Sean Park Portrait
Quote of The Day Title
In the beginner's mind there are many possibilities. In the expert's mind there are few.
- Shunryu Suzuki

On financial networks.

I was cleaning up my office a bit this afternoon and came across my copy of Andy Haldane‘s brilliant paper “Rethinking the Financial Network (April 2009). People (including me) like to complain about the lack of leadership and insight at the commanding heights of the financial system, but based on this paper alone, I’m not sure the UK could ask for a better Head of Financial Stability at the Bank of England. (He was appointed to that position in late 2008, once the horse had not only left the stable but the country…)

If you are interested in the workings and health of the financial system, you simply must read this paper if you haven’t already. I won’t attempt to summarize it here, it is worth reading in its entirety but will excerpt his conclusion:

Through history, there are many examples of human flight on an enormous scale to
avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th
century to polio and influenza in the 20th. In these cases, human flight fed contagion
and contagion fed human catastrophe. The 21st century offered a different model.
During the SARS epidemic, human flight was prohibited and contagion contained.

In the present financial crisis the flight is of capital, not humans. Yet the scale and
contagious consequences may be no less damaging. This financial epidemic may
endure in the memories long after SARS has been forgotten. But in halting the spread
of future financial epidemics, it is important that the lessons from SARS and from
other non-financial networks are not forgotten.

I’m fairly certain he is not a reader so I can take no credit, but it is very rewarding to see someone in his position with such a firm grasp on the concepts I’ve been trying to articulate (much less completely and articulately) for some time now. (see The science of Financial Regulation (June 2009) and Averting (financial) ecological disasters (August 2008)) I hope his voice is listened to and his insight and intellect used to help us build a better, more resilient financial system for the future.

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Permalink||Comments|Filed under 'Banking, Financial Services, Sixth Paradigm, markets'
  • Slav H
    Thanks for pointing this paper. I read it with mixed feelings. I appreciate that someone is trying to understand financial systems in terms of networks and complex adaptive systems. I also enjoyed the flowery language. Only Milton’s “Paradise Lost” is missing. The diagnosis that the financial system players became homogenized - a monoculture - is not surprising. After all, they responded to the same explicit regulations and implicit reward structure.

    What bothers me in the analysis and especially in the prescriptive part is quite strong emphasis on governmental involvement. Haldane postulates (i) more data collection and not only on the financial institutions (nodes in his network-speak) but also directly on their bilateral transactions (links), (ii) creation of “impregnable” centers (counterparty centers), and (iii) “authorities intervening more aggressively when next financial innovation spawns species with undesirable physiological features.” These recipes are not only wrong but pernicious. Data collectors will have to be paid and data themselves kept protected. Do we trust these agencies? Quis custodiet ipsos custodes?

    The impregnable centers will undoubtedly rely on the government for support, unlimited support by definition. Again, who will pay? What about the moral hazard? If I know that my counterparty cannot default I can take more risks. Finally, do we really believe that these oh-so-smart regulators will be able to understand new innovations, weigh and calibrate their responses even if they all graduated from finest universities?

    It is good that people learn about complex systems but having just a bit of knowledge is a dangerous thing. Paradise will not be regained.
  • Slav, thanks for the thoughtful comment. I hadn't really focused on this emphasis on government involvement but I would probably share your caution and perhaps be more guarded in my enthusiasm for this aspect of Haldane's views.

    I think there is much that can be learned in terms of how to deal with these issues (of collecting, managing, analyzing and acting on this data) from the technology and open-source communities. And the solutions should be private with official institutions setting standards and keeping the playing field level and transparent.

    I think one of the most important lessons (that needs to be taken away from this sort of analysis) is that - by definition - complex systems are complex and there are always unknown unknowns. This sort of institutionalized humility is what is required, not the opposite (and more usual) institutionalized hubris: "oh, complex system? yep. got it. no worries." So yes, I agree we need to guard against those who would look for newtonian certainties, the world is fuzzy and will remain so, we need to work with this grain not against it.
  • As luck would have it there is an initiative within the UK to do something about the issues associated with complexity that Andy identifies - http://www.lscits.org/. If you ever get the chance to meet Prof Dave Cliff, who runs LSCITS, then I'm sure you'll find the conversation very engaging (http://www.linkedin.com/pub/dave-cliff/0/a79/6a9).
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