Taleb: Rogue Traders and Why Big Banks Break

My friend Nassim Nicholas Taleb has out a new paper trying to demonstrate, from first principles, the fragility of large banks. Here is the summary, and I’ll try to post something more if/when I have a few moments later today:

Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions

Nassim Nicholas Taleb
NYU-Poly Institute; London Business School

May 2, 2009

Large institutions are disproportionately more fragile to Black Swans.
This paper establishes the case for a fallacy of economies of scale in large aggregate institutions. The problem of rogue trading is taken as a case example of hidden risks where rogue traders and losses are considered independently and dependently of the institution’s size. Both independent and dependent loss and hidden positions are shown to lead to the paper’s conclusion, that size and economies of scale have commensurate risks that mitigate the advantages of size.

He essentially studies rogue trading and "hidden risks", which he defines as unintended and highly risky positions at banks. Given skewness and size, the likelihood of such hidden positions becomes more likely in large banks, while the consequences becomes larger yet, with the result being unhappy, societally speaking.