SciComp SLV Calibrator

Frustration

As you will no doubt know, I have been frustrated by quants for a long, long time. Their modelling of markets is a strange combination of the childishly naïve and the absurdly abstract.

On a one-to-one basis many people working in banks will complain to me about the models they have to implement. They will complain about instability of the Heston volatility model for example. I will explain to them why it is unstable, why they shouldn't be using it, what they can do that's better and they will respond along the lines of "I agree, but I don't have any choice in the matter." Senior quants are clearly insisting on implementations that those on the front line know are unworkable.

And a large number of people complain to me in private about what I have started calling the 'Measure Theory Police.' These 'Police' write papers filled with jargon, taking 30 pages to do what proper mathematicians could do in four pages. They won’t listen to commonsense unless it starts with 'Theorem,' contains a 'Proof,' and ends with a 'QED.' I'll write in detail about the Measure Theory Police at a later date, but in the meantime will all those people complaining to me about them please speak up...you are preaching to the converted, go spread the word!

For several years I tried to argue scientifically, in papers, book, seminars, etc. about all the abysmal modelling I saw. Of all the conferences that I speak at, you would think that quant events would be the ones at which the audience would have the best appreciation of good versus bad modelling. Frustratingly, quant conferences have audiences with great technical skills but the least imagination. If you're not lecturing about the wonders of correlation, but about the stupidity of correlation, then expect a hostile ride. But I battled on, I have a very tough skin!

Then I thought I'd try a different tack. If data, scientific explanations and commonsense won't get the truth across then something else was required. (It turns out that the 'something else' was losses of trillions of dollars and a global recession!)

So I started introducing audiences to relevant aspects of human psychology. I explained about the famous experiments in peer pressure to highlight why people were adopting the same models as everyone else. I explained about the famous experiments in diffusion of responsibility, mentioned recently in an article by Taleb and Triana, so that people would understand why they were sitting around not doing anything about the terrible state of affairs. Perhaps a little bit of cognitive behavioural therapy might help them understand their own motives and this would bring about a change of practice in finance. Of course, I was overambitious. Audiences were entertained and amused, a good time was had by all. And then they went back to their day jobs and the implementation of the same old copula nonsense.

Combine peer pressure with diffusion of responsibility and fear for their jobs and most people will keep quiet. Sad, but expected and, reluctantly I will admit, understandable.

What is not understandable is the role in recent events played by regulators and rating agencies. Their jobs are not to toe the party line. The job of the regulator is to hold up the yellow card to banks with bad practices and the job of the rating agencies is to give an honest assessment of creditworthiness. In neither case should they have been effectively colluding with banks in increasing the amount of risk taken.

I have an analogy for you.

A rating agency or a regulator visits a bank. They are being shown around the premises, looking at all the products they have and how they are managed. They come to one desk on which there is a pile of nuclear material. "That's a large pile of nuclear material. How much does it weigh?" they ask. "Oh, nothing to worry about, only half the critical mass," comes the reply. They go on to the next desk and see a similar pile. "Nothing to worry about, only half the critical mass." They go next door to another bank, and they see the same story. It doesn't take a genius to see the potential risks. The regulators and the credit rating agencies saw something similar, with CDOs and the like being the explosive material.

In the early days of the current crisis the talk was of blame. That was precisely the wrong thing to consider at that time. Shore up the financial system asap, that was the most important thing to do. A quick response was what mattered, the details didn't. Now is the time to start considering blame and punishment. And yes, there has to be punishment. You cannot have obscene rewards for those working in banking, salaries tens or hundreds of times the national averages without expecting and demanding corresponding responsible behaviour. It is both morally objectionable and financially dangerous to not have the huge upside balanced by a matching downside for irresponsible actions. And so I point the finger at rating agencies and regulators as those near the top of those who must take the blame.

Realistically I expect further frustration and a return to business as usual.

P