The system [of finance] is too complex to be run on error-strewn hunches and gut feelings, but current mathematical models don’t represent reality adequately. The entire system is poorly understood and dangerously unstable. The world economy desperately needs a radical overhaul and that requires more mathematics, not less.

This article in the Guardian is a little late to the party and has an intentionally misleading headline, but brings up some points that are usually too esoteric to survive in print:

Any mathematical model of reality relies on simplifications and assumptions. The Black-Scholes equation was based on arbitrage pricing theory, in which both drift and volatility are constant. This assumption is common in financial theory, but it is often false for real markets. The equation also assumes that there are no transaction costs, no limits on short-selling and that money can always be lent and borrowed at a known, fixed, risk-free interest rate. Again, reality is often very different.

There are more false assumptions like Gaussianity of log-returns, complete markets, martingale price paths, etc., but these are merely technical complaints, which can be patched (as many are doing). The real issue is, as the author notes, “… instability is common in economic models … mainly because of the poor design of the financial system.” Namely, there is a lack of accounting for behavioral effects that result in feedback, which give rise to rather more fundamental issues that would require the “radical overhaul” alluded to in the opening quotation to resolve. There are some problems that could be tackled in this area.
(Read the article)

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This article is hilarious:

As a trader turned philosopher, Taleb has railed against Wall Street risk managers who attempt to predict market movements. Even so, Taleb said he saw the banking crisis coming.

“The financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall,” Taleb wrote in “The Black Swan: The Impact of the Highly Improbable,” which was published in 2007. “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.”

…

Taleb is angry that Wall Street is continuing to use traditional tools such as value at risk, which banks use to decide how much to wager in the markets.

“We would like to society to lock up quantitative risk managers before they cause more damage,” Taleb said.

This being recruiting season, there was a guy from the risk management division of a certain big bank here talking up his job and company. (The week after that, their stock was halved and last week it was even in the single digits. That’s another story.)

He wasn’t very specific but I got an impression of the very crude and non-rigorous method of “value at risk”, something like the 90th percentile loss value based on some unverifiable model, but not an actual hard bound. So what do you get? Obviously everybody builds up their portfolio right up against the 90th percentile and a digital waterfall effect at the boundary becomes that much more likely. There is nothing wrong with quantitative risk management. There is something wrong with bad ideas even if they are “quantitative”… Probably worse, because it gives the layman a false sense of invincibility.

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