Risk Management Guru Warns About Brave New World of Finance

It’s one thing when people who have little to no experience in the financial markets worry about the risks posed by derivatives and other innovative financial products. It’s quite another when a concerned individual also happens to have been deeply involved in risk management at major Wall Street firms.

The financial markets insider is Richard Bookstaber, whose book, “A Demon of Our Own Design,” presents the downside of the proliferation of new financial instruments. As set forth in a review in the Economist, Bookstaber describes two dangers. First is that the new contracts have tightened the linkages between various instruments and markets,m making them more likely to move in sync. The Fed and other authorities have taken a benign view of new financial technology based on the belief that risks are well diversified. Bookstaber instead says that the diversification is illusory, since the investments are more interdependent.

Second, Bookstaber sees danger in complexity. While the Economist does not tease out his meaning, I have worked with dealers who were worried about clients unwittingly blowing themselves up with products they didn’t understand. Complexity gives the trader an advantage over many customers, and there have been reports that quite a few investors are buying products that they do not comprehend. Complexity can also produce unintended second and third order effects.

From the Economist:

Spooked by the subprime-mortgage mess? Queasy about collateralised debt obligations? Investors of a nervous disposition should steer clear of Richard Bookstaber’s “A Demon of Our Own Design”. He understands the inner workings of financial markets. And he doesn’t like what he sees.

An options-theory egghead who swapped maths for mammon, Mr Bookstaber spent much of the 1980s and 1990s as a “quant” (designer of mathematical models), and later as a senior risk manager, at Morgan Stanley and Salomon Brothers. He was, as he sheepishly puts it, “in the vicinity” when stockmarkets tumbled in 1987 and Long-Term Capital Management (LTCM), a hedge fund, disappeared down the plughole a decade later.

Bright sparks like Mr Bookstaber ushered in a revolution that fuelled the boom in financial derivatives and Byzantine “structured products”. The problem, he argues, is that this wizardry has made markets more crisis-prone, not less so. It has done this in two ways: by increasing complexity, and by forging tighter links between various markets and securities, making them dangerously interdependent. As the system has grown more tangled, tougher regulation has only made things worse. Ironically, so too has the ocean of capital sloshing through markets in recent years. This has encouraged ever bigger bets with borrowed money, even though every seasoned investor knows that liquidity is the first thing to disappear when trouble strikes.

Worse, the fancy products cooked up by banks often have unintended consequences. That is because they are designed assuming rational behaviour, whereas markets have a nasty tendency to react unpredictably. Mr Bookstaber knows all about this, having played a key role in the creation of, among other innovations, “portfolio insurance” programmes. Instead of reducing risk and dampening shocks, as intended, these exacerbated the October 1987 crash.

Though he accepts that the quants deserve some of the blame, Mr Bookstaber rushes to the defence of the hedge funds that today employ so many of them (including himself). They are to capital what retailers are to clothing, trying to anticipate market demand and stockpiling accordingly. Those who see them as part of the problem are like that mob in an episode of “The Simpsons” that reacts to a meteorite hitting the town by calling for the observatory to be burned down.

This is only one of many non-financial reference points used to make a tough read more accessible. The Three Mile Island nuclear disaster, the medieval origins of primogeniture and evolutionary biology are all enlisted to shed light on different aspects of financial risk. Instead of trying to grapple with every single one of the risks around them, investors should emulate the lowly cockroach, which has survived for millions of years thanks to a defence mechanism that is rudimentary but good at dealing with unanticipated threats. A more unlikely risk-management role-model is hard to imagine….

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