Ahem.

As someone who was unfortunate enough to be working at the bottom of this behemoth as a multitude of management coups and counter-coups replaced what used to be known as 'strategy', I take enjoyment from sharing your bemused viewpoint.

Thanks. You know from the outside it is all so much more clear - and surreal. I know the parallels aren't exact but I can' help to transpose Mega-bank politics and strategy into medieval, feudal Europe: barons, princes, dukes, strategic alliances and schemes, coercion and brute force...(with the odd band of marauding mercenary barbarians thrown in...) Until the peasants revolt. Not a fantastic commentary on human nature unfortunately...

Sean,

“Like many mega-financial services firms, it is a jumble of heterogeneous businesses, risks and activities... the combination of all these businesses injects massive complexity.”

“too complex for any one individual to manage efficiently”...

The complexity of today’s banks, and the lack of understanding of that complexity and the vulnerability it causes, is one of the major problems facing the world economy. Yet it barely registers among commentators. In fact, I’m not even sure how aware the banks are of the potential problem.

The “Tax Research UK” blog recently posted that, “About 3% of the cash in the UK economy is actually issued by the Bank of England. The rest is electronic money.”

http://www.taxresearch.org.uk/Blog/2008/10/20/network-banking-a-radical-solution-for-the-uks-banking-crisis/

Billions, if not trillions of electronic “currency” flow around the globe every week.

Financial institutions today are really data refineries (which is to say money refineries) processing and optimising these flows. But unlike the refineries of the Oil & Gas world they are not subject to the same level of heavy regulation when it comes to how the assets are put together, which means it is only a matter of time before there is a major disaster involving a bank.

Despite performing highly dangerous operations 24/7, Oil & Gas refineries rarely suffer catastrophic accidents. This is because they are legally required to accurately document and understand how the assets of the business interact to enable the flow of product through the assets of the plant.

There is no such requirement in the financial world, or indeed in most sectors of the economy, despite our routine reliance on IT and flows of data between business assets to perform business tasks (“business assets” includes people).

As complexity has built up over time, with systems and technology being piled on top of other systems and technology, the need to understand vulnerabilities is becoming ever more acute. A failure may not cause a physical explosion but it could certainly cause an economic one. (for brevity, I’ll leave aside the dangers of critical data flowing through “The Cloud”).

During the past couple of decades there have been many mergers in the global banking industry. There is at least one major European bank that, after many years, still has not been able to successfully consolidate the systems from the original separate businesses.

Recently experts had to fly-in from around the globe to fix the systems of a leading Israeli bank after they went down for a couple of days. Customers were unable to withdraw cash or access their accounts electronically. The cost of the incident will run to millions.

http://www.haaretz.com/hasen/spages/1040833.html

Given that we are in a period of ‘forced’ bank mergers and consolidations, I believe this will be the first of a number of such incidents in this already complex industry.

Barclays and others have recently cut large numbers of IT staff. Corporate memory retention is weakened as knowledge walks out the door. The likelihood of a major IT problem increases.

With the global economy teetering, we have to hope that the breadth and depth of likely bank system failures will be insufficient to cause a major economic dislocation.

Regards

PJW

Thanks for your great comment Paul.

The complexity of today’s banks, and the lack of understanding of that complexity and the vulnerability it causes, is one of the major problems facing the world economy. Yet it barely registers among commentators. In fact, I’m not even sure how aware the banks are of the potential problem.

Indeed. I don't know if I qualify as a commentator, but even though my soapbox may not be very high, I obviously share your concern about the lack of visibility given to this issue. As for the banks, it would be presumptuous of me to claim to know what the thinking is in the boardrooms and executive committee of the banks of the world, but I did spend many years at a fairly senior level, in banking and my experience is that this is not an issue that is even on the radar screen. Again at the risk of being guilty of a sweeping generalization, I would put this down to a pinch of hubris and a dash of lack of self-awareness. I'd go so far as saying that this is a toxic byproduct of the combination of very smart, ambitious people and testosterone fueled culture that is the norm at the top of these institutions: to acknowledge that such a thing as too much complexity exists would be tantamount to admitting that the management was inadequate in some way, not 'up to it'. Better to keep dancing as they say...

I think Don's idea above of a tax on 'too-big-to-fail' institutions in financial services would go at least some way to focusing minds on excessive complexity. However it is not surprising that it will take a major disaster to catalyze a paradigm shift (away from the linear march to ever bigger institutions) to a more robust economic configuration in our financial system.

Sean,

I've been following your writing for a couple of months now, but I am unclear on your definition/examples of "21st century finance models" and how those compare/contrast with the existing 19/th20th Century models.

Is there a manifesto someplace, or a set of epistle posts that frame the main points of your argument?

I ask because I'm trying to push through on similar issues in the area of heavy asset related information and I have found that the financial area is ahead on the curve (while too slow for some observers...) compared to many other sectors.

In terms of business models I think the financial services industry is completely behind the curve. Product and financial engineering innovation - while welcome in general - has if anything hidden (even or especially to themselves) the fact that the core business model of most mainstream financial businesses has not changed in 50 years...

My "21st Century" business model reflects what I see as the natural result of applying Coase's Theory of the Firm to (a) an industry that for all intents and purposes is 'digital' - ie processing pure information - and (b) a world characterized by abundance (of bandwidth, computing power, information...) as opposed to scarcity.

(Simplifying massively) the current business models in financial services are all pretty much predicated on managing scarcity and information arbitrage, a model that is destined to obsolescence, and the mainstream leadership in the industry is focused all too often on building faster horse and buggies... Perhaps a good place to start to get a feel for where I am coming from is a collection of my posts mentioning Ronald Coase, and in particular my post on Peak Hierarchy.

There's going to be political pressure for a special "Too Big to Fail Tax." If a company is big enough that its failure would require a bailout, make it pay into a bailout fund in advance. That of course would give a competitive advantage to companies small enough to be allowed to fail.

I hope you are right - this is long past due. In many ways this is yet another variation of exploiting the commons. Unless society is successful in appropriately pricing common resources capitalism will not function optimally. ie The incentives will be such that a profit-maximizing firm will very often (if not always) end up degrading the ecosystem in which it operates, whether this ecosystem is the natural environment (pollution of the atmosphere or oceans etc.) or the financial ecosystem underlying our economy. Just as coal-burning generation plants should take into account the externalities of emitting CO2 in judging their true economic benefit, so to should mega-financial institutions have to pay for the fact that they must be underwritten by the public. If this were the case, I think the market would then naturally find the optimal size point for a financial institution rather than the exisisting one-way march to enormity.

But if you thought pricing GHG was tricky, pricing an implicit call on the public purse is almost certainly more difficult by an order of magnitude...certainly an interesting question to ponder.