Thinking about financial system as a network

Andrew Haldane of bank of England is on a roll. In his earlier paper he had questioned many a beliefs about risk management. In the paper, he had asked on the need to look at fin system from a network perspective.

In a new paper he explains the financial system from a network perspective. The paper is quite interestingly written:

This paper considers the financial system as a complex adaptive system. It applies some of the lessons from other network disciplines – such as ecology, epidemiology, biology and engineering – to the financial sphere. Peering through the network lens, it provides a rather different account of the structural vulnerabilities that built-up in the financial system over the past decade and suggests ways of improving its robustness in the period ahead .

All this comparison with other fields makes the paper so fresh to read. The broad findings are:

Using network theory and evidence, it explains the emergence of two characteristics of the financial network over the past decade – complexity and homogeneity. Together, these resulted in a financial network:

Which was at the same time both robust and fragile – a property exhibited by other complex adaptive networks, such as tropical rainforests;

Whose feedback effects under stress (hoarding of liabilities and fire-sales of assets) added to these fragilities – as has been found to be the case in the spread of certain diseases;

Whose dimensionality and hence complexity amplified materially Knightian uncertainties in the pricing of assets – causing seizures in certain financial markets;

Where financial innovation, in the form of structured products, increased further network dimensionality, complexity and uncertainty; and 

Whose diversity was gradually eroded by institutions’ business and risk management strategies, making the whole system less resistant to disturbance – mirroring the fortunes of marine eco-systems whose diversity has been steadily eroded and whose susceptibility to collapse has thereby increased.

I would have loved to cover the key points in the paper but am unable to do so because of lack of time. It is a must read.