Riccardo Rebonato is a man with a clear and deep understanding of the most complex elements of the financial markets. His first book, Interest Rate Option Models, was one of the earliest proper mathematical texts on the complexities of “interest rate options” — investment tools in which the pay-offs depend on the future level of interest rates — and it is still relevant today. But is he the right person to write a book, without equations, about the fundamental problems underlying risk management in the markets? Before I opened Plight of the Fortune Tellers I have to confess to being dubious.

How wrong I was. This is an enjoyable, approachable book that may be read by anyone with an analytical mind. It is free of mathematics, yet it makes no concessions when it comes to explaining the complexities of a problem. The rather dry text of Rebonato’s previous books is utterly gone; instead, I found a flowing prose that was a pleasure to read.

With this book, Rebonato — who is global head of quantitative analysis at the Royal Bank of Scotland and a visiting lecturer in mathematical finance at Oxford University in the UK — seeks to explain what is wrong with financial risk management today, and to suggest ways of putting it right. It is a big subject. Why, when financial institutions spend many millions of dollars on people and computers to manage their risk, do they fail so spectacularly and so regularly? It is not long ago that the UK witnessed the ridiculous sight of long queues of people outside the offices of Northern Rock, a large and respectable bank. They were waiting to withdraw every penny they had, as they had lost confidence in the institution. A run like that on a bank has not been seen in the UK for 140 years. Surely in that time we should have learned enough to stop it happening again?

It takes someone of Rebonato’s intelligence and experience to understand what has happened. It is so tempting to assume — as the media frequently do — that events like this are due to some selfish individuals who use subterfuge to pursue highly risky and improper activities. This is not so, apart from in a few isolated cases. Northern Rock, for example, had no wild card like Nick Leeson, who brought down Barings Bank in the mid-1990s. The problems are systemic and are largely due to the very levels of sophistication that are supposed to guard against them.

Early in the 20th century it became apparent that the failure of a bank was rather different from the failure of, say, a department store. The collapse of the latter would only have a big impact on its immediate employees — customers might be inconvenienced and annoyed but that would be all. The collapse of a bank, on the other hand, can financially ruin hundreds of thousands of people. As a result, governments appointed regulators to draw up “safe” operating practices that banks have to follow, to ensure that such events do not happen.

Rebonato details the initial crude but effective methods that the regulators used in the early days, which were based on rough estimates and rules of thumb as to the amount of capital that the banks needed to set aside to cover the risk of transactions. They might have been rough but they worked — at least until product complexity grew exponentially in the 1990s. Regulators decided, naturally enough, to cope with this growing complexity by adopting the same techniques that the financial institutions themselves used to manage the risk involved in financial deals. At this point the author shows how a process of disconnection occurs, due to different sets of well-meaning people misunderstanding the limits of each others’ tools and knowledge.

Indeed, the highly sophisticated techniques that the regulators borrowed or licensed for use from the traders were only designed for short timescales and risk events that might happen one day in 20. They were not meant for periods of years and 99.97th percentile events, which happen maybe two or three times in 30 years. It might seem that such situations are “safer”, but in fact there are just not enough historical data to correctly judge the probabilities and at these points the limitations of the techniques become severely exposed. The fact that it is mathematically possible to extend them in this manner does not mean that it is right to do so. Rebonato shows the reader clearly and simply why and how the current state of affairs arose, and why the techniques that were supposed to prevent crashes and loss ended up, in many cases, exacerbating them. It is a fascinating tale and well told.

The author then, as a responsible risk manager should, goes on to consider what should be done about the current situation. Here I found the book less satisfactory, but this could be simply due to the fact that it is not a problem with an easy solution. Rebonato advocates the use of Bayesian methods, so that initial views and judgements about risk elements may be incorporated into final decisions. He advises us to rely less on “frequentist” approaches, which assume that the future will be like the past, even when there are not very many past data to go on. While it must surely be a sound idea to give less weight to risk estimates that are derived from small data sets — regardless of the degree of sophistication used to generate them — I remain uneasy about placing reliance on prior judgements. In general, economic forecasts are difficult to do, and rare is the economist who persistently makes the right calls.

Nevertheless, Plight of the Fortune Tellers is a great wake-up call for the industry. It deserves to be widely read since we all would like to be able to rely on the stability of the financial sector. It would be nice to get the risk management right.

• The views expressed in this article are the author’s own and not necessarily reflective of those of Citigroup