Financial risk: who decides the limits?

Bankers are supposed to epitomise stability, prudence and order. Risks are supposed to be measured, and credit priced accordingly.

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Bankers are supposed to epitomise stability, prudence and order. Risks are supposed to be measured, and credit priced accordingly. That is the theory, anyway. Today's financial institutions and their captains of industry have delivered misery, financial panic and debt that have left the markets uncertain on where to turn to next. This raises a fundamental issue - whether in the pursuit of profit in financial markets, or scientific knowledge, unknown risks are part of the game. It leaves open the question of how these risks are justified on a larger societal basis, and just who gets to decide if the rewards are worth the risk? Who exactly will stand to reap the reward versus paying the costs? There is now a sense that the roughest bits of the financial market turbulence have calmed, barring some totally unexpected collapse of another blue chip name to set another round of panic - but the issue of risk management has not gone away.

In the world of science, something stranger than fiction is taking place. And both issues, whether scientific or financial, are related. Physicists from around the world are gathering in Switzerland at the world's largest particle accelerator, the Large Hadron Collider (LHC). Once there, these scientists will begin smashing protons together, trying to recreate conditions that existed just after the "Big Bang". There are real fears that during these experiments, due to the unpredictable nature of quantum physics, that these subatomic collisions could unleash uncontrollable reactions that could spell the earth's end - in essence leaving the possibility that a universe-swallowing "black hole" could be created at LHC. Other scary stuff has been predicted, with some arguing that matter called "strangelets" could be released, which might reduce the earth to a hot, barren lump.

Before we all start to look for the nearest cave to escape to, the majority of physicists discount the chances of either of the above happening, but the point here is that teams of scientists have been checking and rechecking just to make sure, and that neither event "presents a conceivable risk", although none declined to give any odds. Worried citizens however, are not leaving it to scientists to decide outcomes. A legal case has been filed in an effort to halt any experiments at LHC until further studies have been done to guarantee that none of the most dreaded "tail risk" outcomes will happen, and that scientists are not playing dice with our fate.

In the financial world, there appeared to be a similar dice-throwing quality to some of the more exotic investments imagined by financial market scientists. And so they created the MBS (mortgage backed securities), CMOs (collateralised mortgage obligations), CLOs (collateralised loan obligations) and CDOs (collateralised debt obligations), just like the protons at LHC. Little study of the probable outcomes of these financial experimental financial investments was undertaken beyond running a few "value at risk" model simulations. No one ever asked scientific questions, such as for instance, would meshing subprime loan-backed paper with higher quality loans doom financial markets and send the housing market into a crisis?

It was astonishing how quickly the experiments of the financial scientists went wrong. Globalisation, which is supposed to bring good to many, seemed to have brought bad news and jitters to all, as the almost immediate global reaction to the subprime crises shared a subatomic similarity. Like elemental particles communicating faster than the speed of light, global investors seemed to sense the same thing at the same moment and reacted in the same way. In not examining the worst-case financial probabilities, market scientists hardly dreamt that their experiments could create the black hole that swallowed Bear Stearns.

In the final analysis, greed was the driver, as market scientists seemed unperturbed at avoiding accurate measurements of the impact of investment experiments on the financial system, fearing that it would be too disruptive, amid the profit boom. The question, then, is: who gets to decide if the risk of the financial experiment is too great for the reward? Some say that having too many parties involved in determining the limit on risks would halt much of the more provocative scientific or financial studies that often result in ground-breaking discoveries.

However, given the nature of globalised markets, and systematic panic setting in, finding an acceptable way to limit the chances of the experiment - whether scientific or financial - leading to a catastrophic unexpected outcome would seem to be in the best interests of all. What is called for is a wider public debate, especially by experts with no stake in the experiments under consideration. Since all segments of society are affected, a financially savvy public is a prerequisite. This should go some way towards ensuring that we keep an open mind that the outcome of what financial experts or scientists are doing - whether positive or negative - is likely to be different from what they expected it to be.

Dr Mohamed Ramady is a former banker and visiting associate professor of finance and economics at King Fahd University of Petroleum and Minerals