SSRN id 2029092 : How to Prevent Other Financial Crises , Nassim Nicholas Taleb


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SSRN id 2029092 : How to Prevent Other Financial Crises , Nassim Nicholas Taleb

  1. 1. How to Prevent Other Financial Crises Nassim Nicholas Taleb, Distinguished Professor of Risk Engineering, NYU-Poly George A. Martin, Associate Director, CISDM, University of Massachusetts at Amherst This paper is a synthesis and expansion of the deposition of the first author in front of the Financial Crisis Inquiry Commission, 2010. engineers spend time sleeping under the bridges they Introduction: Let us start with our conclusion, have built, to the maritime rule that the captain shouldwhich is also a simple policy recommendation, and one be last to leave the ship when there is a risk of sinking.that is not just easy to implement but has been part ofhistory until recent days. We believe that “less is more” The Hammurabi rule marks the separation between anin complex systems—that simple heuristics and agent’s interests and those of the client, or principal,protocols are necessary for complex problems as she is supposed to represent. This is called the agencyelaborate rules often lead to “multiplicative branching” problem in the social sciences. Often closely associatedof side effects that cumulatively may have first order is the problem of moral hazard, wherein an actor haseffects.. So instead of relying on thousands of incentive to behave in an economically or sociallymeandering pages of regulation, we should enforce a suboptimal manner(e.g. overly risky) because she doesbasic principle of “skin in the game” when it comes to not bear all of the actual and/or potential costs of herfinancial oversight: action. In banking, these two are combined most acutely in the case of large institutions that may be The captain goes down with the ship; every deemed “too big to fail,” as increased risk taking (moral captain and every ship. hazard) may lead to greater interim compensation toIn other words, nobody should be in a position to have management (agent) at the expense of junior claimantsthe upside without sharing the downside, particularly such as shareholders and guarantors (taxpayers, etc.)when others may be harmed. While this principle seems (principals). The Hammurabi rule solves the jointsimple, we have moved away from it in the finance agency and moral hazard problem by ensuring that theworld, particularly when it comes to financial agent has sufficient non-diversifiable risk to incent theorganizations that have been deemed “too big to fail.” agent to act in the joint interest of the agent and the principal.The best risk-management rule was formulated nearly4,000 years ago. Hammurabi’s code specifies: Nor does it contradict capitalism: for example, Adam Smith was chary of the joint stock company form as he If a builder builds a house for a man and does worried it could be gamed by managers. Nor does it not make its construction firm, and the house require much beyond some skin in the game for which he has built collapses and causes the economic agents. death of the owner of the house, that builder shall be put to death. In sum, we believe the crisis of 2007-2008 happened because of an explosive combination of agencyClearly, the Babylonians understood that the builder will problems, moral hazard, and “scientism”—the illusionalways know more about the risks than the client, and that ostensibly scientific techniques would manage riskscan hide fragilities and improve his profitability by and predict rare events in spite of the stark empiricalcutting corners—in, say, the foundation. The builder and theoretical realities that suggested otherwise.can also fool the inspector (or the regulator). Theperson hiding risk has a large informational advantageover the one looking for it. PART I: ETIOLOGYThe potency of the classical rule lies in the idea that The key drivers of the Financial Crisis of 2007-2008 arepeople do not consciously wish to harm themselves. We the interplay of the following five forces, each of whichfeel much safer on a plane because the pilot, and not a can be linked to the misperception, misunderstanding,drone, is at the controls. This principle has been applied and the active hiding of the risks of consequential butby all civilizations, from the Roman heuristic that low probability events (“Black Swans”) by those that © Copyright 2010 by N. N. Taleb. Electronic copy available at:
