The Investment Banking Model Is Flawed

Question: Is the investment banking model fundamentally flawed?  

Robert Engle:
My way of understanding this financial crisis is in terms of two different observations.  One is that risk managers and investment bankers and actually, all kinds of investors took on more risk than they expected.  So there was a failure of risk management.  There was a failure to recognize how much risk there was in some of these securities that people bought. 

But a second and perhaps more important point is that many of these same people were paid very well to ignore the risks, and so there are incentives which are – which distort our ability to measure risk.  That is, many times we’re not risking our own money, we’re risking somebody else's money, or maybe that someone is going to back stop or downside, but we still get the upside.  There are a lot of ways that investment banking models work, but these risks are not internalized by the people that are taking them.  And so, I think that’s something that investment banks have worried about for a long time and are continuing to worry about, but it’s not an easy solution when you have lots of people betting the company’s money, how do you really allocate those risks?  How do you make sure that the people that take the risks are feeling the risks in an appropriate kind of fashion?

Question: Do you agree with author Nassim Taleb that we put too much faith in financial experts?

Robert Engle: Oh well I would agree with that.  I don’t agree – I agree with a lot of the points in Taleb’s book, but I don’t agree with many of his conclusions.  It seems to me that he rightly points out that risk managers miss a lot of the risks, but the conclusion is that he draws, is that we should abandon risk management, whereas my conclusion is we should improve it.  I don’t see what the alternative to risk management is.  If it’s just getting rid of the models and instead using the smart people who can figure it out?  How do you train them?  What do you teach them?  Do you just put them in a cockpit and let them stumble for 10 years of their life and then after that they’re good at it?  I think that **** have gotten so complicated that we need risk management, but we just need to make it better.  We need to be able to understand better where these risks are coming from. 

And I think actually one of the – coming back to one of your previous points about investment strategies.  One of the things we might come out of this crisis and I think that Nassim is sort of an example of this as well is that we might invest a part of our assets in portfolios that we don’t expect to do well not, but we would expect them to do well if we have another crisis.  And this is a different way of thinking about asset allocation.  It’s an old idea in economics, but it hasn’t’ really been at the center of much investment analysis, but I think now there’s a lot of interest in these so called hedge portfolios which will out perform in a crisis.  I mean, we’ve always had gold bugs, but now we sort of realize that Treasure Bills might be in the same category.  And we have derivatives like credit default swaps which are in this category, and we have derivatives like volatilities that are actually an asset class that we can invest in which are now – would out perform if we have another financial crisis.

And so thinking about these different assets and I should say, this extends to lots of other kinds of long term risks, for example, if we think about the long term risks of global warming.  You know, some of the portfolios we might consider buying are portfolios which would do especially well if we have an economy-wide, or I mean, a global climate change that impacts us very negatively there are some companies that will do well, and so it might make sense to hold some of those in your portfolio. 

Recorded May 25, 2010
Interviewed by Andrew Dermont

Investment banks encourage faulty risk management because the risks are "not internalized by the people that are taking them."

Related Articles

Why cauliflower is perfect for the keto diet

The exploding popularity of the keto diet puts a less used veggie into the spotlight.

Purple cauliflower. (Photo: Shutterstock)
Surprising Science
  • The cauliflower is a vegetable of choice if you're on the keto diet.
  • The plant is low in carbs and can replace potatoes, rice and pasta.
  • It can be eaten both raw and cooked for different benefits.
Keep reading Show less

Sex robot brothel in Texas sparks controversy and ethical questions

Some say the proliferation of sex robots could lead to less demand for prostitution, but not all agree.

Will the proliferation of sex robots be a net good or bad for society? (Photo: Shutterstock)
Sex & Relationships
  • A Toronto-based sex robot brothel plans to open another location in Houston.
  • Some critics argue that the proliferation of sex robots would lead to increases in prostitution and sex trafficking.
  • Others say that such technology could help some people find a degree of much-needed companionship.

There are currently no laws against opening a sex robot brothel in Houston, though recently announced plans to open one inspired some residents to say there should be.

