There is clearly a need for scientists and good mathematicians in financial centres while accountants who study maths and physics could encourage some much needed innovation
THERE IS A strange relationship between the bonus points offered to Leaving Certificate students who study higher level maths and the flawed bonuses paid to bankers that has led to the worldwide banking crisis. In the long-term, it could encourage badly needed innovation.
Investment guru Charles Munger, vice president of Warren Buffets’ Berkshire Hathaway, would probably approve of awarding such bonus points. He said of the recent banking crisis: “Thank God we don’t design bridges and airplanes the way we do accounting,” a suggestion that he prefers scientists to accountants.
Munger relied heavily on accounting figures when he invested in Irish banks only to find that they were bankrupt despite reporting healthy profits. Indeed, Munger himself may have acted unprofessionally when, with raw bitterness, he described the accounting profession as a “sewer” that contributed significantly to bank failures.
Major global financial centres, including the IFSC in Dublin, place more trust in accountants than scientists. Accountants assist bankers with tax and regulatory requirements, and also calculate “independently” profits and therefore bonuses.
To describe accountants as a sewer is perhaps harsh. Accusing them of using flawed rules and being ill-trained to deal with the sophisticated banking world is more justified.
Bankers have exploited confused accountants by awarding themselves huge bonuses for reckless lending. Munger’s comments suggest that engineers, mathematicians and scientists have the brainpower and are better placed to innovate the complex world of finance – a debateable point.
In 1973, academic Myron Scholes, along with other rocket scientists borrowed from the world of physics the “heat diffusion equation” to develop a system that allowed banks to reduce the risks of trading derivatives to hedge funds and sophisticated customers. The Black Scholes model is both practical yet elegant and won Scholes a Nobel prize for his contribution to finance.
A student of higher Leaving Cert mathematics would easily understand it. Teachers often use the model to illustrate how abstract higher level maths subjects like integration, geometric progressions and differentiation are used by investment specialists. The innovation allowed pension funds, hedge funds, mortgage providers and sophisticated treasury operations to increase wealth and led to the creation of specialised derivative trading exchanges in London and Chicago.
Munger, however, has warned that the rules accountants use for financial instruments are flawed. He believes that bankers deliberately lobbied for these accounting rules to suit their circumstances. Many accountants admit they don’t understand complex financial engineering and are therefore unaware of the damage they are doing. Scholes’s work never really featured in accounting training despite its huge impact on finance.
Sadly, despite winning a Nobel prize, Scholes’ reputation suffered. He, along with scientists and distinguished academics, were invited to run a hedge fund known as Long Term Capital Management. Scholes may have over-relied on mathematical models and not enough on common sense. His fund collapsed owing billions, and like the current financial crisis, nearly derailed Wall Street. Eventually it was rescued by the US government.
Today history is repeating itself. Bankers continue to use complicated structured products that even they don’t understand. Often these products are designed to produce an accounting profit even though they are, according to Warren Buffet, lethal “weapons of mass destruction”.
Leaving Cert maths students know more about matrix algebra than most accountants. Does it have any use beyond exams? Apart from bank regulators, insurance companies, hedge and pension funds use it to measure risk. A bank that is well diversified, ie not all eggs in one basket, is considered safer than one which has billions of exposure concentrated only on Irish property. Regulators, accountants and bankers got this badly wrong. However, regulators blame accountants who permitted bankers to conceal losses.
Within Dublin’s Central Bank, regulators still pore over the risk models of commercial banks, which are based on matrix algebra. Accountants must report to shareholders on risk policy but very few fully understand the mathematics used to measure such risks.
Recently completed research on the Irish banking crisis by Gerald Flynn, a lecturer at Dublin Institute of Technology, has some worrying conclusions. Regulatory guidelines (known as the Basel rules) worked reasonably well on their own, but when combined with accounting rules, a lethal cocktail emerges.
For instance, bankers are often treated more leniently by regulators when they engage in reckless, as opposed to safe, lending and the bonuses for deliberately lending recklessly are often higher than for prudent lending. There is a “silo” mentality within banking. Regulators who rely on accountants don’t fully understand what they are doing and accountants do not have the technical expertise to see how regulators use published accounts.
The complications caused by the interaction between international accounting standards and Basel guidelines require people with the ability to understand Black Scholes, matrix algebra and probabilities as well as the foresight to see what can happen if banks use flawed bonus schemes.
There is clearly a need for scientists and good mathematicians in financial centres if only to unravel the complicated systems previously developed by rocket scientists that have confused regulators and accountants. Redesigning the financial system from scratch could end the current credit crunch and avoid another. Giving bonus points to regulators and accountants who study mathematics and physics could encourage innovation and is more sensible than giving flawed bonuses to bankers.
Cormac Butler ctkbutler@aol.com is an equity and options trader and has recently published Accounting for Financial Instruments by Wiley