  2. 2. stood to benefit from the obscuring of consequential c- Fragility in the Fourth Quadrant can be re-expressedrisk. Other diagnoses, for example those of the as “concavity to errors,” where losses from uncertainFinancial Crisis Inquiry Commission, focus more on events vastly exceed possible profits from it over shortepiphenomenal aspects of the crisis such as excessive horizons. One class of investment strategies thatborrowing, risky investments, opacity of markets, or typically have this property are so-called "shortfailures of corporate governance.1 volatility" trading strategies or positions (e.g. such as naked put-writing), which are often manifest in “carryThe immediate precursor to the Crisis was the collapse trades.” These exposures increased significantly withof the securitized residential subprime market, which, concentration of positions in and across banks andalong with other forms of collateral, was responsible for other financial institutions as these organizationslosses to financial institutions of more than $500 billion tended to find themselves attracted to similar strategiesin 2007.2 By the end of 2009, the estimate for the total that had an apparent “history” of profitability withoutvalue of write downs to credit instruments held by much realized risk/volatility. As more and moreglobal banking and other financial organizations was organizations found themselves with greater and similarclose to $3.4 trillion.3 This was the result of: exposures, the interconnection of exposure across asset1) Increases in hidden risks associated with low classes and financial institutions contributed to virulentprobability, large-consequence events (also known as effects on asset prices: there were pressures on these“tail risks”) across all aspects of economic life, not just institutions to unwind exposure as well as downwardin banking. Tail risks could not (and cannot) be reliably pressure on the value of assets as future cash flowspriced, either mathematically or practically, as associated with such assets were marked down due touncertainty about key aspects of tail risk has typically increasing risk premia.been on the order of, or greater than, understanding ofthe actuarial price of such risks. Nonlinearity in pricingrisk is also exacerbated by an increase in debt, 2) Asymmetric and flawed incentives that favor riskoperational leverage and complexity, and the use of hiding in the tails. There were three primary flaws incomplex derivatives. the compensation methods which led to artificial earnings and not adequately and appropriately risk-a- The first author has shown that it is impossible to adjusted ones. They are a) asymmetric payoff: upside,measure directly the risks in the tails of the probability limited or no economic downside (a free or underpriceddistributions typical of financial markets. 4 The relative option); b) flawed frequency: annual compensation forerrors swell in proportion to the remoteness of the risks that blow-up every few years, with absence ofevent. Small variations in input, smaller than any claw-back provisions; and c) misattribution:uncertainty we have in the estimation of parameters, compensation for returns that are an attribute of theassuming generously that one has the right model of market (e.g. incentive fees that do not control forunderlying probability distribution, can underestimate market beta or baseline risk premia), or an attribute ofthe probability of rare but recurring events (i.e., "12 the organization (compensation for revenues derivedsigma," that is, 12 standard deviations) by close to a from the use of balance sheet to generate “carry”).trillion times—a fact that has been so far routinelyignored by the bulk of the finance and economics 3) Misunderstanding of elementary notions ofestablishment. probabilistic payoffs across economic life. The general public fails to notice that a manager "paid on profits" isb- Financial institutions amassed exposures in the not really "paid on profits" in the way it is presented"Fourth Quadrant" 5 which is where errors are both and not compensated in the same way as the owner ofconsequential and impossible to price, and the a business, given the absence of negative payment oninstitutional vulnerability to these errors is large. For losses (this is known as “the fooled by randomness”example, a key source of losses to financial institutions argument). States of the world yielding financial failurewas “super senior” tranches of collateralized debt are effectively ignored—this is "probabilistic blindness."obligations (CDOs) which received credit ratings of“AAA” or above and therefore were assumed to have This asymmetry is called the "manager option," or theeffectively zero probability of default (and therefore "free option,"7 as it behaves exactly like a call option onrequired no capital set aside to insulate against default the company granted by the shareholders, for free orrisk).6 These products were retained or purchased by close to little compensation. Thanks to the bailout ofbanks and other financial institutions engaged in 2008-2009 (“TARP”), banks could use public funds toproducing or facilitating the production of CDOs Such generate profits, compensating themselves generouslytranches typically generated positive carry on the order in the process, having the undue assent of, orof 10 basis points (bps), and were held in bank trading otherwise having convinced, the public and governmentbooks so as to avoid capital charges “by the yard” that this compensation was somehow justified since(billion). they brought profits to the public purse. They hid the fact that the public would have been the sole payer in the event of losses from this gamble. 2 © Copyright 2012 by N. N. Taleb. Electronic copy available at:
