But one thing that comes out of the book is the idea that we tend to make systems more complex by adding safety systems on top of them, and that the safety systems themselves create new ways for things to go wrong. That was a key problem in the financial crisis. A lot of banks were taking bets and then insuring themselves with credit default swaps (CDS). Credit default swaps were, basically, insurance contracts that banks wrote, often with [the big insurance company] AIG. Or banks were repackaging sub-prime mortgages into vehicles that were supposed to make risky loans safe. These two innovations – the packages of sub-prime loans and the credit default swaps – were both safety systems. But they were both absolutely crucial in explaining why the system blew up. I think that’s a central and really useful idea, that these safety systems are probably not helpful – and even when they are helpful, they will have unintended consequences.
Interesting, no? Complexity adds risk–even if the complexity is intended to mitigate risk. He closes with the following:
It’s a bit like climbing a mountain. You’re roped together, and you think the rope is making you all safer. Then, suddenly, a couple of people fall off. You realise that it’s the rope that’s dragging you all off the cliff – even people who were never in trouble themselves.
Practically, this is why you never, never, never co-sign a loan for anyone.
HT: Newmark’s Door