Is there a mathematical solution to this problem? Could the regulation requiring a 99.5% chance each year for each individual company to meet its obligations take into account the dependency between different companies, and set the required level to target the chance of industry-wide failure? Taleb has certainly made the point that the assumption of independent failures fails when everyone is adopting the same strategy. They needn’t even be investing in each other for this to happen, just acting as fewer agents than they are.
If you have excellent models, then you could have the regulators adjust requirements as dependencies change. But we don’t have excellent models, far from it...
I think this problem is best understood as two simpler problems:
Imagine UberInsure bought all 10 insurance companies. Then it would be easier for them to comply with the risk requirements (it takes a more extreme event for them to fail to pay off all their obligations), but the sector is no safer than it was (or, equivalently, UberInsure can take higher profits while maintaining the same nominal risk ratio, actually increasing the risk to the sector). So capital requirements need to be weighted by company size, not just a fixed percentage.
Imagine all 10 companies invest in each other. Then although they’re nominally separate companies, they’re actually acting as UberInsure; in a crisis the correlations will go to 1 and the whole sector will collapse.
Honestly we’re already starting to address these problems, in an ad-hoc, crude way: banks that are “systemically important” are a) more tightly regulated, suggesting we’re starting to recognize at least some distinction between large and small banks b) not allowed to own each other’s paper (or rather, not allowed to count it in their assets if they do).
Is there a mathematical solution to this problem? Could the regulation requiring a 99.5% chance each year for each individual company to meet its obligations take into account the dependency between different companies, and set the required level to target the chance of industry-wide failure? Taleb has certainly made the point that the assumption of independent failures fails when everyone is adopting the same strategy. They needn’t even be investing in each other for this to happen, just acting as fewer agents than they are.
If you have excellent models, then you could have the regulators adjust requirements as dependencies change. But we don’t have excellent models, far from it...
I think this problem is best understood as two simpler problems:
Imagine UberInsure bought all 10 insurance companies. Then it would be easier for them to comply with the risk requirements (it takes a more extreme event for them to fail to pay off all their obligations), but the sector is no safer than it was (or, equivalently, UberInsure can take higher profits while maintaining the same nominal risk ratio, actually increasing the risk to the sector). So capital requirements need to be weighted by company size, not just a fixed percentage.
Imagine all 10 companies invest in each other. Then although they’re nominally separate companies, they’re actually acting as UberInsure; in a crisis the correlations will go to 1 and the whole sector will collapse.
Honestly we’re already starting to address these problems, in an ad-hoc, crude way: banks that are “systemically important” are a) more tightly regulated, suggesting we’re starting to recognize at least some distinction between large and small banks b) not allowed to own each other’s paper (or rather, not allowed to count it in their assets if they do).