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Home > Business > Special

The triumph of mathematics, for now

Jamal Mecklai | October 06, 2006

Last week, Morgan Stanley announced record quarterly profits of (I think) $1.38 bn. A few weeks earlier, it was UBS? Or was it Goldman Sachs? Or J P Morgan Chase? It's getting hard to remember which one.

Over the past three or four years, most of the major international banks have been routinely reporting record profits, quarter after quarter after quarter. And even a cursory look at the results shows that trading has been a significant contributor -- if not the mainstay -- of these extraordinary numbers. In some quarters the trading gains are in commodities, in some quarters in bonds, sometimes equities or structured products, but each quarter, each of the large players has made a huge amount of money trading some asset or another.

Now, unless the fundamental rules of life have changed -- and I don't believe they have -- you can't make money trading unless you take risk. And you can't make a huge amount of money trading unless you take a huge amount of risk. Now, while there are observers who feel that the major global banks have become more like hedge funds in terms of the amount of risk they take, it is also a fact that major global banks are listed companies and the financial markets don't seem too perturbed by the amount of risk they carry. In fact, financial sector equity P/Es are quite a bit higher (relative to the broader market) than they used to be in the not so distant past (say, five years), when bank stocks were discounted for volatility of earnings as banks routinely "won some and lost some" as far as trading profits went.

So, what has happened? How come the major international banks continue to deliver "excessive" trading returns so regularly? How come there have been no major trading losses at a major bank in recent years? Markets are certainly as volatile as ever -- indeed, many markets have just recently hit serious volatility highs, resulting in frequent blood-letting on Hedge Fund Street, the $ 6+ bn loss at Amaranth Partners being only the most recent example.

I had been wondering about this for some months now, and one day, while I was talking to a client about risk, it suddenly hit me. I was explaining to the CFO of a large company with a very active treasury that an effective risk management system -- ie one that has been in place successfully for some time -- would reduce the frequency of usually ineffective intervention by the board. If the board is comfortable with the way you are managing risk -- and there is no greater comfort than meeting (or beating) targets quarter after quarter -- it is more likely that senior management will leave treasury to the people that understand markets. Just as, in general, they leave HR to people that understand HR and sales to people that understand sales, and so on.

And that's when it hit me. Of course. The high-trading profits at global banks, which are certainly a result of higher risk-taking, are, in turn, a result of the greater comfort bank managements have with their risk management systems. Remarkable as it may seem, risk management, as an independent discipline, is a relatively new field. It was only as recently as 1994 that JP Morgan came up with Riskmetrics, the now-classic method of measuring risk on a complex trading portfolio. Over the next several years, there has been -- and continues to be -- considerable research in risk management, huge amounts of IT spending, and, probably billions of man-hours of (internal and external) consulting time invested in ensuring that banks' risk systems are largely foolproof. There were many natural stress tests in the intervening years -- Barings, the Asian crisis, LTCM, Latam defaults, Enron, and a slew of others. Some of these found the systems wanting, and resulted in more research, more development, more tightening.

And by now many banks -- certainly the largest, most diversified players -- have had risk management systems in place and tested "live" for at least 4 to 5 years. So now is when they begin to reap the returns from all those years of investment in financial engineering and "rocket scientists" fresh out of engineering and quants-driven B-schools.

And the huge salaries they pay are, of course, driving more and more young people to mathematics, which, to me, is glorious -- I have always loved maths, its purity almost religious.

Now, I know there are some who bemoan the fact that "making money from money" is hardly adding economic value to the world; they see tragedy in the fact that the "best and the brightest" are being drawn via the purity of mathematics to money-grubbing Wall Street. I guess they haven't learned that shaking their fists at the heavens is a waste of time. Life is an incontrovertible cycle, and at different times, there are different "needs of life" that get reflected down into youthful ambition. In the 1960s, for instance, it was chemicals and "plastics"; in the 1980s the law school was the winner; over the past two decades, it has been finance and investment banking and, more narrowly, financial engineering.

In decades to come, who knows? My bet is that the new wave, which is already beginning to gather steam, could be law enforcement, since, in today's age of terrorism, the most difficult job on the planet is being police chief of a major metropolis.

In the meantime, let us enjoy this triumph of mathematics, and learn from it that process pays, and the more rigorously-tested the process, the more it can pay.

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Number of User Comments: 2

Sub: Triumph of Mathematics, for now

Mr. Mecklai's article is very well written and brings out, without any bravado, his life time of experience in the field. It is indeed true ...

Posted by Buck Kulkarni

Sub: Mathematics ,Analytics and Statistics are the key in Risk Management

not only maths,statistics and analytics hold the key in risk management.

Posted by manav



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