“Control Is An Illusion”

“Control is an illusion, you infantile egomaniac. Nobody knows what's gonna happen next: not on a freeway, not in an airplane, not inside our own bodies and certainly not on a racetrack with 40 other infantile egomaniacs.”- ‘Days of Thunder’

a man in a suit

You might have thought that Tom Cruise would have learned his lesson from flying fighter planes in Top Gun – but I guess risk, power, glory and loss are always the ultimate “boys toys”.

It’s this desire to take it to the edge especially in a game against other players that always drives risk takers to engage in the sawtooth pattern that I described in Part 1 of this series on Risk.

In the case of banking, excess capacity, ever-increasing cost-bases, and an absence of the usual market disciplines to balance supply and demand (cf coal industry, ship building industry and many more) have created a microeconomic imperative to max out, leverage up and thereby drive pedal-to-the-metal straight into the next crisis.

Alternative Finance might lack the toxic angle of leverage (well so far anyway) and consequently one might anticipate a less painful cycle.  However, in a winner-takes-all society, in a microeconomic game of musical chairs which ends up with only a few chairs for the oligopolists, there is more than enough incentive to max out. Indeed it’s happened already with Prosper in the US – massive losses and class action suits before the reboot.

We all know the #oldFS Risk end game – vast bureaucratic rule books and risk management descended into box-ticking legalistic compliance.

It’s a form of madness.

Lord Turner the last Chairman of the FSA often spoke about “socially useless trading”. An interesting point not without substance. However he didn’t continue this logic to include socially useless FS Regulation, socially useless Accounting Rules, socially useless Laws etc.

But what led up to this?

How can Alternative Finance avoid going down the same plughole?

When I started the City in ’85 there were no such things as risk managers per se - people whose whole day job was solely to do with other folks’ risk taking. Nobody looked over my shoulder (other than the reporting chain as in any business). 

Credit was a slight exception to this game (doubtless due to excessive historic credit cycle crises). However not many bankers would have seen “Credit” as risk managers – more as the business prevention department :) Bankers were basically origination machines and to a large extent credit departments were the brakes on this expansion.

For non-credit/non-Lloyds-Insurance FS, paradoxically the “no risk managers” world proved remarkably successful and stable in comparison to what came after.

How does one account for this paradox? A big topic.

Here are my most vital risk lessons from thirty years of FS evolution and explosions.

1) Responsibility

Ironically, in a world without rules and without a function “looking after risk” everyone’s attitude was one of individual responsibility.  Whether in the typing pool or on the trading floor you were judged on the outcome

As soon as “Risk” became a box on the organogram at some subtle level everyone else felt let off the hook.  As long as they played within the boundaries set by the risk department/ratings agencies/regulators, as long as they complied, then to a large extent they couldn’t be blamed.

At the firmwide level, family-owned businesses/partnerships where long-term stability was paramount encouraged a whole different game.

At the marketplace level one important pre-Big Bang aspect was perceived as a negative at the time.  The “verticals” (broking/jobbing/…) were seen as “too clubby”.  No doubt they were. However, a club has a wildly different attitude to itself than an “ownerless” market which is merely a tool for individual enrichment.  In a club it’s more obvious that if anyone messes up the 18th green we all suffer.

2) Simplicity

Financial instruments/trades were simple (by and large). With the explosion in computing power and a kind of adolescent “if it can be done let’s do it” vibe all sorts of far more unmanageable demons were let out of Pandora’s Box. 

Furthermore the whole “securitisation” game emerged. If “securitisers” take a large chunk of the value out of something and then slice and dice the remainder for the market (in more complex instruments, harder to manage) then the market gets a bum deal. I shudder when I think of the number of times that ended up with the carpet needing a good Shake n’Vac to remove the bloodstains.

At the firm level simple businesses are easy to understand and hence manage.

At the market level as Haldane (BofE) and May (Professor of Zoology at Oxford) described in a paper in Nature in 2011 a diverse financial ecosystem comprising many small (simple) ecological niches is more robust than one containing a few large near identical players. 

3) Uncertainty

The origins of risk management are more obscure than one might imagine. When I became the first Head of Risk in the City in ’92 I went to Waterstones to see if they had any books on risk management.  There were only two books – one on futures and Fabozzi on mortgage options.

Now shelves are stacked with dot-to-dot books of risk management - which, given what Banks have done, must be about as useful as all those books on how to improve your golf :)

The cardinal sin of risk is very simple to describe but far harder to assimilate.

As per the opening quote we do not know “whats ‘gonna happen next”.  Life is uncertain, unknowable, uncontrollable. Everything, from relationships to Libor, can be static, continuously changing or discontinuously changing. Or all three on different days of the week.

You see I said it was easy to describe. Just try implementing that in your business tomorrow :)

A better word than “risk” is uncertainty.  Keynes worried a lot about this in the ‘30s however he lost the argument to the statisticians who preferred the apparent certainty of manipulating historical data.

If you type “risk measurement” into Google you get over fifteen million links.  Butyou can’t measure risk (uncertainty) – you can only model it.

Now don’t get me wrong – risk modelling is a vital thing to do. Absolutely.

But it’s just a model.


In the next article we move on from history and philosophy to Alternative Finance 2015.

But first a small story to conclude. 

In the mid-90s I signed up for a seminar on “model risk”.  A few weeks later I received a letter saying the seminar had been cancelled due to lack of interest.

Tells you all you need to know about various banking “risk management” crises that happened over the past twenty years… 

Well that plus another Tom Cruise quote - “show me the money” (what else would explain the pre-08 ratings of US mortgage backed securities?)

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