Black Swan Free World (1)

On April 7 2009, the Financial Times published an article written by Nasim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

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.

It does seem safer to that fragile things break when they are small.  Unfortunately, what seems to have happened was that big things were permitted to become fragile.  So large things need to be encouraged to avoid becoming fragile.  It is hard to imagine why such encouragement might be needed.  For something to be large, it is usually very valuable. (Unless it is a US auto manufacturer)  And most sane people work very hard to protect their valuable possessions.  And most of the people who are engaged to run large firms are sane people who would be expected to avoid fragility as well.

So one explanation that fits the facts is that almost everyone did not know that the large firms were fragile.

Which leads to the third sentence.  The easy conclusion is that the risks of the big banks were hidden.  Some they hid themselves – such as all of the off balance sheet risks.  Other risks was hidden even from them.

And fortune favors those with hidden risks because they will hold capital based upon the visible risks and report profits from the actual risks.

So how do we solve the riddle? How do we make sure that large organizations do not become fragile?

The only sensible answer seems to be that there needs to be better risk assessment, probably independent reliable risk assessment.

And because of the extreme complexity of the larger firms, the resources applied to this independent assessment need to be quite substantial.

Time will be required for a thorough risk assessment.  It is unlikely that a good job could be done in time for a financial statement, unless the independent assessors are working inside the institutions with full knowledge of positions at all times.

The second sentence suggests that the risk assessments should have a negative size bias- the larger the firm the more risk would be assumed.  There seems to be some talk in that direction from the regulators.  But the thing that will put that to an abrupt end will be if one or more of the countries with major international banks fails to adopt the same sort of anti-size bias, tilting competition in the favor of their banks.

What can a risk manager take from this?  For assessing investment risk, it may make sense for risk models to take a sector, rather than an index or ratings approach to looking at investment risk.  The financial sector tends to lead the real economy in timing and severity of downturns.  More robust modeling may reveal better strategies for investing that reflect the real risks in financial firms.

And finally, the risk manager should really question whether it ever makes sense to invest in financials unless their risk disclosures become much, much better.  There was really no hint to investors that the large banks had built up so much risk.  Why, from a risk management point of view, does it make any sense to make an investment that you cannot find out the nature or extent of the underlying risks or any usable information about when that risk materially changes.

Black Swan Free World (10)

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Black Swan Free World (3)

Black Swan Free World (2)

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Explore posts in the same categories: Black Swan, Disclosure, Financial Crisis, Investment, Profits, Risk, risk assessment

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