The Credit Crisis Five Years On | 8 June 2012
About the Workshop & Organisers:
Five years ago, the storm clouds that eventually led to the global banking crisis of September 2008 were starting to gather dramatically: in summer 2007, the dangers posed by complex financial securities based on U.S. mortgages became fully evident. Although the effects of the crisis are still very much with us, it is a good moment to stand back and think about what we have learnt concerning the fragility of the financial system and the causes of the crisis. This meeting, supported by a 3-year grant to Donald MacKenzie and Iain Hardie from the UK Economic and Social Research Council (RES-062-23-1958), offers an opportunity for financial-market participants, academics, and interested members of the wider public to discuss these crucial topics.
Friday, 8 June 2012 Location: Chrystal Macmillan Building, 15A George Square, Edinburgh (ground floor), Seminar Room 2
About the Speakers:
About the Research Papers:
Andrew Haldane: ‘Tails of the Unexpected’
Abstract: The history of the normal distribution reveals a tension between what is ‘typical’ and what is ‘normal’. Examples from both the natural and social sciences suggest the ubiquity of normality is exaggerated. Many empirical magnitudes exhibit power law-like features. Economic and financial systems exhibit these features too. Unexpected tail events are the norm, rather than the exception. Yet much of standard mainstream economics abstracts from non-normality by assumption. Work in the natural sciences has tackled the task of explaining and managing fat-tailed and other non-normal phenomena head-on. This has implications for the design and conduct of public policy towards financial stability, including risk management at the individual-firm and system-wide level, where the assumption of normality is pathological.
Donald MacKenzie: 'Crises, Cultures and Organizational Co-ordination: Notes from the History of the Gaussian Copula'
In Wired in February 2009, journalist Felix Salmon wrote that the Gaussian copula (a mathematical model used to estimate the probability distribution of losses on pools of loans or bonds) had ‘killed Wall Street’ and ‘devastated the global economy’. In this talk (based on a much longer paper, which draws upon 94 oral-history interviews conducted between 2006 and 2012) I will explore what lessons can be learned from the history of the Gaussian copula in relation to two questions:
The paper will end with the speculation that this co-ordinating role is actually played by all widely-used models of complex derivatives, and that all that is special in this respect about the Gaussian copula is that its poorly regarded status makes this role evident.
Abstract: Much has been made in discussion of the financial crisis of the complexity of the financial instruments involved and/or the inadequacy of the analysis undertaken by investors. This paper considers whether the Collateralised Debt Obligations (CDOs) at the heart of the crisis - CDOs of Asset-Backed Securities - were in any practical sense analysable. Given the returns that could be made from investing in the AAA tranches of these securities, could investors perform sufficient analysis? In particular, we consider how increasing complexity outran the returns that could pay for analysis. We also consider the regulatory implications of this issue.
Julie Froud, Adam Leaver and Karel Williams: ‘Deep Stall: the Eurozone
Crisis, Banking Reform and Politics’
Abstract: Ismail Erturk, Julie Froud, John Law, Adam Leaver, Mick Moran and Karel Williams: The Eurozone crisis presents as a confusing series of events which have two dominant interpretations. The first is that crisis is caused by the profligacy of South European governments and thus justifies austerity programmes in Greece, Ireland and elsewhere; the second that the crisis is symptom of a North/South divide in terms of trade imbalances and competitiveness which now threatens European monetary union. This paper presents a third account focused on problems arising from the character of banking and finance whose balance sheet interconnects and velocity through rehypothecation threaten sudden collapse. Thus, a specific conjunctural form of international finance challenges Europe as it is presently nationally politically organised. This political-cultural analysis is developed by analogy and disanalogy with an aircraft crash some fifty years ago in October 1963 when a BAC 1-11 prototype crashed disastrously because the new T tail design configuration led to unexpected loss of control and a “deep stall” which the pilot could not recover. In a similar way, the configuration of present day finance is such that control will fail unpredictably in event of major disturbance. In a different way, the situation in finance is more serious because there is no realistic prospect of engineering type redesign for greater controllability as with the 1-11 after the crash. The disanalogy is twofold: first, in finance, there is no possibility of applying relevant technical knowledge and testing as there was with aerodynamics and control surfaces; second, in finance, the private interests of constructors, operators, regulators and the general social interest do not coincide unproblematically as they did when it came to passenger jet aircraft falling out of the sky. In our After the Great Complacence analysis of the Wall Street and London crisis 2008-10, we argued that complacent policy elites would not restrain finance before the crisis and could not radically reform it afterwards, because they had been cognitively captured by a trade narrative about the benefits of the finance sector. We would now add that in the Eurozone crisis, there is an alarming gap between the interventions technically necessary to stabilise finance and what is politically possible. cresc.ac.uk
Daniel Beunza: ‘From Dissonance to Resonance: Cognitive Interdependence in Quantitative Finance’
Abstract: This study explores the elusive social dimension of quantitative finance. We conducted three years of observations in the derivatives trading room of a major investment bank. We found that traders use models to translate stock prices into estimates of what their rivals think. Traders use these estimates to look out for possible errors in their own models. We found that this practice, reflexive modeling, enhances returns by turning prices into a vehicle for distributed cognition. But it also induces a dangerous form of cognitive interdependence: when enough traders overlook a key issue, their positions give misplaced reassurance to those traders that think similarly, disrupting their reflexive processes. In cases lacking diversity, dissonance thus gives way to resonance. Our analysis demonstrates how practices born in caution can lead to overconfidence and collective failure. We contribute to economic sociology by developing a socio-technical account that grapples with the new forms of sociality introduced by financial models – dissembedded yet entangled; anonymous yet collective; impersonal yet, nevertheless, emphatically social.
