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February 03, 2009

Reflexive Modeling for an Uncertain Economy

Daniel Beunza
Assistant Professor, Management
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Models pose a paradox. They hold the key to extraordinary profits but can inflict destructive losses on a bank. Because a model entails a complex perspective on issues that are typically fuzzy and ambiguous, they can lock traders into a mistaken view of the world, leading to billionaire losses. Can banks reap the benefits of models while avoiding their accompanying dangers?

Our research suggests they do, and shows how. We conducted a sociological study of a derivatives trading room at a large bank on Wall Street. The bank, which remained anonymous in our study, reaped extraordinary profits from its models — but emerged from the credit crisis unscathed. For three years, we were the proverbial fly on the wall, observing the traders with the same ethnographic techniques that anthropologists used to understand tribesmen in the South Pacific. We identified a set of managerial procedures, which we call “reflexive modeling,” that lead to superior model development. (View the complete study)

The key to outstanding trades, we found, lies outside the models. It is a matter of culture, organizational design and leadership. The bank that we observed introduced reflexivity in every aspect of its organization. From the junior traders to the supervisors, everyone at the bank was ready to question their own assumptions, listen for dissonant cues and respect diverse opinions.

How? As many have already suggested, individuals certainly matter. The bank hired people with a healthy dose of humility and an appreciation for the limits of their smarts. This often meant opting for older traders rather than younger hotshots.

But the key to the bank’s reflexiveness did not just lie in individuals. By reflexiveness we don’t mean super-intelligent traders engaged in some heroic mental feat, splitting and twisting their minds back on themselves like some intellectual variant of a contortionist. Reflexivity is a property of organizations.

The architecture of the bank, for instance, was crucial. The open-plan trading room grouped different trading strategies in the same shared space. Each desk focused on a single model, developing a specialized expertise in certain aspect of the stocks.

To see why this was useful, think of a stock as a round pie. Investors on Main Street often eat the pie whole, with predictably dire consequences. The professionals that we saw, by contrast, sliced stocks into different properties. Each desk was in charge of a different property, and the different desks then shared their insights with each other. This could happen in a one-minute chat between senior traders across desks or in an overheard conversation from the desk nearby. This communication allowed traders to understand those aspects of the stock that lay outside their own models — the unexpected “black swans” that can derail a trade.

Sharing, of course, is easier said than done. The bank made it possible with a culture that prized collaboration. For instance, it used objective bonuses rather than subjective ones to ensure that envy did not poison teamwork. It moved teams around the room to build the automatic trust that physical proximity engenders. It promoted from within, avoiding sharp layoffs during downturns.

Most importantly, the leadership of the trading room had the courage to punish uncooperative behavior. Bill, the manger of the room, made it abundantly clear that he would not tolerate the view, prominent among some, that if you’re great at Excel, “it’s OK to be an asshole.” And he conveyed the message with decisive clarity by firing anti-social traders on the spot — including some top producers.

In other words, the culture at the bank was nothing like the consecration of greed that outsiders attribute to Wall Street. We refer to it as “organized dissonance.”

Our study suggests that a lack of reflexivity — that is, the lack of doubt on the part of banks — may be behind the current credit crisis. We are reminded of infantry officers who instructed their drummers to disrupt cadence while crossing bridges. The disruption prevents the uniformity of marching feet from producing resonance that might bring down the bridge. As we see it, the troubles of contemporary banks may well be a consequence of resonant structures that banished doubt, thereby engendering disaster.

This blog post was coauthored with Professor David Stark, chair of the Department of Sociology at Columbia University and author of The Sense of Dissonance (Princeton University Press, 2009). Please visit Professor Daniel Beunza’s blog Socializing Finance to learn more about his research on the social studies of finance.

Photo credit: Daniel Beunza