaps we could re-visit – and re-invent in modern form – financial instruments which pre-dated the banking system.

    https://blogs.ucl.ac.uk/resilience/2012/01/09/a-stock-answer/

    We might begin by looking at new variants on the financial instrument known as ‘stock’ – which is actually distinct from shares in joint stock companies traded today – and realise that the origin of the phrase ‘rate of return’ had nothing to do with a fixed rate of interest and everything to do with the potentially variable rate at which stock could be returned to the issuer.

    So maybe it’s ‘Back to the Future’ in what the excellent Ms Tett once described as a ‘Flight to Simplicity’ by a new approach to financing and funding through direct ‘Peer to Asset’ investment in streams of value created by productive assets.

    • http://www.financeaddict.com Finance Addict

      Thanks for this, and for hipping me to the Resiliblog. “Qualitative easing”, eh? Also the larger point about debt/equity swaps on a national scale brings to mind recent comments that Willem Buiter, Citi’s chief economist, is reported to have recently made. The following is a quote of someone else’s hearsay:

      “Overall outlook: advanced economies need mass debt to equity conversion. Household negative equity becomes bank equity. Sovereign debt converts to GDP warrants”

      How we get to this point is the question. Hang on tight. Or not. Maybe hanging on too tightly has been the problem.

  • Richard

    It can’t be done.

    I refer you to the “three body problem” in physics. It’s very difficult to compute, and its universe is only stuff that moves around in individually predictable ways, unlike entities in the market. The market is like an n-body problem, except the attributes and existence of each body changes minute by minute, often directed by the whims and fancies of politicians and voters.

    Try to have the setup govern kinderschool behaviour first, then ramp up to the market.

    • http://www.financeaddict.com Finance Addict

      I hear you and I also get how Soros’ ideas on reflexivity make things even more complicated. But surely there’s something to be done with the vast amounts of data already being spit out by the trading, credit and who-knows-what-other systems already at work in finance. Right now their output is kept in walled gardens, we need to slice it open, rip it out and hold it up to the light. Such a hivemind system would always run behind, but maybe only a few months behind as opposed to a year or several years behind, which is where we seem to be today.

  • Onit2007
    • http://www.financeaddict.com Finance Addict

      thanks for this. of all officialdom, Haldane seems to grok it most.

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  • Da55id

    This article directly addresses financial singularity:

    http://seekingalpha.com/article/107486-simuflation-the-powder-in-the-market-s-keg

    • http://www.financeaddict.com Finance Addict

      whoa — this one is pretty sweeping in scope. very fascinating. this point stood out to me: “no amount of physical/fiat money (utility) can replace trust.” Trust has been ebbing out of the financial markets for the past few years now and Edelman ( http://financeaddict.com/2012/01/trust-in-business-and-politics-reaches-critical-point/) has
      documented what we all sense: people no longer trust the institutions of the past. Every new development in Europe and every instance of gridlock in the U.S. (to name but two examples) vindicates this. An environment of widespread societal distrust as the background to a too-complex-to-understand financial system now worth many times more than its underlying real economies? Sounds like a recipe for fun.

  • http://thechinonomist.blogspot.com/ The Chinonomist

    I characterize this under Didier Sornette’s definition of a Dragon King event.
    http://thechinonomist.blogspot.com/2012/04/as-delicate-as-butterfly.html

    • http://www.financeaddict.com Finance Addict

      thanks for this! intrigued by the point you made about assets denominated in USD held by foreign banks. what do you think is the implication of this? for example, what might happen if the foreign banks need to offload these in a fire sale scenario? or are you thinking about something else?

      • http://thechinonomist.blogspot.com/ The Chinonomist

        You got it. The implication is that their astronomical size (as big as all US banks USD assets combined) coupled with the need to sell in a fire sale scenario, and the interconnectedness in the world economy through international trade create the conditions for a “Dragon King” event (in the terms defined by Sornette). I really don’t want to be an alarmist, but things do not look pretty… at all.

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  • Eeddccbb

    The problem is that nobody has ever understood how financial markets work. The difference now is that the institutions no longer need to, because there’s explicit backing in the form of taxpayer funded bailout – in effect the legalization of theft-by-gambler.

  • Stephen Hearn

    What would the motivation for a public company to give complete transparency on it’s financial structure when reporting is already a hassle.
    The assumption that the financial markets are too complex to understand is ridiculous. No one can understand all of the complex derivative and credit rating systems by themselves, but that’s why fields have respective experts who more often than not, can outclass any CEO in their respective field of expertise. We see a collapse in this understanding when people overstretch their hands.
    What was the quote, “Man’s reach exceeds his grasp”? That happens occasionally, but overtime I think these financial instruments have proved that they are bound by the same rules that they were originally created with.

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  • Daw6201

    Just change the laws so that investment banks can no longer be public corporations, make them go back to partnerships. If you personally lose everything when one of the exotic investments you do not understand blows up, you will only make investments you understand.

  • Jay

    This isn’t exactly uncharted territory.

    It was a general principle of the Soviet Union that everyone was guilty of something. This functioned, in practice, to concentrate power into the hands of the people who decide which crimes to investigate and punish (notably the KGB).

    In a similar manner, if two parties have each signed a bundle of derivatives contracts, and those derivatives contracts cannot realistically be understood by any judge, then power is in the hands of whoever can afford the best lawyers.

    Think of the foreclosure crisis. Banks have widely screwed up their securitization paperwork in ways that are unremediable under New York trust law, but people lose their homes to forclosure anyway. Only a few judges have smacked down banks for their screwups, and these screwups are relatively simple and unarguable.

    Long story short, when the law gets too complex to apply fairly, it gets applied unfairly. Equality before the law takes a dirt nap, and the law favors whoever can afford the best legal technicians.

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