Alberto Mingardi  

An "antifragile" financial system - but how?

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John Kay recently had a must-read piece Financial Times, now available ungated on his website. Kay makes an interesting point: the obsession with "too big to fail" financial institutions and "the lobbying power of incumbent companies" is leading the revamping of financial regulation after the crisis down a dead end alley. Not that new rules are not generously produced, but they would not provide for that "financial stability" that anybody is longing for. "Perhaps the most fundamental confusion in the evolution of financial services regulation," Kay argues, "is the equation of financial stability with the survival of established institutions."

He writes:

Lehman was run (badly) for the benefit of its senior employees rather than customers or shareholders. In a market economy, such organisations fail while rivals with better business models and management structures gain at their expense. That process of selection is the reason market economies have an impressive record of promoting efficiency and innovation. The problem revealed by the 2007-08 crisis was not that some financial services companies collapsed, but that there was no means of handling their failure without endangering the entire global financial system.

Still, would it not be better if proper supervision ensured that no financial institution could ever get into a mess like Northern Rock or Lehman - or Royal Bank of Scotland or Citigroup or AIG? No, it would not. Just replace "financial institution" with "fast-food outlet" or "supermarket" or "carmaker" in that sentence to see how peculiar is the suggestion.

Begin with practicality. It is hard enough to find people capable of running financial conglomerates - the fading reputation of Jamie Dimon, JPMorgan Chase chief executive, confirms my suspicion that managing these businesses is beyond the capacity of anyone. The search for a cadre of people employed on public-sector salaries to second guess executive decisions is a dream that could not survive even the briefest acquaintance with those who actually perform day-to-day supervisory tasks in regulatory agencies. They tick boxes because that is what they can do, and regulatory structures that are likely to be successful are structures that can be implemented by box tickers.

We have experience of structures in which management or regulatory committees in Moscow or Washington take the place of the market in determining the criteria by which a well-run organisation should be judged, and that experience is not encouraging. The truth is that in a constantly changing environment nobody really knows how organisations should best be run, and it is through trial and error that we find out.


In short, Kay maintains that "financial stability is best promoted by designing a system that is robust and resilient in the face of failure." But what should then be the features of a "robust" financial system? Larry White has an insightful article in the last issue of the Cato Journal. He borrows the word "antifragility" from Nassim Taleb's last book. White explains that "the wrong tactic for enhancing antifragility is to have a central authority impose uniform rules" and summarizes antifragility as, "Let a thousand flowers bloom, but do not artificially preserve even one of them." "Banking is ecologically rational only when a standard heuristic of the rule of law is observed: the shareholders, creditors, and management who stand to absorb the upside gain must also absorb all the downside loss". This is what Kay expresses with the terse formula "treat finance and fast food alike."

An often-heard criticism of this viewpoint is that it isn't quite clear how to move from A to B, from today's crony financial capitalism, to something that may have a closer resemblance to a free market. And yet, I think Kay is quite right in maintaining that the very idea that we should aim to restore accountability, free enterprise, and the possibility of failure for big banks (aka the rule of law) is shared neither by regulators nor by public opinion. That's a bigger problem than planning the transition.


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CATEGORIES: Economic Philosophy



COMMENTS (6 to date)
Effem writes:

Nothing better than a deep, long recession to return capital to its rightful owners. Of course, this is a political impossibility.

Dan S writes:

Libertarians are really not very good at talking about finance.

I think you are missing the very basic point here that Lehman Brothers failing is simply not at all the same thing as a fast food joint failing, or even an entire national chain of fast food joints. The collapse of Lehman threatened to plunge the entire financial system into complete chaos, and with it, the rest of the economy, which is why, if you recall in 2008, everybody (including the markets) were COMPLETELY FREAKING OUT. The financial system is interconnected in a way that "Main Street" businesses are not.

Now, we can argue till we're blue in the face about whether an unregulated financial system would be safer (I do happen to think it would, especially with better monetary policy), but let's not kid ourselves into thinking that in the fall of '08 we could have just let Lehman fail, done nothing else, and then just gone about our merry business as if the local convenience store just closed down.

Scott Sumner believes that better monetary policy in '08 could have prevented the financial collapse. Maybe he's right and maybe he's wrong, but the number of libertarians arguing for looser monetary policy in '08, even as we were moving ever closer into the mouth of the beast, was essentially zero.

