Date: September 24th, 2011
Cate: Risk & Stability, Systems

Rogue trader tails and institutional realpolitik

How big is the Rogue trader distribution?  We only get to see the tails of the distribution.

Look out rogue traders exist in banks.

Shocker!  $x billion lost etc.

These headlines are not as worrying as they seem. The real worrying headlines are the ones not written. For every rogue trader loss there are significantly more bad actors and actions going on under the hood.  Institutionally the mega bank approach is antithetical to sound risk management.  Mega-bank structures mean that decision makers end up managing reports and check boxes instead of risk.

Banking isn’t complicated, it is a nice combination of high-wire tightrope walking and magic show.

The more leverage and complexity, the higher the wire. The greater the institutional complexity and size, the greater the need for magic (deception). What depositors and counter parties want is the veneer of a reputation for stability and sound practice. The machine or institution protects that veneer in the short-term at the systems expense in the long term.

In hiding the smaller (errors) rogues from others and itself institutions become blinded to the true nature of operational risk and complexity.  Current reporting on “rogue” activities in banks due to behavioral conventions is akin to flying an airplane with a fuel gauge designed to never report less than half a tank of fuel.

Designing a safe system means designing for components to fail safe.

One way to design a safe system is to acknowledge the reality that institutions die and fail all the time. It is important to acknowledge the foibles of human nature and institutional mortality. Greed and stupidity can’t be managed away, they are hard wired human traits. At best these traits impacts can be minimized or contained. Individual Institutions and banks don’t and shouldn’t matter to the overall economy. It is they economic ecosystem matters. To protect the system the rules needs to designed and managed in such a way that institutions can fail and disappear. The fact is that all institutions fail and disappear.

It is only our limited perception of time which makes large organizations feel permanent. Reading Kindelberger and other economic history is a good antidote to the permanency illusion or the overly great importance placed on today’s institutions. History humbles. History instructs. Sadly ego and vanity mean history is mostly ignored. Our time and place is unique, but probably not that exceptional when viewed in broader context.

Designing a system with smaller compartmentalized  and de-coupled institutionals is one solution. This means a trade off between resiliency versus efficiency. Society should choose, wether to have monolithic institutional titanic elephants with high ROEs (returns on equity) prone to systemic collapse, or smaller institutions with smaller ROEs prone to individual collapse.  Sustainability and resiliency often mean trading off concentrated monolithic efficiency for broader systemic resiliency.

The institutional decision tree below is likely human nature and SOP for most corporations not just banks.

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