I was struck by a headline on the front page of the November 25, 2008 edition of The Wall Street Journal. It read: “Citi Faces Pressure to Slim Down.” What would the result be? Slim Citi. If you drop the “L” you have the name of the popular game “Sim City” in which a virtual city environment is simulated and players go about their activities and decision-making much as they would do in real life.
So what is the relationship here?
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“And what better way to gain an understanding of the impact of such events ["Black Swans"] than through a computerized simulation model”. I disagree.
A computer can only handle what is known. Black Swans are by definition unknown, unexpected events. Presently the only reliable system for preparing for fat tails and black swans is common sense, experience and the ability to ignore our emotions. Chuck Prince (ex-CEO of Citi) said (when defending the bank’s continuing involvement in risky financial instruments), “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing. ” Common sense would suggest Chuck was describing a train wreck – the train will only stop when we smash into a wall. We just did not want to hear what he was really saying. A computer could only tell us the train is going very fast, it would not be able to remind us that eventually we had to run out of track.
Which leads to my worry that the regulators will conclude that, since there is no objective means of measuring fat tails, financial institutions in the future will only be permitted to do what they “know” (i.e. lending to credit worthy customers with meaningful equity) and will be forbidden from relying on exotic financing. The better course for the regulators would be to accept that there will always be black swans and we need to develop controls that can quickly adapt to the unexpected.