The way the financial authorities address threats to financial stability is by resilience. But is that the right way? Might it be better to emphasise shock absorption instead? That is the very question I discuss in my new book The Illusion of Control.
Resilience is the inferior approach. We can make every financial institution highly resilient to shocks but at a vast economic cost and, perhaps counterintuitively, more systemic risk.
There are two reasons why resilience can increase systemic risk.
The first is that if every financial institution is prudent and resilient to shocks, how will it react to the inevitable shocks, some of which will be very large? Get rid of the risky assets now suffering from a tail event. But who can buy those assets if everybody is prudent and guarding their shock resiliency? Not many, and prices will therefore crash until they attract the interest of bargain hunters. And because correlations increase across all assets and asset classes in times of extreme stress, the shock will spread, and in extremis could even take down those highly shock resilient.
And secondly, such resilience requires regulators to impose that very resiliency, which they do with prescriptive rules dictating how the financial institutions see risk and have to react to it. That creates monoculture. Financial institutions that are increasingly the same in outlook and action, procyclically amplifying shocks.
Much better to focus on shock absorption, achieved by diversity.