One of those lessons is directly relevant to the argument that banks should simply be limited to a particular size. If there is any lesson that we have learned from this crisis, it is that size doesn't matter. Banks big and small all over the world have been brought to their knees by this crisis.
Systemic Risk = Large-Scale Correlations in Risk
What brought the financial industry all over the world to its knees can be attributed to a single mistake in reasoning, which was made by managers at every bank that ended up insolvent. Their mistake was in assuming that their risk of loss would range only within the boundaries set by local and recent events. The Royal Bank of Scotland, Kaupthing Bank in Iceland, Lehman Brothers in the United States, and your local Savings & Loan -- all made the same basic mistake of assuming that even if things got ugly for them, then there would be plenty of other banks around to pick up the slack. So long as I can depend on my counter-parties to behave exactly as we expect by contract, we will survive.
One thing that's worth noting is that this mistake wasn't fatal to the financial industry before the subprime mortgage bubble. The financial industry survived several bubbles before that, including the dot com bubble only ten years before. What changed?
The answer is cross-correlation. Over the past ten years, the financial industry became more interconnected through the financial engineering of derivatives and increased leverage than it has been ever before in history.
When any system becomes cross-linked beyond a certain low threshold, correlations in the dynamics of the system can spread from local to global. And this is exactly what we are living through. Although the system became exponentially more interconnected over the last ten years, the individual decisionmakers within the system (for the most part) kept their horizons relatively local and short-term. Nobody was looking at the large-scale, long-term trends and worrying about how those could ripple out in the event of a single default. Nobody was looking because no such cascade had ever occurred before.
The first role of any systemic risk regulator should thus be to quantify and limit the amount of cross-correlation in risk within the financial industry. We just can't afford to have every financial institution making the same kinds of bets. If a few are taking their cut from poker players, then the others need to take their cut from craps-players or roulette-players.
Regulating at Scale: Measuring Fundamental Limits to Growth
Systemic risk regulators have to be especially careful about the problem of scale. As numerous commentators have pointed out, there were a few people within the SEC that noticed the problems that might be caused by the unregulated sale of over-the-counter derivatives and the explosion in growth of the subprime mortgage market. How is putting a new agency in charge -- even if it has access to more information -- going to avoid such cascades in the future? In general, I don't think that any such agency will be able to prevent such cascades without having unintended negative consequences. And the scope of the authority needed to effect system-wide regulations is worrisome too from the point of view of suceptibility to political influence. A thumb on the scale at that scale is enough to crush entire markets.
To deal with systemic risk, any actual regulation will have to gloss over many of the fine details of what particular parties and counter-parties are doing. Getting too involved in these details simply invites corruption anyway. To deal with systemic risk, regulators need to change focus from the short-term and local, to the long-term and global.
For example, has anybody in government ever tried to figure out the highest rate of growth that has ever been achieved by a legitimate (i.e., non-fraudulent, sustainable) large corporation? If a company is growing faster than a certain rate then risk is being spread through the system. Such a company is either a Ponzi scheme or a gamble that some market exists that has not been demonstrated to exist.
A perfectly legitimate way for a systemic risk regulator to operate would be to set a threshold internal rate of return on cashflow -- say 30% annualized -- and then to demand that anybody with a higher IRR has to report to the systemic risk regulator on from whom and to whom that cash is flowing. Such a policy would have flagged the problem with subprime mortgages immediately. The size of the subprime mortgage market did not suddenly go from a few hundred million to billions in a year or two. At the very least, the government should have been carefully scrutinizing it after the cashflow increased by that number of orders of magnitude.
The Big Picture: A Network of Cashflows
At the end of the day, an economy is a network of cashflows. What makes our economy unique in the history of the world is its degree of interconnectedness. Those interconnections are both a blessing and a curse. They are a blessing in that they lower the costs of lending so that more and more people can get access to financing. (Think of Kiva, which is part of that interconnectedness.) The curse is that they permit for system-wide fluctuations to develop even from relatively small losses when decisionmaking is too tightly correlated.
Our goal should not be to go back to the smaller, less interconnected world. It should be to forge ahead into a fully networked economy, but with awareness of and capabilities to manage these global and long-term patterns of growth and decay in the network.
We need to think bigger.
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