Have we arrived at a financial singularity?

financial singularityA 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?

Reply