  3. 3. a- Mismatch of bonus frequency. Less misunderstood 4) Increased promotion of methods helping to hide tailby policymakers is the idea that a manager paid on an risks. Value-at-Risk and similar methods have alsoannual frequency does not have an incentive to promoted tail risks.11maximize profits; his incentive is to extend the time to a- As we note above, knowledge degrades very quicklylosses so he can accumulate bonuses before an in the tails of the distributions, making tail risks non-eventual "blowup" for which he does not have to repay measurable (or, rather, impossible to estimate—previous compensation. This provides the incentive to "measure" conveys the wrong impression). Yet vendorsmake a series of asymmetric bets (with a high have been promoting a method of risk managementprobability of small profits and small probability of large called "Value at Risk" (VaR) that just measures the risklosses) below probabilistic fair value at a particular point in the tail! It is supposed to projectThus, contrary to arguments of financial economists as the expected extreme loss in an institution’s portfoliowell as management, asymmetric incentive structures that can occur over a specific time frame at a specifiedmay be worse for shareholders and/or investors than level of confidence.12 For example: a standard daily VaRfixed payments to management. In addition, there is no of $1 million at a 1% probability tells you that you haveinherent reason to believe that managerial risk less than a 1% chance of losing $1 million or more on atolerance is more or less than shareholder risk given day. There are many modifications around VaR,tolerance, so it is not clear ex ante that capital should such as "conditional VaR,"13 equally exposed to errorsbe afforded an asymmetric payoff structure rather than in the Although such a definition of VaR is often presented asb- Misattribution of performance. The most pernicious a "maximum" loss, it is technically not so in an open-form of this is the compensation of individuals based on ended exposure, since, conditional on losing more thanperceived economic profitability (e.g. arising from a $1 million, you may lose a lot more, say $5 million. Solower cost of finance) that essentially derives from simply put, VaR encourages risk-taking in the tails andimplicit or explicit government guarantee. This the appearance of "low volatility." Moreover, applicationproduces a cost of capital savings for the de facto too of Gaussian VaR models systematically hide thebig to fail firms, as the implicit government backing expected consequence of VaR violations, as larger andserves to lower the perceived probability that lenders larger losses become exponentially smaller inwill be paid back, and in turn, the interest rate that probability.these banks must pay on their debt. Note here that regulators required banks shift fromc- The agency problem is far more vicious in the tails, hard heuristics or protocols—which are more robust toas it can explain the growing “left-skewness” (fragility) model error—to such "scientific" measurements. 14of corporations as they grow larger. 8 The contrary Academics and consultants have supported industryargument—that size is necessary for economies of scale reliance on VaR, and have promoted risk managementand scope in financial services firms, especially when practices based on numerate, often backward lookingadjusted for product mix—is largely unsupported by policies at the expense of policies based on prospective,empirical evidence. Alan Greenspan, in his 2010 mea qualitative risk management protocols. Such tools areculpa, “The Crisis”, notes: particularly dangerous for managing risk in “relative value” or “netted” positions since actual risk becomes For years the Federal Reserve had been very sensitive to estimates of correlation—or concerned about the ever larger size of our dependence more generally—between positions, and financial institutions. Federal Reserve research not just tail risk. had been unable to find economies of scale in banking beyond a modest-sized institution. A Moreover, most of these tools focus on the risk decade ago, citing such evidence, I noted that associated with individual institutions, and ‘megabanks being formed by growth and underestimate the contagion that arises across consolidation are increasingly complex entities institutions, or the concentration of risk in larger that create the potential for unusually large institutions that function as intermediaries to smaller systemic risks in the national and international institutions. Efforts by regulators to develop “predictive” economy should they fail.’ Regrettably, we did models of the probability of systemic risk have largely little to address the problem.9 been unsuccessful--in part because of the difficulty in forecasting systemic risk events, and in part because ofMore recent evidence, which does not directly consider the problem of false positives (also known as “Type Itail risk, has suggested that while there may be some errors”) that, because of the multiple testing problem,economies of scale in U.S. banking 10 beyond those occur at frequencies greater that the actual populationdirectly attributable to the presumption of “too big to” policies, cost savings nevertheless may be achievedby breaking up banks and altering product mix. 3 © Copyright 2012 by N. N. Taleb.
