The fallacy of composition in financial regulations

May 20, 2023

The fallacy of composition in financial regulations is that if all the banks are prudent, keeping all their individual micro risks under control, the entire financial system is safe.

The definition of fallacy of composition is that we infer that something must be true if all or even some parts of it are true.

Hydrogen (H) is not wet. Oxygen (O) is not wet. Therefore, water (H2O) is not wet.

The fallacy of composition in financial regulations is that if all the individual micro risks are kept under control, the entire financial system is safe. The financial system is the simple sum of all its individual activities.

Suppose each and every bank is prudent and does what they are supposed to, with none taking crazy risk. Still, they have to make risky investments like mortgages and loans to small and medium sized enterprises, as otherwise, they would not be a bank. Some of those risky investments have a market price, but the value of the majority can only be determined by a model, while the risk in all is measured by riskometers. The fallacy of composition means that even if all the banks are prudent, the system is not safe.

Blame it on shock absorption, or rather the inability of prudent banks to absorb shocks. Suppose some external shock arrives — Brexit or a tsunami or Ukraine or Trump or an earthquake or China or Covid-19, or just anything — so that the price of some assets held by the prudent banks falls. The consequence is that exogenous risk shoots up, inevitable by design since the riskometers are based on short term historical fluctuations.

What is our prudent bank supposed to do? Dispose of its riskiest assets, of course. However, such selling will just cause prices to fall further, raising exogenous risk. Expect more selling and a vicious cycle of declining prices and increased risk.

If there is no buyer (because all possible buyers are prudent), it can only end in tears (crisis). Nobody does anything wrong. It is like when one passes a hot potato from one person to another, they all pass it on to not get burned. Making all financial institutions prudent will not result in financial stability. Instead, it blinds decision makers to the true dangers.

This is an excerpt from my book The Illusion of Control.

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