Jean-Pierre Landau: Complexity and the financial crisis
Introductory remarks by Mr Jean-Pierre Landau, Deputy Governor of the Bank of France, at
the at the Conference on "The macroeconomy and financial systems in normal times and in
times of stress", jointly organized by the Bank of France and the Deutsche Bundesbank,
Gouvieux-Chantilly, 8 June 2009.
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I am very pleased to welcome you to this second Banque de France-Bundesbank
Conference on "The Macroeconomy and financial systems in normal times and in times of
stress".
Actually, the distinction between normal and stress times may be somehow misleading. It is
of course fascinating and extremely useful to study the behavior of financial systems under
stress. But, from a policy perspective it is essential to recognize that the seeds of instability
are sown in normal times. The crisis has shown that public authorities have very limited
options in stress times but to keep the system afloat at all costs. This involves rescuing
financial institutions whatever previous commitments have been previously made not to do
so. Indeed, the doctrine of moral hazard may be one of the most prominent and lasting
casualties of the crisis. So, collective efforts should mainly concentrate on detecting those
features of financial systems which, even in (apparently) normal times create or amplify
stress. This is the essence of the macro prudential approach to financial supervision. One of
its main challenges is to grasp and deal with the full complexity of contemporary financial
markets and institutions.
Financial systems are complex systems. To day I would like to reflect on that complexity and
its consequences, drawing extensively on a recent illuminating paper by Andrew Haldane
from the Bank of England as well as on previous work published by the Federal Reserve
Bank of New York.
Complexity comes in two forms.
First, it appears in financial instruments themselves, as financial innovation has led, in recent
years to a proliferation of so called structured - and, indeed, very complex - products.
Second, complexity shows up in the structure of the financial systems, which are based on
interdependence between multiple actors and counterparties. Transmissions of shocks occur
through networks whose structure and architecture is constantly transformed by financial
innovation and regulatory arbitrage. This potentially creates numerous feedback loops and
amplification effects.
Looking more specifically at the last decade, this increase in complexity had four main
features and consequences:
•
As techniques for managing and allocating risk became more sophisticated, the
network of counterparties expanded in scale and in complexity. This was, truly, a
systemic change that was properly understood but not fully captured by regulators at
the time. Credit and market risk was supposedly more broadly spread. But
counterparty risk increased. Overall, the overall impact on financial stability may well
have been negative.
•
Complexity led to loss of information, a point underlined by Gorton. Through the chain
of tranching and distributing the risk, fundamental values and risk profiles of
underlying assets became impossible to reconstruct, even for the most informed
investors. There may be a deep paradox here. In principle, financial innovation is
meant to increase efficiency. But, in financial markets, efficiency depends on the
availability of information. And the nature of innovation that occurred in effect
destroyed information. There was only one way out of this paradox: to create and
construct market infrastructures which preserved information, its completeness and
its integrity. As the failure of the rating process amply demonstrated, this did not
happen.
•
Increase in complexity did not come with more diversity. On the face of it, market
participants looked more and more different in their legal status, investment
strategies, and business objectives. It has now become apparent that, behind these
veils of diverse colors, there was a profound uniformity in the approach to risk, its
measurement, its management, as well as in the drivers of risk appetite. This
uniformity had very destabilizing consequences. In normal times, it helped and
crystallize expectations on overvalued asset prices. In times of stress, it made the
adjustment process extremely disorderly.
•
Finally and most importantly, complexity resulted in an increase in overall uncertainty.
- Complex systems exhibit well-known features: non-linearity and discontinuities
(a good example being liquidity freezes); path dependency; sensitivity to initial
conditions. Together, those characteristics make the system truly
unpredictable and uncertain, in the Knightian sense. Hence the spectacular
failure of models during the crisis: most, if not all, were constructed on the
assumption that stable and predictable (usually normal) distribution
probabilities could be used to describe the different states of the financial
system and the economy. They collapsed when extreme events occurred with
a frequency that no one ever thought would be possible.
- Uncertainty itself has huge consequences. As shown by Caballero and
Krishnamurthy episodes of flight to quality and liquidity hoarding can be best
explained by a regime shift, from an environment where risk can be measured
and probabilities attached to different states of nature to a world of total
uncertainty. Such regime changes are "tipping points" for the system as a
whole, whose behavior is suddenly transformed. When they occur, agents
respond by making decisions using "worst-case" scenarios and covering
themselves against the possibility of their own demise. Doing so, they faced
and created a collective action problem since the general rush for protection
only aggravates the stress . This is the best way to rationalize and understand
the liquidity and market freezes which occurred in August 2007 and, again, in
September 2008. Facing such unprecedented reactions, policy makers may
have wondered, "does the market know something that we don't". Actually,
markets participants knew that they could not know. Because they were
directly involved, they were aware it was impossible for them to fully master
the complexity they had themselves created. And they acted accordingly.
