Why the Internet Makes It Impossible to Stop Giant Wall Street Losses

Information technology has allowed banks to make huge bets that can go bust in the blink of an eye, and more regulation won't help.

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Reuters

In 1984, Yale sociologist Charles Perrow published his classic book, Normal Accidents: Living with High-Risk Technologies. The odd term, "normal accident," Perrow wrote, is meant to signal that, given a system's characteristics, multiple and unexpected interactions of failure are inevitable. Perrow studied "normal accidents" that occur in nuclear power and petrochemical plants, at sea where ships collide in open water for no good reason, in air travel, and in defense systems. 

Perrow's work is also applicable to banks, economic systems, and financial networks. When Jamie Dimon, the chief executive of JPMorgan Chase, was at Harvard Business School, Perrow's book should have been required reading. Had Dimon absorbed the book's lessons, instead of blaming the bank's recent embarrassing $2 billion dollar trading loss on errors, sloppiness, and poor judgment, he might have said,  "We should expect accidents like this to occur. No reasonable level of controls can prevent them from happening in tightly coupled, very active financial systems. We can handle it."

In fact, if Jamie Dimon, Christopher Dodd, and Barney Frank had all read Perrow's book, they would have discovered that for a large number of complex systems, neither better organization nor technology will make them less prone to accidents, and that frequently they become even more vulnerable to certain types of accidents. 

The recent history of the financial world reads like a textbook account of normal accidents.  Some big failures of note: Lehman Brothers and AIG during the 2008 financial crisis; the May 6, 2010 Flash Crash when the Dow Jones Averages dropped 600 in five minutes, only to bounce back twenty minutes later; the implosion of the Icelandic economy in 2008 that resulted in a 50 percent drop in the value of that nation's currency, and the unchecked growth in the over-the-counter derivatives market -- from a notional value of $60 trillion in 2000 to over $700 trillion today.

The financial world is more accident prone than ever -- thanks in large part to the Internet, the mother of all interconnections. Not only has the Internet supercharged financial innovation and created high rates of growth, but it lies at the heart of many financial normal accidents in the 21st century. In the case of Iceland, the country was welcomed into the European Economic Area, which enabled Icelandic banks to operate throughout the continent as long as they had deposit insurance.  At the time, Iceland had a gross domestic product of less than $20 billion.  Yet its banks mushroomed in size. By 2008 they had over $100 billion in assets as investors raced to capitalize on high interest rates and the rising value of the Icelandic kronur.  Iceland's online banks sucked in $6 billion in deposits from consumers in Britain and the Netherlands in a few years. 

But when investors lost confidence in the Icelandic economy, it triggered a normal accident. Money that had flowed in over electronic networks, fled at Internet speeds--an electronic run on the banks. There was no way the Icelandic Deposit Compensation Fund could meet its commitments to depositors. Iceland had created banks that were too big to fail in a country that was too small to save them. The kronur went into free fall, and lost half its value. 

Presented by

Bill Davidow is an adviser to Mohr Davidow Ventures and the author of Overconnected: The Promise and Threat of the Internet.

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