Tuesday, April 11, 2017

Market complexity also makes for instability

Since the financial crisis of 2008, an explosion of research has aimed to understand what makes financial markets prone to sporadic crises. The potential sources of trouble are many, including debt and leverage, financial concentration and the problem of “too big to fail,” as well as perverse incentives for bankers to take on large risks. Markets go wrong in any of a thousand ways, and, unfortunately, it seems that understanding each one requires intimate familiarity with the fine details of the financial architecture, contracts, legal regulations, individual incentives and so on.

Yet a narrow focus on details can distract attention from profund similarities. Network scientists know that the topology of a network – the pattern of links or relationships that hold it together – can have a decisive influence on its properties. In the context of financial networks, new research suggests that subtle changes in network topology may be the key to understanding a common pathway by which financial markets become unstable. For all the forbidding complexity of the modern financial system, they suggest, instability tends to follow from the emergence of particular cycles or closed circuits of dependence within the network topology, as these tend to amplify disturbances or distress.

I'll explain the basic logic of the work briefly below. It's a theoretical paper, and not meant as a recipe for detailed practical policy. But it does help clarify a basic mechanism that drives instability, and offers broad insights on the kinds of policies that could avoid it.

First, a little background. Some of the motivation for this work comes from the history of thinking in ecology. Back in the 1970s, ecologists widely believed that the stability of an ecosystem would generally be enhanced by increasing complexity, as reflected in the presence of a large number of interactions between a diverse set of species. But the theoretical ecologist Robert May overturned this intuition, at least partly, by showing in simplified network models of food webs that complexity can in some cases undermine stability. His analysis indicated that networks with a larger number of interactions could be less stable, and inspired ecologists to begin searching for possible new factors that might account for ecosystem stability – for example, the presence of specific topological motifs within food webs.

Just after the financial crisis, May – who was formerly the Chief Science Advisor to the UK Government – joined with the Bank of England's Andrew Haldane in arguing for the relevance of this insight to the stability of financial systems as well. Financial networks have grown enormously more complex in the past 30 years, and, as May and Haldane noted, the pre-crisis literature in economics and finance mostly viewed this as a good thing. Traditional thinking held that more complexity, achieved through a wider spectrum of financial instruments, greater diversification and wider spreading of risks, would improve stability. Yet May and Haldane pointed to a handful of studies, mostly in the last decade, linking rising complexity with increasing instability.

Six years later, this idea that too much complexity can cause trouble is becoming less “radical,” although the story also remains unsatisfyingly complicated. Models serving as examples tend to include fairly intricate details of how financial institutions interact – particulars of contracts, for example, or mechanisms for debt default resolution. Do such details always play a decisive role? Or is there a simple and general story about how changes in network topology create instability that stands above the details?

This is the question asked – and answered, in the affirmative – by this paper. What Marco Bardoscia and colleagues do is to study a class of models of the Interbank network, and probe the stability of the network as they vary two parameters characterizing its complexity. These are 1) market integration, reflecting the number of banks participating in the financial system, and 2) diversification, referring to the proliferation of financial contracts. Importantly, the study doesn't test stability in the usual way of running stress tests and estimating the total losses likely to amount from some assumed shocks to the system. This approach requires specific assumptions on the nature of the financial contracts and mechanisms of distress propagation, making it difficult to draw general conclusions.

Instead, Bardoscia and colleagues study how gradual changes in the interconnection pathways in the network can create mechanisms that tend to amplify small disturbances, rather than dampening them away. For example, the figure below illustrates how the network goes from being stable to unstable just due to gradual diversification, normally thought of as beneficial for risk management. It shows a network eigenvalue λmax reflecting whether the propagation dynamics of the network dampen (λmax < 1) or amplify (λmax > 1) small disturbances. The researchers used the balance sheets of the top 50 listed banks in the European Union as a starting point, and then simulated a process in which banks gradually increase the degree of diversifi cation by creating further exposures towards additional counterparties. They carefully rebalanced the network at each stage to keep the assets and liabilities consistent with the original balance sheets and the interbank leverages of all banks fixed. As the degree of diversi fication increases, a bank's exposures spread out across ever more counterparties. Even though the total interbank exposure of each bank remains constant, the banking system eventually goes unstable, and it doesn't even take a lot of diversification to make it happen. As the figure shows, instability first arises when contracts link together just 3% of all the possible pairs that could in principle be linked.

This example illustrates the transition from stability to instability as complexity increases through diversification. The paper equally establishes that a simular transition takes place if complexity rises just through an increase in the number of banks.

The conclusion is that more complex and highly networked markets should generically tend toward instability. A financial system can go unstable as the number of banks increases, or as the number of contracts among banks increases, even if the individual leverage of banks does not increase. In either case, instability appears as a holistic, network effect, even though each bank individually has an unchanging risk profi le. The implication: financial policies that seem wise from the point of view of the risks to individual banks can actually – and counter-intuitively – increase fi nancial instability to the whole system.

