I think that there are significant incentives for financial institutions to create financial products (derivatives, etc.) that contain (and magnify) the systemic risk that is part of their inputs.

Systemic risk is very costly to hedge against, and to do so requires keeping capital idle that could otherwise be productive.

Also, esoteric financial instruments are always going to be less liquid than simple securities, yet the incentive of financial firms is to create them and find markets for them. This is analogous to any industrial input (raw materials) and output (finished product).

Complex financial products are desirable for use as underwriting capital because they can have specific characteristics that make them preferable to cash. But in fact the actual desirable characteristic is that their usefulness as a hedge against systemic risk has been sold off, leaving something that is legal as risk capital but ineffective against systemic risk.

Hence, the financial system has an incentive to create complex, entangled, webs of risk capital, none of which is cash, and all of which looks fantastic if you just look at its core (non systemic) risk characteristics.

When there has not been a systemic risk event in a while, such systems appear to be ingenious and clever. Regulators "understand" them well enough to deem them suitable as risk capital in good times (due to their non-systemic risk characteristics) and in bad (due to their lower cost).

The issue in 2008 was that the derivatives had baked in resilience to some systemic risk. If you design it with resilience to any systemic risk, it ceases to be useful.

So the game is simply baking in enough resilience to comply with regulations, collect quarterly bonuses, and repeat.

When you think about it there is really no regulatory framework for minimizing systemic risk exposure except for a handful of limits on firm size and some nuances of underwriting capital, created after the great depression.

fascinating, thanks for this post.

Inversion of the yield curve was probably the best signal, but that reversed itself.