1. Rethinking the Financial Network
Andrew G Haldane
Bank of England
2009

2. Plan Financial system = complex, adaptive network
These networks extensively explored in physics, biology, engineering, epidemiology, philosophy, etc
What lessons can we learn?
Evolution in the financial network
Improving network robustness

3. Evolution in the Financial Network
Quest for diversification results in
Complexity
Homogeneity
In finance
Complexity + Homogeneity = Stability
Outside of finance
Complexity + Homogeneity = Fragility

4. Complexity and Stability
1950s ecology: complexity increases robustness
Eg, tropical rainforests
1970s awards: complexity decreases robustness
Eg, rainforests become non-renewable
Finance following a similar track
Channels include: connectivity; uncertainty; innovation

5. Connectivity and Stability
Three well-established network properties
“Robust-yet-fragile” networks – tipping points
“Long-tailed” networks – hub and spokes
“Small world” networks – long hops
International financial networks have developed all three characteristics
In combination, generates a “robust-yet-fragile” and “small world” financial system
Mirrors events during the present crisis

6. Global Financial Network
Chart 1: Global Financial Network: 1985
Chart 2: Global Financial Network: 1995
Chart 3: Global Financial Network: 2005

7. Uncertainty and Stability
Network generates chain of claims – eg CDS market
Knowing your counterparty(’s counterparty….)
Knightian uncertainty, rather than risk
Mirrored in asset price uncertainty
Eg, range for CDS spreads
Adds to fragility of the financial network

8. Network Complexity, CDS Spreads and Crisis
Chart 4: CDS Premia and Network Uncertainty – Pre-crisis
Chart 5: CDS Premia and Network Uncertainty – Post-crisis

9. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence

10. Financial Contract Design
SIV
CDO
LBO’d company
ABCP
Leveraged
loans
Senior
ABS/CDO
tranches
(and
bank debt/ capital)
Senior
AAA
Leveraged
loans
Corporate
assets
MTNs
Mezz/second lien debt
HY bonds
Mezzanine
tranche
Capital Notes
Mezzanine
Equity
Equity
HY bonds
FINANCIAL ECONOMY
REAL ECONOMY
CDO of ABS
HEL ABS/CMBS
CDO2
Sub-prime mortgages/
Commercial mortgages
CDO
mezzanine
tranches
Senior
Senior
Mezzanine
Senior
BBB- rated
HEL ABS/
CMBS or
synthetic
Equity
Mezzanine (often BBB-)
CPPI on CDO equity
Principal protected notes
CDO
equity
tranches
Mezzanine
Equity
Equity

11. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence
RMBS =

12. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence
RMBS = 200 pages

13. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence
RMBS = 200 pages
CDO =

14. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence
RMBS = 200 pages
CDO = 30,000 pages

15. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence
RMBS = 200 pages
CDO = 30,000 pages
CDO2 =

16. Innovation and Stability
Structured credit generates further chains of claims – CDOs, CDO2 etc
Increases the dimensionality and complexity of the financial web – impossibility of due diligence
RMBS = 200 pages
CDO = 30,000 pages
CDO2 = 1 billion pages
Further increases financial network fragility

17. Diversity and Stability
Species diversity increases robustness
Eg, fish-species diversity in the oceans over the past 200 years reduces probability of collapse exponentially
For banks, homogeneity of business strategies – mutuals became commercial banks became investment banks became hedge funds became investment funds….
Homogeneity of risk management strategies too – Basel II, VaR, stress-testing….
Finance became a monoculture
Like the oceans, less disease-resistant financial system

18. Cumulative Returns to Financial Sectors

19. So……. Financial system: Complex and homogeneous Robust-yet-fragile
Subject to Knightian uncertainty
Lacking immunity to disease
Fragility

20. Improving Network Stability
Mapping the financial system
Regulating the financial system
Structuring the financial system

21. Mapping the Financial Network
Existing approach – sample the notes, not the links
Improved network data – eg, electricity grid
International financial accounts – evidence after the Great Depression
Collect diagnostics on network robustness – path length, degree distribution etc
Improved communication of network risk – contrasting the SARS and Lehmans’ experience

22. Regulating the Financial Network
Lessons from fisheries – (eco-)system based approach to management
Lessons from epidemiology – target the “super-spreaders” of financial contagion
Financial regulation needs to follow suit – unlike historical experience
Systemic “tax” for large and connected institutions

23. International Banks – Size and Capital Buffers
Global Banks’ Size and Capital Ratios (a)
Global Banks’ Size and Leverage ratios(a) 1 2 3 4 5 6 7 8
0.0
0.3
0.6
0.9
1.2
1.5
1.8
Total Assets (£ trn)
Tier 1 Ratio (%) 2 4 6 8 10 12 14 16 18
0.0
0.5
1.0
1.5
2.0
Tier 1 Ratio (%)
Total Assets (£ trn)
(a) As at end 2007 due to data availability issues
(a) As at end 2007 due to data availability issues

24. Restructuring the Network
Creating a network which is “decomposable” and hierarchical – separable sub-structures
Central counterparties – creating a hub-and-spokes to reduce network dimensionality (ie beyond CDS)
“Netting” of intra-system claims to reduce network dimensionality (eg across financial instruments)
Curbing financial innovation which increases system fragility (eg CDO2)
Altering network structure to make “decomposable” (eg Glass-Steagall)

25. Range of CDS Premia (bp) and Central Counterparties

26. Conclusion
Important (non-financial) network lessons for the design of the future financial network
Radical rethink of approach to
Data and communications
Systemic regulation
Restructuring the network
Now is the right time to think big/differently