The paper also goes into some detail on the origin of such instability, which lies in the fact that in both processes banks get increasingly involved in multiple cycles (i.e. closed chains) of contracts. This is an interesting technical detail that I won't get into, although such factors might well prove useful as targets for monitoring by authorities. In any event, it's clear that systemic risk cannot be reduced through measures long thought to reduce risks in standard economics. Banking proliferation and diversification, if excessive, can create worse problems than they solve.

20 comments:

  1. Great post. I was checking continuously this blog and I am impressed!
    Very useful info specifically the last part :) I care for such info much.
    I was looking for this certain information for a very long time.
    Thank you and best of luck word cookies answers | word cookies game | word cookies game answers | hotmail email login | hotmail account login

    ReplyDelete
  2. My name is Mrs Sharon Sim. I live in Singapore and i am a happy woman today? and i told my self that any lender that rescue my family from our poor situation, i will refer any person that is looking for loan to him, he gave me happiness to me and my family, i was in need of a loan of S$250,000.00 to start my life all over as i am a single mother with 3 kids I met this honest and GOD fearing man loan lender that help me with a loan of S$250,000.00 SG. Dollar, he is a GOD fearing man, if you are in need of loan and you will pay back the loan please contact him tell him that is Mrs Sharon, that refer you to him. contact Dr Purva Pius,via email:(urgentloan22@gmail.com)

    ReplyDelete
  3. Are you in need of a loan? Do you want to pay off your bills? Do you want to be financially stable? All you have to do is to contact us for more information on how to get started and get the loan you desire. This offer is open to all that will be able to repay back in due time. Note-that repayment time frame is negotiable and at interest rate of 3% just email us (urgentloan22@gmail.com)

    ReplyDelete
  4. I actually appreciate your own position and I will be sure to come back here. I hope people visit my website.
    GirlsGoGames

    ReplyDelete
  5. It is very interesting content and explained nicely.

    ReplyDelete
  6. Hello all! In my opinion, this article is a huge knowledge base! Thank you for sharing your knowledge and experience I like it! :) check out Cogxim's full information of Finance Software.

    ReplyDelete
  7. cute blog with colourful images, really I appreciate your works. All the articles are very interesting to read
    Ear plugs for Sleeping
    Musicians Earplugs
    Motorcycle Ear Plugs
    Ear Plugs for Swimming
    Custom Ear Plugs

    ReplyDelete
  8. Hey!

    THanks for detailed information about the current situation. I liked your eye for detail and the way you have represented the information!

    Regards
    Life saver essays

    ReplyDelete
  9. Your article is detailed, thanks to it I solved the problem I am entangled. I will regularly follow your writers and visit this site daily.
    html color picker

    ReplyDelete
  10. شركة نقل عفش
    اهم شركات مكافحة حشرات بالخبر كذلك معرض اهم شركة مكافحة حشرات بالدمام والخبر والجبيل والخبر والاحساء والقطيف كذلك شركة رش حشرات بالدمام ومكافحة الحشرات بالخبر
    شركة مكافحة حشرات بالدمام
    شركة تنظيف خزانات بجدة الجوهرة من افضل شركات تنظيف الخزانات بجدة حيث ان تنظيف خزانات بجدة يحتاج الى مهارة فى كيفية غسيل وتنظيف الخزانات الكبيرة والصغيرة بجدة على ايدى متخصصين فى تنظيف الخزانات بجدة
    شركة تنظيف خزانات بجدة
    شركة كشف تسربات المياه بالدمام
    شركة نقل عفش واثاث

    ReplyDelete


  11. شركة نقل عفش بالرياض وجدة والدمام والخبر والجبيل اولقطيف والاحساء والرياض وجدة ومكة المدينة المنورة والخرج والطائف وخميس مشيط وبجدة افضل شركة نقل عفش بجدة نعرضها مجموعة الفا لنقل العفش بمكة والخرج والقصيم والطائف وتبوك وخميس مشيط ونجران وجيزان وبريدة والمدينة المنورة وينبع افضل شركات نقل الاثاث بالجبيل والطائف وخميس مشيط وبريدة وعنيزو وابها ونجران المدينة وينبع تبوك والقصيم الخرج حفر الباطن والظهران
    شركة نقل عفش بجدة
    شركة نقل عفش بالمدينة المنورة
    شركة نقل اثاث بالرياض
    شركة نقل عفش بالدمام

    ReplyDelete
  12. This self tested formula gives a financial security more better with company to handle a request in that manner.

    Commodity Trading Tips
    Nifty Future Tips

    ReplyDelete
  13. Many thanks for sharing this very diverse opinion post where each expert has no doubt shared his best knowledge on the topic. Have more success in your journey. Assignment Help Melbourne

    ReplyDelete
  14. Market stability is one of the hottest debates. It is a fluctuating matter which needs to be studies very keenly. Thanks for helping us realize this subject. Here is Cheap resource to get help for your assignments.

    ReplyDelete