The owner of Kinky S Dolls, a Toronto-based company where $120 gets customers 80 minutes alone with a robotic sex doll that moves and talks, plans to open another location in the Houston area. It would be the first sex robot brothel in the U.S.

On advice from counsel, owner Yuval Gavriel doesn't call his business a 'sex robot brothel' but rather a kind of try-it-before-you-buy-it shop for realistic sex dolls, which he sells for $2,000 to $5,000.

"I consulted with a lawyer and the lawyer said, 'Listen, there are no rules to it, but if you are smart you don't go out and say you are operating a brothel,'" Gavriel told the Washington Examiner. "He went through all the laws and all of the regulations and currently there are no regulations for this kind of service. The States is a bigger market, and a healthier market, and God bless Trump."

A sex doll sold by Kinky S Dolls for about $3,500.

Sex dolls and toys may be legal in the U.S., but some believe that establishing what's essentially a robot sex brothel would cross a line. In response to Gavriel's plans, Elijah Rising, a Christian organization in Houston that combats sex trafficking, published a petition titled 'Keep Robot Brothels Out Of Houston'.

"As a nonprofit whose mission is to end sex trafficking we have seen the progression as sex buyers go from pornography to strip clubs to purchasing sex—robot brothels will ultimately harm men, their understanding of healthy sexuality, and increase the demand for the prostitution and sexual exploitation of women and children," reads the petition, which currently has nearly 6,000 signatures.

Elijah Rising's argument is based on a paper written by Kathleen Richardson, a professor of ethics and culture of robots at De Montfort University.

"I propose that extending relations of prostitution into machines is neither ethical, nor is it safe," Richardson argues in the paper. "If anything the development of sex robots will further reinforce relations of power that do not recognise both parties as human subjects. Only the buyer of sex is recognised as a subject, the seller of sex (and by virtue the sex-robot) is merely a thing to have sex with."

How would sex robots affect rates of prostitution?

One argument, to which Gavriel subscribes, says that increased availability of sex robots would lower the demand for human prostitutes. It's an idea tangentially related to the longstanding body of research that shows countries tend to see decreases in sexual assaults and rape after they legalize porn.

In his bestselling book Love and Sex with Robots, A.I. researcher David Levy explores the future of human relationships with robots and suggests that sex robots could lower prostitution or even someday render it obsolete.

But that's "highly speculative philosophy," according to Richardson.

"The reality is that it will just become a new niche market within the pornography industry and within the prostitution trade," she said in an interview with Feminist Current. "If people buy into the idea that you can have these dolls as part of your sexual fetish, it will become another burden that actual living human beings will have to undergo in the commercial sex trade."

A sex doll sold by Kinky S Dolls.

Richardson elaborated on this idea in her paper.

"...studies have found that the introduction of new technology supports and contributes to the expansion of the sex industry," she wrote. "Prostitution and pornography production also rises with the growth of the internet. In 1990, 5.6 percent of men reported paying for sex in their lifetime, by 2000, this had increased to 8.8 percent."

However, those rates aren't necessarily causally linked.

Richardson also wrote that if sex toys, such as RealDolls and blow-up dolls, actually led to lower prostitution demand then we would have already seen decreases, but "no such correlation is found."

Still, that last point might soon become invalid as a sort of apples-to-oranges comparison if technology can produce artificially intelligent and lifelike sex robots unlike anything the industry has seen before.

An illusion of companionship

Image: Film4, from the 2015 film 'Ex Machina'

Image: Film4, from the 2015 film 'Ex Machina'

Critics argue that the proliferation of sex robots would serve to reinforce the objectification of women in men's minds, and also reduce the ability for some men to empathize, a necessary component of healthy social interaction.

Houstonian Andrea Paul voiced a simpler objection to the brothel:

"There's kids around here and it's a family-oriented neighborhood and I live right here and to have that here is just gross."

Gross, sure. But to Matt McMullen, creator of the RealDoll, the future of sex robots looks a bit more uplifting.

"My goal, in a very simple way, is to make people happy," McMullen told CNET. "There are a lot of people out there, for one reason or another, who have difficulty forming traditional relationships with other people. It's really all about giving those people some level of companionship—or the illusion of companionship."