Sunday, 06 Apr 2008

Why can't Wall Street plan for emergencies?

When not following the election, I've found the latest financial crisis to be pretty interesting; how can so many smart people be collectively so stupid as to put the entire system at risk? I don't pretend to fully understand this stuff, but here are a few thoughts, from a spectator.

The financial system is built on promises of future payments. Some of these promises would survive any kind of catastrophe but most wouldn't. Determining exactly which promises would survive what kind of disaster seems to be something that people in finance don't do nearly enough of.

This seems to be because there are huge incentives to maximize the promises you make. Outside of fraud, it's not so crude as making promises you know you can't keep; instead people make promises that can only be kept if things continue to go as they hope. In good times, confidence is all you need to look smart.

Maximizing profits is usually about maximizing efficiency in the most likely scenario, and that usually means having lower reserves available for emergencies. Preparing for emergencies looks inefficient most of the time, because emergencies don't happen every day. Even insurance companies seem to have a hard time consistently charging enough to cover the risks they take on. (We can point to Berkshire Hathaway, but they're an exception, and they make mistakes too.)

This seems to be an amplification of basic human nature; many people are unprepared for an earthquake, for bad health, for old age, or even for losing their job. Even when we do plan for these things, we tend to be lousy at estimating risks and putting things in proper perspective.

And of course you can expect people will do even worse when taking risks with other people's money. Securitization and leverage spread risk and turn it into a rat's nest of dependencies.

Would it be possible to change the financial industry so that we can trust it not to make choices that collectively put the whole system at risk?

There's some basis for hope. There are some industries that do a good job at safety, at least in certain respects. The airline industry isn't very good at avoiding bankruptcy but they do keep their passengers safe. The people who design airplanes seem to be able to make the right tradeoffs between efficiency and safety and it's not just because of the FAA. It's not enough for a few government regulators to care about safety; it has to be everyone's job. Safety is a mindset.

Unfortunately, there seem to be a lot of otherwise smart people who argue that safety isn't their job, just because this is the way it's always been. It's up to the customer to evaluate the risks and decide which ones they're okay with.

This makes about as much sense as expecting someone buying a plane ticket to inspect the plane. You have to be an insider just to get access to the most relevant data and have the right education to understand it. (And if you do have insider access, profiting from it is often illegal!) Buyer beware makes no sense for complicated services used by the mass market.

In short, the system is like the car industry before Ralf Nader came along. Fixing it seems difficult but not impossible. What politician would take on the challenge of changing Wall Street's incentives and culture?

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