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December 10, 2009

"How Have Quantitative Financial Models Been Used and Misused?"

A recent symposium on Financial models and financial innovation at Columbia University wonders "Why all the Fuss?":

Financial Models: Why All the Fuss?, by Catherine New: The research symposium “The Quantitative Revolution and the Crisis: How Have Quantitative Financial Models Been Used and Misused” at Columbia Business School on December 4 explored the causes and effects of the proliferation of quantitative finance. Donald MacKenzie, a professor of sociology at the University of Edinburgh, gave the keynote speech (PDF).
Professor Bruce Kogut, in his opening remarks, acknowledged that financial engineering and innovation have received an onerous rap in the fallout from the financial crisis. However, he suggested that the field was ripe for public debate.
“It might be easy to leap to the conclusion that the subtext of today is that financial models created the crisis and hence innovation is bad. But such a deduction is in fact deeply complex and largely suspect,” he said. “Why is there such debate over financial innovations? After all, innovation is a driver of economic growth and wealth, so why all the fuss?” Kogut suggested three possibilities, including the disparity between private and social value, unanswered questions about systemic risk and the speed at which innovation takes place.
Professor Paul Glasserman pointed to popular media portrayals, like WIRED’s “Recipe for Disaster: The Formula That Killed Wall Street” (Feb. 2009), which excoriated the financial industry’s use of models, as perpetuating misunderstanding about the uses and capabilities of quantitative finance.
“The article sets the record for the most incorrect statements packed into a title,” Glasserman said. “In a very short time there has been a dramatic shift in perception of quantitative finance.”
Glasserman moderated the panel “Does the Practice of Quantitative Finance Need to Be Changed?”...
Much of the panel’s discussion focused on when models are useful — and not useful — in financial markets. Derman, author of My Life as a Quant, led the discussion and offered a discourse on what models are and how they can be applied (download presentation PDF). He cautioned that there is never a “right” model but rather ”somewhere north of common sense and south of hubris lies the appropriate use of models.”
Beunza, formerly a visiting professor at the Business School, cautioned that the use of models is a “doubled-edged sword”; his research shows that they lead both to increased arbritrage and better reflexiveness.
Goldman Sachs’ research director Kent Daniel argued that models benefit many fields, such as airline safety, and not only financial markets. However, he cautioned that exacting data was fundamental to the use of models. “A successful quant model has to be subjected to every kind of scrutiny you have,” he said. “If your organization doesn’t do that, you’ll have a failure.”

There are important uses for financial products, even complicated ones, so I don't want to impugn innovation generally, but I also don't want to adopt the position that it was all useful - it clearly wasn't and stronger regulatory oversight is needed. As for the defense of financial models and innovation described above, the statement that innovation generally is the source of economic growth, therefore financial innovation must also be good, isn't much help. Similarly, if saying "models benefit many fields, such as airline safety, and not only financial markets" is the best defense of risk models available, that's telling.

[For those of you tempted to cite or that already have cited Paul Volcker's recent statement that ATMs are the only useful thing to come out of the financial industry in recent decades, I'd be more comfortable with your citing him as an all-knowing authority if you also adopted his position against auditing the Fed, and his position that the Fed ought to be the primary systemic risk regulator. But rather than listening to Volcker and others you have found to be trustworthy and wise in the past, many of you seem to find the arguments of people like Ron Paul and Jim DeMint compelling, and you have thrown your support behind their positions (something you'd be unlikely to do in any other context -- that alone ought to cause you to rethink this -- whose interests do you think people like DeMint are promoting?). If you get your way and congress, and by extension the financial industry, begins to have a strong influence over both policy and regulation, I hope you get the results you were hoping for. But I don't think you will.]

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