Banking connections

12th June 2012

Right? Well, up to a point, Lord Copper, up to a point, as journalist William Boyd was fond of telling his boss in Evelyn Waugh's Scoop. Science writer Mark Buchanan in Physics World suggests that diversification of risk works only so far; after that, the more a financial institution spreads its portfolio around, the greater the chances of something going wrong.

Learning from ecology and Ms Kardashian

Financial firms need to learn lessons that ecologists took on board some three decades ago. They discovered the more complex a structure in nature, the greater was the chance of the unexpected. This might explain the inexplicable (to most people) popularity of TV reality person Kim Kardashian – she is the creation of structures so involved and so apparently random that few understand them.

It is the interactions that count – not the status of each player. So while banking regulators insist on greater balance sheet strength for individual organisations, they fail to examine the often tangled relationships between financial institutions.

This can involve banks taking back their own risks onto their own books when they thought they had hedged it onto to others. It is reminiscent of the Lloyd's of London insurance market at the start of the 1980s. Then risks were re-insured and re-insured again until the syndicate which issued the original policy ended up re-insuring itself. The professionals managing the market earned commissions out of this to the detriment of the investors backing the cover.

Don't put eggs into too many baskets

Diversification's role in reducing risk is one of the most repeated investment mantras.

"Don't put all your eggs in one basket" and "aim for assets that are not correlated with others in your portfolio" are just two of the statements that financial advisers love to issue to clients who are mindful of what is involved – and even more so to the less sophisticated to show their duty of care.

And everyone knows that a standalone bank presents more risk than one with multiple links. The former can collapse with just one bad loan; the latter survive as they can parcel up the money owed and spread it around the system – no one can survive a £1bn hit but 1,000 banks can deal with a £1m bad debt apiece.

But it was not just that the loans behind the intense slicing and dicing turned out to be based on shifting quicksands that caused and magnified the banking crisis which resonates across Europe. It was the very act of attempting to reduce risk by spreading it across many banks that would have caused greater instability anyway irrespective of the underlying quality of the mortgages.

The trap the credit ratings agency fell into was to assume that because a risk was divided up, it could come with a higher rating than if it had  been restricted to one or two banks.  But as it soon became evident, the investment grade ratings handed out to the derivatives produced from sub-prime loan books were unmerited. 

What happened – and could easily happen again – is that the slicing and dicing was so complex that banks ended up with some of their own risks – but at higher cost as they had gone around the circle, attracting fees at each turn. 

 While most economists believe that banks which share risks make the whole financial system as well as individual banks safer and less prone to disaster, recent work by Mauro Gallegati at Italy's Marche Polytechnic University, contradicts this. Because banks are involved in complex networks, the probability of a bank going bust only decreases with the number of links to other banks up to a certain point.  Then the probability starts to rise again.

Banks in trouble get into worse trouble

It is called trend reinforcement ~This means that once a bank is in trouble, its difficulties increase in a way that cannot be predicted. This in turn leads to infection in those other institutions with which it has links. This is similar to the long discovered lessons in ecology that interactions between stable populations can cause instability.

An trend reinforcement example is the queue. When others see it, as they did with the UK's Northern Rock in 2007, they join it. This brought out the media, and caused a run with unknown and unknowable implications. In the Northern Rock example, it is possible that the bank's internal difficulties might have been resolved without the crowds and the top spots on television news – during that episode some of the longest queues were outside branches near television studios. Everyone wants their 15 seconds of TV fame.

Which Kim to follow?

A second is the way that popularity on Twitter or other social media brings more popularity.  Most people would rather follow Kim Kardashian with her near 15 million twitter fans than Kim Neverheardofher or Kim Jong Eun, the North Korean dictator even if the latter two are more interesting.

All this trend reinforcement has implications for banking regulation.  Bank solvency ratios are currently governed by the Basel II rules. These are due to be replaced later in this decade by tougher controls – Basel III.  But no matter how tough the new version will prove, it controls the banks themselves, not their inter-relations.

A bank might be stable but its dense and often unknown connections to connections can bring it to its knees. The dynamics of financial networks owes more to physicists and ecologists than to economists.

Basel banking accords miss t
he point

Gallegati himself believes that Basel III will be an improvement. But he adds that "it fails to address the most serious part of the problem. The proposed rules do not focus on the networks of interconnection and interdependence between banks."

All institutions are subject to random shocks. And they can insure or hedge those risks. But they cannot insure or hedge against the risks further along the chain of risk reduction and it is that which can lead to economic uncertainty and stability.

The big question for investors as they watch the latest goings-on in Spain and Greece is how far their problems will infect the whole system. It might be that the financial forces have factored trend reinforcement into their model. But no one should hold their breath.


More on Mindful Money:

Future winners of the European Championship

How safe are your savings in a European bank?

Financial crisis: Alternative routes to recovery

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