Economic consequences of having no must-never-happen events in the financial sector

–Water flows from the tap, the lights turn on, and the natural gas supply is there—even during (especially during) bad times.

The same cannot be said for the financial services sector. Liquidity, defined as being there when needed, proves not to be. In fact, that’s the definition of unreliable. There are no agreed-upon must-never-happen events in financial services as there in other critical infrastructures.

In electricity, reliability is driven by dread associated with loss of containment at a nuclear generator or islanding of the entire electric transmission grid. In large water supplies, there must never be overtopping of irreplaceable dams and water reservoirs. Nuclear explosions occur, dams are overtopped, and grids do separate and island, but these events are rare—rare because of their management beyond technology and design—and when they do happen they serve to reinforce their must-never-happen dread.

–In contrast, financial services have “should-never-happen events”—bank runs should be avoided and financial crises shouldn’t happen when they too could be avoided. The standard of operating reliability is not one of precluding financial crises from ever happening, but rather of treating these crises (1) as avoidable though not always, or (2) as inevitable (“busts are part of market capitalism”) or at least (3) compensable after the fact (as in the pre-2008 assurance that it’s better to clean up after a financial bubble bursts than trying to manage it beforehand).

Not having reliability of financial services based on a (set of) must-never-happen event(s) has major consequences for economic stability and growth.

–There are two orthogonally different standards of reliability when it comes to the economy: the retrospective standard or the prospective standard of economic stability/growth.

The retrospective standard holds the economy is performing reliably when there have been no major shocks or disruptions from one point up through now. The prospective standard holds the economy is only reliable until the next major shock.

Why does the difference matter? The retrospective standard favors design approaches—that economic stability/growth can be established on the basis of the past record. In contrast, the prospective standard favors actual practice in the present and real-time performance forward. From the prospective approach, the past is like a lantern on the stern, in Samuel Taylor Coleridge’s words: It tells you where we’ve been, not where we are going.

In practical terms, the economy is prospectively only as reliable as its foundational critical infrastructures are reliable, right now when it matters for economic productivity. In fact, if economy and productivity were equated only with recognizing and capitalizing on retrospective patterns and trends, economic policymakers and managers could never be reliable prospectively.

–Global financial crises illustrate how the different standards for economic stability/growth work. A retrospective orientation to where we are today (December 2020) is to examine economic and financial patterns and trends since 2008; a prospective standard would be to ensure that—at a minimum—the 2008 financial recovery could be replicated, if not bettered, for the next global financial crisis. (Careful here: I am not saying we compare only today’s average values with yesterday’s best.)

The problem with the latter is that such a benchmark—do no worse in the financial services sector than what happened in the 2008 crisis—means that benchmark would have to reflect a must-never-happen event for the sector going forward.

What are the chances it would be the first-ever must-never-happen event among all of that sectors’ should-never-happen ones?

Principal source

This is an updated and edited section from Emery Roe and Paul Schulman (2017). “Analysis. When Critical Infrastructures Are Interconnected: Lessons for Financial Services.” European Financial Review (December – January): 33-37.

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