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Taleb: The Risk Externalities of Too Big to Fail

Too Big to Fail” is a dilemma that has plagued economists, policy makers and the public at large. In Nassim Taleb’s lastest paper (with co-author Charles S. Tapiero) he takes a look.

Abstract

This paper examines the risk externalities stemming from the size of institutions. Assuming (conservatively) that a firm risk exposure is limited to its capital while its external (and random) losses are unbounded we establish a condition for a firm to be too big to fail. In particular, expected risk externalities’ losses conditions for positive first and second derivatives with respect to the firm capital are derived. Examples and analytical results are obtained based on firms’ random effects on their external losses (their risk externalities) and policy implications are drawn that assess both the effects of “too big to fail firms” and their regulation.

The conclusion is worth reading even if you don’t read the paper — a small tease

However, the non- transparent bonuses that CEOs of large banks apply to themselves while not a factor in banks failure is a violation of the trust signaled by the incentives that banks have created to maintain the payments they distribute to themselves. For these reasons, too big too fail banks may entail too large too bear risk externalities. The result we have obtained indicate that this is a fact when banks internal risks have an extreme probability distribution (as this is often the case in VaR studies) and when external risks are an unbounded Pareto distribution.

Paper

(H/T Simoleon Sense)