Opinion

Felix Salmon

The risks of consolidation

By Felix Salmon
May 5, 2009

I had a short chat with Nassim Taleb this morning about his new paper with Charles Tapiero, entitled “Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions”.

There’s a great deal of mathematics in the paper, which is full of equations and greek letters, but the gist of it is explained in pretty plain English:

Societe Generale lost close to $7 Billions dollars, around $6 Billions of which came mostly from the liquidations costs of the (hidden) positions of Jerome Kerviel, a rogue trader, in amounts around $65 Billions (mostly in equity indices). The liquidation caused the collapse of world markets by close to 12%. The losses of $7 Billion did not arise from the risks but from the loss aversion and the fact that costs rise disproportionately to the size of the bank…

Consider the following two idealized situations.

Situation 1: there are 10 banks with a possible rogue trader hiding 6.5 billions, and probability p for such an event for every bank over one year. The liquidation costs for $6.5 billion are negligible. There are expected to be 10 p such events but with total costs of no major consequence.

Situation 2: One large bank 10 times the size, similar to the more efficient Société Génerale, with the same probability p, a larger hidden position of $65 billion. It is expected that there will be p such events, but with $6.5 losses per event. Total expected losses are p $6.5 per time unit – lumpier but deeper and with a worse expectation.

In other words, small mistakes we can live with. Large mistakes we can’t, because when a mistake the size of Kerviel’s is unwound, the costs are enormous — not only to SocGen, which lost upwards of $6 billion, but also to all shareholders globally, who saw the value of their holdings marked down by trillions of dollars thanks to the effects of SocGen’s enormous and chaotic forced unwind.

The lessons here are broader, and apply to the practice of M&A more generally: when industries consolidate, there might well be economies of scale — but at the same time tail risks increase. What happens when a massive amount of technology outsourcing is consolidated in Bangalore, or computer-chip manufacture is consolidated in Taiwan? Efficiency rises — but so does the risk that one disastrous event could have massive systemic consequences.

The solution for banks is relatively simple: just put a cap on their size. (I’ve been suggesting $300 billion.) What’s the solution for other industries, which also naturally tend to consolidate and cluster? I’m not sure, but in an increasingly interconnected and just-in-time world, the risks are greater than ever.

Update: A couple of good comments from dsquared; the first points out that the paper ignores problems of correlation, which is true. But as Rick Bookstaber is more than happy to point out (and Taleb is no fan of Bookstaber), correlations tend to pop up in the most unlikely places, and in general they just make everything more dangerous — not only the systemic risk of lots of small players failing at once, but also the systemic risk associated with one large failure. So add in correlations to Taleb’s model and I think it only becomes scarier.

Dsquared then asks whether we really want to move to a world of “Fewer SocGens, More Barings”. My memories of the systemic implications of the Barings collapse are hazy (maybe John Gapper or even Nick Denton can help out here), but I think the answer might well be yes: while the Barings collapse was bad for Barings, it didn’t have the kind of negative externalities that we saw with Kerviel. But I might be wrong on that front.

Comments
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[ all shareholders globally, who saw the value of their holdings marked down by trillions of dollars thanks to the effects of SocGen’s enormous and chaotic forced unwind.]

One doesn’t have to be Eugene Fama to think that there’s something screwy about attributing permanent losses to an event that by definition only took place because of short-term technical trading conditions.

Also, for NNT, of all people, to assume that the shocks which affect the ten smaller banks will be uncorrelated … words literally fail me! Why assume this? Why not assume that the conditional probability p given a failure at one of these banks is close to 1? Surely the S&Ls crisis (or the Spanish banking crisis of the 80s) shows us that you can have very big crises without very big institutions.

Posted by dsquared | Report as abusive
 

In fact, thinking about it, what were the “losses inflicted on investors” like caused by the disorderly unwinding of Nick Leeson’s positions? “Fewer SocGens, More Barings” doesn’t really sound like a very attractive solution to me.

Posted by dsquared | Report as abusive
 

In the same way, are you and Taleb advocates for states rights? After all, locating more authority in the federal government only concentrates risk, making the USA too-big-to-fail. And when California asks the other 49 states for a bailout, it must really keep Nassim up at night …

 

There’s a good post on this at The Economics Of Contempt:

http://economicsofcontempt.blogspot.com/ 2009/05/too-big-to-fail-experts-on-make- them.html

He mentions the following post:

“Addressing TBTF by Shrinking Financial Institutions: An Initial Assessment Gary H. Stern President Federal Reserve Bank of Minneapolis Ron Feldman Senior Vice President Supervision, Regulation and Credit Federal Reserve Bank of Minneapolis”

It’s a good and sensible post. Here’s one quote:

“On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms’ stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Current academic research finds potential scale benefits in all bank size groups, including the very largest.3 (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.)”

This makes sense to me, and even applies to the idea of taxing the size of banks, which I prefer. I prefer Narrow/Limiting Banking precisely because it’s harder to change politically. No doubt, there will be movements to change it. But we need a simple plan with simple rules. We’ve proven that we can’t handle complexity or lobbying or regulating very well.

An, yes, I bring this up just so that this plan will be considered. By the results so far, I’m not really the best person to advance this plan.

 

Talib made a series of favorable trades in the early 1990s, wrote a book that describes Mandelbrot-Levy curves in layman’s language, and now represents he’s an authority on risk. Talib is trying to sell his book IMO.

Posted by Ray Lopez | Report as abusive
 

A fellow named Taleb once scolded
that banks should be easily folded.
Once too big to fail
They cast too fat a tail,
And served not the world, but controlled it.

Posted by bdbd | Report as abusive
 

Perhaps we should expand this discussion to industries besides the financial industry; after all, Taleb isn’t arguing in his paper that just the financial industry needs to be smaller…he argues against any large institution, so not just Citi or Socgen need to be smaller, but also GE.

The problem isn’t simply “large things are bad”, it’s also “complex things become inscrutable when they’re big”.

After all…how can anyone know what’s really happening at any division of a major corporation, be that division AIG Financial Products or GE’s DIP financing arm.

 

Will: I don’t think the players in other industries are as mutually interdependent as they are in finance. If Pratt & Whitney folded tomorrow for idiosyncratic reasons, I think the reaction from GEAE and Rolls-Royce would be more along the lines of “yippee” rather than “we are now surely doomed”.

dsquared makes a good point about correlation, but I think has misunderstood NNT’s point. Banks get into trouble for idiosyncratic or systemic reasons. By definition, a systemic cause will affect the entire industry, whether it’s concentrated or not. But an idiosyncratic event will only affect the entire industry if it affects a single very large bank that is tightly linked to the rest of the industry.

Posted by ajay | Report as abusive
 

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