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How to Prevent the Next Financial Crises

Politics / Financial Crash Mar 30, 2012 - 10:20 AM GMT

By: Jesse

Politics

Best Financial Markets Analysis ArticleNassim Taleb presents a very simple principle for avoiding financial crises.

But sometimes the simplest principles are the most difficult to implement.  For example:

Thou shalt love the Lord thy God, with your whole heart, and your whole mind, and your whole strength, and love your neighbor as yourself.  This is the whole of the law.


But even as we fail to achieve its simple perfection, the principle remains, and one can judge how well they are doing by how close, or far away, they are to it.

Obviously the failure to aggressively prosecute fraud, and even the rewarding of participants as agents, when they both succeed and fail, has created a system that is completely, utterly broken.  The regulations proposed as remedy are complex, and that is no accident, because fraud revels in complexity and loopholes.

And the watershed event in all this was the decision, and I would say the glaring policy error, to bailout the banks and cover up their crimes.  That cover up continues and grows like a cancer, distorting policy and public discussion with its corruption, even to the highest reaches of the system. 

There are no heroes here, just craven, compromised, and even badly used men who promote the interests of the powerful monied interests, and their own illusions and delusions, on the broken backs of their fellows and their oaths to uphold the law. 

They will either change and reform the system, or they will eventually be thrown down and cast out in disgrace and dishonor.   It is hard to imagine it while they are riding high, but that is the simple lesson of history.

SAIS Review Volume XXXII No. 1
How to Prevent Other Financial Crises
Nassim Nicholas Taleb and George A. Martin

This article argues that the crisis of 2007–2008 happened because of an explosive combination of agency problems, moral hazard, and “scientism”—the illusion that ostensibly scientific techniques would manage risks and predict rare events in spite of the stark empirical and theoretical realities that suggested otherwise. The authors analyze the varied behaviors, ideas and effects that in combination created a financial meltdown, and discuss the players responsible for the consequences. In formulating a set of expectations for future financial management, they suggest that financial agents need more “skin in the game” to prevent irresponsible risk-taking from continuing.

Introduction

Let us start with our conclusion, which is also a simple policy recommendation, and one that is not just easy to implement but has been part of history until recent days. We believe that “less is more” in complex systems— that simple heuristics and protocols are necessary for complex problems as elaborate rules often lead to “multiplicative branching” of side effects that cumulatively may have first order effects.

So instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of “skin in the game” when it comes to financial oversight: “The captain goes down with the ship; every captain and every ship.”

In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed. While this principle seems simple, we have moved away from it in the finance world, particularly when it comes to financial organizations that have been deemed “too big to fail.”

The best risk-management rule was formulated nearly 4,000 years ago.  Hammurabi’s code specifies:
“If a builder builds a house for a man and does not make its construction
firm, and the house which he has built collapses and causes the death of the
owner of the house, that builder shall be put to death.”
Clearly, the Babylonians understood that the builder will always know more about the risks than the client, and can hide fragilities and improve his profitability by cutting corners—in, say, the foundation. The builder can also fool the inspector (or the regulator). The person hiding risk has a large informational advantage over the one looking for it...


Read the rest here.

All those who are in favor of reform, and justice,
and equal protection under the law for all, including
the weakest and the least among us, please raise your hand.

By Jesse

http://jessescrossroadscafe.blogspot.com

Welcome to Jesse's Café Américain - These are personal observations about the economy and the markets. In providing information, we hope this allows you to make your own decisions in an informed manner, even if it is from learning by our mistakes, which are many.

© 2012 Copyright  Jesse's Café Américain - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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