Thursday, April 30, 2009

next financial innovation spawns species with undesirable physiological features

TO BE NOTED: In the FT: Via Felix Salmon, Alea: I just realized that I'd already read this paper:

"Quote of the Day

…an investor in a CDO2 would need to read in excess of 1 billion pages to understand fully the ingredients.

In Rethinking the financial network, Andrew Haldane, BofE
Finance could learn from ecology, suggests BofE

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Posted by -jck "

Finance could learn from ecology, suggests Bank

By Chris Giles, Economics Editor

Published: April 29 2009 03:00 | Last updated: April 29 2009 03:00

Financial risk management and regulation should cast aside many elements of traditional finance theory and learn lessons from ecology, the spread of diseases, biology and engineering, according to a senior Bank of England official.

Andy Haldane, the Bank's head of financial stability, said studying the ecology of rainforests and fish stocks was not a sign of the regulators going soft in response to the crisis, but was needed because other disciplines had a more advanced understanding of complex networks.

The panic and system-wide collapse in the face of a "relatively modest" shock would have been easier to predict had much of the theory of finance not been lagging behind ecology by about a generation, he said.

He likened financial mathematical models which "pointed to the stabilising effects of financial network completeness" to the now-discredited 1970s-style ecological orthodoxy that asserted the complex networks of enemies and parasites in rainforests would always guarantee their survival.

In particular, Mr Haldane noted that as players in the financial system pursued increasingly similar strategies this decade, they created networks "exhibiting both greater complexity and less diversity".

"In just about every nonfinancial discipline - from ecologists to engineers, from geneticists to geologists - this evolution would have set alarm bells ringing," he argued.

The result was a system that was "robust-yet-fragile . . . a network which, like the little girl with the curl, when the going was good was very, very good - but when it turned bad was horrid".

Mr Haldane drew three conclusions for the future of financial regulation from his study of network theory from other disciplines.

First, that the biggest and most interconnected banks should be subject to tougher regulations than smaller firms because they were most likely to be a super-spreader of financial risk. He likened them to heroin users or promiscuous homosexuals who were most likely to spread the HIV virus.

A second lesson was the need to gather better data on the network dynamics of the financial system, much as the electricity grid understands its vulnerability to failures of power plants and its transmission systems.

If there had been a better understanding of links, Mr Haldane said it would have shown that few of the world's largest financial institutions had more than two or three degrees of separation from AIG, the failed insurance giant.

And third, creating a more robust financial network should include greater use of central counterparties to reduce the complexity of the network and the possibility of curbing the growth of excessively complex products, such as collateralised debt obligations.

"There is a strong public policy case for the authorities intervening more aggressively when the next financial innovation spawns species with undesirable physiological features", Mr Haldane said.

For full speech go to"

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