If risk is so important to the financial industry, what of uncertainty?

This blog post is part of the investigation: 

In the financial industry, risk is everything. Whether it be market risk, operational risk, representational risk, or credit risk, actors in financial markets base their decisions on measures of risk: calculations of potential losses and future events. Most risk today can be quantified to some degree – numerical indicators such as Value at Risk (VaR) allow financial analysts to simplify predictions and parse out precise degrees of probability. On the basis of these calculations, trades are made, companies are bought and sold, stocks are valued. Risk both defines and creates the market.

During my interview with A.A., a first-year student at in a computational finance master's program, he touched on the centrality of risk in the financial industry: 

“Banks are only going to assume market-making roles, which are essentially connecting buyers and sellers, and which doesn't have a lot of risk whereas prop shops and hedge funds are going to have more risk, and definitely more reward if things go right. So trading is shifting from big banks to the smaller firms.”

Here, A.A. equates risk with potential for growth and profit. For a financial organization to succeed, it must both seek out and manage risk.

For actors entering into or working in the financial industry, this centrality and necessity of risk is taken for granted. Many students that I interviewed during my fieldwork did not know why I was asking them to explain these concepts to me. They also stressed the distinction between risky behavior (in making hasty trades, or life-altering personal decisions), and using risk as a mathematical tool in the financial market.

When I asked him whether or not the people who develop complex financial models should be held responsible for the models' use and implementation, second-year computational finance student D.S. hesitated to answer. When the topic came up in his own answers to other questions, he pushed it aside:

“For everything, the banks are taking out huge risks. And they have to manage that risk, right? … So the way I think it has changed after the crisis is that I think is that there is like, at every bank they have a bigger risk management department, and risk management also is done through a lot of mathematics. Because you have so much risk and you have to manage it. There are a lot of risk management models. In many cases banks have to hedge their risk using derivatives. So I personally don't think that the notion of derivatives as killing us is actually right, not at all, because if they are not able to use derivatives then they are not be able to hedge their risks. But then you can say OK well some people are probably using it more for speculation as opposed to hedging. That's a different question to answer. But I think the use of mathematics in finance is extremely important and I think it is going to be even more going forward.“

But what of uncertainty? Frank Knight and John Maynard Keynes, both fathers of modern economic theory, “drew a conceptual distinction between risk and uncertainty that remains of fundamental importance today.” However, this distinction has been pushed to the margins of economic and financial theory: this “conventional view that we live only in a world of calculable risk is mistaken and leaves us with a stunted and dangerously incomplete view of economic life,” argue Steven Nelson and Peter J. Katzenstein (Nelson and Katzenstein 2011)

Unlike risk, uncertainty cannot be calculated. It is, as former Secretary of Defense Donald Rumsfeld now famously put it, an “unknowable unknown.” Contemporary American economic theory is still largely based on the assumption that market actors and policy makers operate in a world of calculable risk and rational decision makers. As a result, these unquantifiable risks – or uncertainties, rather – are often ignored. I would not be the first to argue that this can lead to crisis.

Nelson, Steven and Peter J. Katzenstein. “Risk, Uncertainty, and the Financial Crisis of 2008” (draft). Prepared for the International Political Economy Society Meeting, University of Madison-Wisconsin. November 2011.