This team of economists and physicists emphasizes that systemic risk is a complex and collective problem, not something that can be read off the balance sheet of individual units. They take into account all kinds of indirect influences – managers in business schools and quants at trading desks comprise a social network whose members consume more of less the same information – to investigate how strong correlations can arise between seemingly unrelated institutions at dispersed areas of a network. Strongly correlated clusters of institutions, they say, are what regulators need to watch out for.
Saturday, 13 April 2013
What Financial Regulators Can Learn from Network Theory
This team of economists and physicists emphasizes that systemic risk is a complex and collective problem, not something that can be read off the balance sheet of individual units. They take into account all kinds of indirect influences – managers in business schools and quants at trading desks comprise a social network whose members consume more of less the same information – to investigate how strong correlations can arise between seemingly unrelated institutions at dispersed areas of a network. Strongly correlated clusters of institutions, they say, are what regulators need to watch out for.
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For instance, it is amazing how we correctly want to assure the existence of independent central bankers, but then do not worry at all about how independent our central bankers really are.
Yes; a couple of years ago I proposed a countervailing solution called a virtual interactive think tank for macro prudential regulation, a kind of Internet supported "college of wise and connected" that would have the comprehensiveness and depth of understanding needed to understand and counter those risks.
Val Samonis
Toronto
The financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).
Under buyer beware, investors know they are responsible for all losses on their investments. As a result, they have an incentive to both use the information disclosed and, more importantly, to limit the size of their investments to what they can afford to lose given the risk of the investment.
When buyers limit their risk to what they can afford to lose, it eliminates financial contagion.
Our ongoing financial crisis has revealed that one of the toxic byproducts of opacity is financial contagion.
In this case, a lack of transparency combined with cheerleaders (think regulators for banks and rating firms for structured finance securities) led market participants to believe that the risk of these investments was less than it truly was. This led to investors over-investing.
One example of an investor that over-invested was our financial institutions. They took on more exposure to each other than they could afford to lose and maintain a positive book capital level.