Saturday, 18 April 2009

Globalization and the illusion of stability

I am nearing the end of reading “The Black Swan” by Nassim Nicholas Taleb. It’s a very interesting book, and I recommend it you anyone curious about the possibility of Black Swans or the highly improbable events that affect our lives. The author explains the fallibility of using the median in the Gaussian bell curve for making predictions, while in reality many things defy this logic.

In chapter 15 he predicts the possibility of Black Swans occurring in our current highly globalized world:
“I spoke of globalization in Chapter 3; it is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized in their risk measurement) – when one falls, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur...I shiver at the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It means that we know less and less about the possibility of a crisis.”
He continues by saying that in a network there are a few nodes that are highly connected while others are barely so. Although networks seem more robust, because a random hit is more likely to affect a poorly connected spot, they are more vulnerable to Black Swans because if there is a problem with a major node, this will have a major impact on the rest of the network.

Actually this is quite an accurate prediction of the present economic crisis, and considering the book was published in 2007, Taleb was clearly ahead of his times. He favours a larger number of smaller banks rather than a small set of very big banks. In such a scenario, banks can be allowed to go bust, without tax payer funded bail-outs, and new ones take their place. This would allow the banking industry per se to be more resilient and reduce the risk of a major crisis unfolding when one bank fails.

Once the current crisis has passed, the government should consider breaking up the current nationalised behemoths such RBS and Lloyds Banking Group. A more diversified banking industry is probably to everyone’s benefit. As well as that, there must be more effective regulation. Recently, an anonymous whistleblower has accused the Financial Services Authority (FSA) of being complacent in its dealings with building societies, which is quite a major indictment of the financial services regulator.