Monday, February 11, 2013

The Bank That Ran Out of Money

Over the Christmas break I started watching the tale of the RBS, Inside the Bank That Ran Out of Money. This is the story of how one of the most successful banks in the world ran up the biggest corporate loss in history, a loss of €24.1Billion. 

There have been many reasons offered for the cause of the 2007 and 2008 global financial crisis including availability of easy access to loans for subprime borrowers, overvaluation of bundled sub-prime mortgages as well as the result of "high risk, complex financial products. It is the creation and evaluation of high complex products that caught my interest. Basically mortgage derivative products, where risky mortgages were packaged with more traditionally secure mortgages and sold to corporate investors and other banks as secure investment products.

The documentary RBS, Inside the Bank That Ran Out of Money interviewed an ex-executive of the bank who described how some of the best mathematician and physicist were running complex financial models to evaluate risk and predict earnings.

I wanted to look at the type of the mathematics and modelling that is used in the financial sector. Amongst numerous factors, some say the Black-Scholes equation was the mathematical justification for the trading that ultimately helped plunge the world's banks into catastrophe. The equation, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run. And the equation itself can’t be blamed for the credit crunch.

The formula is fine if it is to be used sensibly and abandoned when market conditions become inappropriate. The trouble was its potential for abuse. It allowed derivatives to become commodities that could be traded in their own right. Courtesy of Wikipedia here is the equation.

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