  4. 4. Criticism has been countered with the argument that Indeed principal errors by the financial economics"we have nothing better"; ignoring iatrogenic effects establishment contribute to financial fragility by meansand mere phronetic common sense. of:b- Iatrogenics of measuments (harm done by the a- Ignorance of "true" fat tail effects. Also,healer). These estimations presented as "measures" are misunderstanding that fat tails lead to massiveknown to increase risk taking. Numerous experiments imprecision in the measurement of low probabilityprovide evidence that professionals are significantly events (such as the use of Poisson jumps by Merton18,influenced by numbers that they know to be irrelevant or the more general versions of subordinatedto a professional decision, like writing down the last processes—these models fit the past with precision onfour digits of ones social security number before paper but are impossible to calibrate out of sample inmaking a numerical estimate of potential market practice and induce a false sense of confidence).moves. German judges who rolled dice before Misunderstanding that true-fat-tails cancels the core ofsentencing showed an increase of 50% in the length of academic financial theory and econometric methodsthe sentence when the dice showed a high number, used in practice.without being conscious of this subconscious b- Lack of awareness of the effect of parameterinfluence.15 estimation on a model. Some models—actually almostc- Linguistic conflation and reification. Calling these risk all models—take parameters for granted when theestimation "measures" creates confusion, making process of parameter discovery in real-life leads topeople think that something in current existence (not massive degradation of their results (due to “negativeyet existing in the future) is being measured. Usually, convexity effects” from layers of uncertainty).these metrics are not appropriately presented as mere c- Interpolation vs. Extrapolation. Misunderstanding ofpredictions with an abnormally huge error (as we saw the "atypicality of events" leads to looking for pastduring the most recent financial crisis, several orders of disturbances for guidance when we have obviousmagnitude). evidence of lack of precedence. For instance, Rogoff5) Increased role of tail events in economic life thanks and Reinhart look at past data without realizing that into "complexification" by global telecommunications and fat tailed domains, one should extrapolate someglobal economic integration, in addition to optimization properties from history, instead of interpolating orof the systems. looking for naive similarities.19a- The logic of winner take all effects: The Black Swan d- Optimization. It can be shown that optimizationprovides a review of "fat tail effects" coming from the causes fragility when the payoff is concave underorganization of systems.16 Consider the “island effect,” perturbation errors (i.e., in most cases, particularlywhich shows how a continent will have more acute when loss functions are based on convex functions).concentration effects as species concentration drops in e- Economies of scale. There are fragilities coming fromlarger areas. The increase in "winner-take-all" effects— size—as efficiencies typically rely on non-redundancies--which includes blowups—is evident across economic both for financial institutions themselves, as well asvariables. failure in size being more likely tocause externalities.20b- Optimization. Specifically the elimination of slack orredundancy, makes systems left-skewed and moreprone to extreme losses—this can be seen in concavityeffects under the perturbation of parameters. PART II: THE RESPONSIBLE PARTIES6) Growing misunderstanding of tail risks. Ironically,while tail risks have increased, financial and economictheories that discount tail risks have been more Government officials: They promoted blindness to tailvigorously promoted; historically, operators understood risks and nonlinearities (e.g. Bernankesrisks more heuristically.17 This was particularly the case pronouncement of a "great moderation" inafter the stock market crash of 1987 and after the macroeconomic volatility) and flawed tools in the hands"Nobel" was handed out to the creators of modern of policymakers not making the distinction between"portfolio theory." Note the outrageous fact that the different classes of economics establishment missed the rise inthese risks up to and including 2008, without incurring Bankers/company executives: These individuals had ansignificant and extensive problems in credibility—for incentive to hide tail risks as a strategy to collectexample, how well have business school curriculums bonuses.been updated to incorporate the lessons of 2007- Risk vendors and professional associations: The2008? Chartered Financial Analyst (CFA) designation and International Association of Financial Engineers promoted Gaussian or quasi-Gaussian portfolio theory 4 © Copyright 2012 by N. N. Taleb.
