Innovating Our Way to a Meltdown

Some say the root cause of the global financial crisis was a few regional financiers selling risky mortgages to poor people. How can that be? The subprime mortgage market is a fraction of the U.S. mortgage market, which is a fraction of the U.S. credit market, which is a fraction of the global credit market. How can defaults in a sub-sub-submarket destroy banks on two continents and send several countries to the brink of bankruptcy?

In his landmark analysis of the Three Mile Island nuclear accident, sociologist Charles Perrow argued that that meltdown was not caused by any particular component or operator failure. Rather, it was caused by a number of small component failures that interacted in unpredicted ways. Those failures ranged from a pressure-relief valve that didn’t reseat properly to a meter that gave deceptive information to some perceptual errors by operators.

If a system has high interactive complexity, then by definition it is hard to predict the impact of a particular action on other elements within the system. If the system is tightly coupled, to use Perrow’s terminology, an action at one point propagates rapidly throughout. Perrow argued that systems with high interactive complexity and tight coupling are more prone to systems accidents.

The financial sector meltdown in the fall of 2008 was a systems accident. However, rather than failures interacting, the byproducts of innovations interacted. With the possible exception of some regulatory decisions — and the definite exception of illegal activities — many of the factors leading up to the financial crisis involved innovations to the system, rather than existing system components that failed. Within the financial industry’s system of rewards and values, people innovated to improve their job performance. One group innovated by creating the subprime mortgage category; another by finding a way to lend people down payments; a third by working out how to turn mortgages into securities; a fourth by figuring out how to price those securities. The list goes on.

Innovations alter the systems in which they are embedded in three ways. First, wherever innovation occurs, the relationship with the rest of the system changes. In this case, the innovations created mismatches between the actual financial system and the financial system the regulators thought they were regulating. It is the interactions of these mismatches that caused the systems accident. Second, some innovations increase the complexity of the system. Third, some innovations tighten the system’s coupling, increasing the probability that failures will propagate and interact.

To understand these effects, it is useful to differentiate between radical and regular innovations. Radical innovations fundamentally transform core processes within a system. In so doing, they often increase interactive complexity and always change the relationship between the system and its environment. For instance, LED lights produce light in a different way than Tungsten filaments. They also change the relationship with the environment, in that LEDs produce less heat than Tungsten bulbs but require a much more stable voltage. Similarly, repackaging mortgages and bonds into tradeable securities was a radical change from banks holding individual mortgages. Securitization created fundamentally different relationships between the mortgages and the rest of the financial system. Mortgage issuers had much less interest in the loans they had made because the issuers were rid of the loans after selling them. Instead of being held locally, mortgages were now spread across the globe. And it was harder for a purchaser to assess the risk associated with a set of securitized mortgages.

In contrast, regular innovations generally involve using the same resources more efficiently. For example, in terms of the technical processes and linkages into the broader system, a subprime mortgage is basically a regular mortgage, pitched at a different market segment. By deploying resources more efficiently, innovators remove slack from the total system. As a result, regular innovations tighten coupling in a system — and, in the process, increase systemic risk.

Over time, innovations in the financial sector progressively increased complexity and coupling and created mismatches between the financial sector and regulatory assumptions. The meltdown occurred because of the way such mismatches interacted. The question society now faces is: Can we do anything to reduce the risk of future systems accidents?

Regulators can respond by addressing risk at the system level and by preventing individual innovations from creating the mismatches that can feed systems accidents. One option is to try to alter behavior in the financial industry. Professions such as medicine and law use not only the threat of punishment but also shared professional norms about ethical behavior to ensure that their members behave with integrity. In finance, in contrast, we have actively chosen the ideology of agency theory. In other words, we have invited people to act in their short-term self-interest up to the limits of coercive threats. We advocate this in the finance and economics departments of our universities and business schools. We embrace it every time we applaud “shareholder activism” by pension funds or union busting by corporations.

If, instead, we want integrity, we need to create true professionals organized around an ideology larger than self-interest. To achieve that, regulators could mandate professional education and force any participants from whom we expect ethical conduct (investment bankers, mortgage originators, etc.) into industry bodies that control the right to work in the profession and impose and enforce stringent behavioral expectations, as is done by professional associations in medicine and law.

Alternatively, if we want a finance industry in which people pursue self-interest, unfettered by the behavioral norms of a profession, then we must have active, vigilant and empowered regulators who carefully delimit the extent of that behavior. At minimum, regulators should ensure that individuals’ incentives are aligned with the broader population’s moral expectations.

At the systems level, regulators must reduce the level of interactive complexity and tight coupling within the financial system. If the system is less complex, then they have a greater chance of being able to analyze it to intervene appropriately. A number of people have called for regulations to reduce complexity. The most important of those is probably the call to limit the use of derivatives. Derivatives are designed to shift financial risk from one entity to another. While they move that risk around, derivatives can increase the total amount of risk in the system and also obscure where the risk is located, making the system harder to analyze.

Meanwhile, if the financial system’s coupling is looser, problems are less likely to spill across the world. Coupling is reduced by adding slack and buffers into the system, such as by requiring investment banks to hold adequate capital reserves.

These days, everyone seems to think innovation is a great thing. While innovation can be extraordinarily valuable, innovations, whether in genetically modified organisms or financial instruments, can contribute to systems accidents. Consequently, an innovation economy needs a strong and intelligent regulatory regime that aggressively manages systemic risks.