It just occurred to me that risk and entropy are the same thing

I have an amateur interest in economics that I indulge from time to time, primarily by reading economics-focused blogs. While I was doing that this week I was interested to see Brad DeLong (whose blog is definitely worth following) point to a discussion from the Economist about compensation for bankers and the relation between that and their ability to accurately judge risk.

Some of the arguments seem to run along the lines that bankers may not be competent to recognize risk, and that therefore they may not charge an adequate risk premium for risk they are taking on, which can result in some of the kinds of problems we’ve seen lately with high risk mortgage debt causing an avalanche of financial woe.

This is certainly credible, especially if you’re a cynic who tends to think that most people are pretty incompetent.

Of course, it turns out you don’t necessarily need to be particularly cynical, since current research seems to suggest that in areas like debt securitization, it’s effectively impossible to determine the level of risk you’re taking on, or to determine later if something like a CDO was structured with a higher real degree of risk than it was represented as having. The research says this kind of analysis is an NP-complete problem, which is not the same thing as “impossible”, but is close enough for sloppy discussion. Given those findings you can hardly blame a banker for not assigning the correct risk to a CDO.

(You can perhaps blame them for not knowing that they were dealing with something they didn’t–and possibly couldn’t–understand. There’s no shame in not being able to solve an NP-complete problem, but there’s not a lot of excuse for pretending you know the solution, and making decisions based on your faulty solution, when you don’t.)

What strikes me the most out of the whole discussion though is this quote:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium… The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

This was offered in the context of explaining how some bankers ended up carrying much more risk than they thought they were, but I think it’s much more poignant if you consider not the banker but the investor, who has even less chance of assigning risk correctly than a financial professional, and who stands to lose their savings and not just a bonus.

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Creative Commons Attribution-NonCommercial-ShareAlike 2.5 Canada
This work by Chris McLaren is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 2.5 Canada.