The Wall Street Journal has been running an excellent series of stories this week about the astounding lack of disaster preparedness at Tokyo Electric’s Fukushima nuclear plant. Among the revelations from this and other recent media reports:
- The plant’s disaster plan called for only one stretcher, one satellite phone, and 50 protective suits. In case of disaster, the fax machine was envisioned as a principal means of communication with the outside world.
- Tokyo Electric’s modelers decided to ignore any earthquake and tsunami data prior to 1896 when modelling worst case scenarios for the plant. As a result, they did not take into account an enormous quake and tsunami that hit the same area around 1,000 years ago. The plant was designed to cope with only an 8.6 magnitude earthquake, and the flood walls protecting the backup electric generators were only designed to withstand with an 18-foot tsunami, much less than the 27 foot wall of water that hit the plant on March 11.
- Japanese regulators reportedly discussed in recent months the use of new cooling technologies at nuclear plants that may have prevented the disaster. However, they chose to ignore the vulnerability at existing reactors and instead focused on fixing the issue in future ones. There was no serious discussion of retrofitting older plants.
- Japan’s Nuclear and Industrial Safety agency, which is supposed to act as a watchdog, falls under the umbrella of the Ministry of Economy, Trade and Industry, which advocates for the development of Japan’s nuclear industry. A revolving door of personnel between the government and the industry compromised the independence of the regulators.
When reading this catalogue of cascading failures, one wonders if Japan borrowed its disaster preparation manual from the US financial regulators. Excessive faith in the willingness of industry to regulate itself? Check. An overconfidence in the ability to manage complex systems? Check. Let’s just consider a few of the other ways in which poor regulation and disaster preparedness left the global financial system completely unprepared for the shock that came in 2008.
- Capital requirements for banks and other large financial institutions — the financial equivalent of the flood walls at the Fukushima nuclear plant — were completely inadequate. As a result, massive infusions of taxpayer money were required when the banking system froze up.
- Regulators and central bankers such as Alan Greenspan ignored repeated warnings from as early as 2000 that fraudulent lending was widespread, and in some cases they actively blocked state regulators from reining in abuses.- Regulatory agencies such as the Securities Exchange Commission were severely understaffed and compromised by a cosy relationship with Wall Street. The leadership of key institutions like the US Treasury and New York Federal Reserve is staffed by a revolving door of ex investment bankers.
- There was no resolution process in place to close and liquidate large, systemically important non-bank financial institutions in the case of failure.
I could go on and on, but I think you get the point.
So what are the lessons of Fukishima and the 2008 financial crisis? When you are dealing with complex systems such as nuclear power or the global financial markets, you need to build in large buffers of safety against the possibility of catastrophic events that are by their nature unpredictable.
The Japanese nuclear disaster is undoubtedly going to have a large impact on the design of future power plants in earthquake prone areas. But what about the financial system? Have we learned the lessons of 2008?
Disturbingly, it appears not. In fact, the system is just as vulnerable today as it was two years ago. Large US financial institutions such as JPMorgan Chase have grown even bigger, entrenching their “too big to fail” status. Financial industry lobbyists and the Republican Party have succeeded in watering down efforts at financial reform. And even Basel III, the new international regulatory framework for financial institutions, appears to be completely inadequate.
The big problem with the banks is that they are still too highly leveraged. This means that they have too much debt and not enough equity. Equity, is, as I said earlier, the financial equivalent of a flood wall, since when banks are highly leveraged, their thin sliver of equity can easily be wiped out by even modest declines in asset values. Many very successful businesses, such as Apple or Google, are essentially 100% financed by equity. Since banks are financial intermediaries, it would not be realistic to expect them to do the same, but it is clear that their current levels of equity are far too low.
The Basel III reforms agreed on last year set minimum bank equity at between 4.5% and 7% of “risk-weighted assets”, which are significantly smaller than total assets for most banks. But many academics argue that this level is dangerously low. For example, Anat Admati of Stanford University says:
The Basel III bank-regulation proposals … fail to eliminate key structural flaws in the current system. Banks’ high leverage, and the resulting fragility and systemic risk, contributed to the near collapse of the financial system. Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.
In other words, banks need to hold around two to three times the amount of equity that they currently hold. But disturbingly, instead of retaining earnings and further building up their equity as a buffer against future crises, US banks (with the blessing of the New York Fed) are itching to return capital to their shareholders in the form of dividends.
Needless to say, the profits that make these dividends possible would not exist if the banks hadn’t been bailed out with taxpayer money, obtained government guarantees on their debt issuance and benefited from zero interest rates. But this is entirely rational behavior by bank CEOs. After all, they will probably be bailed out again in the next crisis. Heads, the bankers win; tails, the taxpayer loses.
The nuclear industry will probably learn its lesson from Fukushima. But how many catastrophes does it take for financial regulators to wake up?
So far the bankers are winning the battle. This should make us all very worried.