Al-Qaeda. IBM. Power grids. Dominoes. Pollution. Facebook friends.
These are just some of the subjects Andrew Haldane, the Bank of England’s executive director of financial stability, manages to touch upon in his highly-readable effort to answer `The $100 Billion Question‘ — $100bn being one estimate for the cost of the most recent banking crisis in the US.
The question, then, is how do you prevent another such crisis from occurring?
Regulators around the world are looking at things like limiting banks’ sizes, restricting their activities, or encouraging them to hold more capital — all in an effort to avert what’s become known as the problem of `Too Big to Fail Banks.’ And here’s the TBTF problem in action during the last financial crisis:
As Haldane puts it, it looks like “if anything, these relationships are positively sloped,” with larger, more diversified banks encountering bigger losses during the financial crisis. This suggests to him that:
This evidence is no more than illustrative. But it suggests that, in the arm wrestle between diversification and diversity, the latter appears to have held the upper hand. Bigger and broader banking does not obviously appear to have been better, at least in a risk sense.
By now you should be able to see where he’s going with this.
If bigger banks are more prone to risk, the only thing that should be stopping regulators from breaking them up is the argument that larger banks create greater value for society — economies of scale, and all that. Only, according to Haldane, they don’t above a certain threshold. As he puts it:
To sum up, the maximum efficient scale of banking could be relatively modest. Perhaps it lies below $100 billion. Experience suggests there is at least a possibility of diseconomies of scale lying in wait beyond that point. Conglomerate banking, while good on paper, appears to be more mixed in practice. If these are not inconvenient truths, they are at least sobering conjectures. They also sit awkwardly with the current configuration of banking.
And if you’re wondering where the terrorist thing comes in to all this, here’s the theory.
Terrorist networks operate on a modular model. They’re divided into cells, so that should one cell be caught by the authorities, the other cells can continue. As Haldane describes it :
A series of decentralised cells, loosely bonded, make infiltration of the entire Al’Qaeda network extremely unlikely . . . These are all examples where modular structures have been introduced to strengthen system resilience. In all of these cases, policy intervention was required to affect this change in structure.
And so, to the inevitable conclusion:
The history of banking is that risk expands to exhaust available resources. Tail risk is bigger in banking because it is created, not endowed. For that reason, it is possible that no amount of capital or liquidity may ever be quite enough. Profit incentives may place risk one step beyond regulation. That means banking reform may need to look beyond regulation to the underlying structure of finance if we are not to risk another sparrow toppling the dominos.
Today’s financial structure is dense and complex, like a tropical rainforest. Like the rainforests, when it works well it is a source of richness. Yet it is, as events have shown, at the same time fragile. Simpler financial eco-systems offer the promise of greater robustness, at some cost in richness. In the light of a costly financial crisis, both eco-systems should be explored in seeking answers to the $100 billion question.
Financial reform; thy inspiration is, err, Al-Qaeda?
Or deforestation?
Can that be right?
Related links:
Financial reform checklist – FT Alphaville
The bank problem in a single chart – FT Alphaville
BarCap calculates the cost of Too Big to Fail – FT Alphaville