Megabanks: too complex to manage

Having come across Chris Arnade, I'm currently reading everything I can find by him. On this blog I've touched on the matter of financial complexity many times, but mostly in the context of the network of linked institutions. I've never considered the possibility that the biggest financial institutions are themselves now too complex to be managed in any effective way. In this great article at Scientific American, Arnade (who has 20 years experience working in Wall St.) makes a convincing case that the largest banks are now invested in so many diverse products of such immense complexity that they cannot possibly manage their risks:

This is far more common on Wall Street than most realize. Just last year JP Morgan revealed a $6 billion loss from a convoluted investment in credit derivatives. The post mortem revealed that few, including the actual trader, understood the assets or the trade. It was even found that an error in a spreadsheet was partly responsible.

Since the peso crisis, banks have become massive, bloated with new complex financial products unleashed by deregulation. The assets at US commercial banks have increased five times to $13 trillion, with the bulk clustered at a few major institutions. JP Morgan, the largest, has $2.5 trillion in assets.

Much has been written about banks being “too big to fail.” The equally important question is are they “too big to succeed?” Can anyone honestly risk manage $2 trillion in complex investments?

To answer that question it’s helpful to remember how banks traditionally make money: They take deposits from the public, which they lend out longer term to companies and individuals, capturing the spread between the two.

Managing this type of bank is straightforward and can be done on spreadsheets. The assets are assigned a possible loss, with the total kept well beneath the capital of the bank. This form of banking dominated for most of the last century, until the recent move towards deregulation.

Regulations of banks have ebbed and flowed over the years, played out as a fight between the banks’ desire to buy a larger array of assets and the government’s desire to ensure banks’ solvency.

Starting in the early 1980s the banks started to win these battles resulting in an explosion of financial products. It also resulted in mergers. My old firm, Salomon Brothers, was bought by Smith Barney, which was bought by Citibank.

Now banks no longer just borrow to lend to small businesses and home owners, they borrow to trade credit swaps with other banks and hedge funds, to buy real estate in Argentina, super senior synthetic CDOs, mezzanine tranches of bonds backed by the revenues of pop singers, and yes, investments in Mexico pesos. Everything and anything you can imagine.

Managing these banks is no longer simple. Most assets now owned have risks that can no longer be defined by one or two simple numbers. They often require whole spreadsheets. Mathematically they are vectors or matrices rather than scalars.

Before the advent of these financial products, the banks’ profits were proportional to the total size of their assets. The business model scaled up linearly. There were even cost savings associated with a larger business.

This is no longer true. The challenge of risk managing these new assets has broken that old model.

Not only are the assets themselves far harder to understand, but the interplay between the different assets creates another layer of complexity.

In addition, markets are prone to feedback loops. A bank owning enough of an asset can itself change the nature of the asset. JP Morgan’s $6 billion loss was partly due to this effect. Once they had began to dismantle the trade the markets moved against them. Put another way, other traders knew JP Morgan were in pain and proceeded to ‘shove it in their faces’.

Bureaucracy creates another layer, as does the much faster pace of trading brought about by computer programs. Many risk managers will privately tell you that knowing what they own is as much a problem as knowing the risk of what is owned.

Put mathematically, the complexity now grows non-linearly. This means, as banks get larger, the ability to risk-manage the assets grows much smaller and more uncertain, ultimately endangering the viability of the business.

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Strategic recklessness

Some poignant (and infuriating) insight from Chris Arnade on Why it's smart to be reckless on Wall St.:

... asymmetry in pay (money for profits, flat for losses) is the engine behind many of Wall Street’s mistakes. It rewards short-term gains without regard to long-term consequences. The results? The over-reliance on excessive leverage, banks that are loaded with opaque financial products, and trading models that are flawed. ... Regulation is largely toothless if banks and their employees have the financial incentive to be reckless.

