Banking & Biology

www.hof.uni-frankfurt.de/lemf/
“Banking & Biology”
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Analyzing financial systems as
complex adaptive ecosystems
in case of Systemic Risk
Luca Amorello
PhD Forum:
21 March 2014

Banking & Biology
 What do the financial system and a tropical
rainforest have in common?
1. Both are complex adaptive systems;
2. Comparing them would allow to identify and
analyze financial structural vulnerabilities;
3. Important conclusions about how to best
manage the financial network;

Complex adaptive systems?
 Yes. There are analogies between biological ecosystems and
banking markets!
 CASs are 'complex macroscopic collection' of relatively 'similar
and connected micro-structures' – formed in order to adapt to
the changing environment, and increase its survivability as a
macro-structure (Prof. Mitleton-Kelly);
– They are characterized by four features:
1. Competition;
2. Fitness;
3. Complexity;
4. Homogeneity (risk of);

 “Standard economics can be predicted as products of
a struggle for survival among competitors, without
need to assume conscious profit maximization by any
of them” (Armen Alchian, 1950)
1) Competition
Idea of Social Darwinism

 In Darwinian theory means adaptation to the
environment.
 A competitive environment favors firms that adapt to a
specific environment. In particular:
“To determine whether a market is working well from an
overall social standpoint, one has to understand the
environment and the business behavior that best enables
a firm to survive” (R. Posner)
2) Fitness:

3) Complexity
 Three main level of complexity can be found in
financial systems:
A) Banking structure complexity;
B) Products complexity
C) System complexity:
 in particular defined as network of nodes and
number of links between them;

4) Homogeneity (risk of)
• In biology homogeneity is recognized to be dangerous
because - along with complexity - stands for fragility and
instability;
• The risk is always a “cross-contamination” (i.e. the process
by which an infection is unintentionally transferred from one
substance or object to another, with harmful effect).
• For species-rich – that is, diverse – eco-systems the rate of
collapse has been as low as 10%; for species-poor eco-
systems, as high as 60%.
 Ex.: with homogeneous population there is greater risk that
a disease may spread out.

What to do against homogeneity?
 Need to diversify risk of “cross-contamination”:
 Researchers have shown that ecosystems
collapse when there is too little diversity and a
high degree of connectedness between species.
 Such idea exactly replicates the need of
diversification in the financial markets within
the complexity spectrum of above.

But if banking systems replicate the
main features of ecosystems...
 ...can we analize financial
structural criticalities under a
“biological” point of view?
 ...can we learn from biology
how to deal with them?
 ...what are the consequences
in the regulation of financial
markets?

The case of systemic risk
• On 16 November 2002, the first case of SARS in
Guangdong Province. China. Panic ensued.
• Uncertainty about its causes and contagious consequences
brought many neighboring economies across Asia to a
standstill.
• Media and modern communications fed this frenzy and
transmitted it across borders. In North America, (ex.
parents kept their children from school in Toronto and there
was a boycott of large numbers of Chinese restaurants
across the US). People clearly have reacted to it with a
level of fear that is incommensurate with the size of the
problem”.
• The macroeconomic impact of the SARS outbreak will
never be known with any certainty. It is estimated to stand
at anything up to $100 billion. Across Asia, growth rates
were reduced by SARS by between 1 and 4 percentage
points. Yet in the final reckoning, morbidity and mortality
rates were, by epidemiological standards, modest. Only
around 8000 people were infected and fewer than 1000
died.
• On 15 September 2008, Lehman Brothers filed for
Chapter 11. Panic ensued.
• Uncertainty about its causes and contagious
consequences brought many financial markets and
institutions to a standstill. The market for Credit
Default Swaps (CDS) froze, as Lehman was believed
to be counterparty to around $5 trillion of CDS
contracts.
• Media and modern communications fed this frenzy
and transmitted it across markets. Banks hoarded
liquidity for fear of lending to infected banks.
• The macroeconomic impact of Lehman Brothers’
failure will never be known with any certainty. IMF
forecasts of global growth for 2009 have been
revised down by over 5 percentage points since
Lehman’s failure. Yet in the final reckoning, the direct
losses from Lehman’s failure seem likely to be
relatively modest. Net payouts on Lehman’s CDS
contracts amounted to only around $5 billion.
• (Haldane, 2009)
The similarities between nature and finance are striking: the image of
spreading disease is forceful:

 Both events were manifestations of the behavior
under stress of a complex, adaptive network:
 Complex because these networks were a cat’s-cradle of
interconnections, financial and non-financial.
 Adaptive because behavior in these networks was driven by
interactions between optimizing, but confused, agents.
 Both are Robust-yet-fragile systems, susceptible to a loss of
confidence in the key hubs and with rapid international
transmission of disturbances.

