Lessons of the fall - Innovating our way to a meltdown

To understand the financial crisis, we should view it as a systems accident. 

Some would say the global financial crisis stemmed from a few regional financiers selling risky mortgages to poor people. But how can that be? The subprime mortgage market is a fraction of the U.S. mortgage market, which in turn is a fraction of the U.S. credit market, which is a fraction of the global credit market. How can defaults in a sub-sub-submarket destroy banks on two continents and send several countries to the brink of bankruptcy?

Last fall's financial meltdown was akin to the Three Mile Island nuclear accident: No particular component or operator failure caused the meltdown. Rather, it was a number of small component failures interacting in unpredicted ways. At Three Mile Island, those failures ranged from a pressure-relief valve that didn't reset properly to a meter that gave deceptive information and to operators who made some perceptual errors.

If a system is complexly interactive, then it becomes hard to predict how one action will affect other elements within the system. As well, if this system is tightly coupled, one action can propagate rapidly throughout. Thus, systems that possess both these characteristics are more prone to accidents.

As for the financial sector, it wasn't that its failures interacted but that the byproducts of its innovations did. With the exception of some regulatory decisions - and all illegal activities - the factors leading up to the financial crisis came from system innovations, rather than existing system components. For instance, people within the financial industry innovated in order to improve their job performance. One group created subprime mortgages. Another found a way to lend people down payments. A third group worked out how to turn mortgages into securities. A fourth figured out how to price those securities. The list goes on.

To understand these effects, it's useful to differentiate between radical and regular innovations. Radical innovations transform a system's core processes. Repacking mortgages and bonds into tradeable securities was a radical change from banks holding individual mortgages. Securitisation created different relationships between the mortgages and the rest of the financial system. Mortgage issuers were much less interested in the loans they'd made because they were rid of them after selling them. Instead of being held locally, mortgages were spread across the globe. And it became harder for purchasers to assess the risks associated with a set of securitised mortgages.

Regular innovations, in contrast, involve using the same resources more efficiently. So a subprime mortgage is basically a regular mortgage but pitched to a different market segment. Here, resources became more efficient, but also tightened the coupling in the system - and, in the process, increased systemic risk.

Over time, the financial sector's innovations increased complexity and coupling and created mismatches between the financial sector and regulatory assumptions, which caused the meltdown. The question we now face: Can we do anything to reduce the risk of future systems accidents?

Regulators need to address systems-level risks. One option is to alter the financial industry's behaviour. The medical and legal professions use not only punitive measures but also shared ethical norms to ensure their members behave with integrity. In finance, by contrast, we have invited people to act in their short-term interests, up to the point that they act coercively. We advocate this in finance and economic departments in our universities and business schools. We embrace this every time we applaud "shareholder activism" by pension funds or union busting by corporations.

If we want to behave with integrity, we need to organise around an ideology larger than self-interest. To achieve that, regulators could mandate professional education and force those whom we expect to behave ethically (investment bankers, mortgage originators, etc.) into industry bodies that control the right to work in the profession and impose and enforce stringent behavioural expectations.

Alternatively, if we want people in the finance industry to be able to pursue self-interest, unfettered by professional behavioural norms, then we need vigilant and empowered regulators who carefully delimit the extent of that behaviour. At a minimum, regulators need to ensure that individual incentives are aligned with the broader population's moral expectations.

And, at the systems level, regulators need to reduce interactive complexity and tight coupling. The less complex the system, the greater the chance of being able to analyse it to intervene appropriately. The most important way to do this is to limit the use of derivatives. Derivatives are designed to shift financial risk from one entity to another. While they move that risk around, they actually increase the total amount of risk in systems, as well as obscuring where the risk is located.

Meanwhile, if a financial system's coupling is looser, problems are less likely to spill across the world. We can reduce coupling by adding slack and buffers into the system, such as requiring investment banks to hold adequate capital reserves.

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