How Regulators Are Making Finance More Fragile 2
Considering the severity of 2008 and how quickly the largest banks in the US became insolvent, it is quite clear that the financial system had too many mega-banks even then.
Which means that the American financial system at even greater risk today, considering how much the US banking industry has consolidated and shrunk in the decade plus since.
Banks’ business models have not changed; commercial banks and some parts of investment banks are still collecting spreads and short convexity, just in a more concentrated fashion.
But why don’t the people in charge see the danger posed by the massive short convexity position they have created in the financial system post 2008?
The simple answer would be that they don’t understand the nature of convexity in the first place. Moreover, it would seem that they also do not believe the storm which can overwhelm their regulatory and legislative response exists.
But, if history has taught us one thing, it is that such storms do exist; and that the previously unexpected and impossible to predict event always comes along.
In this sense, centralizing risks while raising required capital buffers is the same as raising the threshold over which the system collapses. Which is not the same as addressing the risks inherent in the system itself.
This vulnerability was actually highlighted in early 2021 by, of all things, Reddit’s rampage, and the closely related madness in Gamestop.
Which begs the question – If a stampede of retail investors can cause such widespread concern in a supposedly robust system, what happens when retail and institutions rush in the same direction together?
Ultimately, the point is that centralizing risks in a world where unexpected events occur fairly regularly is counterproductive.
Drawing from an example outside of finance, tall buildings constructed in earthquake prone areas are built to withstand tremors. This is done by constructing the building in a way that allows it to sway with the quaking ground, as opposed to constructing a building with more reinforcing material to make it more rigid.
Likewise, the simple method of throwing more resources (capital) at the financial system does not allow it to move as the financial ground shifts, with potentially catastrophic consequences.
A new response is needed, one that is more nuanced and directly acts to mitigate the system’s inherent convexity short.
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