Sudip Bandyopadhyay’s Blog

In Pablo Triana’s recent  book “Lecturing Birds on Flying” he suggests that probably Nobel Prize for economics should be abolished.  His assertion is that financial models such as value at risk (VaR), Black-Scholes-Merton (BSM) model have done more harm than good.  He goes on to say that “quantitative – finance” had a very large hand in what could be the worst financial crisis in the history of mankind.  From the opening chapter, “Playing God”,  Triana maintains that the fundamental assumptions on which mathematical finance theories are based are wrong.  Yet the theory continues to hold sway.  The biggest villain of the piece is the financial academic establishment.  Much of its work, he says, has been unnecessary.  Before mathematical finance, traders had working models for things such as option pricing.  By and large, these models were effective and accurate.  Then came BSM, which Triana claims does not work and was also largely responsible for the 1987 stock market crash.  What is more, he maintains, most traders know it does not work and only pretend to use it because finance theory is fashionable and criticizing BSM is a heresy.  BSM is not the only case.  The Gaussian copula model, which was intended to measure default probability, failed to identify toxic structured securities and led to massive errors in valuation and credit ratings, says Triana.  Likewise VaR “failed to measure risk even half –accurately and, worse, decisively encouraged and sanctioned the wild risk-taking  that brought  Wall Street (and consequently the world) down”.

To an extent, his criticism of financial economics seems appropriate.  Fear of the unknown and our desire for certainty led us to believe in these  financial models.  As Nassin Taleb mentioned that giving someone a wrong map is worse  than giving no map at all.  The efficient market hypothesis, the underlying assumption in most economic models is probably to be blamed for all this confusion.
As opposed to the efficient market hypothesis (EMH), the  Adaptive Markets Hypothesis (AMH) – essentially an evolutionary biologist’s view of market dynamics – is at odds with economic orthodoxy, which has been heavily influenced by mathematics and physics.  This orthodoxy has emerged for good reasons: economists have made genuine scientific breakthroughs, such as general equilibrium theory, game theory, portfolio optimization and derivatives pricing models.  But any virtue can become a vice when carried to an extreme.  The formality of mathematics and physics, in which mainstream economics is routinely dressed, can give outsiders – especially business leaders, regulators, and policymakers – a false sense of precision regarding our models’ outputs.

The AMH offers an internally consistent framework in which the EMH and behavioral biases can coexist.  Behaviour that may seem irrational is, instead, behaviour that has not yet had time to adapt to modern contexts.  The origins of human behaviour are similar, differing only in the length of time we have had to adapt to our environmen, and the speed with which that environment is now changing. Like the six blind monks who encountered an elephant for the first time - each monk grasping a different part of the beast, and coming to a wholly different conclusion as to what an elephant is - disciples of the EMH and behavioural finance have captured different features of the same adaptive system. The implications of the AMH for regulatory reform are significant. Markets can be trusted to function properly in normal times, but if humans are subject to emotional extremes, animal spirits may overwhelm rationality, even among regulators and policymakers.

Therefore, fixed rules that ignore changing environments will almost always have unintended consequences: those enacted in the aftermath of crisis may be too severe during normal times, and those repealed after long periods of prosperity may lead to future excesses. The only way to break this vicious cycle is to recognise its origin - adaptive behaviour - and design equally adaptive regulations to counterbalance human nature.