The Illusion of Control: Why Financial Crisis Happen and What We Can (and Can’t) Do About It
by Jon Danielsson, Yale University Press, 2022
In 1751, a young Dutchman living in Amsterdam, Leendert Pieter de Neufville, founded a bank. It was a favorable move. A few years later, the Seven Years’ War began, prompting several European powers to seek new sources of financing for their armies. De Neufville became a major lender to Prussia, his loans secured against huge reserves of commodities such as wheat and oats. He made substantial profits until the war ended in 1763, at which point food production rose again and prices plunged. De Neufville’s creditors grew cold, and with no money to repay, he was forced to sell his stock, pushing commodity prices even lower. The bank quickly went bankrupt, and the effect quickly spread to other banking centers, including Hamburg and Berlin. Icelandic economist Jon Danielsson believes that de Neufville’s mistakes in the banking sector caused the first modern global financial crisis. He argued that 1763 was different from what had come before, as it was caused “not by war or crop failure but by shadow banking and the widespread use of financial instruments that enabled it.” hidden and contagious risks.” Over the next 250 years, we had many other similar crises. What is stopping us from stopping them?
According to Danielsson’s new book, Illusion of control, it has to do with our love-hate relationship with finance. For the economy to grow, we need banks to take risks when it comes to lending, but we also need them to accept amount risk. Too little, and no one can borrow. Too much, and the system will explode. The rubbing: find out what that matching amount is. Doing so has proven extremely difficult, even as the increasingly necessary role banks play has made the largest of them too big to fail. Danielsson quotes a former attorney general, Eric Holder, who admitted that he did not punish HSBC for failing to stop Mexican drug traffickers from using its service because he was worried it would cause a more serious crisis. Attempts to keep bankers on fire after the 2008–2009 global financial crisis were unsuccessful not only for this reason but also because proving wrongdoing was difficult. Spanish lawmakers were determined to punish the former leader of Bankia, Rodrigo Rato, for crimes that bank’s failure in 2012but only succeeded in imprisoning him for misusing his company credit card.
We ask bankers to accept the risk. Engaging them so they can only make the safest loans will reduce their profits, drive up borrowing costs for entrepreneurs and prospective homeowners, and lower interest rates for savers. In the words of Danielsson, “people won’t save and companies won’t borrow. Factories won’t be built and the economy won’t grow.” It is clear that there is an acceptable level of risk, one that allows innovation and progress but does not cause the system to collapse. The problem is we don’t know what it is.
In the most convincing (and brutal) part of Illusion of controlDanielsson explains why our efforts to measure and predict risk are more of a “risk theater” than reliable analysis. To properly appreciate risk, we need to realize that different investors care about different things, depending on their exposure and timing. However, it is much faster and more profitable to combine all types of risks into one aggregate number. The author mocks the European Central Bank’s alleged ability to measure systemic stress in the financial system to six decimal places on any given day. Such accuracy looks impressive but has little correlation with what actually goes on. According to the ECB’s panel, systemic stress is close to an all-time low just before the 2008–2009 crisis and peaked after the crisis began. Certainly, Danielsson argued convincingly, it should have been the other way around.
It is clear that there is a degree of risk that allows innovation and progress but does not cause the system to collapse. The problem is we don’t know what it is.
Another difficulty with predicting and preventing systemic financial crises is that they do not occur often enough. Danielsson has calculated that a member state of the Organization for Economic Cooperation and Development is subject to such an event every 43 years: too long to institutionalize the memory of the crisis, which tends to Lasting only for one generation, passed down. We also tend to adjust to prevent a repeat of the previous crisis instead of looking unbiasedly at future vulnerabilities. Finally, regulators and bankers are engaged in a constant “cat and mouse game”, in which authorities impose new rules while those who follow them try to Try to work around them. Quite often, the dexterity of the mouse wins.
With Danielsson outlining the challenges of rigorously applying “Goldilocks” regulation to the financial industry — that is, regulation with the right balance of risk-taking and aversion — then It’s a little surprising that he’s confident about our future reduction prospects. fall. His policy provisions are based on one word: diversity. He believes that the biggest problem facing the industry is the deviation towards multiculturalism, with its tendency to “amplify the same shocks and inflate the same bubbles”. Investors, as de Neufville discovered, always move in herds. This trend has been encouraged by the adoption of common “best practices” initiatives and similar risk gauges. Danielsson wants regulators to allow the creation of many smaller banks, especially those that operate differently from the big banks. He wants barriers to entry down and more players accepting of countercyclicality. However, after more than 250 years of booms and busts, this will require a major shift in how we think about risky behavior.
Author profile:
- Mike Jakeman is a freelance journalist and has previously worked for PwC and the Economist Intelligence Unit.
