Complex systems: The FLAW of large numbers
Sunday, 20 March, 2011 2 Comments
Image by hans.gerwitz via Flickr
Financial and Political elites appear intent to ignore lessons from nature and history…even though such short-sightedness may be amongst their final acts before the rigidity and complexity of the ecosystem they have created proves to be their undoing.
Their unstinting commitment to such, patently, flawed belief systems – when the evidence is laid bare for others to see – WILL be their undoing. i has written so many blogs covering this that I feel I am repeating myself time and again but I am sure the links (below) will prove interesting for anyone kind enough to take an interest in my thoughts…or my interpretation of the thoughts of others.
Regulators want big, complex banks to hold larger buffers of capital to protect the financial system. Big banks argue this is unnecessary because risk is diversified across their larger balance sheets. Who is right? Natural sciences – especially epidemiology, ecology and genetics – provide clues.
Are big banks less prone to failure? The traditional economics of diversification suggest so. By scaling up balance sheets across different classes of asset, risks to portfolios will tend, on average, to cancel each other out. Aggregate balance sheet risk is dampened the bigger the balance sheet. Big banks thus benefit from a law of large numbers.
Complex systems – those found in nature, but also in finance – tell a different tale. Here, scaling up risks may cause them to cascade rather than cancel out. The bigger and more complex the structure, the greater this risk.
Why? Because size and complexity increase the chances of cross-contamination of the whole barrel, even if there is only one bad apple. Errors do not cancel; they cascade. There is a flaw of large numbers.