Sean Park Portrait
Quote of The Day Title
I say profound things
Einstein

Oversimplification? Maybe. But no less true.

As someone who worked in banks and capital markets for many years but is now on the outside looking in, many people I know have been asking for my take on the seeming collapse of the existing financial and banking system. With so many talking heads already contributing to the cacophony of fact, rumour, opinion and innuendo surrounding the financial markets, I have been loathe to add to the noise.

However, in particular I have been struck by the sheer volume of spurious information and the overwhelming complexity of many of the explanations emanating from a seemingly endless array of ‘experts’. At the risk of falling into the same trap I think we (in the financial community) are at great risk of creating even greater confusion and mistrust: by talking too much about the trees, we have lost sight of the forest.

The key to understanding the current fracas is this:

[(Leverage + Short Term Funding)*Opaqueness]^Hubris = Explosive Risk

Activate said risk with an exogenous shock leading to a decline in asset values, and….

tick, tick, tick…BOOM.

This is not really hard to understand. Most people could get this if explained to them. Indeed, I tried to do just that over a year ago when Northern Rock was (one of the) first to fall victim to this toxic cocktail.

So why did all those ostensibly clever people running banks and such not know about and/or understand the equation above? Well, the short answer I would posit is that they did, or at least most of them did, and they either:

  • (a) thought they were clever / nimble enough to get out quickly when the tide would turn
  • (b) rationally (and cynically) traded their implicit free-ish option; ie the NPV of a few years of bonuses on steroids would compensate for the bust
  • (c) figured it was easier to “keep dancing” than to explain to staff, customers and shareholders why they were missing the party
  • or..(d) all of the above.

And it didn’t start out as a problem. Much of what went wrong started out as intelligent and robust financial innovation and smart management, creating real value. But it worked too well. Made too much money. And somewhere along the way, critical thinking was left in the dust. The ability to question the business model, to continue to innovate, to remain open-minded was mostly crushed by the profits juggernaut that seemed unstoppable.

And this proved fatal. Because also along the way – as with all industrial revolutions – the juice was arbitraged away. But no one wanted to admit this. Inventing new and better, more profitable ways to serve your customers is hard. Something to be avoided. Delayed at least. “The next guys problem.” Better, there was a built-in mechanism allowing one to ignore it. Just add a bit more leverage. Stretch the funding gap a week. A month. A year. Obfuscate both with some structuring. Toss in the hubris that inevitably emerges when people make millions and millions commanding the heights of the economy… Lather. Rinse. Repeat. And so you have the proverbial frog that cooked in a pot slowly but inexorably brought to a boil.

The business model, the compensation paradigm, the culture, all were predicated on scarcity – of information, of competition, of resources – that drove high margins. This was once true. It ceased being so (at least) several years ago. This is what I was trying to get at when I wrote these essays in 2002 and 2003 (!)

So why is this important? How does it help us move forward? First, we need to understand that the old way of doing things – the historical business model of banking – is (and has been for a few years) obsolete. That out of this obsolescence will rise a new and different approach to providing financial services and that many of the extraordinary innovations in finance and technology can truly help create great wealth in our economies and are not the problem but are – applied intelligently – part of the solution. In these very trying circumstances, my fear is that as a society we retrench into some sort of financial dark age. Especially since I am convinced that we now have all the tools at our disposal to create an epochal change in the financial services landscape, in particular I see the potential for a radical democratization of finance. The importance and effect of such a shift over the next 30-40 years would be analogous in its impact on our society as to the impact of the Protestant Reformation: removing the monopoly heretofore enjoyed by the financial papacy would I think create a less risky financial substrate for the global economy.

I don’t want to minimize or trivialize the current crisis. But there is reason for optimism amongst all this gloom. The best catalyst for change, the best bromide against inertia is of course catastrophic failure. I think we can all agree on that.

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Comments
  1. At 3:41 pm on 14 Oct 08 Eddie said:

    There is so much cacophony, we are reminded time and again that the human ego is such that people want to be seen as being know-it-alls and experts at / in something. Very very few people have the courage to stay humble and sometimes say, “I don't know”. Thanks for making it easier to parse, I like your simple algebraic equation!

