Bouncy Castle Finance

A year ago, the fall of Lehman Brothers marked the end of Wall Street. Fundamental reform was just around the corner. ... Or so we thought. One year later, Wall Street has been reconstituted, refinanced, and refurbished. The biggest bull rally in history has followed swiftly on the heels of its greatest collapse. Top traders are still pulling in nine-figure salaries, and top banks are back to record-breaking profits. Why?

COMMENTS (1) SHARE:

Digg

 

Facebook

 

Reddit

 

More...

Part of the answer is that we went from a world in which regulators and politicians refused to see systemic risk to one where all they see is systemic risk. As a consequence, the lesson of Lehman was that not only are some banks "too big to fail" -- we also found out that the system as a whole is "too big to bail." This subtle change lies at the heart of our current regulatory climb-down.

Since Lehman's collapse, rather than making the world safe from financial firms, we've made the world safer for them by socializing the risk and privatizing the profits. Governments in highly financialized economies like the United States and Britain prioritized shoring up financial firms rather than regulating them, turning Wall Street into something like a big inflatable bouncy castle for the kids -- where they can bounce higher and harder than ever before, with the guarantee that the government will keep the whole thing inflated. How did we get here?

Part of the blame rests with the influence of three persistent, flawed ideas about markets. First is the "microfoundations critique": Truths about aggregates must be ground in truths about individuals. As such, the financial system has no identity apart from the sum of its parts. Second is the "efficient-market hypothesis": Prices of publicly traded assets like stocks reflect all known information -- a theory mistakenly treated as a rule. Third is the proposition that investors have "rational expectations": That is, investors use information efficiently so that while individual investors may make mistakes, the market as a whole tends to an optimum. Thus, the market price is by definition right.

These ideas, taken together, managed to convince governments and financial firms that regulation was part of the problem rather than part of the solution. Everyone believed that self-interested actors in a transparent environment made optimal trading decisions based on their own risk-reward trade-offs. The people holding an asset best managed its risk, risk that is divisible down to a single stock or bond or collateralized debt obligation. The only thing regulators needed to avoid was moral hazard. If individual institutions made bad bets and went bust, bailing them out would just encourage other firms to assume that they would be bailed out, too.

In short, risk is individual; regulation is best left to those with "skin in the game"; bailouts should be avoided at all costs. This was the thinking behind letting Lehman Brothers go under. Doing so was supposed to stop the rot. But it failed spectacularly.

The problem with this view of the world was that its focus on the microrational completely ignored the possibility of systemic risk. We now know the interlinking of market agents' positions leads to a form of risk that is neither reducible to the sum of individual positions, nor knowable a priori because what matters is how these positions are interlinked when market risk as a whole changes. That lesson had to be learned the hard way, with the death of Lehman Brothers and the discovery (by the rest of the world) of things like collateralized debt obligations.

Why couldn't we see -- or even conceptualize -- systemic risk until Sept. 15, 2008? First, because we did not recognize that the conceptual framework governed by the hypotheses of microfoundations, efficient markets, and rational actors was, well, just conceptual. Another related problem lay in allowing banks to regulate themselves by relying on internal risk-assessment models based, in part, on these ideas.

12NEXT