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From facebook friends to Al'Qaeda: lessons from the banking crisis

01 April 2010  |  8752 views  |  1 London skyline - old Natwest tower and gherkin

From facebook friends to Al'Qaeda terrorist cells, the Bank of England's cerebral executive director for financial stability Andrew Haldane draws on a rich variety of source material to argue that banks with assets over $100 billion may be just too complex to manage.

Speaking at the Institute of Regulation & Risk, North Asia (IRRNA), in Hong Kong, Haldane considers the costs and benefits of structural reform to the banking system and asks whether regulatory policy should consider the prohibition of 'too big to fail' banks.

On the issue of industry structures, he looks to the modular organisational framework used to create discrete, decentralised, terrorist cells by Al'Qaeda

"Al'Qaeda has exhibited considerable systemic resilience in the face of repeated and on-going attempts to bring about its collapse," notes Haldane, describing the network as a prime example of modularity in action.

Other examples can be found in the computer hardware industry, the management of forest fires and infectious diseases, the operation of firewalls and even in attempts on the world domino toppling record, "which involve arranging the dominos in discrete blocks to minimise the risk of premature cascades".

On the 'too-big-to-fail' debate, Haldane suggests that neurological, rather than technological, issues might be the limiting factor, as larger organisations become over-wieldy and too complex to manage effectively:

States Haldane: "The number of relationships humans are felt able to maintain is believed to lie below 150 - so-called Dunbar's Law. That number has been roughly the same since the dawn of time, despite the extra-ordinary recent advance of technology and social networks."

The financial crisis, he contends, provides many examples of failures rooted in an exaggerated sense of knowledge and control, where risks and counterparty relationships outstripped banks' ability to manage them.

"Servers outpaced synapses," he says. "Large banks grew to comprise several thousand distinct legal entities. When Lehman Brothers failed, it had almost one million open derivatives contracts - the financial equivalent of facebook 'friends'. Whatever the technology budget, it is questionable whether any man's mind or memory could cope with such complexity."

Haldane suggests that the maximum efficient scale of banking could be relatively modest, existing at some point below $100 billion, beyond which diseconomies of scale begin to kick in.

In 2008, 145 banks globally had assets above $100 billion, he notes, most of them universal banks combining multiple business activities. Together, these institutions account for 85% of the assets of the world's top 1000 banks ranked by Tier 1 capital.

"Crisis experience has demonstrated that the apparatus does not currently exist to resolve safely these institutions," states Haldane. "There are no examples during this crisis of financial institutions beyond $100 billion being resolved without serious systemic spillovers. Instead, those in trouble have been bailed-out. The same 145 institutions account for over 90% of the support offered by governments during the course of the crisis."

Restrictions on scale may be inevitable, he suggests.

"Profit incentives may place risk one step beyond regulation," Haldane concludes. "It is possible that no amount of capital or liquidity may ever be quite enough. That means banking reform may need to look beyond regulation to the underlying structure of finance."

Read the full speech:» Download the document now 90.4 kb (PDF File)

Comments: (1)

Nick Collin
Nick Collin - Collin Consulting Ltd - London | 02 April, 2010, 12:33

This chap really is good value - highly recommended!

A while ago he published a paper arguing that the financial crisis was best understood as a more or less inevitable consequence of complex adaptive systems - every so often "chaotic" events occur.  My simplistic understanding of this is by analogy with the well known scenario of a butterfly beating its wings on one side of the world and eventually causing a hurricane in another.

Now he extends the argument to suggest that the best hope of mitigating fututre financial crises is to simplify the global banking system by breaking it up into smaller, simpler manageable chunks. 

Despite the huge volume of analyses of the financial crisis it's still a bit of a mystery.  This systems approach is the one which makes most intuitive sense to me.

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