    Now for a question about this sentence fragment you wrote:

    > my fear is that as a society we retrench into some sort of financial dark age

    Is it not true that the current root of our problems moving forward is that banks will be highly reluctant to lend to each other, because they can not make sense of each others' balance sheets due to the inability to understand (value) collateralized debt obligations (CDOs) — whatever the hell those things are? Heaven help us, how long might it take for banks to lend to each other? Is this the dark age you fear? Could this dark age perpetuate for decades because of how painful this has been and how strongly the “Pain of 2008” will be etched into the long term memory of human brains worldwide? East Asia might be better off than the West because they already have been through pain etched into neurons (Japan bubble / Asian Financial Crisis 1998)? China is a force that is not going to stop (even if it gets slowed down by the “Mess of the West”). All things being relative, if Asia can pick up on some western entrepreneurial spirit and loosen up on some of its legacy Confucianism, add a dose of “do no evil”, then the East might be able to be better off psychologically relatively speaking. And andy way, Asians have the long term habit of being savers, Americans have the learned behavior, for decades, of being debtors (think brains and neurons, long term memory!) What happens if the banks, because of their own stupidity dealing with crap they didn't understand ever (CDOs), takes credit away from the American credit junkies? Americans with guns in the Dark Age, I don't like that.

    Can your new start up company do something to avert this possible Dark Age? Not to be facetious, but might you be able to save the world? Let's take some cues from Google. Their corporate philosophy page says point blank:

    http://www.google.com/corporate/tenthings.html

    6. You can make money without doing evil.

  2. At 10:57 pm on 14 Oct 08 parkparadigm said:

    The financial dark age I fear isn't the continued failure of the interbank market – although it will be very important to avoid that; my guess is that the massive (and global) government intervention of the past week will, eventually, help us avoid that. (Although it might take several quarters before a reversion to what would historically be considered as 'normal'.)

    Rather the dark age I fear is one in which society (government, business and citizens) rejects out of hand anything that smacks of innovation or engineering in the realm of finance. We've discovered the “risk quark” and yes unfortunately the first thing we did was to create a dangerous bomb that blew a gigantic hole through the global financial system with all sorts of devastating fall out for our economies. And so a visceral, uncompromising negative reaction to anything that relies on engineering based on our ability to create and manage risk quarks would not at first glance be unreasonable.

    However, and this is the source of my anxiety, the marriage of information and financial technologies can – for the first time in history – drive a fundamental paradigm shift in markets and financial services towards a more robust, distributed, efficient and democratic system (as opposed to yet another permutation of centralized control.) To give just one example – derivatives can and should play a central role in such a transformation: coupled with powerful and cheap information and communications technologies, derivatives are vital tools to help disseminate information and risk units throughout the global economy in an optimal fashion. But the 'derivatives baby' risks being thrown out with the 'financial meltdown bathwater' as (some of) these same tools were used irresponsibly to cause great harm.

    I'm frustrated that the financial services industry – of which I am a part – has repeatedly and obstinately refused to take a more enlightened view towards their business and their customers, and in so doing has brought what I believe to be enormously powerful forces for human wealth, growth and progress into disrepute. I'm frustrated because not only is this obviously good in and of itself, but I believe it is also the best way – the only way – for the industry to maximize its own returns over the medium to long term. Not only do I agree (with the Google founders) that you “can make money without doing evil” but, unless you have the coercive power of a despot, I remain convinced that making money in a free society by doing evil is impossible. The events of the past year seem to bear this out…

    As to whether our new venture can save the world. Probably not. Certainly not on our own! I guess our hope is that we will be able to catalyze others, spark a new paradigm that perhaps, in time, will contribute to building this new financial age that is within our grasp.

  3. At 8:56 pm on 22 Oct 08 Eddie said:

    > Rather the dark age I fear is one in which society (government, business and citizens) rejects out of hand anything that smacks
    > of innovation or engineering in the realm of finance. … And so a visceral, uncompromising negative reaction to anything that relies
    > on engineering based on our ability to create and manage risk quarks would not at first glance be unreasonable.

    Recently (a week ago or so) Nouriel Roubini was interviewed by Bloomberg TV for an hour. It was a fascinating interview (its on YouTube but I can't find the link at the moment). I took notes when I watched it yesterday. The woman interviewing him how does the economy recover and what fundamentally is the underlying strength that will help the deal with the forthcoming economic problems. His response reflects your anxiety when he said (paraphrased):

    —————————————————————————————–

    The economy in the past 20 – 30 years has been growing very fast but we've had asset bubbles starting in the 80s with S&L which bust, then the Internet bubble followed by recession 2001, then we created the housing bubble and now we're running out of bubbles to create.