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Networks in finance

Just over a week ago, the journal Nature Physics published an unusual issue. In addition to the standard papers on technical physics topics, this issue contained a section with a special focus on finance, especially on complex networks in finance. I'm sure most readers of this blog won't have access to the papers in this issue, so I thought I'd give a brief summary of the papers here.

It's notable that these aren't papers written just by physicists, but represent the outcome of collaborations between physicists and a number of prominent economists (Nobel Prize winner Joseph Stiglitz among them) and several regulators from important central banks. The value of insight coming out of physics-inspired research into the collective dynamics of financial markets is really starting to be recognized by people who matter (even if most academic economists won't wake up to this probably for several decades).

I've written about this work in my most recent column for Bloomberg, which will be published on Sunday night EST. I was also planning to give here some further technical detail on one very important paper to which I referred in the Bloomberg article, but due to various other demands in the past few days I haven't quite managed that yet. The paper in question, I suspect, is unknown to almost all financial economists, but will, I hope, gain wide attention soon. It essentially demonstrates that the theorists' ideal of complete, arbitrage free markets in equilibrium isn't a nirvana of market efficiency, as is generally assumed. Examination of the dynamics of such a market, even within the neo-classical framework, shows that any approach to this efficient ideal also brings growing instability and likely market collapse. The ideal of complete markets, in other words, isn't something we should be aiming for. Here's some detail on that work from something I wrote in the past (see the paragraphs referring to the work of Matteo Marsili and colleagues).

Now, the Nature Physics special issue.

The first key paper is "Complex derivatives," by Stefano Battiston, Guido Caldarelli, Co-Pierre Georg, Robert May and Joseph Stiglitz. It begins by noting that the volume of derivatives outstanding fell briefly following the crisis of 2008, but is now increasing again. According to usual thinking in economics and finance, this growth of the market should be a good thing. If people are entering into these contacts, it must be for a reason, i.e. to hedge their risks or to exploit opportunities, and these deals should lead to beneficial economic exchange. But, as Battiston and colleagues note, this may not actually be true:

By engaging in a speculative derivatives market, players can potentially amplify their gains, which is arguably the most plausible explanation for the proliferation of derivatives in recent years. Needless to say, losses are also amplified. Unlike bets on, say, dice — where the chances of the outcome are not affected by the bet itself — the more market players bet on the default of a country, the more likely the default becomes. Eventually the game becomes a self-fulfilling prophecy, as in a bank run, where if each party believes that others will withdraw their money from the bank, it pays each to do so. More perversely, in some cases parties have incentives (and opportunities) to precipitate these events, by spreading rumours or by manipulating the prices on which the derivatives are contingent — a situation seen most recently in the London Interbank Offered Rate (LIBOR) affair.

Proponents of derivatives have long argued that these instruments help to stabilize markets by distributing risk, but it has been shown recently that in many situations risk sharing can also lead to instabilities.

The bulk of this paper is devoted to supporting this idea, examining several recent independent lines of research which indicate the more derivatives can make market less stable. This work shares some ideas with theoretical ecology, where it was once thought (40 years ago) that more complexity in an ecology should generally confer stability. Later work suggested instead that complexity (at least too much of it) tends to breed instability. According to a number of recent studies, the same seems to be true in finance:

It now seems that the proliferation of financial instruments induces strong fluctuations and instabilities for similar reasons. The basis for pricing complex derivatives makes several conventional assumptions that amount to the notion that trading activity does not feed back on the dynamical behaviour of markets. This idealized (and unrealistic) model can have the effect of masking potential instabilities in markets. A more detailed picture, taking into account the effects of individual trades on prices, reveals the onset of singularities as the number of financial instruments increases.

The remainder of the paper goes on to explore various means that may be taken, through regulations, to try to manage the complexity of the financial network and encourage its stability. Stability isn't something we should expect to occur on its own. It demands real attention to detail. Blind adherence to the idea that "more derivatives is good" is a recipe for trouble.