  5. 5. and Value-at-Risk methods without sufficient critical underinsured small risks, an economic system with acontext. severe agency problem builds a natural tendency to push and hide risks in the tails, even without help fromBusiness schools and the financial economics the academic economics establishment. When risksestablishment: Specifically, promotion and teaching of keep growing where they can be seen the least, thereGaussian portfolio theory and inadequate risk is a need to eliminate moral hazard by making everyonemeasurement methods on grounds that "we need to involved in the accumulation of material risksgive students something" (such arguments were used accountable both chronologically and medieval medicine). They still teach this.21 Hence the principle of symmetry in rewards—or “skin inIt would be rare to find an airplane pilot who would the game”—that we presented in the introduction. Itaccept using a map of Saudi Arabia when flying over mandates that captains go down with ships.the Himalayas on grounds that "there is nothing else"— Accountability for everyone involved in risk-bearing forhuman intuitions know better. Yet once framed in others, especially systemically; no exception, not afinancial terms, the reasoning reverses thanks to the single one—contractually, morally, legally, or by meansagency problem: it is others that are harmed. of whatever can be done to evade responsibility. ThisRegulators: They promoted quantitative risk methods includes the academic finance establishment (including(VaR) over heuristics, the use of flawed risk metrics those that legitimate bad practice, such as rating(credit ratings, such as AAA), and encouraged a certain agencies, forecasters, bank managers, etc.) 22 Theclass of risk taking. academic establishment, including professional organizations, has only engaged in limited introspectionBank of Sweden Prize, a.k.a. the "Nobel" in Economics: and self-criticism, and has largely been exempt fromThis gave the Nobel stamp of scientific validity to criticism from outside the academy (for an example ofempirically, mathematically, and scientifically invalid this, see the report of the Financial Crisis Inquiryfinancial theories, such as Gaussian portfolio theory Commission). It is time to realize that capitalism is not(Markowitz and Sharpe), option pricing (Scholes and about providing free options.23Merton), Engles GARCH, Modigliani-Miller and manymore. In general their scientific invalidity comes fromthe use of wrong models of uncertainty that provide WHAT SHOULD WE DO?exactly the opposite results to what an empirically andmathematically more rigorous model of uncertainty Preaching is largely ineffective in the background ofwould do. such natural resistance and absence of accountability. Legal recourse and regulatory change is needed toNote that the entities listed above do not have enforce skin in the game.meaningful “skin in the game”—they have anasymmetric version of it. That is, they get the upside International regulatory and supervisory authoritiesbenefits when things work out well without direct have recognized that “compensation practices at largedownside. and systemically important financial institutions were aEthical considerations key contributing factor to the global financial crisis”24 and these bodies have in turn proposed principles andSurprisingly, the financial economics establishment policies designed to align compensation and risk-takingshould have been aware of the use of the wrong tools at large financial institutions. While it is laudatory thatand the complete fiasco in implementing these theories, compensation policies for large and systemicallybut they kept pushing the warnings under the rug, or important financial institutions are now viewed ashiding their responses. There has also been some within the purview of regulatory and supervisorydiffusion of responsibility that is at the core of the authorities by those authorities, and that there havesystem moving forward. The first author has debated: been some efforts at larger institutions to instituteRobert Engle, Myron Scholes, Robert Merton, and compensation policies that, at least on the surface, areStephen Ross, among others, without any hint of their designed to mitigate compensation for risk-taking,willingness to accept the risks they were creating with nevertheless, these policies 1) have seen limitedtheir “Procrustean Bed” methods of approximation— enforcement,25 2) have suffered from substantial time-forcing reality to fit theory, at the expense of accurate inconsistency, with the implementation of actual claw-practice, and in a manner that has induced greater net backs being rare, 3) have not addressed the linkrisk taking. between short term actions and the problem of long- term risk bearing (e.g. compensation in shares is PART III: A SUGGESTED REMEDY: SYMMETRY IN essentially compensation in a random cash flow that is REWARDS AND SKIN IN THE GAME largely unaffected by individual actions).As we saw with banks, Toyotas problem, the BP oil In many circumstances, particularly for financialspill, and other similar cases of blowups from institutions subject to implicit government guaranty, it 5 © Copyright 2012 by N. N. Taleb.
