Ecology for bankers

In Feb 21 2008 Nature, ecologists Robert May, Simon Levin, and George Sugihara write about how ecological thinking can be used to illuminate financial dynamics in their commentary Complex systems: Ecology for bankers:

‘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 collaborated 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.

Two particularly illuminating questions about priorities in risk management emerge from the report. First, how much money is spent on studying systemic risk as compared with that spent on conventional risk management in individual firms? Second, how expensive is a systemic-risk event to a national or global economy (examples being the stock market crash of 1987, or the turmoil of 1998 associated with the Russian loan default, and the subsequent collapse of the hedge fund Long-Term Capital Management)? The answer to the first question is “comparatively very little”; to the second, “hugely expensive”.

4 thoughts on “Ecology for bankers”

  1. our bell curve model of risk is wrong. it’s good to see bankers are starting to look at powerlaws and dynamic system models. if you’re model of risk is wrong you will have pianos fall on your head more often than you think is reasonable.

  2. Models of risk systematically tend to underestimate agency risk (my interests are counter to my employers) and liquidity risk (that thing that’s worth $1m? you can’t sell it). These risks tend to accumulate and reinforce each other, leading up to catastrophic collapses where the whole big sand pile of risk assumptions falls down upon itself.

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