1) Diagnosis
 Banking Crisis as Epidemics:
 Homogeneity: diversification strategies by individual firms
generated a lack of diversity across the system as a whole.
 Complexity: during this century financial system exhibits greater
complexity.
 Connectivity: Beyond a certain range, connections serve as shock-
amplifiers.
 Instability: complexity plus homogeneity spelt fragility.
 The system acts not as a mutual insurance device but as a mutual
incendiary device.

Response by rational agents:
 In epidemiology:
 Impact of a disease depends on
mortality rate and the
transmission rate across agents;
 Agents’ responses to infection, or
indeed the fear of infection, are
crucial in determining its rate of
transmission;
 Responses typically take one of
two forms: “hide” or “flight”;
 Both responses have the aim of
removing infected individual from
circulation with other, potentially
infectious, agents;
 In banking crisis:
 During financial crisis, faced with
fears about infection, similar sets of
behavioral responses by financial
institutions;
 The “hiding” takes the form of
hoarding of liquidity.
 The “flight” from infected cities
takes the form of flight from infected
assets, as institutions sell toxic
assets.
 As risk materialized, banks rationally
sought to protect themselves from
infection from other banks by
hoarding liquidity rather than on-
lending it;

 Unable to fund their asset
portfolio, other firms instead opted
for flight through sales of assets.
 In escaping the plague, asset
flight propagates it;
 But implications of these
responses across the system are
potentially very different.
 Hide responses tend to contain
infection locally, thus protecting
the system globally. (SARS
experience).
 Flight, by contrast, tends to
propagate infection globally.
(yellow fever experience)

2) Treatment
 What could be done to protect the financial network from
future such dynamics? What does biology teach us?
1. Mapping the network:
 In 2000, the World Health Organization (WHO) established the Global
Outbreak Alert and Response Network (GOARN). This brings together over
120 international institutions and networks to share resources to better
identify and manage outbreaks. In the case of SARS, the speed and scale of
response was striking.
 At present, risk measurement in financial systems is atomistic, evaluated
node by node. This approach gives little sense of risks to the nodes, much
less to the overall system. The market repercussions of Lehman’s failure
were in part the result of such restricted visibility.

2. Regulating the network:
 By 2003, the per capita prevalence of HIV in the US was ten times that
in Australia. What explains these differences? Government policy:
 In the US, the policy stance since the early 1980s has been largely
theological and since the mid-1990s, the US has invested in the less
contentious areas of HIV/AIDS treatment.
 In Australia policy since 1980s has, by contrast, been systematic, with
policy evidence-based and preventative with education and prophylactic
measures.
 Importance of targeting high-risk, high-infection individuals – the “super-
spreaders”;
 Importance of a system-wide approach to the management of network
problems;

 Policy prescriptions:
 There is essentially no relationship between banks’ systemic
importance and their Basel capital ratios.
 No targeted vaccination of the super-spreaders of financial
contagion. The super-spreaders may historically have had lower
capital buffers;
 Basel vaccinated the naturally immune at the expense of the
contagious: “the celibate were inoculated, the promiscuous
intoxicated”;
 Need plans to introduce tighter regulatory requirements for
systemic institutions;
 Need to improve network robustness and diversity (ex. Glass-
Steagall Act).

What we learned:
The similarities between ecosystems and financial markets are striking: financial systems
are complex adaptive networks and we may use biology and biological tools to analyze the
behaviors of interconnected agents.
Diagnosis:
 Homogeneity and complexity beyond
a certain point lead to instability;
 Rational agents respond by “hiding”
or “flying”, that means “hoarding” or
“selling” capital and assets.
 Such choice may affect the entire
system by spreading the infection .
Treatment:
 Mapping the network: need to build an
unified structure able to collect, process
and communicate data;
 Regulating the network: need to identify
“super-spreader” and preventive
measure; vaccination trough different
capital requirements;
 Restructuring the network.
For any suggestion, inquiry or criticism:
do not hesitate to contact me:
lucamorale@gmail.com
Biology of epidemics can provide some insights that can help policymakers to deal with financial
criticalities and systemic risk :

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