The second paper in the Nature Physics special issue is "Reconstructing a credit network," by Guido Caldarelli, Alessandro Chessa, Andrea Gabrielli, Fabio Pammolli and Michelangelo Puliga. This work addresses an issue that isn't quite as provocative as the value of the derivatives industry, but the topic may be of extreme importance in future efforts to devise effective financial regulations. The key insight coming from network science is that the architecture of a network -- its topology -- has a huge impact on how influences (such as financial distress) spread through the network. Hence, global network topology is intimately linked up with system stability; knowledge of global structure is absolutely essential to managing systemic risk. Unfortunately, the history of law and finance is such that much of the information that would be required to understand the real web of links between financial institutions remains private, hidden, unknown to the public or to regulators.

The best way to overcome this is certainly to make this information public. When  financial institutions undertake transactions among themselves, the rest of us are also influenced and our economic well being potentially put at risk. This information should be public knowledge, because it impacts upon financial stability, which is a public good. However, in the absence of new legislation to make this happen, regulators can right now turn to more sophisticated methods to help reconstruct a more complete picture of global financial networks, filling in the missing details. This paper, written by several key experts in this technical area, reviews what is now possible and how these methods might be best put to use by regulators in the near future.

Finally, the third paper in the Nature Physics special issue is "The power to control," by Marco Galbiati, Danilo Delpini and Stefano Battiston. "Control" is a word you rarely hear in the context of financial markets, I suppose because the near religion of the "free market" has made "control" seem like an idea of "communists" or at least "socialists" (whatever that means). But regulation of any sort, laws, institutions, even social norms and accepted practices, all of these represent some kind of "control" placed on individuals and firms in the aim, for society at large, of better outcomes. We need sensible control. How to achieve it?

Of course, "control" has a long history in engineering science where it is the focus of an extensive and quite successful "control theory." This paper reviews some recent work which has extended control theory to complex networks. One of the key questions is if the dynamics of large complex networks might be controlled, or at least strongly steered, by influencing only a small subset of the elements making up the network, and perhaps not even those that seem to be the most significant. This is, I think, clearly a promising area for further work. Let's take the insight of a century and more of control theory and ask if we can't use that to help prevent, or give early warnings of, the kinds of disasters that have hit finance in the past decade.

Much of the work in this special issue has originated out of a European research project with the code name FOC, which stands for, well, I'm not exactly sure what it stands for (the project describes itself as "Forecasting Financial Crises" which seems more like FFC to me). In any event, I know some of these people and apart from the serious science they have a nice sense of humor. Perhaps the acronym FOC was even chosen for another reason. As I recall, one of their early meetings a few years ago was announced as "Meet the FOCers." Humor in no way gets in the way of good science.

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The intellectual equivalent of crack cocaine

That's what the British historian Geoffrey Elton once called Post-Modernist Philosophy, i.e. that branch of modern philosophy/literary criticism typically characterized by a, shall we say, less than wholehearted commitment to clarity and simplicity of expression. The genre is represented in the libraries by reams of apparently meaningless prose, the authors of which claim to get at truths that would otherwise be out of reach of ordinary language. Here's a nice example, the product of the subtle mind of one Felix Guattari:

“We can clearly see that there is no bi-univocal correspondence between linear signifying links or archi-writing, depending on  the author, and this multireferential, multi-dimensional machinic catalysis. The symmetry of scale, the transversality, the pathic non-discursive character of their expansion: all these dimensions remove us from the logic of the excluded middle and reinforce us in our dismissal of the ontological binarism we criticised previously.”

I'm with Elton. This writer, it seems to me, is up to no good, trying to pull the wool over the reader's eyes, using confusion as a weapon to persuade the reader of his superior insight. You read it, you don't quite get it (or even come close to getting it), and it is then tempting to conclude that whatever he is saying, as it is beyond your vision, must be exceptionally deep or subtle or complex, too much for you to grasp.

