The growth of complexity and widespread pursuit of similar products and strategies has created a fragile financial network in need of reform, according to a senior Bank of England (BoE) official.
In a 41-page paper delivered this week at the University of Amsterdam, Andrew Haldane, the bank's executive director of financial stability, outlined the network weaknesses in the financial system that led to the crisis, drawing parallels with non-financial phenomena such as the outbreak of Severe Acute Respiratory Syndrome (Sars) in China in 2002.
"Both events were manifestations of the behaviour under stress of a complex, adaptive network," said Haldane, explaining that, just as the outbreak of Sars led to global panic and major economic problems in the region, the bankruptcy of Lehman Brothers led to a multitude of dire consequences for the global financial system.
Haldane attributes the spread of the financial crisis to the growing complexity of products and the tendency of institutions to migrate simultaneously to products that look profitable, such as leveraged loans and collateralised debt obligations (CDOs). The complexity of these products, he argues, made it difficult to conduct proper due diligence. "An investor in a CDO-squared would need to read in excess of 1 billion pages to understand fully the ingredients... though it had aimed to dampen institutional risk, innovation in financial instruments served to amplify further network fragility," he said.
The interconnected nature of the financial network also meant a modest crisis, such as the US subprime crisis, was able to induce a global meltdown. The reaction of market participants has either been to hoard liquidity and reduce lending, or to quickly sell toxic assets in panic. Both responses, argues Haldane, have aggravated the situation: "Banks' mutual interdependence in inter-bank networks meant that individually rational actions generated a collectively worse funding position for all."
Haldane also expressed concern about the difficulty of measuring counterparty risk. Taking the example of a credit default swap, a protection buyer can never truly know its counterparty's risk as that would necessitate analysis of a long chain of counterparty relationships. "Counterparty risk is not just unknown; it is almost unknowable," he said, "and the higher the dimensionality of the network, the greater that uncertainty."
The paper proposes three policy options to tackle the weaknesses in the financial network. Firstly, there needs to be better data on transactions, better analysis of that data and better communication of the results. Haldane advocates an international register of claims between financial institutions, as suggested in the European Union's recent de Larosière report.
Secondly, he calls on regulators to target high-risk banks with heavy-handed rules, drawing the parallel with Sars and measles, where roughly 20% of the population is responsible for 80% of the spread. He believes regulators have failed in the past by allowing big banks to hold lower capital buffers because of the implict promise of government support in the event of a crisis. "Incentives to generate and propagate risks may have been strongest among those posing greatest systemic threat. Basel vaccinated the naturally immune at the expense of the contagious," he said.
Lastly, Haldane calls for changes to the structure of the financial network, backing the move towards central clearing platforms for credit default swaps as a means of condensing relationship chains into a single link and eliminating uncertainty over counterparty risk. But he calls for wider use of such platforms: "A much broader range of OTC financial instruments, both cash and derivatives, could potentially benefit from the introduction of a central counterparty."
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