You can’t trust bankers

“You can’t trust bankers” says Nassim Nicholas Taleb, author of “The Black Swan: The Impact of the Highly Improbable”
Taleb is an econometrician and trader – meaning he makes his money betting on financial instruments, like a professional poker player.

Bankers specialize in asymmetric risk. They borrow a lot of other people’s money, and every day they make a small, reasonable, predictable profit with it, and take their fee, except that once in a while they have a gigantic loss, and decline to refund their fees.

When banks get sufficiently large, and sufficiently interconnected, the loss becomes really rare, but really gigantic, and taxpayers find themselves on the hook.

Bankers have a variety of mechanisms for generating asymmetric risk, but one of the biggest is maturity transformation. Singapore survived the financial crisis in fine shape, possibly because the Singaporean central bank monitors its financial institutions for maturity transformation, and is apt to remind investors from time to time that certain debts and loans are not implicitly backed by the Singaporean government nor the Singaporean central bank.

Maturity transformation is borrowing short and lending long. This works most of the time, because when one short term lender calls in his loan, another short term lender makes a loan. People lend short, however, because they are worried about a rainy day, and want their money available when it rains. And when it rains, it is apt to rain on everyone at once – the black swan – so everyone calls in their short term loans at the same time – which is apt to become the time when long term loans are selling at a horrible discount.

Asymmetric risk tends to become fraud, because the financier arranges matters that when he wins, he wins, and when he loses, someone else loses and he does not. So the financier is encouraged to increase fat tail risk, rather than reduce it.

To give financiers an incentive to control and reduce fat tail risks, to reduce the risk of black swan events, you have to make sure that bad things happen to them if they lose large amounts of other people’s money in a black swan event. I suggest unlimited personal liability for financiers as Lloyds of London used to have, debtors prison, and indentured servitude, to the extent that a financier is in a position to negligently or intentionally expose other people to risks that they will find hard to judge, predict, or observe. This will give the financier an incentive to judge, predict, limit, and report such possibilities, and make contractual provision for such events, rather than brush the possibility of such events under the carpet.

Taleb’s proposed solution, however, is less drastic: That government should refrain from making a bad situation worse. That rather than preventing financial institutions from failing, which merely leads to less frequent but bigger collapses later, government should allow them to fail early and fail often.