You need some self confidence to come instead to the other logically possible conclusion -- that the text is actually purposeful nonsense, all glitter and no content, an affront against the normal, productive use of language for communication, "crack cocaine" as the writer gets the high that comes from appearing deep and earning accolades without putting in the hard work to actually write something that is insightful.

Having said that, let me also say that I am not in any way an expert in postmodernist philosophy and there may be more to the thinking of some of its representatives than this Guattari quote would suggest.

In any event, I think there's something deeply similar here to John Kay's point in this essay about Warren Buffet. As he notes, Buffet has been spectacularly successful and hence the subject of vast media attention, yet, paradoxically, he doesn't seem to have inspired an army of investors who copy his strategy:

... the most remarkable thing about Mr Buffett’s achievement is not that no one has rivalled his record. It is that almost no one has seriously tried to emulate his investment style. The herd instinct is powerful, even dominant, among asset managers. But the herd is not to be found at Mr Buffett’s annual jamborees in Omaha: that occasion is attended only by happy shareholders and admiring journalists.

Buffet's strategy, as Kay describes, is a decidedly old-fashioned one based on close examination of the fundamentals of the companies in which he invests:

If he is a genius, it is the genius of simplicity. No special or original insight is needed to reach his appreciation of the nature of business success. Nor is it difficult to recognise that companies such as American Express, Coca-Cola, IBM, Wells Fargo, and most recently Heinz – Berkshire’s largest holdings – meet his criteria. ... Which leads back to the question of why Berkshire has so few imitators. After all, another crucial insight of business economics is that profitable strategies that can be replicated are imitated until returns from them are driven down to normal levels. Why do the majority of investment managers hold many more stocks, roll them over far more often, engage in far more complex transactions – and derive less consistent and profitable results?

The explanation, Kay suggests, is that Buffet's strategy also demands an awful lot of hard work and it's easier for many investment experts to follow the rather different strategy of Felix Guattari, not actually working to achieve superior insight, but working to make it seem as if they do, mostly by obscuring their actual strategies in a bewildering cloud of complexity. Sometimes, as in the case of Bernie Madoff, the obscuring complexity can even take the very simple form of essentially no information whatsoever. People who are willing to believe need very little help:

... the deeper issue is that complexity is intrinsic to the product many money managers sell. How can you justify high fees except by reference to frequent activity, unique insights and arcana? But Mr Buffett understands the limitations of his knowledge. That appreciation distinguishes people who are very clever from those who only think they are.

One final comment. I think finance is rife with this kind of psychological problem. But I do not at all believe that science is somehow immune from these effects. I've encountered plenty of works in physics and applied mathematics that couch their results in beautiful mathematics, demonstrate formidable skill in building a framework of theory, and yet seem utterly useless in actually solving or giving insight into any real problem. Science also has a weak spot for style over content.

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Obscurity and simplicity

The British economist John Kay is one of my favorite sources of balanced and deeply insightful commentary on an extraordinary number of topics. I wish I could write as easily and productively as he does. He has a great post that is, in particular, on Warren Buffet, but is more generally on an intellectual affliction affecting finance whereby purposeful obscurity often wins out at the expense of honesty and simplicity. Well worth a read. BUT... I think this actually goes way beyond finance. It's part of the human condition... more on that tomorrow.... 

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The housing market in pictures

A blogger named Irvine Renter (aka Larry Roberts) knows an awful lot about the housing market and writes about it here. He also produces (and links to) some great cartoons, like this one...



and this one...



and this one...
 


and this one...

