Part 1: Topology of the financial network In many important respects, the current financial crisis is cut from familiar cloth. Its genesis was the over-extension of credit, over-inflation of asset prices and over-exuberance of participants. From the South Sea bubble to the sub-prime crisis, this roll-call of excesses is familiar. Gerald Corrigan, ex-President of the New York Fed, said ahead of the crisis: “In recent years the pace of change and innovation in financial markets and institutions here and around the world has increased enormously as have the speed, volume and value of financial transactions. The period has also seen a greatly heightened degree of aggressive competition in the financial sector. All of this is taking place in the context of a legal and a regulatory framework which is increasingly outdated and ill-equipped to meet the challenges of the day. This has led to…concern that the fragility of the system has increased, in part because the degree of operational, liquidity and credit interdependency has risen sharply”. 2 Corrigan was speaking in January 1987. The crisis foretold was the October 1987 stock market crash. Plus ça change. Yet in some more fundamental respects this time’s crisis feels different – larger probably, more discontinuous, complex and interconnected certainly. There are already numerous accounts of why that might be. Here, I argue that these knife-edge dynamics can essentially be explained by two structural features of the financial network. These have developed over many years but at particular pace over the past decade.

In setting quotas, no account was taken of interactions between species and the surrounding eco-system. During this century, fisheries management has pursued a different strategy – Ecosystem-Based Fishery Management (EBFM). 32 EBFM takes as its starting point the management of the eco-system. It develops system-level standards and single-species targets are calibrated to ecosystem-wide objectives. The EBFM approach is already being implemented in Alaska, California and the Antarctic. Existing regulatory rules for financial institutions have echoes of fisheries management in the 1970s. Risk quotas are calibrated and applied node by node, species by species. This approach takes no account of individual nodes’ system-wide importance – for example, arising from their connectivity to other nodes in the network or their scale of operations. Charts 8 and 9 illustrate the problem. They plot the relationship between global banks’ capital ratios and their size, where size is used here as a rough proxy for connectivity and scale. Chart 8 shows there is essentially no relationship between banks’ systemic importance and their Basel capital ratios. There has been no targeted vaccination of the super-spreaders of financial contagion. Chart 9 uses leverage ratios rather than risk-weighted Basel capital ratios. It suggests that, if anything, the super-spreaders may historically have had lower capital buffers. One potential explanation of these findings is that large banks have benefited from the diversification benefits – those words again – of Basel II. Another is that financial markets have allowed these banks lower capital buffers because of the implicit promise of government support.