Rock star economist Tim Harford explains one of the big reasons for the financial crisis – tightly coupled systems. Its also the danger lurking in nuclear reactors, big IT projects and most importantly, dominoes (the sport not the pizza).

Everything below is from this interview with Tim (my emphasis) …

… there was a weird interaction between a collection of apparently-sensible rules about how banks had to hold more capital if they had riskier portfolios, and how portfolios were regarded as safer if they were insured with credit default swaps. All reasonable-seeming stuff, but the consequence was that when trouble struck a single big bond insurer, everyone was legally obliged to sell the same stuff, simultaneously. From a safety regulation to a global price crash in one easy step.

So we need to be smarter about the way we regulate finance in future. What really interested me — and I stumbled across this literature completely by accident — is the idea of applying principles of safety engineering to the banking system. For instance Charles Perrow, a sociologist, James Reason, a psychologist, and Trevor Kletz, an engineer, have been thinking really hard about how complex, tightly-coupled systems go wrong and how to make them safer. I think there’s some real insight there. (A few financial experts such as Andrew Lo, Rick Bookstaber and John Kay have picked up on the safety literature. But not many.)

So for example, safety experts understand that safety systems can often be counterproductive. They can encourage people to be careless — as with the case of credit default swaps, which regulators approved of as a way to load up on extra risk. The banking system didn’t get safer but it certainly got harder to understand, because the risk ended up in weird places.

Safety devices also make the whole system more complex and unpredictable. Three Mile Island was triggered by a false alarm system; the Piper Alpha disaster, a truly tragic drilling-rig fire, might have been prevented if the rig’s huge sea-water pumps had been operational, but they were disabled by default for safety reasons because they were dangerous to divers. And repackaged subprime debt, apparently safer thanks to the repackaging, was in fact simply more incomprehensible and more fragile in the face of small mathematical errors.

The bottom line is that it’s worth looking for ways to make the banking system simpler and more modular and less interconnected. And at the moment regulators are focusing more attention instead on bigger, better safety systems. I doubt that alone will fix much.

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EXCERPT: From Adapt: Why Success Always Starts With Failure by Tim Harford

The rather quirky sport of domino toppling is perhaps the ultimate example of a tightly-coupled system. You’ve seen domino stunts as the last item on the evening news: record attempts in which someone has painstakingly stacked up thousands upon thousands of dominoes, ready to topple them all with a single gentle push. Dominoes, unlike banks, are supposed to fall over — but not too soon. One of the first domino toppling record attempts — 8000 dominoes — was ruined when a pen dropped out of the pocket of the television cameraman who had come to film the happy occasion. Other record attempts have been disrupted by moths and grasshoppers.

It might be possible to topple dominoes in a strictly controlled environment, free of insects and television crews. This would reduce the complexity of the domino system, meaning that being tightly coupled isn’t so much of a problem. But it is clearly far more practical to loosen the coupling of the system instead. Professional domino topplers now use safety gates, removed at the last moment, to ensure that when accidents happen they are contained. In 2005, a hundred volunteers had spent two months setting up 4,155,476 stones in a Dutch exhibition hall when a sparrow flew in and knocked one over. Because of safety gates, only 23,000 dominoes fell. It could have been much worse. (Though not for the hapless sparrow, which a domino enthusiast shot with an air rifle — incurring the wrath of animal rights protesters, who tried to break into the exhibition centre and finish the job the poor bird had started.)

The financial system will never eliminate its sparrows (perhaps black swans would be a more appropriate bird), so it needs the equivalent of those safety gates. If the system’s coupling could be loosened — so that one bank could run into distress without dragging down others — then the financial system could be made safer even if errors were as common as ever.

Banks can act like dominoes — toppling many other firms when they fall over — in two ways. Most obviously, they can go infectiously bankrupt, meaning that they can collapse while holding their customers’ money. The nightmare scenario is that depositors from ordinary consumers to large companies find their cheques bouncing, not because they have run out of money but because the bank has.

Then there are zombie banks. They avoid going bankrupt, but only by stumbling around in a corporate half-life, terrorising other businesses. Here’s what happens. All banks have assets (a mortgage is an asset because the homeowner owes money to the bank) and liabilities (a savings account is a liability because the bank has to give the saver her money back if she asks for it). If the assets are smaller than the liabilities, the bank is legally bankrupt. Banks have a buffer against bankruptcy, called ‘capital’. This is money that the bank holds on behalf of its shareholders, who are at the back of any queue for repayment if the bank gets into trouble.

If the assets are barely larger than the liabilities, the bank is on the brink of bankruptcy — and to avoid that fate, it is likely to resort to the undeath of zombiehood. We’d ideally want the bank to avoid bankruptcy by seeking fresh capital from shareholders, inflating the capital cushion and letting the bank continue doing business with confidence. Yet most shareholders would be unwilling to inject capital, because much of the benefit would be enjoyed by the bank’s creditors instead. Remember: the creditors get paid first, then the shareholders. If the bank is near bankruptcy, the capital injection’s biggest effect is to ensure that creditors are paid in full; shareholders benefit only if there’s money left over.

So zombie banks do something else. Instead of inflating their capital cushion, they try to shrink in size so that a smaller cushion is big enough. They call in loans and use the proceeds to pay off their own creditors, and become reluctant to lend cash to any new businesses or homebuyers. This process sucks cash out of the economy.

Both zombie banks and infectiously bankrupt banks can topple many dominoes. No wonder governments responded to the financial crisis by guaranteeing bank debts and forcibly injecting big chunks of capital into banks. This prevented the crash from having more serious effects on the economy, but it had a cost — not only the vast expenditure (and even bigger risks) that taxpayers were forced to take, but also the dangerously reassuring message to bank creditors: ‘Lend as much as you like to whomever you like, because the taxpayer will always make sure you get paid.’ Instead of a capital cushion, it was the taxpayer who was pushed into the middle of the crash to soften the impact on the financial system. Decoupling the financial system means setting up the financial equivalent of those safety gates, so that when a bank such as Lehman Brothers gets into distress in future, it can be allowed to topple.