Unpacking the Crisis | 9 June 2012
About the Workshop & Organisers:
Finance at the beginning of the 21st Century has become a socio-cultural phenomenon. Recent events such as the financial crisis of 2008 and its subsequent fallout into the 2011 EU Sovereign Debt Crisis has seen finance come to the very forefront of the public imagination, in the wake of global protests for direct action for financial market regulation and transformation such as the Occupy Wall Street movement. Voters want to see meaningful banking regulation and bail outs that bite. Moreover, the very nature of the 2008 crisis, related to the methodologies in the pricing of credit-based assets, and organisational cultures of banks and related financial institutions, has seen the profession not only under public scrutiny, but also undertaking self-reflection of its methods and culture. The burgeoning research areas of the social studies of finance and accounting have never been more poignant. The workshop’s purpose is to specifically interrogate what the social studies of finance and accounting contribute to our understanding of financial risk, regulation through their processes of knowledge construction and social practice.
The workshop was funded by the World Class PhD Initiative Award at the University of Edinburgh Business School awarded to Desné Masie in December 2011.
About the Speakers:
About the Research Papers:
Daniel Beunza & Yuval Millo: ‘The Social Algorithms of the NYSE’
Abstract: In recent years, algorithms have become particularly pervasive in financial markets. How to characterize the social aspect of a market when both buyers and sellers are computer programs? Our ethnographic and historical study compares the market microstructure of the New York Stock Exchange before automation in 2003 and after automation, in 2008-10. It finds that the same three social processes that characterized trading in 2003 are also present after automation in 2008-10. Both floor brokers and specialists are engaged in actively connecting buyers and sellers, providing partial disclosure, and controlling the pace of trading. We interpret this as a reproduction of the social processes generated by the trading floors in an automated setting shaped by algorithms. Our study thus points at the ways in which an algorithmic market remains social.
Doreen McBarnet: ‘Financial engineering or legal engineering? The challenge of creative compliance’
Abstract: The banking crisis has been frequently described as financial engineering gone wrong. Characterising the financial products and transactions that led to the crisis primarily as financial engineering, however, tends to gloss over the other innovative elements involved in their construction. This paper identifies an essential component as not just financial engineering but legal engineering, legal engineering specifically designed to systematically thwart regulation and bypass regulatory control, raising questions about the allocation of responsibility for the crisis. The paper also analyses the culture of competitive ‘creative compliance’ underlying this approach, and pervasive in business in general, setting out some implications for future policy and practice in business, government, regulation and the professions.
Jakob Arnoldi: 'Cheating Models: Algorithmic Trading and the Normative Reconfiguration of Financial Trading '
Abstract: The article discusses the use of algorithmic models for so-called High Frequency Trading (HFT) in finance. HFT is controversial yet widespread in modern financial markets. It is a form of automated trading technology which critics among other things claim can lead to market manipulation. Drawing on two cases, this article shows that manipulation more likely happens in the reverse way, meaning that human traders attempt to make algorithms ‘make mistakes’ or ‘mislead’ algos. Thus, it is algorithmic models, not humans, that are manipulated. Such manipulation poses challenges for security exchanges. The article analyses these challenges and argues that we witness a new post-social form of human-technology interaction that will lead to a reconfiguration of professional codes for financial trading.
Marc Lenglet: 'The Janus-faced Character of Regulation: Compliance Officers and the Making of Financial Practices '
Abstract: This paper is about the normative role played by compliance officers within European investment firms. Holding a very specific place between regulators and their firms’ management, compliance officers contribute to the shaping of financial practices while providing contextualized interpretations of market rules and regulations. Their ambivalent location, apparently situated on the margins of both realms (regulation and control on the one hand, allowing for the deployment of business possibilities and innovations on the other hand) makes them face issues that are often complex, and still understudied: situations where responsibility has to materialize, in environments where rules are not always easily understood, nor even understandable. Drawing on ethnographic materials gathered during a three-year period, I show how compliance officers take part, on a daily basis, to an embedded hermeneutic of normativity, and discuss the way they construct discourses legitimating the development of financial objects and practices.
