Bank For International Settlements On Complexity And The Financial Crisis
After I read about William White I became interested in the Bank for International Settlements. Below is a recent speech on the topic of Complexity and the financial crisis.
Introduction (Via BIS)
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.
Excerpts (Via BIS)
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.
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.