Many years ago in London, having organized a client party, I was privileged to have as a guest speaker and presenter, Nassim Nicholas Taleb, who developed the Black Swan theory in 2004. The expression originated from Juvenal, a Roman poet active in the last 1st and early 2nd century A.D.
The Black Swan theory is a metaphor that describes an event that is a surprise (to the observer), has a major effect, and after the fact is often inappropriately rationalized with the benefit of hindsight. Within this frame work, the various financial crises should teach us at least two very valuable lessons:
1. The over-use of assumptions
The Black Swan theory was based on the assumptions that a Black Swan could not exist, until they were discovered in the 17th century.
Most of us make assumptions based on what we see, know, and assume mostly based on historical knowledge even though we know that rare and improbable events do occur much more than we like to think. Examples around the last financial crisis are self-explanatory:
• The role and dependence of the rating agencies and the assumptions that they could not understate the risks!
• Historical knowledge and assumptions made the banks ignored the 2006 rise in default rate on sub – prime mortgage in the US.
• Boards made the assumptions that risk and credit departments assessed the risk properly whereas the latter assumed that the former understood the complexity of the structure.
• Assuming that challenging a situation will be viewed as weakness
2. The over-relying on financial models and the lack of using some common sense
According to George Box (an English Statistician), ‘’all models are wrong, but some are useful,” which can be illustrated with:
• The over-relying on the VaR model, a weak single measure of risk for any portfolio.
• The failure to price properly the risk that exposures to certain off-balance sheet vehicles might need to be funded on the balance sheet precisely when it became difficult or expensive to raise such funds externally.
• The disparity of fair valuation of assets with different assumptions / models being used by the banks for the same assets
Based on this theory, and as a financial executive, I always ensure a balanced decision process by: Challenging assumptions, using common sense and avoid relying on single financial model that can always be tailored-made to reach a given result.
In this blog I will share with you some of my ideas or comments on a wide range of subjects.