Taylor Spears: 'Reconstructing
the ‘risk-free rate of interest’ after the credit crisis: the switch from LIBOR
to OIS discounting in the OTC
prominent theme in the social studies of finance literature is the
“naturalization” of valuation
methods, i.e., understanding the social processes by which mathematical models and tools come to be accepted as the
correct or “natural” way to value a certain asset. Recently attention has begun to shift
towards the naturalization of one of the most important of all financial valuation practices:
discounted cash-flow analysis. In this project, I explore a related question: how do market
participants come to agreement about which discount factor to use in making present value
calculations, and what implications does this choice have for the social organization and practice of
modern finance? I address this question by examining an ongoing – and at times, controversial
– episode. Since 2008, financial institutions have chosen to switch from the LIBOR rate,
which has been widely used since 1986, to a rate called the overnight indexed swap (OIS) rate. Market
dislocations caused by the recent credit crisis that effectively impaired LIBOR’s ability to
accurately measure the risk-free rate of interest have been the primary driver of this
change. The primary aim
of this project is to understand how the financial derivatives community has come to collectively agree that the OIS
rate is the “natural” replacement for LIBOR given the potential stakes involved in such a
switch. Second, I examine the cognitive, legal, and at times material efforts undertaken by
quants and lawyers working at banks and within ISDA (the industry’s self-regulatory group)
to construct and stabilize the OIS rate as a “risk-free rate” that can be used to discount
derivative cashflows in a routine and unproblematic manner.
1 This research is partially funded by the ESRC project on “The Development and Exploitation of Financial Innovation” (RES-598-25-0054). Additional funding comes from the TSB, NESTA and the BIS.
Desné Masie: 'Narrative Epidemiology in the Anatomy of the Crisis'
Abstract: The power of news media narratives in financial markets and crises has been insufficiently explored, even though the media and its narratives are central to market formation. Research in narrative, evolutionary psychology and behavioural finance has shown that the human brain has a propensity to process information in narrative form. In this view, storytelling is a formative and primal process and an intrinsic part of the human mind's sensemaking when it is overwhelmed with information. Narratives are thus an intrinsic calculative frame for the interpretation of economic events, and therefore for the valuation of assets in financial markets. In serving as prostheses for human cognition, narratives augment distributed calculation in processes of marketisation. Further, the news media sways thinking among large groups of people. Hence, journalists’ knowledge construction processes and narratives can become viral during a financial crisis because they are primarily storytellers. This paper uses interviews with financial journalists, as well as market data to demonstrate narrative epidemiology in the anatomy of the 2008 financial crisis as a self-fulfilling prophecy.
Andrea Mennicken & Yuval Millo: 'Testing Values: Financialization and the Emergence of Impairment Rules'
Abstract: During the past few years, many organizations have faced enormous impairment losses upsetting their balance sheets, organizational structures and market values. While impairment write-downs impact on multiple factors in an organization, such as profit calculations, risk management and investment strategies, the accounting and organizational literature, so far, has given little attention to the ideas and instruments through which impairment rules came about and to the roles that standardised impairment tests play in challenging organizational structures and processes, and the relationship between accounting, organizations and markets. This paper uses the case of impairment testing to draw out a specific historical episode of the ways in which the boundaries between markets and organizations, and between external and internal reporting, are being blurred and new accounting categories are being constructed. Tracing the history of impairment testing rules in the UK, based on archival research and interviews, we argue that standardized impairment tests are an important vehicle in the financialization of organizations. Combining managerial and market-based valuation approaches, impairment tests put accounting at the interface between markets and organizations. Managers are being made aware of the importance of markets through the implication of market-based information in organizational impairment valuations. At the same time, market-based information becomes more managerialized. In tracing the intertwinement of managerial knowledge and market-based information in impairment tests, we nuance debates about financialization and fair value. Financialization is not a one-way process, where finance and financial markets capture and colonize organizations. In impairment tests, market-generated numbers are combined and hybridized with organizationally generated managerial estimates. We highlight the eclectic nature of impairment valuations and the relevance of accounting technologies for bringing market-oriented valuation about. In so doing, the paper adds not only to our understanding of the dynamics underlying the emergence and change of accounting categories. It also contributes more broadly to the sociology of economic valuation, by shedding light on the different forms of calculability engrained in the establishment of market-economic loss and value.