Fear grips the system which, in consequence, seizes. The resulting collateral damage is wide and deep. Yet the triggering event is, with hindsight, found to have been rather modest. The flap of a butterfly’s wing in New York or Guangdong generates a hurricane for the world economy. The dynamics appear chaotic, mathematically and metaphorically. These similarities are no coincidence. Both events were manifestations of the behaviour under stress of a complex, adaptive network. Complex because these networks were a cat’scradle of interconnections, financial and non-financial. Adaptive because behaviour in these networks was driven by interactions between optimising, but confused, agents. Seizures in  BIS Review 53/2009  1  the electricity grid, degradation of eco-systems, the spread of epidemics and the disintegration of the financial system – each is essentially a different branch of the same network family tree. This paper considers the financial system as a complex adaptive system. It applies some of the lessons from other network disciplines – such as ecology, epidemiology, biology and engineering – to the financial sphere. Peering through the network lens, it provides a rather different account of the structural vulnerabilities that built-up in the financial system over the past decade and suggests ways of improving its robustness in the period ahead. Part 1 provides the diagnosis. Using network theory and evidence, it explains the emergence of two characteristics of the financial network over the past decade – complexity and homogeneity.

There are perhaps three key robustness results from this literature which are relevant to the financial system. Perhaps the key one concerns the “robust-yet-fragile” property of connected networks. 6 The intuition behind this result is beguilingly simple, but its implications profound. In a nutshell, interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. Connectivity engenders robustness. Risk-sharing – diversification – prevails. But beyond a certain range, the system can flip the wrong side of the knife-edge. Interconnections serve as shock-amplifiers, not dampeners, as losses cascade. The system acts not as a mutual insurance device but as a mutual incendiary device. Risk-spreading – fragility – prevails. The extent of the systemic dislocation is often disproportionate to the size of the initial shock. Even a modest piece of news might be sufficient to take the system beyond its tipping point. This same basic logic has latterly been applied to financial systems, using mathematical models and simulated data. 7 These knife-edge dynamics match closely the behaviour of the financial system in the recent past. A lengthy period of seeming robustness (the Golden Decade from 1997 to 2007) was punctuated by an acute period of financial fragility (the period since). The shock causing this tipping point to be reached – the sub-prime crisis – was by global financial standards rather modest. The robust-yet-fragile property of networks helps make sense of these non-linear financial dynamics.