ssoc - sights and sounds of the crisis - Finance

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

Stephanie Russell-Kraft — Sun, 27 Jan 2013 20:58:59 +0000

This blog post is part of the investigation:

Quantifying Risk: Security and Certainty in the Financial Industry

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.

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Finance and the City

Stephanie Russell-Kraft — Wed, 24 Oct 2012 15:22:44 +0000

This blog post is part of the investigation:

Quantifying Risk: Security and Certainty in the Financial Industry

In a recent article posted on The Atlantic Cities blog, urban studies theorist Richard Florida (most well known for his 2001 book, The Rise of The Creative Class) examines the new geography of finance within the United States.

He writes: "The 2008 financial crisis set in motion shock waves that are still reverberating through the American, European, and global economies, touching everything from housing to jobs to college tuition... Several years into the crisis, I wanted to look at how the crisis might have affected the geography of finance across America."

Florida's findings, which he compiled with the help of Charlotta Melander of the Martin Prosperity Institute, caught my attention. He writes that while the Greater New York Region is by far the largest financial center in the USA (with nearly half a million people working in finance-related occupations!) it ranked only 18th in a map charting "the share of total regional employment composed of people who work in all finance-related occupations." Only 5.8% of the New York workforce falls into this category. In Washington, D.C., by contrast, financial occupations make up nearly 10% of local employment.

In what ways, then are the cultures of cities defined by their leading industries? New York represents the financial capital of the United States, but can we define it as a financal city? To what extent is the Big Apple shaped by Wall Street?

These questions came up a few times while I was conducting my research among graduate students in computational finance this past September. The students enrolled in this particular program had the option of completing their degree at the university's main campus (in Pittsburgh) or at its satellite campus in New York City.

So, I asked, why did students choose New York?

For the most part, it was a calculated professional choice. The students acknowledged that daily on-campus access to professors might have had its advantages, but that these were minimal when compared to the benefit of living and studying in such close proximity to so many potential employers. Said one first-year student, “This is where the industry is. It's all about broadening your net. .. I'm here to get a job. It's not about my GPA, it's about networking and taking advantage of every opportunity.”

At the same time, other students told me that New York itself, as a complete city which happened to contain a financial hub, was the primary attraction. "I read a lot about New York and how rich it is in culture and opportunities, the melting pot of the whole world, the biggest financial center in the West and possibly the world, so .. it looked like the big league," another first-year explained. "So that's why I decided to move here....You walk down the street, you hear tens of languages, skyscrapers, the city is very rich in all aspects, not only in cash."

This last sentence leaves me wondering: to what extent can we parse through these various aspects of richness? And how can we qualify, or perhaps even quantify, non-material wealth?

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Behind the noise: New York City

Stephanie Russell-Kraft — Wed, 03 Oct 2012 14:04:08 +0000

This blog post is part of the investigation:

Quantifying Risk: Security and Certainty in the Financial Industry

When I arrived in New York at the end of August to begin my field research on graduate programs in quantitative finance, I was struck by the overall level noise of the city. I knew that New York was loud – I had lived there for six years – but I had just how many individual sounds contribute to the the white noise of the city's streets.

As I explored the Lower Manhattan streets outside of the building where I conducted most of my fieldwork, I strained to parse what I was hearing. Delivery trucks, muddled conversations of passers-by, sirens, cell phone ring tones, these were easier to distinguish. But what about that low, audible-yet-uncharacterizable hum coming from... the buildings? Or was it a more of a drone? And why was it still there – and even seem louder – at 9:30 in the evening?

The inside of the office building where the graduate program in finance was housed was, by contrast, very quiet. In the common area, I heard the sound of laptop keys, pens, highlighters, (calm) conversations about homework and (energetic) social interactions. The students usually had the TV in the common area switched to CNBC, a financial news program. The news was at times merely background noise – when no one was in the room, when students were talking amongst themselves – while at others a focal point – for students taking a lunch break.

Every time I stepped outside of the building, I was struck again by how loud it was. What was the sound of the city? Were the sounds worth distinguishing, or were they more meaningful through their combined effect? At what point does sound become background noise?

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