    We have to think about a fundamental change in our economic priorities … we have invested too much into the stock of housing, but not enough into machinery, software. We have invested too much human capital into the financial system with too many financial engineers and not enough computer engineers and mechanical engineers. Both the human and physical capital of the country has to go toward the things of the future such as alternative energy, green technologies.

    —————————————————————————————–

    Its really hard to counter Roubini's logic. Even if he is an academic, he's not totally living in an Ivory Tower like many academics who get fat and happy on tenure. Perhaps what's needed, is a new type of financial engineer who is a hybrid with a multi- disciplined background (per your suggestion, a hybrid who collaborates with Cory Doctorow). A hybrid who, for example, has training in both computer engineering and finance. A finance dude who gets his hands dirty and cuts code instead of hiring someone else to cut code. This is an educational problem that doesn't get solved overnight. For people of all ages with the will to learn which equates to the will to not only survive but to thrive, anything is possible. They have to be willing to put their mind to something. This mantra of “anything is possible” is the heart of the American entrepreneurial spirit, the spirit of “can do”, which will always be taken up by a small % of people but will never die IMHO.

    Good luck in your hybrid pursuits.

  4. At 9:56 pm on 22 Oct 08 Eddie said:

    > Rather the dark age I fear is one in which society (government, business and citizens) rejects out of hand anything that smacks
    > of innovation or engineering in the realm of finance. … And so a visceral, uncompromising negative reaction to anything that relies
    > on engineering based on our ability to create and manage risk quarks would not at first glance be unreasonable.

    Recently (a week ago or so) Nouriel Roubini was interviewed by Bloomberg TV for an hour. It was a fascinating interview (its on YouTube but I can't find the link at the moment). I took notes when I watched it yesterday. The woman interviewing him how does the economy recover and what fundamentally is the underlying strength that will help the deal with the forthcoming economic problems. His response reflects your anxiety when he said (paraphrased):

    —————————————————————————————–

    The economy in the past 20 – 30 years has been growing very fast but we've had asset bubbles starting in the 80s with S&L which bust, then the Internet bubble followed by recession 2001, then we created the housing bubble and now we're running out of bubbles to create.

    We have to think about a fundamental change in our economic priorities … we have invested too much into the stock of housing, but not enough into machinery, software. We have invested too much human capital into the financial system with too many financial engineers and not enough computer engineers and mechanical engineers. Both the human and physical capital of the country has to go toward the things of the future such as alternative energy, green technologies.

    —————————————————————————————–

    Its really hard to counter Roubini's logic. Even if he is an academic, he's not totally living in an Ivory Tower like many academics who get fat and happy on tenure. Perhaps what's needed, is a new type of financial engineer who is a hybrid with a multi- disciplined background (per your suggestion, a hybrid who collaborates with Cory Doctorow). A hybrid who, for example, has training in both computer engineering and finance. A finance dude who gets his hands dirty and cuts code instead of hiring someone else to cut code. This is an educational problem that doesn't get solved overnight. For people of all ages with the will to learn which equates to the will to not only survive but to thrive, anything is possible. They have to be willing to put their mind to something. This mantra of “anything is possible” is the heart of the American entrepreneurial spirit, the spirit of “can do”, which will always be taken up by a small % of people but will never die IMHO.

    Good luck in your hybrid pursuits.

  5. At 10:07 am on 18 Jan 09 The Park Paradigm - Edge finance said:

    […] Oversimplification? Maybe. But no less true. […]

  6. […] Oversimplification? Maybe. But no less true. Permalink||View commentsComments|Filed under ‘Business, Sixth Paradigm, Web X.0’ Cool for cats. User generated information architecture and market structure […]

  7. […] This post was mentioned on Twitter by Midas Oracle, Nauiokas Park. Nauiokas Park said: [(Leverage + Short Term Funding)*Opaqueness]^Hubris = Explosive Risk http://bit.ly/7t89hv Apply to #Dubai. Rinse. Repeat. […]

  8. […] [(Leverage + Short Term Funding)*Opaqueness]^Hubris = Explosive Risk Share This: […]

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