Richard Bookstaber has spent a career in finance studying risk, managing risk, and even trying to regulate it. He’s worked in risk management for a range of Wall Street firms and prominent hedge funds, including Morgan Stanley, Salomon Brothers, Bridgewater, and Moore Capital. He also served at the SEC and in the US Treasury, where he helped to craft the Volcker Rule. Before the 2008 global financial crisis struck, Bookstaber presciently warned of the dangers that complex new financial instruments posed to the system. In his two books A Demon of Our Own Design and The End of Theory, Bookstaber brings his deep knowledge of finance and history to bear on the subject of risk and resilience in financial systems. Recently he spoke to Deloitte about his work.
"If you don’t have a model that understands that we’re not in a world of equilibrium, that we’re not in the same stable state as before, you can’t really understand and deal with crises and risks."
Deloitte: Rick, it’s a pleasure to speak with you today. I’ve been a fan since your first book back in 2007. In it, you tell stories from a range of disciplines to illustrate your points. One that has stuck with me all these years is that of the poor furu, a once-plentiful fish in Lake Victoria that was wiped out in short order when gamekeepers introduced a new commercial fish, the Nile perch. Why did the furu prove so vulnerable?
Bookstaber: The furu illustrates a broader point. There are species that are very comfortable in their niche. They work really well in the existing environment. They never have to change their standard approach, and because of that, they become more and more specialized. They have behaviors that are completely and optimally suited to their environment. But if that environment changes in unexpected ways, they don't have the mechanisms to adapt. With the furu, which was perfectly adapted to the unique conditions in Lake Victoria, a new predator suddenly appeared. The furu had never had to worry about predators, and so it couldn't really adapt.
There’s an extreme case on the other side, which is the cockroach. Unlike the furu, the cockroach is not ideally suited for any one environment. It doesn’t smell and it doesn't see and it doesn’t hear. All it does is move in the opposite direction in reaction to any sort of air gust. It would never win the Insect of the Year award for its fit in any particular environment. But it’s good enough for almost any. That’s the essence, to me, of resilience. It’s having that sort of coarse adaptation. You may not be ideal in any one environment, but you do well enough in any so you can adapt when the environment changes.
Deloitte: How does that insight apply to people? Is it a mistake to specialize, to become really, really good at one thing?
Bookstaber: The difference is that people have the ability to learn and change. If you’re not ideally suited to the current environment, but the change in the environment moves slowly enough for you to adapt, then everything’s fine. The problem that occurs in the biological sphere is that the changes can occur more quickly than animals can adapt. So resilience can either consist of a coarse response that may not be optimal in any one environment, but is well suited for a range of environments, or it can be the ability to adjust and adapt as quickly as the world is changing.
Deloitte: Your world is financial risk. You have anticipated and lived through and analyzed the biggest financial crises of the past four decades. You’ve written that even though the economy may be becoming more stable, markets and institutions are becoming less resilient. Can you explain that contradiction?
Bookstaber: In the financial system, success is based on being ahead of the rest of the market in one respect or another. If you’re going along with the herd, you may be stable, but you’re not outperforming. You have to find some way to innovate, which means changing the markets in a way that’s to your advantage, that allows you to collect big gains until the innovation becomes standard and the ability to make outsized returns declines. The other way is to develop new sources of information so you know more than the rest of the market, or, somewhat cynically, you create products that obscure information and give you an edge because you can understand them, but other people can’t. That means there are natural incentives in the market to force changes or add complexity, even if those changes don't make sense from a public perspective or add any real value.
Deloitte: That certainly seems to have happened in 2008 with CDOs and other instruments. What is the solution?
Bookstaber: It’s a matter of regulation. You have to regulate the markets in a way that prevents this type of unnecessary innovation or gaming. And really, that’s the largest role of regulation: to prevent people from creating opportunities for themselves that are costly in some sense to the market and to others, and to protect the essential function of the market, which is to provide capital for opportunities.
Deloitte: Financial crises seem to occur quite regularly. Is that the result of technology, or have we forgotten how to regulate effectively?
Bookstaber: Markets become less resilient with more complexity, and part of the reason they become more complex is new technology. Another reason can be tighter coupling, where one thing immediately triggers the next, which triggers the next, and things spiral before anybody can intervene. What’s happened is that regulation takes about as long to do now as it took 40 years ago. It’s a very deliberative process of interviewing and understanding what’s going on and getting feedback, setting up the proposed rules, getting comment on the rules. We have a process for putting regulation in place that hasn’t changed, whereas the tight coupling and the complexity and the speed of change in the market is increasing. It’s not that regulation is worse now; it’s that it just hasn’t kept up.
The largest role of regulation is to prevent people from creating opportunities for themselves that are costly in some sense to the market and to others, and to protect the essential function of the market, which is to provide capital for opportunities.
Deloitte: Is there anything we can do about that?
Bookstaber: The solution, in a sense, is what I was talking about earlier, which is the notion of coarse adaptation. You can’t be adaptable at all in our current rules-based regulatory environment. The rules are the rules, and they don’t adapt. They’re codified or canonized or whatever. But there’s another approach, which is called principles-based regulation, where you say, “Look, here's the basic idea. This is the principle. You’re a professional, and you know what we're getting at.” When questionable things start to happen, the regulator steps in and says, “This little game that you're playing right now doesn’t work within this principle, so you can’t do it.” Now you have an adaptive approach. It’s coarse in that it’s ill-defined. There’s not an exact rule for every possibility. It’s not going to be perfect, in the same way the cockroach isn't perfect, but it will be able to adjust at the same rate as the environment is adjusting so it can keep up with the pace of change. Opportunities will not be as great for people to do some of the innovating and gaming we’ve seen because they won’t be able to get ahead of the regulation. You’ll get a market that's more stable and less complex because some of the incentives for unnecessary levels of complexity will be gone.
Deloitte: I want to ask you about one more idea of yours, and that is the agent-based model for looking at markets and how you would apply that to some of the issues around risk that we’ve been talking about.
Bookstaber: As the markets become more tightly coupled and complex, nothing occurs in isolation. Say somebody has an exposure. They think that they have enough collateral—based on conditions today—to deal with that exposure because they think, “Well, if there’s a crackup, I’ve got enough collateral to sell off and cover the exposure.” What they don't realize is, they’re not in the world all by themselves; that when they sell, other people will also be selling, and the people who normally would buy will no longer be buying. You have all of these interactions. Every firm in the market can be taking actions that change the market environment, causing every other institution to then change their behavior. Your old model, which assumed some sort of equilibrium, won’t work. Markets are a complex, dynamic system. You have to ask, “As the environment changes, what are other agents going to do? How does that change the environment, and what I should do?”
If you don’t have a model that understands that we’re not in a world of equilibrium, that we’re not in the same stable state as before, you can’t really understand and deal with crises and risks.
Deloitte: OK. So how do you apply that in the real world?
Bookstaber: Step one is to know your exposure. Step two is to understand how much those markets might move in a crisis. Step three is to have enough collateral so that if the markets do move that much, you can sell off your positions. You have to take into account that other agents with the same exposure will be trying to do the same thing. Your collateral won’t be worth as much, so you’ll need more of it. We need to recognize in our decision-making the fact that not just us, but other people will also be selling. They’ll be changing the environment to the point where we won’t be able to sell at the price we thought we could, so maybe you need to mark your collateral as if it’s not worth a hundred dollars; it’s really worth seventy-five.