Why Aren't Banks Built More Like Bridges?

When we drive or walk over a bridge do we think it might collapse? Do we think it would collapse with extreme weather or heavy traffic? We know many have and experience teaches us to never-say-never. But I suspect we also think this is a negligible risk for the bridges we use on daily basis - bridges that have withstood decades or even centuries of stress providing a seamless journey from A to B. From the Romans and the Victorians to today’s civil engineers, these feats of intellectual and material prowess make our life easier and provide a visual achievement that are synonymous with some of the greatest cities.

Can we say the same about banking? 

At the mCD Exchange, we think it is helpful to compare banks to bridges, as like bridges, banks are structures we use on a daily basis and depend on for the stable and unconscious part of our lives. Because of this dependence, we need them to work not just in normal conditions but when put under stress.

Banks like bridges have been around for centuries and we feel the right to expect that not only has every weakness or flaw been discovered and remedied but that with the passage of time and extension of human ingenuity we have increased overall welfare and overcome great obstacles.

The 2007-2008 financial crisis led to the closure of 465 failed banks in the US. In the UK, Northern Rock failed and then HBOS and the once mighty RBS narrowly avoided collapse by government rescue plans. Globally, almost all major banks were supported by their governments using emergency measures to prevent further collapses.  

So why were banks so poorly engineered?  It's not like scientists and engineers of the civil, electrical and chemical sort did not work in banks. They became the “quants”  working alongside traders designing new and innovative financial instruments but also managers and modellers responsible for measuring and managing financial risk. See Emanuel Derman's excellent book for an account of this development. 

A major irony of the crisis is that during and after the event, the term, "financial engineering", took on a very sinister meaning as the finger of blame was pointed at the financial derivatives, securitizations, off-shore schemes and off-balance sheet vehicles that were supposedly spawned by these "rocket scientists".  

In real rocket science, deadly errors and miscalculations are made. But banking is not rocket science. Hindsight of course is a wonderful thing, but whereas the reasons for a space ship exploding at some point between here and the moon, can remain inscrutably difficult after the event, the reasons for CDOs, SIVs and banks themselves blowing up appear obvious: excessive reliance on maturity transformation that is exposed with excessive leverage and periodic bouts of liquidity shortages. 

Which suggests the real work of financial engineering is yet to come. When a new class of financial engineers  - or the old ones with a new confidence - take a fresh look at the structure of the banking system itself, to ensure in the future that banks are built as strongly as bridges.