  6. 6. is particularly important that compensation policies notbe allowed to devolve into subsidization of risk-takers, 4 N. N. Taleb, "Black Swan and Domains of Statistics,"nor allow compensation to deplete capital cushions. In The American Statistician, 61 (3), August 2007; N.N.many cases where systemic risks are high and implicit Taleb, “Errors, Robustness, and the Fourth Quadrant,”subsidies are present, we believe that meaningful International Journal of Forecasting, 25 (4), 2009.; N.asymmetry in compensation should be prohibited. We N. Taleb, “Antifragility, Robustness, and Fragility,believe that shareholders should be similarly concerned. Inside the Black Swan Domain,” 2010. 5 N. N. Taleb, “Errors, Robustness, and the FourthBut it is not just material risk takers who need to be Quadrant,” International Journal of Forecasting, 25held to account; those who enable moral hazard by (4), 2009.breaking or obscuring the link between risk taking and 6 UBS, “Shareholder Report on UBS’s Write-asymmetry in rewards should be held responsible too. Downs,” April 18, 2008. 7 The “option” terminology is used in order toOf course, academics can claim exemption as the connote the actual financial products that are calledgenerators of speculative thought. It would be hard to, “options” in order to emphasize that these structuralsay, make postmodern theorists accountable for their asymmetries in contracts or other forms of privateideas on health and medicine. However, to the extent ordering have concrete and material economic value tothat finance academics offer themselves as sources of the agent. 8 Left-skewness is shown in F. Degeorge et al., andprofessional education on financial risk (as so many dothrough business schools), they should be subject to rediscussed in the argument on convexity. See F. DegeorgeD., et al., “Earnings Management to Exceedcriticism. So it is those helping to implement misguided Thresholds,” Journal of Business, 72 (1), 1999, pp. 1-33.ideas on risk in practice who need to be made 9 A. Greenspan, “The Crisis,” Brookings Papers inaccountable. A theoretical biologist does not bear the Economic Activity, 2010, p. 33.same responsibility for harm as, say, the American 10 J. Hughes and L. Mester, "Who Said Large BanksMedical Association or a private doctor. Dont Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function,” Federal ReserveTwo final parties that need to be brought to critical Bank of Philadelphia Working Paper 11-27, July 2011.account are: 1) those associations and vendors that put 11 Even Alan Greenspan makes a limited version ofthe above flawed risk techniques into the hands of this observation post hoc: “It is in such circumstancespractitioners and cause unwarranted increased that we depend on our highly sophisticated globalconfidence; and 2) the Bank of Sweden Prize that has system of financial risk management to contain marketgiven (and still gives) the "Nobel” stamp of scientific breakdowns. How could it have failed on so broad alegitimacy to these techniques. For the "Nobel" stamp scale? The paradigm that spawned Nobel Prize winnershas given these methods the credibility to propagate in economics was so thoroughly embraced by academia, central banks, and regulators that by 2006 it becameand partially displace time-tested risk management the core of global regulatory standards (Basel II). Manyheuristics and protocols. quantitative firms whose number crunching sought to expose profitable market trading principles were successful so long as risk aversion moved incrementally (which it did much of the time). But crunching data that covered only the last 2 or 3 decades prior to the current crisis did not yield a model that could anticipate aENDNOTES crisis.” See A. Greenspan, “The Crisis,” Brookings Papers in Economic Activity, 2010, p. 11. 1 By epiphenomenal we mean that they were 12 P. Jorion, Value at Risk—The New Benchmarkpresent in situations without crisis, and in and of for Controlling Market Risk, Irwin Professional:themselves were not causal. For instance “greed” is Illinois, 1997. 13 Data show that with methods meant to improvealways observed when there is a crisis, but we canobserve situations of greed without crises. The primary the standard VaR, like "expected shortfall" orreason behind the 2008 crisis was the accumulation of "conditional VaR" with economic variables, past lossestail risks, as global financial markets had never (or lack thereof) do not predict future losses in thepreviously become so sensitive to such risks. extreme tails. Stress testing may also be suspicious 2 CreditFlux, as cited in cited in A. K. Barnett-Hart, because of the subjective nature of a "reasonable stress"“The Story of the CDO Market Meltdown: An Empirical number—we tend to underestimate the magnitude ofAnalysis,” Harvard University, 2009, p. 3. outliers due to the dynamic nature of financial markets 3 International Monetary Fund, Global Financial (we do not have a static history from which to formStability Report, October 2009, p. 5, actuarial estimates of events). The frequency and severity of "jumps" (negative or positive) in financialdf/text.pdf. asset values is not predictable from past jumps. 14 Joe Nocera writes in a 2009 NYT article: "In the late 1990s, as the use of derivatives was exploding, the 6 © Copyright 2012 by N. N. Taleb.