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A real model of Minsky

Noah Smith has a wonderfully informative post on the business cycle in economics. He's looking at the question of whether standard macroeconomic theories view the episodic ups and downs of the economy as the consequence of a real cycle, something arising from positive feed backs that drive persisting oscillations all on their own, or if they instead view these fluctuations as the consequence of external shocks to the system. As he notes, the tendency in macroeconomics has very much been the latter:

When things like this [cycles] happen in nature - like the Earth going around the Sun, or a ball bouncing on a spring, or water undulating up and down - it comes from some sort of restorative force. With a restorative force, being up high is what makes you more likely to come back down, and being low is what makes you more likely to go back up. Just imagine a ball on a spring; when the spring is really stretched out, all the force is pulling the ball in the direction opposite to the stretch. This causes cycles.

It's natural to think of business cycles this way. We see a recession come on the heels of a boom - like the 2008 crash after the 2006-7 boom, or the 2001 crash after the late-90s boom - and we can easily conclude that booms cause busts.

So you might be surprised to learn that very, very few macroeconomists think this! And very, very few macroeconomic models actually have this property.

In modern macro models, business "cycles" are nothing like waves. A boom does not make a bust more likely, nor vice versa. Modern macro models assume that what looks like a "cycle" is actually something called a "trend-stationary stochastic process" (like an AR(1)). This is a system where random disturbances ("shocks") are temporary, because they decay over time. After a shock, the system reverts to the mean (i.e., to the "trend"). This is very different from harmonic motion - a boom need not be followed by a bust - but it can end up looking like waves when you graph it...

I think this is interesting and deserves some further discussion. Take an ordinary pendulum. Give such a system a kick and it will swing for a time but eventually the motion will damp away. For a while, high now does portend low in the near future, and vice versa. But this pendulum won't start start swinging this way on its own, nor will it persist in swinging over long periods of time unless repeatedly kicked by some external force.

This is in fact a system of just the kind Noah is describing. Such a pendulum (taken in the linear regime) is akin to the AR(1) autoregressive process entering into macroeconomic models and it acts essentially as a filter on the source of shocks. The response of the system to a stream of random shocks can have a harmonic component, which can make the output look roughly like cycles as Noah mentioned. For an analogy, think of a big brass bell. This is a pendulum in the abstract, as it has internal vibratory modes that, once excited, damp way over time. Hang this bell in a storm and, as it receives a barrage of shocks, you'll hear a ringing that tells you more about the bell than it does the storm.

Still, to get really interesting cycles you need to go beyond the ordinary pendulum. You need a system capable of creating oscillatory behavior all on its own. In dynamical systems theory, this means a system with a limit cycle in its dynamics, which settles down in the absence of persisting perturbation to a cyclic behavior rather than to a fixed point. The existence of such a limit cycle generally implies that the system will have an unstable fixed point -- a state that seems superficially like an equilibrium, but which in fact will always dissolve away into cyclic behavior over time. Mathematically, this is the kind of situation one ought to think about when considering the possibility that natural instabilities drive oscillations in economics. Perhaps the equilibrium of the market is simply unstable, and the highs and lows of the business cycle reflect some natural limit cycle?

Noah mentions the work of Steve Keen, who has developed models along such lines. As far as I understand, these are generally low-dimensional models with limit cycle behavior and I expect they may be very instructive. But Noah also makes a good point that the data on the business cycle really doesn't show a clear harmonic signal at any one specific frequency. The real world is messier. An alternative to low dimensional models written in terms of aggregate economic variables is to build agent based models (of much higher dimension) to explore how natural human behavior such as trend following might lead to instabilities at least qualitatively like those we see.

For some recent work along these lines, take a look at this paper by Blake LeBaron which attempts to flesh out Hyman Minsky's well known story of inherent market instability in an agent based model. Here's the basic idea, as LeBaron describes it:

Minksy conjectures that financial markets begin to build up bubbles as investors become increasingly overconfident about markets. They begin to take more aggressive positions, and can often start to increase their leverage as financial prices rise. Prices eventually reach levels which cannot be sustained either by correct, or any reasonable forecast of future income streams on assets. Markets reach a point of instability, and the over extended investors must now begin to sell, and are forced to quickly deleverage in a fire sale like situation. As prices fall market volatility increases, and investors further reduce risky positions. The story that Minsky tells seems compelling, but we have no agreed on approach for how to model this, or whether all the pieces of the story will actually fit together. The model presented in this paper tries to bridge this gap. 