Overall, complexity may have resulted in more fragility, an evolution already foretold by
Minsky who saw structural changes in financial systems over time as an essential cause of
their vulnerability
Complexity has deep implications for public policy and the future of financial regulation.
•
First, about transparency. Improving transparency is the first item on the G20
international agenda, for financial regulation reform. Transparency is normally
considered as a prerequisite to the existence of efficient financial markets. More
recently, full transparency on aggregate positions and exposures by main financial
intermediaries tends to be seen by financial supervisors as necessary to assess
potential systemic risk. However, when the system is constantly morphing into new
structures, and permanently changing networks, a comprehensive, but static vision
may prove inadequate, because it will not eliminate the uncertainty stemming from
the potential discontinuities embedded in market dynamics. What is needed, at least,
is an overall understanding of the complex dynamics at work, which may be better
reached through a permanent reexamination of their structure and constantly testing
against very adverse circumstances.
•
Second, robustness. A natural reaction to financial fragility is to strengthen the ability
of financial institutions to withstand shocks by increasing their capital and liquidity
requirements. While necessary, it is doubtful whether this "buffer" approach will help
when uncertainty settles in. Then, the net demand for both liquidity and capital
becomes infinite, because gross demand is unknown and hoarding creates little or no
supply. In sum, in times of stress, "enough" capital or liquidity is never enough. Even
explicit contracyclical requirements may provide little or no relief. One possible
solution is to offer - or impose - ex ante liquidity and capital insurance. Over the last
two centuries liquidity insurance in times of stress has been provided through the
lender of last resort. Proposals have been made to explicitly price that insurance
which would better internalize its cost. Capital insurance, has also been suggested,
among others, by Kashyap, Rajan and Stein and can be seen as a new - and
potentially powerful - way to provide contingent support.
•
Looking beyond individual institutions, the robustness of the system as a whole
depends on the solidity of some of its key components (the "nodes" in the language of
networks). This is to day perfectly understood and it is widely expected that
"systematically important institutions" will, in the future, be subject to more stringent
regulatory requirements and closer supervision. This may, or not, be related to their
size. "Too big to fail" certainly warrants special treatment. But, the position and role of
even smaller or medium size actors may also put them in a situation to have a strong
influence on the system's dynamics.
•
Ultimately, however, robustness in complex financial systems may be best addressed
by shaping the structure itself of those systems. Without prejudice to the answer, the
crisis makes it legitimate to ask whether some separation or segmentation of financial
activities between institutions with different legal status and abilities would be
justified. While it is grossly exaggerated to argue that the abolition of Glass-Steagall
is a cause of the present crisis, a case can be made for regulating activities that a
same institution is allowed to engage into, thus limiting the potential interactions and
feed back loops it can create or to which it would contribute .
•
Finally, complexity can be limited through standardization of financial instruments.
Such standardization would bring two benefits in: it would make products more
transparent, hence their behavior more predictable and would reduce or eliminate
uncertainty created by the loss of information. And, second, it would allow them to be
traded and/or cleared in organized exchanges and clearing houses, thus reducing by
a considerable scale the size and complexity of the network of bilateral
counterparties. Current efforts to set up central counterparties and clearing houses
for credit derivatives are clearly a major step in that direction.
Obviously, there is a trade off since standardization could create obstacles to financial
innovation. But it is also true that contemporary financial innovation, by creating enormous
complexity in the financial system, all too often has contributed to conceal the true level of
leverage and risk. It may be that, as in other economic activities, innovation in finance will
inevitably entail increasing complexity. In most cases, whether we think of the
pharmaceutical industry or big utility networks, the risks attached to this complexity have
been identified and mastered. This may be more difficult when human behavior is directly
involved, as in financial or epidemiological systems, thus adding another, and different layer
of complexity. Both the industry and regulators will have to rise up to this formidable
intellectual and operational challenge and I am convinced that your conference to day will
provide invaluable help in this regard.
Thank you.
References
Caballero, Krishnamurty "Collective Risk Management in a Flight To Quality Episode" The
Journal of Finance VOL. LXIII, NO. 5, October 2008.
Caballero, Simsek: Complexity and Financial Panics, NBER Working Paper 14997, May
2009
Federal Reserve Bank of New York "New Directions For Understanding Systemic Risk"
Economic Policy Review Volume 13, number 2, November 2007.
Gorton: The panic of 2007. Paper presented at the Economic Symposium of the Federal
Reserve Bank of Kansas City. Jackson Hole. August 2008.
Haldane Andrew: "Rethinking The Financial Network", Speech delivered at the Financial
Student Association, Amsterdam, April 2009 (available on the BOE website).
Kashyap, Rajan, Stein: "Rethinking Capital Regulation", Paper prepared for Federal Reserve
Bank of Kansas City symposium on "Maintaining Stability in a Changing Financial System",
Jackson Hole, Wyoming, August 21-23, 2008.
Landau: "Extreme events in finance: some reflexions", Remarks at the Conference on
Extreme Events jointly organised by the Banque de France and Toulouse School of
Economics (TSE), September 3, 2008.