exchanges or blood transfusions. There are multiple routes of
transmission.’ In finance, contagion can also come from several
different sources. ‘It isn’t just lending relationships, it’s also about
shared assets and other exposures.’
A long-standing idea in finance is that banks can use diversification
to reduce their overall risk. By holding a range of investments,
individual risks will balance each other out, improving the bank’s
stability. In the lead up to 2008, most banks had adopted this
approach to investment. They’d also chosen to do it in the same way,
chasing the same types of assets and investment ideas. Although
each individual bank had diversified their investments, there was little
diversity in the way they had collectively done it.
Why the similarity in behaviour? During the Great Depression that
followed the 1929 Wall Street crash, economist John Maynard
Keynes observed that there is a strong incentive to follow the crowd.
‘A sound banker, alas, is not one who foresees danger and avoids it,’
he once wrote, ‘but one who, when he is ruined, is ruined in a
conventional way along with his fellows, so that no one can really
blame him.’[88] The incentive works the other way too. Pre-2008,
many companies started investing in trendy financial products like
CDOs, which were far outside their area of expertise. Janet Tavakoli
has pointed out that banks were happy to indulge them, inflating the
bubble further. ‘As they say in poker, if you don’t know how to spot
the sucker at the table, it is you.’[89]
When multiple banks invest in the same asset, it creates a
potential route of transmission between them. If a crisis hits and one
bank starts selling off its assets, it will affect all the other firms who
hold these investments. The more the largest banks diversify their
investments, the more opportunities for shared contagion. Several
studies have found that during a financial crisis, diversification can
destabilise the wider network.[90]
Robert May and Andy Haldane noted that historically, the largest
banks had held lower amounts of capital than their smaller peers. The
popular argument was that because these banks held more diverse
investments, they were at less risk; they didn’t need to have a big
buffer against unexpected losses. The 2008 crisis revealed the flaws