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

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Presentation on theme: "Rethinking the Financial Network Andrew G Haldane Bank of England 2009."— Presentation transcript:

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 a)“Robust-yet-fragile” networks – tipping points b)“Long-tailed” networks – hub and spokes c)“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, CDO 2 etc Increases the dimensionality and complexity of the financial web – impossibility of due diligence

10 ABCP Equity SIV HY bonds Mezzanine Leveraged loans Mezzanine tranche Senior AAA Senior ABS/CDO tranches (and bank debt/ capital) CDO mezzanine tranches Senior Mezzanine Equity Capital Notes CDO HY bonds Mezz/second lien debt Corporate assets Leveraged loans Equity LBO’d company CDO 2 Mezzanine (often BBB-) Sub-prime mortgages/ Commercia l mortgages Senior Equity HEL ABS/CMBS Mezzanine BBB- rated HEL ABS/ CMBS or synthetic Senior Equity CDO of ABS CDO equity tranches Principal protected notes CPPI on CDO equity FINANCIAL ECONOMY REAL ECONOMY MTNs Financial Contract Design

11 Innovation and Stability Structured credit generates further chains of claims – CDOs, CDO 2 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, CDO 2 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, CDO 2 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, CDO 2 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, CDO 2 etc Increases the dimensionality and complexity of the financial web – impossibility of due diligence –RMBS = 200 pages –CDO = 30,000 pages –CDO 2 =

16 Innovation and Stability Structured credit generates further chains of claims – CDOs, CDO 2 etc Increases the dimensionality and complexity of the financial web – impossibility of due diligence –RMBS = 200 pages –CDO = 30,000 pages –CDO 2 = 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 a)Mapping the financial system b)Regulating the financial system c)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) (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 1)Central counterparties – creating a hub-and-spokes to reduce network dimensionality (ie beyond CDS) 2)“Netting” of intra-system claims to reduce network dimensionality (eg across financial instruments) 3)Curbing financial innovation which increases system fragility (eg CDO 2 ) 4)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


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