The Investment Banking Model Is Flawed
Robert Engle is a Nobel Prize-winning economist. After completing his Ph.D., Engle was a professor of economics at the Massachusetts Institute of Technology from 1969 to 1977. He joined the faculty of the University of California, San Diego (UCSD) in 1975, where he retired from in 2003. He now is a Professor Emeritus and Research Professor at UCSD. He currently teaches at New York University, Stern School of Business where he is the Michael Armellino professor in Management of Financial Services. Engle is also the co-founder of the Society for Financial Econometrics (SoFiE). He won the Nobel Memorial Prize in Economic Sciences in 2003.
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."
What would happen if you tripled the US population? Matthew Yglesias and moderator Charles Duhigg explore the idea on Big Think Live.
Is immigration key to bolstering the American economy? Could having one billion Americans secure the US's position as the global superpower?
How Nobel Prize winner physicist Lev Landau ranked the best physics minds of his generation.
Rank 0.5 – Albert Einstein<img type="lazy-image" data-runner-src="https://assets.rebelmouse.io/eyJhbGciOiJIUzI1NiIsInR5cCI6IkpXVCJ9.eyJpbWFnZSI6Imh0dHBzOi8vYXNzZXRzLnJibC5tcy8yNDQ0NDY3NS9vcmlnaW4uanBnIiwiZXhwaXJlc19hdCI6MTYzNjI2NTU4OH0.FtBYC7oJz-ZOiiGC9y0Z50_JvQChmp-ONa3jhR3SuLA/img.jpg?width=980" id="d6f66" class="rm-shortcode" data-rm-shortcode-id="61288810a4f035ec2af8957fad4e9015" data-rm-shortcode-name="rebelmouse-image" />
Albert Einstein With Displaced Children From Concentration Camps. 1949.
Photo by Keystone-France/Gamma-Keystone via Getty Images
Rank 1<p>The group in this class of the smartest physicists included the top minds that developed the theories of quantum mechanics.</p><p><a href="http://en.wikipedia.org/wiki/Werner_Heisenberg" target="_blank">Werner Heisenberg</a> (1901 - 1976) - a German theoretical physicist, who's achieved pop-culture fame by being the name of Walter White's alter ego in <em>Breaking Bad</em>. He is known for the Heiseinberg Uncertainty Principle and his 1932 Nobel Prize award flatly states it was for nothing less than "the creation of quantum mechanics".</p><p><a href="http://en.wikipedia.org/wiki/Erwin_Schr%C3%B6dinger" target="_blank">Erwin Schrödinger</a> (1887 - 1961) - an Austrian-Irish physicist who gave us the infamous "Schroedinger's Cat" thought experiment and other mind-benders from quantum mechanics. The Nobel-prize-winner's <a href="https://en.wikipedia.org/wiki/Schr%C3%B6dinger_equation" target="_blank" rel="noopener noreferrer">Schrödinger equation</a> calculates the <a href="https://en.wikipedia.org/wiki/Wave_function" target="_blank">wave function</a> of a system and how it changes over time. </p>
Erwin Schrödinger. 1933.
Satyendra Nath Bose. 1930s.
Enrico Fermi. 1950s.
Rank 2.5<img type="lazy-image" data-runner-src="https://assets.rebelmouse.io/eyJhbGciOiJIUzI1NiIsInR5cCI6IkpXVCJ9.eyJpbWFnZSI6Imh0dHBzOi8vYXNzZXRzLnJibC5tcy8yNDQ0NDcwNy9vcmlnaW4uanBnIiwiZXhwaXJlc19hdCI6MTY0NDE1MDIxM30.Eg6tca61EredHxjqNH29HY3UeJbgBVa1nA13EhXTooU/img.jpg?width=980" id="90f86" class="rm-shortcode" data-rm-shortcode-id="0f1e6c5e13263a77b2061e1191fd8baf" data-rm-shortcode-name="rebelmouse-image" />
Lev Landau. 1962.<p><strong>Rank 2.5</strong> is where Landau initially ranked himself, rather modestly, thinking he didn't produce any foundational accomplishments. He later moved his prominence, as his achievement mounted, to the higher <strong>1.5.</strong></p>
Controversial physics theory says reality around us behaves like a computer neural network.
- Physicist proposes that the universe behaves like an artificial neural network.
- The scientist's new paper seeks to reconcile classical physics and quantum mechanics.
- The theory claims that natural selection produces both atoms and "observers".
Vanchurin interview:<span style="display:block;position:relative;padding-top:56.25%;" class="rm-shortcode" data-rm-shortcode-id="539759cbfd8fcd5b6ebf14a3b597b3f9"><iframe type="lazy-iframe" data-runner-src="https://www.youtube.com/embed/bmyRy2-UhEE?rel=0" width="100%" height="auto" frameborder="0" scrolling="no" style="position:absolute;top:0;left:0;width:100%;height:100%;"></iframe></span>
Vanchurin on “Hidden Phenomena”:<span style="display:block;position:relative;padding-top:56.25%;" class="rm-shortcode" data-rm-shortcode-id="18886ffd5e5840bb19d4494212f88d82"><iframe type="lazy-iframe" data-runner-src="https://www.youtube.com/embed/2NDVdNwsHCo?rel=0" width="100%" height="auto" frameborder="0" scrolling="no" style="position:absolute;top:0;left:0;width:100%;height:100%;"></iframe></span>Vitaly Vanchurin speaking at the 6th International FQXi Conference, "Mind Matters: Intelligence and Agency in the Physical World." The Foundational Questions...
A strange weakness in the Earth's protective magnetic field is growing and possibly splitting, shows data.
- "The South Atlantic Anomaly" in the Earth's magnetic field is growing and possibly splitting, shows data.
- The information was gathered by the ESA's Swarm Constellation mission satellites.
- The changes may indicate the coming reversal of the North and South Poles.
Is the Magnetic Field Reversing?<span style="display:block;position:relative;padding-top:56.25%;" class="rm-shortcode" data-rm-shortcode-id="e3e0b16dac3b05dab808a4ddf04d198b"><iframe type="lazy-iframe" data-runner-src="https://www.youtube.com/embed/51usJ74pPP8?rel=0" width="100%" height="auto" frameborder="0" scrolling="no" style="position:absolute;top:0;left:0;width:100%;height:100%;"></iframe></span>
43% of people think they can get a sense of someone's personality by their picture.
If you've used a dating app, you'll know the importance of choosing good profile pics.