Wednesday, 11 February 2009

Getting serious about banking

We do not think banking is a serious occupation. If we take a job seriously, like the law, medicine, accountancy, engineering, teaching or plumbing, we expect the workers to have passed exams and to keep up with developments in the profession throughout their careers. The Financial Services Authority, rightly, does not allow anyone to sell an endowment mortgage to a private individual unless they have passed a series of exams. If someone fails their FSA exams, not to worry, they could get a job in an investment bank and sell Mortgage Backed Securities to other investment banks. It is up to the banks to make the judgement as to whether or not their employees are competent. The consequence of the chairmen and chief executives of RBS and HBOS not being qualified, is that they were not competent to judge if their employees were capable.

Hector Sants, the Chief Executive of the FSA, said in October that he had over thirty years experience in banking. That is nice to know, but if I owned a jet aeroplane in 1950 I might prefer a mechanic who has three years experience of jet engines to one with thirty years in aviation. This is the root of the problem; finance is developing too fast for people with thirty years experience. As a financial mathematician, researching and teaching how you make good, scientific, decisions in the uncertain world of finance, I am not overawed by the complexity of the financial products the banks are trading. I am stunned by the simplicity of the mathematics that many bankers were using to manage these products. Nuclear power plants are complex, and so we expect the engineers who operate them to use cutting edge technology. The human body is complex, we expect doctors to use up to date research in treating us. In investment banking, Collateralised Debt Obligations are complex but the reaction of the "quants" designing them was to dumb down the maths so that the managers, who did not have the professional qualifications of an engineer or a doctor, could keep up.

What happened in the lead up to the credit crisis is not difficult to explain. When I was in my late teens, l embarked on a short-lived experiment in producing ginger beer. Having brewed the beer in a large bucket, I bottled it in twenty-four bottles and stored them in my wardrobe. If I had presented a newly sealed bottle to an independent expert and asked them to asses the probability of the bottle exploding, they may have given the chance as one in twenty four, and so I could expect one of my twenty four bottles to explode. If I was concerned with losing many bottles, I could do some basic maths and conclude that there was a 99.99% chance that I would not lose more than five bottles.

A few weeks later one bottle exploded, followed by the remaining 23 over the course of a few days. When I had done my sums, I had treated each bottle as being independent of the others. Of course, since each bottle contained the same product, if one exploded, they probably all would. This was an object lesson in what are called dependent risks, essentially there was a one in twenty four chance of losing everything rather than a near certainty of only losing a little.

Investment banks had bought beer, sub-prime mortgages, and sold crates of bottles to investors on a sort of "money back guarantee" deal. Like some of Sir Alan's naive apprentices, they focused on turnover, since salesmen are paid on commission, rather than worrying about profitability.

Bankers, not just in the UK but all around the world, blame "nature" for mis-behaving when all the bottles exploded. This is a smokescreen to protect their reputation. Since 2000, there have been a series of concerns raised by mathematicians as to whether the equations bankers were using to manage the risk of their investments were adequate. In particular, that the key equation they use would underestimate the number of bottles that would blow up, and another, that valued their finished products would over re-act to a bottle being lost and the value of all the beer, not just the ginger beer, they were selling would collapse. The problem is, not only did bank management not understand this, but also, it is exactly what happened.

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