Haldane & May: Systemic risk in banking
Tuesday, 17 May, 2011 1 Comment
Assuming (dear reader) that you have some interest in the topic(s) this is a very interesting piece. It can be found/downloaded here.
Andy Haldane (Director at Bank of England), Mervyn King and Lord May have been on this “tack” for at least 2 years – I have come speeches, papers or presentations on the subject if anyone is interested – and I have referred to their views in various blog articles over that period.
However, I did want to share this section from the conclusion. Because, these gents have recognised that there is a great deal that we can learn, about, both, cause and solution, from Nature. However, as they point out, due to the Political processes that will, inevitably, affect Bank of England, it is unlikely that solutions will be implemented quickly!
Insurers, other institutions, major Corporations…in fact any business would be ill-advised to ignore something that is so fundamental to the survival of systems – whether natural, societal or commercial – that “hard-nosed” bankers at the very top of their profession are prepared to pursue the point so frequently and in such a manner.
What THEY understand is, that much of what appeared as an external (exogenous) or market threat, was the “networked” effect of excessively complex and self-similar internal (endogenous) strategies. Add to that poor Governance, inadequate risk management, skewed incentives, the “assurance” of TBTF status and the climate for systemic risk and contagion into every other domain was set…
They also understand that we cannot afford a repeat!
Shaping the topology of the financial network
The analytic model outlined earlier demonstrates that the topology of the financial sector’s balance sheet has fundamental implications for the state and dynamics of systemic risk. From a public policy perspective, two topological features are key.
First, diversity across the financial system. In the run-up to the crisis, and in the pursuit of diversification, banks’ balance sheets and risk management systems became increasingly homogenous. For example, banks became increasingly reliant on wholesale funding on the liabilities side of the balance sheet; in structured credit on the assets side of their balance sheet; and managed the resulting risks using the same value-at-risk models. This desire for diversification was individually rational from a risk perspective. But it came at the expense of lower diversity across the system as whole, thereby increasing systemic risk. Homogeneity bred fragility (N. Beale and colleagues, manuscript in preparation).
In regulating the financial system, little effort has as yet been put into assessing the system-wide characteristics of the network, such as the diversity of its aggregate balance sheet and risk management models.
Even less effort has been put into providing regulatory incentives to promote diversity of balance sheet structures, business models and risk management systems. In rebuilding and maintaining the financial system, this systemic diversity objective should probably be given much
greater prominence by the regulatory community.
Second, modularity within the financial system. The structure of many non-financial networks is explicitly and intentionally modular. This includes the design of personal computers and the world wide web and the management of forests and utility grids. Modular configurations prevent contagion infecting the whole network in the event of nodal failure. By limiting the potential for cascades, modularity protects the systemic resilience of both natural and constructed networks.
The same principles apply in banking. That is why there is an ongoing debate on the merits of splitting banks, either to limit their size (to curtail the strength of cascades following failure) or to limit their activities (to curtail the potential for cross-contamination within firms). The recently
proposed Volcker rule in the United States, quarantining risky hedge fund, private equity and proprietary trading activity from other areas of banking business, is one example of modularity in practice. In the United Kingdom, the new government have recently set up a Royal Commission
to investigate the case for encouraging modularity and diversity in banking ecosystems, as a means of buttressing systemic resilience.
It took a generation for ecological models to adapt. The same is likely to be true of banking and finance.