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. * * * 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

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 contra