What have we learned from the financial crisis?

As authorities move toward new regulations for international banking, scientists question whether they will address the most important causes of instability.

Deliberations over new regulations for international banking are now in the final stages. In September of last year, the Basel Committee on Banking Supervision proposed new rules that would raise capital requirements on individual banks and also set limits to their overall level of borrowing or leverage. These so-called “Basel III” rules aim to make banks more resilient and to prevent a repeat of the financial crisis.
All of which is good as far as it goes, say experts in the stability of networks, although they doubt it will really touch on the deeper roots of major banking failures.
“The proposed rules don’t focus on the networks of interconnection and interdependence between the banks,” says economist Mauro Gallegati of the Polytechnic University of Marche, a participant in a new European research project, FOC, coordinated by Guido Caldarelli from CNR, Italy, which aims to build a deeper science of the stability and resilience of complex financial networks (www.focproject.net), in part by using advanced ideas from physics and applied mathematics.
As he points out, problems initiated by the sub-prime mortgage industry only triggered a full blown financial crisis because of dense linkages between financial institutions made trouble in one part of the network spread quickly elsewhere. Hence, it’s not just individual banks that need to be made resilient, but the complex international network of banks and other institutions.
“What they propose goes in the right direction,” adds Gallegati, “but it really falls short of addressing the most serious part of the problem. You have to monitor the whole network.”

Build resilience into the system, not only its parts

The FOC research group suggests that the stability of the financial system depends not only on the stability of  individual financial institutions — the system’s parts — but on the entire pattern of interconnections between those institutions.
In a recent study, for example, physicist Stefano Battiston of the ETH-Zurich, working with Gallegati and other economists including Nobel Prize winner Joseph Stiglitz of Columbia University — showed that network effects can lead to crises in ways that ordinary risk analyses simply fail to see. As the number of contracts linking financial institutions grows, it leads naturally to positive feedbacks which can amplify an initial shock affecting only one or a few institutions into a full fledged systemic crisis (see “Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk,” Stefano Battiston et al., NBER Working Paper No. w15611)..By limiting banking leverage and increasing capital requirements, the proposed Basel III regulations partially address this threat by decreasing the chance that one institution will be put at risk by virtue of shocks to its counterparties. But the rules do not consider moving beyond rules on individual banks to regulations that would manage the global resilience of the financial network itself.

We can’t go back to the past

Economists and financial experts widely acknowledge that policy makers currently lack adequate tools for monitoring so-called “systemic risk” in financial systems — risks tied to the collective organization of the system as a whole, which may not appear as high risks for particular institutions. Doing so effectively would demand  more integrated information systems to gather and process key financial data, better analytic approaches that would focus explicitly on the network of financial interdependences, and new risk indicators able to capture these effects.
Inspired by the financial crisis, but also by an explosion of research on complex networks over the past decade, the FOC research project aims to address such issues in an interdisciplinary way. It starts from the perception that financial integration and financial innovation create additional links (often invisible to both regulators and investors) in the global financial network, which increase the interdependence of institutions and stir up new instabilities even as institutions have the illusion of greater diversification.
So far at least, the Basel III regulations — like the  Basel II accords on which international banking is currently based — do not respect this insight in their efforts to build a more stable financial system and to limit systemic risk. No one knows the right answers yet, representatives of FOC emphasize, but they suggest important research efforts in this direction — focussed on quantifying measures of systemic risk and keeping from building up — will be necessary to avoid future crises. Currently, the Basel Committee on Banking Supervision aims to have the new regulations implemented by late 2012.

Mark Buchanan, science writer

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