Rethinking Markets

Part of my talk this coming week is a criticism of the turn from commensuration to quantification. In particular, one of the striking comparisons between (auction) art markets and financial capital markets is the extent to which art specialists decry quantification. As specialists gain more experience, they are more willing to say that their valuations come from ‘a feeling’, ‘the gut’, or ‘the heart’, less willing to make claims about quantitative modeling. There is commensuration still, though it is more often expressed as centrality with regard to conventionally-determined art categories (impressionist/modern, contemporary, photography, Indian Art), and not a quantified metric (i.e., the market price). That a Chagall and a Cezanne are the same price rarely implies that they are worth the same, in any meaningful sense other than the pure market one. And that has surprisingly little traction among specialists. These pieces are comparable, but the quantified metric seems to have less importance than one might suspect.

By contrast, finance has become enamored of quantification to an unexpected degree. Value at Risk (VaR), the now-ubiquitous way to measure market risk, volatility, and assess capital requirements for financial trading, is a quantified measure of commensurated risk. That is, the various conditions around different sorts of assets are transformed (and made comparable) via this quantified metric. Stocks, bonds, private equity, mortgages, consumer credit, currencies, all are transformed into risk-measurable assets.

But the problem with VaR has become somewhat evident in recent history, and there are some moves afoot to replace VaR with something…well, something resembling the ‘expertise’ and intuition-based measures found more often in the Art World than on a trading floor:

What should replace VaR? We should reintroduce the spirit behind the way we calculated risk before VaR took over on trading floors and in the offices of regulators in the early 1990s. That means using intuition and experience-honed common sense. It means accepting the principle that toxic assets should be considered riskier than liquid assets—and that fancy math and past performance can be deceiving predictors that often deliver a lethal dose of leverage. We need rules and risk committees that limit a bank’s “bad” leverage by requiring much more capital to cushion, say, a subprime collateralized debt obligation than to offset Treasuries. It’s time to give up analytics so that real risk can be revealed.

On one level, I’m astounded by the call to ‘give up analytics’ in order to reveal real risk. On another, it’s a reasonable shift away from quantification, and back towards a kind of ‘qualitative’ commensuration.