By contract design, the overall financial system became impossible to decompose into separable sub-structures. Such a structure is in fact worse even than Tempus’s complex production line. Structured credit was equivalent to taking one part randomly from each of 1000 watches and reassembling the pieces. No watchmaker in their right mind would expect the resulting timepiece to keep time for too long. Such was the CDO story. However sensible structuring of credit may have seemed for individual firms, it is difficult to conceive of a network which could have been less structurally robust. Darwinian evolution is currently in the process of naturally deselecting CDOs. But there is a strong public policy case for the authorities intervening more aggressively when next financial innovation spawns species with undesirable physiological features. Finally, the business strategies of financial firms have over the past decade created a network structure which is much less easily decomposable. Under the old financial order, mutuals were a sub-structure, as were commercial banks, investment banks and investment funds. In some cases that was by choice. In other cases it was the result of regulatory  38  President’s Working Group (2008). 39  For example, as proposed in King (2008). BIS Review 53/2009  17  design: for the larger part of the past century, the Glass-Steagall Act in the US prohibited inter-breeding between commercial and investment banking. Deregulation swept away banking segregation and, with it, decomposability of the financial network. The upshot was a predictable lack of network robustness.

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.