Too big to fail? Wall Street, we have a problem

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We should learn lessons from the Apollo programme and the people who design our television sets. Modular constructions are more robust.

The moon vehicle system was based on a modular design. One advantage of such a design – that failure in one component is less likely to compromise the whole – was demonstrated on the Apollo 13 mission. The astronauts were brought back safely to earth despite an explosion that damaged systems on the principal craft. Any engineer will tell you of the importance of making complex systems robust. You need inspections to prevent failure, to be sure: but since failures are inevitable it is equally important to try to ensure that the consequences of such failure are contained.

This observation is as relevant to economic and financial systems as to technological ones. Designing them with components too important to fail is a prelude to disaster, as we know. In the financial sector, the problem of disruptive linkages between components has become known as the problem of systemic risk – a term that is used in several different ways.

Often it describes macro-prudential risk, which arises mainly from the ability of financial market participants to persuade each other of absurd things. The cyclical booms and busts that result damage the non-financial economy, and economic policy can counteract this. Regulation should take away the punch-bowl as the party is starting, as William McChesney Martin, Federal Reserve chairman for nearly two decades until 1970, had it. But this is not a politically popular course. It is much easier, in the style of Alan Greenspan, to persuade yourself that what is plainly a party is just an outburst of rational exuberance.

The traditional systemic risk was the run on the bank. When deposit-taking institutions failed, the people at the front of the queue got their money back and those at the end got nothing. This process created the potential for any element of doubt about a bank’s solvency to jeopardise not just the bank, but all banks. In 1933, that process brought the US economy to a halt. But adequate deposit protection deals with this problem.

The recent issue has been counterparty risk. Credit risk in wholesale financial markets means that exposures that seem to be matched may turn out not to be when it matters – and this fear is what prompted the rescue of Bear Stearns and AIG. But to treat this problem as systemic risk to be dealt with by public authorities is to cast the government as an unpaid credit insurer.

There are two objections to such a course, both overwhelming. One is that it is simply not an appropriate thing for taxpayers to do. They make their contributions to build schools and hospitals, not to subsidise Masters of the Universe in transactions of little, if any, social benefit. The second objection is that government intervention gets in the way of the development of market mechanisms for solving the problem of counterparty risk.

These complications risk distraction from the key issue: the main source of systemic risk is within large financial conglomerates themselves. The financial products group at AIG brought down America’s leading insurer, and 120,000 people with it. It was based in London and employed barely 100 of these people. At Royal Bank of Scotland, with 170,000 employees around the world, the business was crippled by activities that more than 169,000 of them did not know about and were not engaged in.

If you unscrew the box on most modern domestic appliances, you will find it contains a small number of modules. The normal way of fixing such appliances is to take out the defective unit and replace it. If this seems a costly solution, remember that it has given us appliances that need little servicing, function reliably for years and are easy to repair – none of which can be said of our financial system.

We should learn lessons from the Apollo programme and the people who design our television sets. Modular constructions are more robust. In the business context, modularity means that different activities are conducted through different corporate vehicles.

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