The model is in crude terms like many I've described earlier on this blog. The agents are adaptive and try to learn the most profitable ways to behave. They are also heterogeneous in their behavior -- some rely more on perceived fundamentals to make their investment decisions, while others follow trends. The agents respond to what has recently happened in the market, and then the market reality emerges out of their collective behavior. That reality, in some of the runs LeBaron explores, shows natural, irregular cycles of bubbles and subsequent crashes of the sort Minsky envisioned. The figure below, for example, shows data for the stock price, weekly returns and trading volume as they fluctuate over a 10 year period of the model:

Now, it is not surprising at all that one can make a computational model to generate dynamics of this kind. But if you read the paper, LeBaron has tried hard to choose the various parameters to fit realistically with what is known about human learning dynamics and the behavior of different kinds of market players. The model also does a good job in reproducing many of the key statistical features of financial time series including long range fundamental deviations, volatility persistence, and fat tailed return distributions. So it generates Minsky-like fluctuations in what is arguably a plausible setting (although I'm sure experts will quibble with some details).

To my mind, one particularly interesting point to emerge from this model is the limited ability of fundamentalist investors to control the unstable behavior of speculators. One nice feature of agent based models is that it's possible to look inside and examine all manner of details. For example, during these bubble phases, which kind of investor controls most of the wealth? As LeBaron notes,

The large amount of wealth in the adaptive strategy relative to the fundamental is important. The fundamental traders will be a stabilizing force in a falling market. If there is not enough wealth in that strategy, then it will be unable to hold back sharp market declines. This is similar to a limits to arbitrage argument. In this market without borrowing the fundamental strategy will not have sufficient wealth to hold back a wave of self-reinforcing selling coming from the adaptive strategies.   

Another important point, which LeBaron mentions in the paragraph above, is that there's no leverage in this model. People can't borrow to amplify investments they feel especially confident of. Leverage of course plays a central role in the instability mechanism described by Minsky, but it doesn't seem to be absolutely necessary to get this kind of instability. It can come solely from the interaction of different agents following distinct strategies.

I certainly don't mean to imply that these kinds of agent based models are superior to the low-dimensional modelling of Steve Keen and others. I think these are both useful approaches, and they ought to be complementary. Here's LeBaron's summing up at the end of the paper:

The dynamics are dominated by somewhat irregular swings around fundamentals, that show up as long persistent changes in the price/dividend ratio. Prices tend to rise slowly, and then crash fast and dramatically with high volatility and high trading volume. During the slow steady price rise, agents using similar volatility forecast models begin to lower their assessment of market risk. This drives them to be more aggressive in the market, and sets up a crash. All of this is reminiscent of the Minksy market instability dynamic, and other more modern approaches to financial instability.

Instability in this market is driven by agents steadily moving to more extreme portfolio positions. Much, but not all, of this movement is driven by risk assessments made by the traders. Many of them continue to use models with relatively short horizons for judging market volatility. These beliefs appear to be evolutionarily stable in the market. When short term volatility falls they extend their positions into the risky asset, and this eventually destabilizes the market. Portfolio composition varying from all cash to all equity yields very different dynamics in terms of forced sales in a falling market. As one moves more into cash, a market fall generates natural rebalancing and stabilizing purchases of the risky asset in a falling market. This disappears as agents move more of their wealth into the risky asset. It would reverse if they began to leverage this position with borrowed money. Here, a market fall will generate the typical destabilizing fire sale behavior shown in many models, and part of the classic Minsky story. Leverage can be added to this market in the future, but for now it is important that leverage per se is not necessary for market instability, and it is part of a continuum of destabilizing dynamics.

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