The 2007-08 crisis resulted not because of a natural Black Swan, but because of one bred by the Basel Committee.

“Martial arts legend Bruce Lee, whom many people regarded as immortal, died at the age of only 32 of a cerebral edema, or brain swelling, after taking some sort of aspirin. I have not the faintest idea whether that pill actually had anything to do with his death but I have frequently used (or misused) this sad death as an example of how an organism could be in such a highly tuned and perfect condition that it could not resist a small external shock.

And as a consultant I often used this metaphor to explain why companies nowadays, pressured by the stock market’s expectations for the next quarterly results; the latest theories in corporate finance as to how squeeze out the last drop in results; and, perhaps, even some bit of creative accounting, might be so well-tuned (no little reserve fat left) that they would not be able to withstand any minor recession. (Whenever I expose this theory, I can see in my wife’s eyes that she believes this is just my preparing an excuse for my growing—ok, grown—midline.)”

That and which I wrote in my book Voice and Noise (2006) should be more than enough evidence on how much I share and enjoy Nassim Nicolas Taleb’s discussions on fragility and the need for redundancy.

But where I have serious disagreements with NNT is when he relates his “black swan” to the financial crisis that occurred in 2007-08. And not because it was not a black swan event to most, it sure was, but because it provides bank regulators with the perfect excuse to avoid accountability. That Black Swan was not a natural black swan, it was a man made black swan… it was a Black Swan bred by the loony portfolio-invariant-credit-risk-equity-requirements for banks. 

For instance when NNT writes in “Thinking” 2013 “use of probabilistic methods for the estimation of risks did just blow up the banking system” I have to jump out of my chair to shout No! It was the use of the wrong risk factors that blew up the banking system. The Basel Committee used the risks of the banks assets when setting the equity requirements for banks, and not the risks banks would not be able to manage the risks of those assets.

Empirically, in terms of causing major bank crises, it is clear that banks are much worse managing “safe” assets than “risky” ones.

And when NNT, in the same chapter of “Thinking” writes about his four quadrants: Simple binary decisions in Mediocristan; Simple decisions in Extremistan; Complex decision in Mediocristan and; Complex decisions in Extremistan…no matter how much I agree and find that interesting, it has nothing to do with the bank 2007-08 bank crisis.

My more directly applicable to banks quadrangle, which explains the consequences for bank based on the ex ante perceptions of asset risks and ex post realities, IS THIS

Could the science of moral psychology help to explain the greatest regulatory mistake in history?

In Chapter 15 of “The New Science of Morality” by Jonathan Haidt in “Thinking”, 2013, edited by John Brockman we read:

“We need metaphors and analogies to think about difficult topics, such as morality… let’s think of… a perceptual analogy…

I think taste offers the closest, the richest, source domain for understanding morality. First, the links between taste, affect, and understanding behavior are as clear as could be. Tastes are either good or bad.

The good tastes, sweet and savory, and salt to some extent, these make us feel ‘I want more’. They make us want to approach. They say ‘this is good’. Whereas sour and bitter tells us, ‘Whoa, pull back, stop.’

Second, the taste metaphor fits with our intuitive morality so well that we often use it in our everyday moral language. We refer to acts as ‘tasteless’, as ‘leaving a bad taste in our mouths. We make disgust faces in response to certain violations.”

And I want to ask whether something of that could be helpful in explaining what is a great mystery to me, namely current bank regulations. Here a brief resume of my problem:

One of the pillars of current regulations is the risk-weighted capital requirements for banks;which in general terms requires banks to hold more equity against assets perceived as risky, than against assets perceived as safe. The justification of that is of course that what is perceived as risky carries more dangers for the banks than what is thought safe.

That could indeed occasionally be true for some individual banks but, for the bank system at large, I hold that what ex-ante is perceived as very safe, but that ex-post can turn out to be very risky, is what poses the real dangers.

And if my opinion were correct, then current regulations would, in principle, be 180 degrees off the target.

So here is the question to Professor Haidt, or to anyone else related to this field of “moral psychology”.

Does "risky" and "safe" play the same role as what tastes bad and what tastes good… and is there anything down this line of thought that could explain a mistake that I feel is endangering the economies of the Western world… as those regulations introduce a very serious distortion in the allocation of bank credit to the real economy.

Does this not represent an urgent, vital and fascinating research topic for you in the field? 

Are credit-risk weighted equity requirements for banks just regulators’ soothing blankets and teddy bears?

Bruce Hood, in “Essentialism” in “Thinking” edited by John Brockman, 2013, writes: “The reduction in funding in this country has impacted upon my field quite dramatically (behavioral sciences)… Now we have to justify with a view to application”.

Great! And do I have an application to suggest!

Bank regulators succumbed entirely to the intuition of if-more-risky-then-more-equity and if-less-risky-then-less-equity completely ignoring that for the banking system as such, what is ex ante perceived as risky poses little risks. It is what is perceived as “absolutely safe” but that later can pop up as very risky that which contains the true dangers.

And so regulators decided banks needed to hold much more equity against what is perceived as risky than against what is perceived as risky; and that resulted in that banks are now making much higher risk-adjusted returns on equity on what is perceived as safe than on what is perceived as risky.

And that leveraged the natural risk adverseness of banks into the skies; that one to which Mark Twain refers to as “they lend you the umbrella when the sun shines and what it back as soon it looks like it is going to rain”.

And, since our economies move forward thanks to for instance the risk-taking of banks on small businesses and entrepreneurs, the Western world is now stalling and falling.

Hood refers to among other to work he’s done with Paul Bloom about “bizarre behavior you find in children of the West [with their] emotional attachments to blankets and teddy bears [when] they need to self-soothe.” 

And it hit me that it could be an extraordinarily application if Hood and Bloom researched whether these bank regulations are the equivalent self-soothing instruments to regulators. Because if so then we would have some arguments in hands to go and tell the members of the Basel Committee for Banking Supervision and the Financial Stability Board that it is their role to regulate banks as society needs banks and not so to help them be calm when they suck their thumbs.

PS. The Western world was built upon a lot of risk-taking, among others by its banks... but in 1988 it got hit by the Basel Accord asteroid.