How to Prevent Other Financial Crises [Taleb]

By Nassim Nicholas Taleb and George A. Martin

This article argues that the crisis of 2007–2008 happened because of an explosive  combination of agency problems, moral hazard, and “scientism”—the illusion that  ostensibly scientific techniques would manage risks and predict rare events in spite  of the stark empirical and theoretical realities that suggested otherwise. The authors  analyze the varied behaviors, ideas and effects that in combination created a financial
meltdown, and discuss the players responsible for the consequences. In formulating a  set of expectations for future financial management, they suggest that financial agents  need more “skin in the game” to prevent irresponsible risk-taking from continuing.

Let us start with our conclusion, which is also a simple policy recommendation, and one that is not just easy to implement but has been part of  history until recent days. We believe that “less is more” in complex systems—
that simple heuristics and protocols are necessary for complex problems as  elaborate rules often lead to  “multiplicative branching” of  side effects that cumulatively  may have first order effects.  So instead of relying on thousands of meandering pages of  regulation, we should enforce  a basic principle of “skin in  the game” when it comes to  financial oversight:  “The captain goes down  with the ship; every captain  and every ship.”
In other words, nobody  should be in a position to  have the upside without sharing the downside, particularly  when others may be harmed. While this principle seems simple, we have  moved away from it in the finance world, particularly when it comes to  financial organizations that have been deemed “too big to fail.”

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