Uncertainty abounds in the financial systems of the world today. Clear, quantifiable risk measurements are muddied with existential issues of State solvency and banking sector fragility. The old stories of risk-averse investors being able to get rid of a lot of their risk by diversifying seem like ‘just-so’ stories today. We don’t have models of what we don’t know, though people like Nassim Taleb and his co-authors are trying to build them for us.
Financial engineering is a strange profession. Engineers usually build things that work. That plane has to get in the air. If it doesn’t, you’re probably a bad engineer, and you’re sacked. That is not what has happened in financial engineering. The planes they built didn’t fly, so they decorated the hulls with complex mathematical symbols, and got paid shedloads. Good for them.
The question we must ask ourselves, or at least, the question I ask myself, is why there has been so little progress in financial engineering, in particular, to make the practice of finance more robust, less prone to the slings and arrows of outrageous fortune.
The video below is ‘Galloping Gertie’, an early suspension bridge in the Tacoma Narrows that tore apart in 1940 during a storm with winds of 35 to 46 miles per hour. Essentially the suspension bridge was caught in the rapid fluctuations of air moving at high speed, wasn’t able for the stress, and so buckled. Modern engineers can correct for this problem, but in 1940 no one had the tools. They weren’t discovered until the 1950s and 1960s.
The Brooklyn Bridge was completed sixty years before Gertie fell into the Tacoma Narrows. It is also a suspension bridge. It was designed by an engineer called John Roebling. Roebling didn’t have access to the tools to model rapid wind movement across suspension bridges either. But he knew he didn’t have those tools. So Roebling designed the Brooklyn bridge 6 times stronger in places that it needed to be given the size and shape of the bridge and the construction technologies he had available. This safety proofing is excessive, time consuming, and no doubt much more costly. Why did Roebling do it? He knew that he didn’t know the effects of the wind lift on the bridge. So he overcompensated to buttress the bridge against the limits of his knowledge. He went further, building a criss-crossing structure of diagonal stays down to the roadway. These further stiffen the entire bridge structure.
Modern financial engineers need to be more like Roebling. They need to build asset pricing models knowing that they don’t know how to price these things properly. There has to be excessive proofing, increased regulation, and a stiffening of the entire structure. Basel II, III, and even IV will not go far enough because they do not adopt this prudential position.
If you don’t believe me, look at the language even a reformist regulator like Lord Turner uses when talking about the reinvention of modern regulation.
We’re just rebuilding Gertie.