In light of JP Morgan’s $2 Billion blunder this is a very crucial question we all should be asking ourselves. If a bank can’t even manage its own finances, what makes you think they can manage your finances?
This isn’t the Wild West. This is an institution that takes customer deposits that are explicitly insured by U.S. taxpayers and is suppose to operate conservatively lest it suffers a major “blow up.” Continue reading
In order to create a more robust economic environment that can accommodate incompetency at our large banks while rewarding the responsible and penalizing the reckless, we need to change the current state of things and our way of thinking about free-markets. I believe one of the greatest contemporary thinkers on this topic is Nassim Nicholas Taleb, a veteran trader and creative writer on things that matter.
Sound ideas are worth repeating over and over. Here is Taleb’s principles for a more vigorous economic ecology:
…Ten principles for a Black Swan-proof world
By Nassim Nicholas Taleb, author of The Black Swan
1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.
2. No socialization of losses and privatization of gains. Whatever may need to be bailed out should be nationalized; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organizations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalization and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning. Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumors are a product of complex systems. Governments cannot stop the rumors. Simply, we need to be in a position to shrug off rumors, be robust in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be”de-financialised.” We should learn not to use markets as storehouses of value: they do not harbor the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.
Then we will see an economic life closer to our biological environment: smaller companies, richer ecology; no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.
In other words, a place more resistant to black swans… N.N.T.
Taleb’s philosophical outline above gives us a clear path to what needs to be done to protect investors and taxpayers, limit government involvement in our financial markets, and at the same time, not reward reckless risk-taking by institutions that are too big to fail.
Ten years ago President Clinton signed the Gramm-Leach-Bliley Act which repealed the Glass-Steagall Act giving rise to financial conglomerates that apparently are considered too big to fail, and therefore turn to taxpayer handouts when they find themselves in financial trouble. This latest round of bailouts is already putting trillions of dollars of taxpayer funds at risk.
Congress passed Glass-Steagall in 1933 after speculative activities by large US banks brought the financial system close to collapse. Sound familiar? The intent of the act was to separate investment-banking from lending and deposit-taking. The idea is that investment banking involves more speculative and complex undertakings than commercial banking, and therefore deposit taking institutions should be limited in the amount and types of risks they assume to safekeep depositors’ funds. The repeal of Glass-Steagall allowed the creation of megabanks like Citigroup; look how wonderful that experiment turned out.
The latest round of bank failures has forced mergers that have made banks larger and more concentrated in their risks. We have moved away from a diversified banking system with varied lending practices, to a more concentrated, homogeneous structure where all banks resemble one another. We are living in an economy with fewer but larger banks which constitutes a non-diversified financial ecology ripe for another crisis. Most banks are now so interrelated that when one falls, they all fall. Our banking system is now more vulnerable than ever to even the slightest hiccup.
Congress is now considering the reinstatement of Glass-Steagall. Representative Paul Kanjorski plans to offer the legislation as early as next week. Certainly the banking industry is fighting this. Rob Nichols, president of the Financial Services Forum whose lobbyists represent the largest financial institutions contends that “the U.S. needs big financial firms.” He said he’ll be “vocal and persistent in the halls of Congress.” I believe Mr. Nichols has underestimated the anger that Americans harbor for the shenanigans that have gone on in our banks. If we don’t take the opportunity to properly fix our banking system now, large US financial institutions will undoubtedly once again be laughing all the way to the bank.