To understand (or prevent) the next crisis, read ‘The Money Formula’

Do you want to know how the next financial crisis will arrive, and how it could be prevented? In that case, read “The Money Formula“, a book by Paul Wilmott and David Orrell published earlier this year.

It shows you, with mathematical precision, what the financial world did not learn from the previous crisis. It also shows why it is so difficult for the rest of the world to catch them out.

In the end, it all boils down to mathematics, or rather, the fear that a lot of people feel when faced with an equation.

This book is somewhat of an antidote to that fear. Irreverent and fun, it is at the same time very rigorous in explaining how some fairly basic mathematics has hijacked the world of finance — and with it, possibly, your prosperity.

The two authors go through the ways financial wunderkinds use various formulas for valuation, derivatives pricing, or risk concealment management, and dissect them into manageable chunks, exposing their flaws.

Of particular significance is the issue of recalibration — an innocent-sounding word, but which sometimes can hide fiddling with the model until it fits the requirement. That requirement could be to lessen a bank’s risk exposure, or it could be claiming to offer a way to value a derivative instrument that is, in fact, impossible to value.

As a consequence, that bank could take on too much risk and end up blowing up the financial system. That badly valued derivative instrument could multiply like toxic algae on a lake, suffocating the global economy.

Benevolent regulators play a major role in this. The book also exposes the way in which policymakers and regulators fell into the trap of the “quants” and their mathematical models.

Part of the problem was that no matter how bright they themselves were, policymakers fell for the myth that finance is efficient and, therefore, self-regulatory.

In the authors’ words:

“Quantitative finance has therefore pulled off a truly amazing stunt, by bringing all the relevant players together on the same page. And here again we see the connection between making models and writing fiction — both involve creating a universe that people can believe in. The difference is that quants spin their stories out of mathematical formulas.”

Besides revealing the insides of the financial world and its imperfect mathematical models, the book makes a series of recommendations on how to fix it in order to prevent the next crisis.

They were all important, but I personally found two of them especially significant. One is the introduction of a “malus” — the opposite of a “bonus” for those in the financial sector. Perhaps if money comes out of their pockets in case of failure as easily as it pours in in case of success, they will be more careful.

The other is the fact that we must not rely only on economists, mathematicians, regulators, policymakers, financial journalists, to fix the system.

We need to learn to rely less on debt, and all of us need to participate in order to achieve that cultural shift. After all, our jobs, businesses and futures are at stake.