Nassim Taleb’s Latest Paper: Too Big to Fail, Hidden Risks, & The Fallacy Of Large Institutions
This is Taleb’s most recent piece. As a fan of Taleb’s work I feel obliged to link to this paper. Perhaps Taleb’s words will serve to caution future business people against mindless empire building. (Note-certain parts of the paper are not for the lay person and involve some pretty heavy mathematics and analysis.)
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.
