Thursday, 5 February 2009

Was the credit crunch a science story?

A recent report from the LSE has raised some important questions concerning financial journalism. Specifically, in relation to the credit crisis it reports that Robert Peston, the BBC’s Business Editor, had found it difficult to explain some of the complex derivatives being constructed by banks since “even the bankers creating the CDOs were unable to explain them in terms that make sense to non-specialists”. The role of these complex derivatives is central to understanding the credit crisis, and key to understanding the derivatives is mathematics. This raises the question, could science journalists have contributed to reporting the credit crisis.

The storm clouds of the credit crisis broke following BNP Paribas’s announcement that it was unable to value assets on 9 August 2007. The following day, Goldman Sachs reported that one of its funds had lost 30% of its value in the week, equiring a, now paltry, $3 bn bailout. In explanation the Chief Financial Officer of Goldman Sachs said
“We were seeing things that were 25-standard deviation moves, several days in a row. There have been issues in some of the other quantitative spaces. But nothing like what we saw last week.”
Financial Times, August 13 2007, Goldman pays the price of being big
Essentially, his point was that the economic environment had been so perverse that the losses, incurred by the most respected investment bank in the world, were inevitable. The Financial Times2, along with much of the established financial press, took this as a reasoned explanation but, almost immediately, commentators in the blogosphere revealed it to be what it was, rubbish. Goldman’s models were wrong, not nature.

It is unlikely that a science journalist would have accepted the pseudo-scientific explanation Goldman’s offered. Would they have done a better job understanding the crisis as a whole?

Since the 1960s investment banks have been using increasingly complex mathematics, literally rocket science, to price and manage the risks of the assets they trade. The current credit crisis is unique in that for the first time, quants, physicists and engineers, using mathematical formulae rather than economists using their knowledge of markets, have been managing the assets at the heart of the crisis. Since experienced managers in banks have been at a loss to grasp the mathematics, it is hard to see how a financial journalist should be expected to do so. However, a journalist who is accustomed to investigating safety critical systems in technology is well capable of coming to terms with risk management systems in an investment bank. While a journalist who is able to explain the latest research coming from a physicist in a research lab, would be able to describe the pricing algorithm developed by a physicist in a bank.

If the types of journalists investigating science turn their attention to banks, would the risk of future crises be reduced? There is a strong argument that it would. A key role that science-reporting plays is in ensuring that technology is not misused and that it is properly regulated. Medicine is better off for the reporting of Thalidomide and the environment benefits by journalists scrutinising the energy industry.

In the 1990s, central bankers became concerned that the rules for defining how much capital a bank held in reserve were quickly becoming redundant, given the explosive growth of sophisticated derivative products. In 1996, the Bank for International Settlements, the gnomes of Basel who regulate the banks in relation to the credit crisis, began a process of re-writing banking regulation, called Basel II. Realising that they would never be able to keep up with the activities of the banks, the regulators specified a framework for regulation rather than a set of hard and fast rules. The framework, which is only now beginning to be implemented, is based on three pillars; the minimum standards for calculating how much money a bank needs to keep in reserve; the supervisory review process in the bank overseeing those calculations and market discipline ensuring the reviews and calculations are adequate.

In 2000, a mathematician working at the US Federal Reserve, checked the formulae used in Basel II to calculate capital reserves, but raised concerns
--> about whether it would be adequate if finacial products became too sophisticated (in the Discussion). The Basel committee had selected a formula that did not model the connections in the economy in a sophisticated manner and so it was inadequate if loans were inter-connected. The root cause of the credit-crisis has been that loans were connected, by the housing market, banks ran out of capital, precipitating the liquidity crisis that led to the collapse of the retail banks and the credit crunch.
The Basel II accord still uses the simplified formula, because the accord is clear; under the supervisory review process, a bank needs to match the calculation of capital reserves to the omplexity of their operations. The accord expects that banks will adequately execute the supervisory review process because of market scrutiny. Consequently, informed journalism plays a fundamental role in the new framework for banking regulation. Science journalists should take up this role given their knowledge and skills.

The Public Relations machines of banks are happy that discussion around regulation focuses on issues such as bonuses and banning complex derivatives, because the banks know that governments will not set such regulations. Turning the public’s attention to the science underpinning the bank’s business will not only put the focus on where the problem is, but is already part of the regulatory framework. In addition, putting banking managers under pressure to explain the details of the technology they are using will force better communication, debate nd understanding within the banks bridging the gap in banks between the quants and conventional financiers.

Finally, if the failure, because of poor use of science, of a section of the energy or pharmaceutical businesses had lead to a trillion-dollar rescue package, it is inconceivable that the managers of he industry would still be in place. Why have so few bankers been fired by their shareholders? Is it because the bankers have successfully blinded the shareholders with pseudo-science?

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