Enial Cattesi writes:

@Dan S:
From the article:

The problem revealed by the 2007-08 crisis was not that some financial services companies collapsed, but that there was no means of handling their failure without endangering the entire global financial system.

From your post:

I think you are missing the very basic point here that Lehman Brothers failing is simply not at all the same thing as a fast food joint failing, or even an entire national chain of fast food joints.

Actually that was the point.
Continuing:
The collapse of Lehman threatened to plunge the entire financial system into complete chaos, and with it, the rest of the economy, which is why, if you recall in 2008, everybody (including the markets) were COMPLETELY FREAKING OUT. The financial system is interconnected in a way that "Main Street" businesses are not.

I have been reading for years about this and I am still at pains to find a good reason why this is true. What we actually saw was a bankrupt industry very dependent bailouts looking in amazement at one of their own being betrayed.

And most industries are more interconnected than people think. The reason we don't see the kind of fragility displayed by the financial sector is that the bad players are easy to spot and avoid while the financial sector doesn't have the necessary antibodies for some reason (we pretend don't know why).

And now:

Scott Sumner believes that better monetary policy in '08 could have prevented the financial collapse. Maybe he's right and maybe he's wrong, but the number of libertarians arguing for looser monetary policy in '08, even as we were moving ever closer into the mouth of the beast, was essentially zero.

So Scott Sumner must be right, or closer for being right, because he advocated a looser monetary policy, while the libertarians you know didn't didn't. No comment.

Dan S writes:

@Enial,

Yes, it's true that the article says "there was no means of handling their failure without endangering the entire global financial system" and that this is a problem, but the proposed "solution" of "treat finance and fast food alike" is not solution at all. It would be nice in a sufficiently deregulated system but was woefully inadequate to suddenly decide to apply to Lehman at the 11th hour.

The fact of the matter is that in September '08, the course of action libertarians by and large advocated was, do nothing, allow pretty much every financial institution to collapse via contagion, and have the Fed do pretty much nothing. They insist that this wouldn't have been so bad, but I think they are really just being obtuse. The stock market just does not move like that if everything would've been fine.

This is what I mean when I say libertarians are not good at talking about finance. This concept of financial interconnectedness and fragility in a high-leverage environment, which is obvious to anybody who was there during the crisis, is simply ignored by libertarians.

It kind of reminds me of many libertarians' views on foreign policy, which is basically, do nothing ever, and then if an invading army comes through your borders or on your shores, fight that army. Better yet, fight with militias! It is obvious to all non-libertarians that if you have not taken any steps to prevent an enemy army from showing up in the first place, you have severely mismanaged the situation up to that point. This is doubly true in the era of nuclear weapons.

Mark V Anderson writes:

I just read a book called After the Music Stopped by Alan Blinder, about the reasons for the Great Recession and ways to prevent it from happening again. There was much to criticize in the book, mainly that he had far too much faith in the ability of regulators to fix the problem next time, and far too little faith in the market to work better if the incentives were fixed.

But I found him somewhat convincing in his discussion of the problem of letting these giant financial firms collapse. The issue is the vast number of inter-connections that these giant firms have with other entities; and the unwinding of these connections in the event of bankruptcy would be enormously disruptive to the economy. I think that is the key issue of "too big to fail."

So one of the solutions that Blinder suggested was creating a mechanism for unwinding these connections in an orderly fashion when a giant firm fails. That is exactly what we must solve to solve the "too big to fail" conundrum, so that big firms can fail, and so the free market can begin to work for the financial industry. I think that organizing this unwinding is the one contribution government can make to our financial system.

Blinder claimed that a system of allowing this unwinding was one of the attributes of Dodd-Frank. I am skeptical of that, but I hope that is true, since every other "solution" the government has created to solve our financial system will make it worse.

Enial Cattesi writes:

@Dan S:

The fact of the matter is that in September '08, the course of action libertarians by and large advocated was, do nothing, allow pretty much every financial institution to collapse via contagion, and have the Fed do pretty much nothing.

The article is about how the regulators and the financial sector want to maintain the status-qua, although they pretend otherwise.

The solution proposed by libertarians is in reality the most practical and less painful one. The orderly unwinding of these institutions will only translate in more regulations and more problems down the road with those institutions becoming even bigger. It sounds reasonable, but lets get real, it is an utopia.

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