Nassim Taleb's Latest Paper: Too Big to Fail, Hidden Risks, & The Fallacy Of Large Institutions

Abstract (Via SSRN)

Large institutions are disproportionately more fragile to Black Swans.This paper establishes the case for a fallacy of economies of scale in large aggregate institutions. The problem of rogue trading is taken as a case example of hidden risks where rogue traders and losses are considered independently and dependently of the institution’s size. Both independent and dependent loss and hidden positions are shown to lead to the paper’s conclusion, that size and economies of scale have commensurate risks that mitigate the advantages of size.

Introduction (Via Nassim Taleb @ NYU Polytechnic & London School Of Economics)

Naive optimization may lead us to believe in economies of scale that ignores the stochastic structure that  results from an aggregation of entities,  their associated vulnerabilities and  their costs.   While companies  get  larger  through mergers and  industries become concentrated, based on  the premises of “economies of  scale”  ([Pareto  [10],  Taleb  [14]).    This  does  not  take  into  account  the  effects  of  an  increase  of  risks resulting from both “dependence” and the latent risks that beset big and small economic entities equally.  For example, the risk of blowups –in fact, under any form of loss or error aversion, and concave execution  costs, gains from an increase in size should show a steady improvement in performance, punctuated with large and more losses, with a severe increase in negative skewness [7],[ 9].

Additional Excerpts (Via Nassim Taleb @NYU PolyTechnic & London School Of Economics)

As a result, too big to fail and its risk moral hazard consequential risk, “too big to bear”, is a presumption  that while  driving  current  financial  policy  and  protecting  some  financial  and  industrial  conglomerates  (with other entities  facing  the  test of  the market on  their own), can be misleading.   Size  for  such  large  entities  thus matters as  it provides a safety net and a guarantee by public authorities  that whatever  their  policies, their survivability will be ascertained for the greater good and at the expense of public funding.   The  rationality  “too  big  to  allow  to  fail”  is  therefore misleading,  based  on  a  fallacy  of  aggregates  that  misrepresent the effects of latent, dependent and rare risks.

Scale is not necessarily robust, in particular with respect to off-model risks.  In fact, under loss aversion, the gains  from a merger may show a steady  improvement  in performance, punctuated with  large  losses,  with a severe compensatory  increase  in skewness.   The essential question  is  therefore can economies of  scale savings compensate the risks and fragility they may be subject to.

Click Here To Read Nassim Taleb’s Latest “Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions”

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03. May 2009 by Miguel Barbosa
Categories: Curated Readings, Risk & Uncertainty | Leave a comment

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