Black swan or fat turkey?

Geoff Booth and Elias Mazzawi assert that the recent failings of financial regulation are attributable more to improper application ...

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"Black swans” seem to be on the minds of many in the financial world. If you have been tracking the recent turbulence in finance – the mortgage mess that is causing some homeowners to lose their house and others to be unable to buy one, the major banks skating on the thin ice of shallow liquid assets, and the numerous depressing news reports of economic slowdowns or recessions – then you have probably also encountered references to black swans.

Black swans certainly exist, though you’ve probably never seen one, cautions Nassim Taleb; and they gave rise to the title for his recent topselling book, The Black Swan: The Impact of the Highly Improbable (Penguin 2008). In it, former financial trader Taleb highlights the lack of understanding of events that, though perceived as statistically rare and extreme in occurrence, arise with unexpected frequency and impact. Some might be tempted to see recent events in the financial markets as just such black swans.

But this would be quite wrong, in our view. Many of the flaws that have led to current turbulent conditions have not ridden in on the back of a black swan. Instead, they are the result of weaknesses and failings in the interpretation of risk analysis and the processes of oversight. Have markets conveniently forgotten similar outcomes of the last 10 years?

Consider the 1998 bailout of Long Term Capital Management, orchestrated (though not funded) by the Federal Reserve Bank of New York after the company suffered losses of more than $4 billion in less than four months. Lessons that should be apparent here include an unexpected breakdown of historic correlations, modelling risk, inadequate stress testing, a lack of transparency and disclosure, and generous extensions of credit. All this has an all-too-familiar sound.

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