Posted by: Nicholas Davis | March 14, 2009

More thoughts on robustness

CHONGQING, CHINA - OCTOBER 9:  A black swan re...

As I’ve mentioned in previous posts, the events of the financial crisis have led a few of us in Geneva and New York to think about a question that seems increasingly relevant for policymakers, academics and CEOs alike: “How might we increase the robustness of the global financial system, both through structural changes and by influencing the decision-making processes of key players?”.

There are two key ideas here. The first is built very much upon Nassim Taleb‘s work on “Black Swans“. The core of this argument is that the financial system is one in which normal distributions do not apply – it lives in “extremistan”. That is to say, global finance is a complex system where outliers completely dominate the rest of the distribution, producing rare events of massive impact that are also extremely random. The challenge is that black swans have the ability to be unimaginably destructive and yet can’t be anticipated. That doesn’t mean that we are helpless, however – Nassim has been speaking a lot recently about what actions could be taken to change the structure of the financial system to make it more robust to such events. One analogy is that the financial system is like an aeroplane; rather than optimize a plane for a single, desired environment (say, clear skies), it is far more useful for it to be stress-tested in numerous conditions and be robust to a changing, more realistic environment (by using stronger materials, fail-safe mechanisms etc). Then, while storms may arise without warning, the aircraft will be able to continue to operate safely.

The second idea is tied to decision-making problems and expert error. This is the work of people like the highly esteemed Anil Gaba from INSEAD, as well as Daniel Kahneman and many others. Both research and experience show that even (and sometimes especially) expert decision-makers make critical mistakes that lead to loss and damage. Cognitive biases such as over-confidence, framing, selection biases, anchoring, hindsight bias etc all can impact the interpretation of data, perception of the environment or the assessment of choices to respond appropriately to a given situation. When errors by large numbers of people in a system mount, they can precipitate black swans. Hence, Anil and others would like to design a set of heuristics that put decision-makers on the right side of bias. The analogy here is of the pilot of the aeroplane, who can be as responsible for crashing it as the weather conditions can.  In fact, the pilot’s checklist is a system for countering the fallibility of human memory and reasoning in a complex environment (apparently first designed for use with the Boeing Model 299, later the B-17, in 1935).

Combining these two elements results in the second central question above. Naturally, a global financial system that was more robust would be desirable – it may have prevented (or at least reduced) the loss of something like $4.5 trillion by banks alone to date, let alone the cost to the real economy. Part of that robustness, as Taleb argues, could come from structural and regulatory shifts that create redundancy, slack or reduce contagion – for instance through limiting the size of hedge funds and banks (since the cost of failures is non-linear to size: having failures across multiple, smaller entities is far less costly in total than a single large failure).

However there are also myriad biases degrading the quality of decisions made by “pilots” within the system that have contributed to the crisis. Some of these seem now obvious, for instance the existence of asymmetric incentive systems like bonuses in financial institutions. Combating the source of these distortions in behaviour could add to the robustness of the system by ensuring that fewer stakeholders contribute to the conditions for a black swan through excessive or blind risk-taking.

It’s going to be a tough call to combine work in these two areas to find opportunities for how to increase the overall robustness of the global financial system, and even tougher to then push through the implementation of these ideas with a highly fragmented global (and national, in the case of the US) regulatory system, and banks who desperately want to go back to business-as-usual. If you’d like to contribute your ideas, we’d love to hear them!

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