  7. 7. Securities and Exchange Commission ruled that firms 23 Speculators using their own funds have beenhad to include a quantitative disclosure of market risks reviled, but unlike professors, New York Timesin their financial statements for the convenience of journalists, and others, speculators (particularly thoseinvestors, and VaR became the main tool for doing so. without the free option of societys bailout) bear directlyAround the same time, an important international rule- the costs of their mistakes.making body, the Basel Committee on Banking 24 Financial Stability Board, “2011 Thematic Review onSupervision, went even further to validate VaR by Compensation,” 2011,saying that firms and banks could rely on their own VaR calculations to set their capital 111011a.pdf.; Basel Committee on Banking Supervision,requirements." J. Nocera, “Risk Management,” NYT, “Range of Methodologies for Risk and PerformanceJanuary 4, 2009. Alignment of Remuneration,” May 2011, 15 B. Englich and T. Mussweiler, “Sentencing under; “BankingUncertainty: Anchoring Effects in the Courtroom,” Compensation Reform: Summary Report of ProgressJournal of Applied Social Psychology, 31 (79), 2001, and Challenges Commissioned by the Financial Stabilitypp. 1535-1551; B. Englich, et al., “Playing Dice with Board,” 2010,Criminal Sentences: The Influence of Irrelevant on Experts’ Judicial Decision Making,” 100330b.pdf.Personality and Social Psychology Bulletin, 32 (2), 25 Financial Stability Board, “2011 Thematic ReviewFebruary 2006, pp. 188-200; R.A. Le Boeuf and E. on Compensation,” October 7, 2011,Shafir, “The Long and Short of It: Physical Anchoring,” Journal of Behavioral Decision Making, 19, 111011a.pdf.2006, pp. 393-406. 16 Taleb, Nassim Nicholas (2007/2010). The BlackSwan: The Impact of the Highly Improbable. NewYork: Random House and Penguin. 17 The key problem with finance theory has beensupplanting embedded and time-derived heuristics,such as the interdicts against debt and forecasting, withmodels akin to "replacing a real hand with an artificialone". 18 R. C. Merton, “Option pricing when underlyingstock returns are discontinuous,” Journal of FinancialEconomics 3, pp. 125–144. 19 K. Rogoff and C. Reinhart, This Time isDifferent, Eight Centuries of Financial Folly,Princeton University Press, 2010. See also themetaphor of Lucretiuss largest mountain in N. N.Taleb, 2007-2010.20 N. N. Taleb, “Antifragility, Robustness, andFragility, Inside the Black Swan Domain,” 2010; N.N. Taleb and C. Tapiero, The Risk Externalitiesof Too Big to Fail, Physica A: StatisticalPhysics and Applications, 2010; P. Triana,Lecturing Birds On Flying: Can MathematicalTheories Destroy The Markets? (Wiley, 2009). 21 In early 2009 a Forbes journalist in the process ofwriting a profile of the first author spoke to NYUsRobert Engle who got the Bank of Sweden Prize("Nobel") for methods that patently have never workedoutside papers. The reporter noted to the first authorthat Engle’s response was that academia was notresponsible for tail risks, since it is the government’sjob to cover the losses beyond a certain point. This isthe worst type of moral hazard argument which playedinto the hands of the too big to fail problem. 22 Author conversations with the King of Swedenand members of the Swedish Academy resulted in thefollowing astonishing observation: they do not feelconcerned, nor act as if they are in any way responsiblefor the destruction since, for them, "this is not theNobel", just a bank of Sweden prize. 7 © Copyright 2012 by N. N. Taleb.