Geir Freysson – The Internet Industrialist

“Cars have brakes,” an Icelandic banker told me before the crash, “so we can drive faster.”

One factor behind today’s financial crash less frequently mentioned than a housing bubble and a lack of government regulation is overconfidence in flawed risk management models.

Bubbles build and pop every 10-20 years. Blaming the US sub-prime market for the current financial melt-down is like blaming the great fire of London on Thomas Farriner’s bakery, where it started. The problem in London wasn’t a bakery, but an overcrowded street plan, thatched roofs and wooden houses.

The problem with the world’s financial system is the underestimation of the unpredictability and volatility of a highly correlated, complex system and overconfidence in our capability to model and predict it.

Nassim Nicholas Taleb has been warning against various industry standard risk-management models since 1997. Robert Goldstein’s book “When Genius Failed” told the story of Long Term Capital Management (LTCM), the hedge fund that brought Wall Street to the brink of destruction when an unforseen event, Russia defaulting its bonds, caused their sophisticated risk models to fail.

Warren Buffett summed it up nicely: “Beware geeks baring formulas”. We didn’t learn after LTCM, hopefully we will now.

Laurence Lessig wrote an excellent article in this week’s newsweek on this theme, “Why the banks all fell down” where he points out that the market isn’t composed of individual, uncorrelated, rational decision makers, like most models assume, but irrational herds.

Risk management models were supposed to be the brakes in the speeding car of the world’s financial system. But because of blind faith in these models the car was going way too fast, hence the enormity of the crash.