...and back

I took a break in early January to do some research, and found myself still researching four months later. I've found that my tendency to write about things I don't understand is balanced by a quixotic desire to understand everything before I write anything. The latter has kept my from writing lately. And the fact that I am posting today does not mean that I believe I understand very much.

I've been following Simon Johnson and James Kwaak at thebaselinescenario.com, and they, in turn, have been following the power struggle within banking system. Their belief is that the large banks and financial instiutions in the U.S. have formed an oligarchy, and that the oligarchs have now captured the regulatory and political system. They believe, and Johnson written as much in an Atlantic article, that the U.S. is becoming more like an emerging market, with all of the associated problems that that entails. They believe that in order to prevent crisis such as the current one from recurring more and more frequently, we will need to ensure that financial institutions are smaller and have less power. Banks that are "too big to fail", are also too big to control.

The struggle for power between these banking giants and the Obama administration is epic. It is easy ask why the government cannot just do something about these banks, or to assume that they are not unnecessarily rewarding them for their colossal failures. But to understand the power that the industry has, we must understand the manner in which it's derived. The Atlantic article is an excellent place to start.

Johnson and Kwaak have made a convincing argument the banking industry, and, indeed, the entire financial industry, must be reduced, both in scope and concentration. They focus mainly on the negative aspects of oligarchy and regulatory capture. However, a professional risk-management analyst has written a book which I believes points out another reason for the breakup of large banks and a downsizing of the industry. Richard Bookstaber's "A Demon of Our Own Design" makes the point that financial complexity can increase risk in a non-linear fashion, and that the industry's quest for perfect allocation of capital, and the realization of complete market efficiency, leaves it exposed to unseen risks.

In other words, the marginal efficiency gained from complex systems is overwhelmed by the added, and unseen, risk inherent in such a system. If you haven't been following the financial industry, the past 30 years or so have been marked the proliferation of modeling (which attempts to predict the future based on the recent past, through complex mathematical theories), an accompanying explosion in complex derivative securities (which add opacity and complexity to an already complex system), and the mergers and growth of financial institutions into corporations which are so big they cannot possibly understand or react to the risks they face.

These are issues that need to be resolved. The outcome is uncertain. Our government has loaned, given or committed to the cause close to the gross domestic product of the United States for an entire year, in an attempt to save the system. Some of this money was necessary. Some was not. Some was an outright gift to the management and shareholders of the institutions that precipitated the collapse. There are no easy answers here, no room for blind ideology or sound bite solutions. If we are going to have a say in our future, we need to learn and engage. And then speak out.