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Neglecting tail risk

It's not just governments that neglect the risk of disaster. So too do investors and company bosses
Neglecting tail risk

Critics of the government say it was unprepared for the Covid-19 outbreak by having insufficient ICU beds, protective equipment and testing kits. What makes this charge plausible is that it is common to ignore tail risk – the small chance of disaster – not just in government, but in finance and industry as well.

Nassim Nicholas Taleb has called this “picking up pennies in front of a steamroller”. Sometimes, we can get a small regular income stream by exposing ourselves to the chance of catastrophe. Ensuring that the NHS was working flat out, for example, held down taxes for years, but left it under prepared for a pandemic.

We saw the same thing in the run-up to the 2008 financial crisis. In the mid-2000s, AIG sold insurance against defaults on mortgage derivatives. For months, it earned steady profits. But then those derivatives did default, leading AIG to need the biggest government bailout in history. Similarly, Northern Rock expanded by borrowing in the interbank market. That worked until the hitherto-unthinkable happened and the market froze up, leading to the first run on a UK bank since 1866.

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