Thursday, July 15, 2010

Complex systems: Ecology for bankers

Article from February 2008.

There is common ground in analysing financial systems and ecosystems, especially in the need to identify conditions that dispose a system to be knocked from seeming stability into another, less happy state.

'Tipping points', 'thresholds and breakpoints', 'regime shifts' — all are terms that describe the flip of a complex dynamical system from one state to another. For banking and other financial institutions, the Wall Street Crash of 1929 and the Great Depression epitomize such an event. These days, the increasingly complicated and globally interlinked financial markets are no less immune to such system-wide (systemic) threats. Who knows, for instance, how the present concern over sub-prime loans will pan out?

Well before this recent crisis emerged, the US National Academies/National Research Council and the Federal Reserve Bank of New York collaborated1 on an initiative to "stimulate fresh thinking on systemic risk". The main event was a high-level conference held in May 2006, which brought together experts from various backgrounds to explore parallels between systemic risk in the financial sector and in selected domains in engineering, ecology and other fields of science. The resulting report was published late last year and makes stimulating reading.

Catastrophic changes in the overall state of a system can ultimately derive from how it is organized — from feedback mechanisms within it, and from linkages that are latent and often unrecognized. The change may be initiated by some obvious external event, such as a war, but is more usually triggered by a seemingly minor happenstance or even an unsubstantial rumour. Once set in motion, however, such changes can become explosive and afterwards will typically exhibit some form of hysteresis, such that recovery is much slower than the collapse. In extreme cases, the changes may be irreversible.

As the report emphasizes, the potential for such large-scale catastrophic failures is widely applicable: for global climate change, as the greenhouse blanket thickens; for 'ecosystem services', as species are removed; for fisheries, as stocks are overexploited; and for electrical grids or the Internet, as increasing demands are placed on both. With its eye ultimately on the banking system, the report concentrates on the possibility of finding common principles and lessons learned within this medley of interests. For instance, to what extent can mechanisms that enhance stability against inevitable minor fluctuations, in inflation, interest rates or share price for example, in other contexts perversely predispose towards full-scale collapse?


Related links:

New Directions for Understanding Systemic Risk

On Robustness & Fragility

Related books:

The Age of the Unthinkable

The Black Swan