Jan

21

 Ecology and Financial Markets is on the front page of current Nature.

"In the run-up to the recent financial crisis, an increasingly elaborate set of financial instruments emerged, intended to optimize returns to individual institutions with seemingly minimal risk. Essentially no attention was given to their possible effects on the stability of the system as a whole. Drawing analogies with the dynamics of ecological food webs and with networks within which infectious diseases spread, we explore the interplay between complexity and stability in deliberately simplified models of financial networks. We suggest some policy lessons that can be drawn from such models, with the explicit aim of minimizing systemic risk."

http://www.nature.com/nature/journal/v469/n7330/full/nature09659.html

and from

http://www.scientificamerican.com/blog/post.cfm?id=can-ecological-models-explain-globa-2011-01-19

'Bananas, cacao and bee-pollinated crops are all threatened with collapse in part because of their monoculture management. When a biological or social system is full of uniform individuals—be they bean plants or banks—one shared weakness can spell disaster for the whole lot. Even when a new beneficial trait or tool enters the picture, if all organisms adopt it, as many financial institutions did with credit default swaps and other risky trades that led to the financial meltdown of 2007-08, a tenuous balance can be quickly upset, argued an economist and an ecologist in a new essay.

"Excessive homogeneity within a financial system—all the banks doing the same thing—can minimize risk for each individual bank, but maximize the probability of the entire system collapsing," Bank of England's Andrew Haldane and Oxford University's Zoology Department's Robert May wrote in their new paper, which will be published in the January 20 issue of Nature (Scientific American is part of Nature Publishing Group). Thus even as banks themselves were pursuing internal diversity by adopting new financial tools, across the board "banks' balance sheets and risk management systems became increasingly homogeneous," they wrote. And that similarity led to a vulnerable system.

A thoroughly interconnected food—or financial—web might provide the illusion of security, as "high connectivity distributes, and thereby attenuates risk." But as the authors pointed out, when a shock does hit the system, it will affect more institutions.

One way to combat this issue is to establish more self-contained "nodes" as has been employed in forest management and even computer networks, so that if one element takes a hit, it doesn't take down the entire system.

And rather than regulating with the aim of individual institution stability, Haldane and May noted, attention should be tuned to the overall system's risk. Like the spread of an infectious disease, financial troubles can be launched by so-called "super-spreaders," such as Lehman Brothers. By "focusing preventive action on 'super-spreaders' within the network to limit the potential for system-wide spread," regulators might be able to avoid the contagious hemorrhaging that occurred with the 2008 Lehman Brothers collapse.

Not everyone is convinced the ecological model is ready to be incorporated into policy-making decisions. Haldane and May asserted—and reasserted—that the dynamics they present are "deliberately oversimplified" and that "there are, of course, major differences between ecosystems and financial systems" (including preference of speed over long-term fitness and the interference of governments). Nevertheless, "rigorous statistical validation of any toy model or analogy is essential before policies are suggested," asserted University of Miami physicist Neil Johnson in an essay published in the same issue of Nature. By way of comparison, he asked: "Would you fly in a paper plane that had been scaled up to the size of a 747?"

But other non-biologists are ready to entertain the ecological model. University of Kiel economics professor Thomas Lux noted in another essay in the same issue of Nature that it is "essential" to "take stock of the accumulated knowledge on network structures when studying systemic risk in the banking sector."

Whether or not experts agree that biology is a useful lens through which to study financial markets, Haldane and May suggested that financial regulation is already "following in the footsteps of ecology, which has increasingly drawn on a system-wide perspective when promoting and managing ecosystem resilience."'

Gary Rogan comments:

Good article, but let's look at this conclusion:

'Whether or not experts agree that biology is a useful lens through which to study financial markets, Haldane and May suggested that financial regulation is already "following in the footsteps of ecology, which has increasingly drawn on a system-wide perspective when promoting and managing ecosystem resilience."'

To extend the parallel, who is it that's "promoting and managing ecosystem resilience", generally speaking, in nature? Since we were asked not to talk about religion, I won't answer the question but it's clear where the role of the system-wide regulator fits in this analogy. Of course most ecosystems reach robustness simply by following the rules of survival of the fittest, so it's interesting how a mostly good analogy is used to reach a politically correct, but unworkable conclusion.


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1 Comment so far

  1. Kristian Blom on January 22, 2011 5:09 pm

    Robustness can be reached many ways, in nature and elsewhere….

    http://www.bbc.co.uk/news/science-environment-11063939

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