In the arcane world of derivatives trading, banking has become a branch of applied mathematics. How do the managers cope? Rudi Bogni, of Swiss Bank Corporation, explains why he is going back to universityby / October 20, 1995 / Leave a comment
Published in October 1995 issue of Prospect Magazine
I am a 47-year-old banker-chief executive of Swiss Bank Corporation in London, to be precise-and I have just decided that I need to go back to university for two years to study mathematics. Some of my friends think I am mad, and perhaps they are right. But perhaps something strange has happened to banking too.
It is hard to imagine that there is anything really new in banking. The tools of the trade have been around and in use, pretty much unchanged, for hundreds of years. Yet within the span of my own career, the world of international finance has enjoyed a renaissance-a spurt of creativity in the 1970s and 1980s, when new techniques emerged which have transformed the conduct of many banks and bankers. These techniques-collectively known as derivatives-have spawned a new jargon (would you know what to do with a Jellyroll, or an Alligator Spread?), huge new sources of profit, and mystifying new types of risk. They have even crept into the popular consciousness as a kind of sorcerer’s apprentice-an all-purpose bogey for mythologising the modern City. Was it the power of these strange new instruments which allowed a 28-year-old trader in Singapore to bring down a 200-year-old banking dynasty?
Derivatives-so called because their pricing is derived from the underlying “cash” markets for loans, equities and foreign exchange-were originally designed to provide users with a way of reducing financial risk. The user might be any kind of organisation-corporations, governments and investment funds are all exposed to financial risks of one kind or another: the risk, say, that their cost of borrowing will rise if interest rates go up, or that the value of their foreign assets will fall if the exchange rate moves the wrong way. Swaps, options and futures are simply contracts which allow the parties concerned to exchange one form of payment for another. Even housebuyers keen to lock in fixed rates are unwittingly using swaps and options.
Now the tail has come to wag the dog. The efficiency and effectiveness of these instruments has meant that the derivative markets are so large and so liquid that they now drive the real markets, rather than the other way around. Some economists even fear that derivatives threaten the stability of the financial system. They have certainly made the financial condition of companies more opaque, as accounting conventions have not kept pace with invention. Whereas 15 years ago the bulk of a bank’s business would be accounted for in the traditional way, today much of the important business is in derivatives which do not show up on the balance sheet at all, but are recorded in contingent accounts.
So the effect of derivatives on banks’ ability to monitor and manage their businesses has been profound. As a consequence, in my view, a “knowledge gap” has developed for all those managers in banks who, by age or educational background, lack the mathematical skills to understand the new machinery of the markets in which they work.
When eventually I faced up to the knowledge gap, the question was what to do about it. There was the easy option-to pretend that the problem did not exist. I was obviously in good company in suffering this knowledge gap, so perhaps nobody would notice. This might seem an attractive proposition, but it struck me as intellectually dishonest and fundamentally risky.
Another option would be to retire early, but I hated the thought of leaving the battlefield before my time was up and without a fight. I could surround myself with bright and trusted young people, and rely on them as a kind of surrogate brain. Is that not what all good managers do? Naturally, I have done the same, like many another. But is it a viable option in the long run? Perhaps, but it is not to my taste.
Finally, I could go back to study, and attack the knowledge gap head on. When I first put the idea to my good friend, Professor Gerry Salkin of the Research Centre for Quantitative Studies at Imperial College, London, he initially thought it was a passing mood. Next he thought me mad for leaving, albeit temporarily, a senior position and a good career.
Professor Salkin finally decided with good grace to accept me as a student, keeping any doubts about my ability to reactivate my brain cells to himself. I suggested a one year sabbatical. He thought it would take at least four years to achieve my objectives. We compromised on two, on the basis that I would put my brain into overdrive.
So why has this knowledge gap arisen, and why does it matter so much for bankers? The mathematics required to understand the basic pricing of swaps, futures and options is not too complicated-not beyond the reach of a skilled financial professional with a reasonable base of calculus. I did study calculus, but that was 25 years ago. And over the past decade the complexity of the structures which can be assembled using these instruments has increased dramatically, as have the uses to which they can be put-in particular in managing the banks’ own exposure to risk. This increase in complexity now pervades all aspects of banking-even the most “traditional” businesses throw up opportunities to reduce or transform financial risk. Exploiting these opportunities-and managing the attendant risks-demands both a deeper and a broader base in the different disciplines of mathematics. Bankers without this mathematical sophistication-such as myself-are increasingly at arm’s length from the businesses in their care.
This might seem like a common enough problem for the “general” manager. The managers of many successful engineering companies are not engineers. You do not have to know much about how a car works to be able to sell one, or to manage the people who design and assemble them. So why are banks different?
The answer has to do with risk. Unlike most other types of business, banks make money by taking on risk-it is at the heart of what they do. Skills in assessing, pricing and pooling risks have always been the source of bankers’ profits. Furthermore, because of the inherent leverage in the business, the risks in banks tend to be on a rather large scale. Despite their efforts to appear as models of caution, bankers place bigger bets than most.
A business of this kind is not obviously suited to the standard model of management by delegation. In the old days the solution was to have bureaucratic and hierarchical processes for sanctioning transactions, and pre-ordained limits for trading positions. The job of management was to establish and supervise these processes and structures. This approach works well with simple types of risk, but managing derivatives in this way is a bit like trying to herd cats.
What evidence is there that these new risks have actually led to serious problems? The collapse of Barings was, in fact, not caused by the special difficulties of derivatives, but by old-fashioned failures of control. It could have happened 100 years ago (and did). By contrast, the equally spectacular collapse of the German conglomerate Metallgesellschaft possibly was an example of the knowledge gap at work: it was in part the failure of its senior management to understand the nature of the risks which their derivatives traders were running which led to the company’s downfall. (Professor Franklin Edwards of the Graduate School of Business at Columbia University has analysed this case, and presents some conclusions about the difficulties of managing derivatives businesses in his paper “Derivatives Can Be Hazardous To Your Health: The Case Of Metallgesellschaft” LSE Financial Markets Group, Special Paper No. 64-December 1994).
This kind of failure shows why the old management model will no longer do. The nature of the risk is now more complex because derivatives are exposed not to simple variables such as exchange rates and interest rates, but instead to obscure, second-order variables-such as the volatility of a given market price, or the correlation between two market indices. The vast increase in available computing power also means that it is possible now for a few people at the centre to measure, analyse and-using the same armoury of derivative instruments-manipulate a bank’s risk exposure.
I decided that one of those “people at the centre” should be the chief executive. It took me some time to convince my senior board colleagues. After all, our bank already has an excellent mix of young colleagues at board level with in-depth knowledge of derivatives and of the mathematics underlying them. If anything, Swiss Bank Corporation is better off than most; it does not need another ageing expert. However, when the time came for a decision, my senior colleagues supported me unconditionally. Now I shall have to deliver the goods-not only for myself, but to reward the confidence they placed in me.
Will I make it? After 25 years, will I be able to go back successfully to academic work? I hope so, but there is no certainty. My sabbatical starts in January 1996. Until then and beyond, for those of you who have read to the end of this article and are interested in debating with me the views I have expressed above, my Internet address is: