The world is in serious trouble. Recession is hitting most parts of the world. While many people debate the exact reasons for it, most agree that the reason it has grown to the current extent is due to structural problems with our banks. We have become too reliant on them and they have grown so intermingled that our politicians believe they are too big to fail.
While we can talk about all kinds of things, such as sub prime mortgages, monetary policies etc. etc. The real problem is one of risk.
Risk is not a number
Imagine you going to a horse race to bet on a horse that is such a sure bet that it is only 1/10 chance that it will lose. The horse is faster than all the others, has a great jockey, you are set to win. You take out all your cash, take out all the money from your credit cards and remortgage your house to make a huge bet. After all there is no way you can lose. You make the bet and 10 meters before the finish line the horse falls. Against all odds you have lost all your money and are now in incredible debt.
This is essentially what has happened to the worlds financial system. It is irrelevant (but interesting) to discuss why the horse fell. The real issue is the lack of understanding of risk that made you put all on that one horse.
The banks of the world all went together and borrowed all of our money and all at the same time made the same really, really safe bet. After all it was a sure thing. The only problem was that the impossible happened and now everyone is trying to hide from the bookmaker.
Banks like most other people don’t understand risk. In many cases Banks don’t even understand themselves. Most very large banks have no clue of their own liquidity (how much cash they have) at any given time.
Imagine if you started writing checks like crazy without really having an idea how much money you have in your checking account. Banks frown on it if you do it, but they themselves are for the most sake guilty of this.
Because of this you get situations where you have one risky trade and they’re gone. We have seen this before with individual banks, however this time all of them made the same bet and most of them are in serious trouble.
Traders love risk numbers. What I mean by risk numbers is a number generated by some magic formula that condenses certain factors about an investment. This makes it easy for them to compare how risky an investment is.
Regulators also love risk numbers. It makes it easy for them to regulate the banks. They can specify what risk formula their banks should use and then look at a spreadsheet and see quarterly risk numbers for each bank. If a banks risk number is too high, they can send scary letters to the banks saying you need to take less risks.
The Black Swan
The only problem is what Nassim Taleb calls the Black Swan. Before the discovery of Australia Europeans thought there was no such thing as a black swan, it was impossible. Yet they were in for a surprise when they discovered it in the land of the Koala.
In other words the improbable will happen. The Black Swan is an unforeseeable event, that nevertheless happened. If you can’t imagine something happening you can’t calculate the possibility of it happening, thus any particular risk number can never take a black swan in to account.
Nassim states that Black Swan’s happen all the time. Sometimes they’re good, sometimes they’re bad. Yet in most cases they have had much larger influence on the world than anything we ever planned for or predicted.
The current financial crisis could not be seen in the analysts risk numbers. Yet it happened and the banks were not ready.
Risk numbers are good for black jack and other casino games, where all different outcomes can be calculated. But they can never be trusted if you can’t 100% guarantee you have taken into account all outcomes.
Outside the casino there are very few areas where you can calculate all outcomes, thus they are useless in the real world.
In short “shit happens”.
For more on the Black Swan check out these quite entertaining two podcast interviews with Nassim:
Any fix to the banking system must accept this. Risk can be managed through limits and real diversity, but not by relying on a single number or forumla.
So, who is going to fix our banking system?
You would think the banks would like to fix themselves. They might but most are too big to fix. I am willing to bet they even know this themselves. The only way save them without huge fundamental changes is through some sort of artificial protection.
Who will protect them? The same people who are meant to keep them under control of course, the regulators. The regulators are the government agencies looking after the banks. In the US the FDIC and Federal Reserve. Every country has one or more government regulators.
So far the regulators have been very busy. They’ve given us lots of words, spent lots of our money and not made any real changes.
The problem is that regulators are not innovators. Their solution? Besides limiting the bonuses of high level bank employees, which has absolutely nothing todo with any of the causes of the current crisis, their gut instinct is to regulate harder.
They raise limits and increase reporting requirements. In reality they are not physically capable at the moment of doing anything but raising limita and telling people off after the fact.
What this actually does is that it raises the barriers of entry for new banks or banks trying to innovate. Large established banks can easily afford to pay themselves out of this by building up larger compliance departments. Regulators think this makes their job easier and it also allows them to say to the public that they are getting tough on banks.
What we really need is innovation. The system is broken and we need to think differently. We as entrepreneurs are stuck with the job. Innovation can only come from small startups and activists. These are the only ones without vested interests in keeping the system the way it is. But as I mentioned the regulators make it very hard to innovate in banking.
I have a plan!!!
Where in we go back to basics, but lets rewind things a bit first.