Too Complex to Fail

Is our financial system too complex?

With LIBOR scandals, commodity-broker fraud, and big bank bailouts still making the news, many people are saying, “Stop the financial system, I want to get out!”

But exiting our current financial system just isn’t practical. Sure, you could move off the grid, raise your own wheat, and exit the cash economy, but that’s all you would do. Moving back to an 18th century lifestyle would mean moving back to an 18th century standard of living, where basic survival was a priority and pestilence and famine weren’t that uncommon.

And 18th-century life wasn’t financially that simple, either. There were competing gold-based, silver-based, and paper currencies, some of which were “not worth a Continental.” The first Bank of the United States was a political hot-potato, dishing out equal parts scandal and graft. It gradually evolved into our modern central bank.

And our current financial system isn’t so much a complex system as a highly interconnected one. We have local banks, global banks, brokers, insurance companies, mutual funds, and hedge funds all playing in the same sandbox. There isn’t enough hierarchy and modularity, so a few centralized players become “too big to fail” and a potential insolvency could threaten to pull down the entire financial infrastructure. That’s what TARP was all about.

What we need is a modular system, where one sector’s failure wouldn’t threaten the others. That’s what we see in biological systems, where a broken bone doesn’t endanger our heart, or in education systems, where problems in elementary schools are distinct from issues in community colleges or research universities. That’s what the proponents of a return to Glass-Steagall are getting at, even if their attempts to turn back the clock are misguided.

A modular financial system could still be complex enough to handle the modern world, but would have subsystems whose failure wouldn’t endanger the others. Yes, our financial world is complex—always has been. But it could be safer.

Douglas R. Tengdin, CFA
Chief Investment Officer
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