Sunday, June 5, 2011

So quickly we forget...

One of the lessons we'd supposedly learned from the financial crisis is the need to look seriously at systemic risks -- risks not tied to the well-being of just any one institution, but which emerge out of their interconnections and interdependence. Systemic risk is the new buzz phrase for research on banking network stability. The Dodd-Frank financial reforms still under negotiation aim to improve systemic stability (in some small way, at least), in part by raising capital requirements on individual banks.

It's doubtful this will be enough. As a number of studies (notably this one) have shown (see further comment below), the propagation of distress through a banking network depends on more than the situation facing each individual bank -- the density of links between banks matters too. More links of financial dependence between banks can share risks and make a network more stable, in some cases, but they can also make the system more fragile. So raising capital requirements isn't enough. Still, it's at least a step in the right direction.

After all, if there's one thing we've learned about the risks linked to rare fat-tail-associated crises is that years of apparent profitability can be wiped out in a few tumultuous weeks. Two years ago financial writers couldn't repeat often enough what they'd learned from Nassim Taleb's Black Swan -- that there's real danger in pushing up leverage and ignoring those tail risks in pursuit of short term profits, and that "profitability," sensibly considered, has to refer to the long term. Now they have apparently forgotten, as this article in today's New York Times makes clear. Bank stocks are down. They're worried about all the new regulations eating into their profits. Especially those pesky capital requirements:
... new international rules now being developed to require major institutions to hold more capital as a buffer against future financial crises will also erode profitability. That is because money set aside as ballast is cash that will not be available to lend out or pay dividends or buy back stock.
This is only true if you take "profitability" in a special, narrow, short term sense. That money set aside as ballast might just enable the bank to survive tough times in the future, and might also make the entire banking network itself more stable, as well as the broader economy. The kind of "profitability" this paragraph is talking about isn't what we need.

Coincidentally, the paper I mentioned above -- which studies a model network of interdependent banks -- explores a scenario that economist Mark Thoma describes quite beautifully (without apparently having it in mind, though perhaps he did). The point is that there's an interesting trade-off we don't understand very well between the increasing safety that comes from diversification as the network grows more dense, and the simultaneously increasing danger of cascading distress which dense ties make more likely. As Thoma puts it,
When I think of an interconnected network that can spread problems from institution to institution, there are two possible scenarios. First, think of a drop of poison in the ocean. The ocean is so big that even a powerful poison can be neutralized as it spreads.... This is much like traditional financial risk sharing where large individual losses are spread throughout the system so that the losses to any one person are tiny.

But now think of a poison that acts more like an infection. As it spreads it does not become less toxic, it continues to be lethal to anyone who comes in contact with it. In this case, you want to break the network connections -- i.e. compartmentalize -- as soon as possible to prevent the spread of the lethal infection. You may even want to have the compartments set in advance if you cannot sever the ties fast enough.