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Author: Alan Shipman

The financial crash: Could it happen again?

Updated Wednesday, 23rd September 2009

Surely the financial collapse of 2008 will be the crash to end all crashes... right? Alan Shipman isn't so sure.

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A sign warning of the dangers of falling Risk of collapse? The guru of central bankers, Alan Greenspan, calls it a once in a century event. Other bankers, regulators and economists who spoke to The Love of Money describe the September 2008 crisis, and developments before and after it, as the most dramatic of their lifetime. While there have often been recessions, and stock market crashes, there has been no comparably global and brutal combination of crash and recession, at least not since the Great Crash of 1929 and Great Depression that followed.

Yet Nassim Nicholas Taleb calls it a Black Swan, an improbable event that occurs far more frequently than we expect – partly because wrongly confuse the improbable with the near-impossible. Those who study the London, New York and other major stock markets find that ‘extreme events’ happen with unnerving regularity.

How we answer this question will have a profound effect on how we now approach financial regulation – and the regulation of many other activities with unpredictable and potentially damaging effects. Until now, we have tended to take a ‘risk-based’ approach to future contingencies. This means, crudely, calculating the financial impact of what could go wrong, and the probability of its going wrong, and multiplying the two to put a monetary value on the cost if things go wrong.

The Taleb view leans in favour of a ‘hazard-based’ approach, which focuses on the impact of the disaster when it occurs. This means paying more attention to extremely unlikely events that have serious consequences. If such ‘Black Swans’ had been taken more seriously, the calamitous events of 2007-9 would have been better prepared for, or detected and averted at a far less damaging stage.

While recent events have been something of an oil slick to the Black Swans argument, hazard-based thinking risks extreme caution and conservatism. The chemical industry is currently up in arms over an EU switch towards hazard-based assessment, which would grade compounds according to their toxicity – what they can do if people are exposed to them – without regard to the likelihood of such exposure. It’s like taking the impact part of the risk-based calculation, but leaving out the probability part.

Critics say it is an intolerably strict implementation of the precautionary principle: the sort of approach that would ban all cars because of the fatal consequences when they hit pedestrians at speed, or disconnect all houses from piped gas because of the occasional explosion. But there may be factors that justify its application to financial services, even if it’s a retrograde step regarding fertilisers and detergents.

The risk-based approach may have fallen down by underestimating the likelihood of extreme events, and the severity of their impact when they happen. Both underestimations arise from the extreme interconnectedness of the financial system compared with other sectors. Instead of spreading and transferring risks so that mismanaged financial institutions can fail in isolation, globalisation and financial innovation appear to have heightened interdependence so that a few misguided players – Northern Rock and Lehman Brothers in 2007-8, Long Term Capital Management in 1998 – can rapidly jeopardise the whole global economy. When the costs of retrieving the situation run into billions if not trillions, the case is made for preventing the hazard, however remote its likelihood of occurrence seems to be.

Defenders of the risk-based approach would say that this is still too cautious. In curbing hazardous practices (like high leverage, securitisation, derivatives trading and credit default swaps) because of the immense damage when something goes wrong, we would forgo the equally immense benefits these confer most of the time, when everything goes right. We still risk the financial equivalent of keeping all cars behind a red flag because of the occasional road death if they travel at normal speeds.

But are the benefits really so immense? This question has long been asked by those in the ‘real economy’ mystified by the source of bankers’ and brokers’ vast wealth, and was raised in August by none other than the chair of the Financial Services Authority, one of the regulators at the centre of the recent banking crisis. Lord Turner admitted that some banking activities may be ‘socially useless’, and some financial innovations simply complications introduced to give intermediaries extra profit, like a roadblock at which highwaymen extract their toll from honest traders.

Turner is not the first to point out that, if financial services are supposed to grease the wheels of commerce and reduce transaction costs, then it is not obvious why the financial sector grows rather than shrinks as an economy grows richer. The bonus-fuelled bankers say they are promoting investment and growth by letting enterprise raise funds more cheaply, get higher returns and reduce or insure against risks.

At root, though, the most useful contribution of banking is the very basic one: channelling short-term savings into longer-term investment and supplying liquidity to businesses that must buy before they sell. These operations can be – and until recently were – run and regulated separately from those of higher-risk investment banking. If the growth of exotic ‘wholesale’ operations in London and New York is not essential to – and now endangers - the safety of ‘High Street’ borrowers and savers, then a hazard-based approach to the financial sector may be justified. Less like banning the car than fitting compulsory anti-lock brakes.

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