In the Great Financial Crisis of 2007 to 2009, investment portfolios took big hits on their value, with indices like the Dow Jones falling to less than half of their pre-crisis peak by March 2009.
Analysts said that the financial system had had a heart attack.
This analogy was not far off. The lifeblood of finance – the money supply – had stopped circulating, starving all the organs of the economy. Payments due in to a financial institution were delayed and reduced, so that institution delayed or cancelled making its own payments out. This seizure of liquidity across the entire global financial system was out of all proportion with the initial embolism of losses from sub-prime mortgage lending.
Since then, there has been a lot of analysis to understand just how the contagion spread and amplified through the financial system, not least to introduce regulatory frameworks to prevent future crises. Regulators, practitioners, and analysts have been developing techniques for analysing how the financial system is interconnected, and how future crises might propagate.
This has now become an established area of study and a recent gathering at Cambridge University showcased the latest thinking in financial risk and network theory to inaugurate a new Journal of Network Theory in Finance.
These studies represent a number of ground-breaking techniques, collations of big data, and analyses that map out the interconnectivity of the financial system and dissect the financial flows that underpin our economy. Understanding the networks of our financial system could be as revolutionary to investment risk management as William Harvey’s discovery of the blood circulatory system of the human body was to medicine in 1628. Mapping the arteries and veins of the blood system of the body was an entirely new way of looking at physiology, and provided the platform for a great leap forward in medical science and improvements in healthcare.
So what are the anatomical features of the financial circulatory system?
There are tens of thousands of banks that serve national markets but many of these are subsidiaries of global financial institutions that span across international boundaries. Some of these are designated as Globally Systemically Important Banks (G-SIBSs). The local markets retain their individual characteristics, and in each market, there is a core cluster of banks that are well connected with each other, and then a large number of smaller, peripheral banks that are dependent on the core. The connections in this vast cardiovascular system of finance have evolved organically and are opaque – they have to be inferred through detective work from data that gets disclosed – but those who have pieced together pictures of the connectivity show that this is driven by historical, personal, and social relationships. These relationships are persistent but variable and evolving over time.
Regulators, such as the U.S. Federal Reserve and the European Central Bank, have the best data and are working to build a complete picture of the interrelationships between all the banks in their own areas of jurisdiction, but this is confidential and is not available to the actual banks themselves. Regulators use their private network models to mandate the risk management actions and safety margins of the banks in their jurisdiction, but the banks themselves do not have access to similar network models to protect themselves. The regulators can see their own regional section of the world’s system but have little insight into all the other regions that may pose contagion risks to their market. It is possible that nobody has detailed information on the entire system. And yet it is clear that this global web of interconnectivity operates as an entire system across markets and jurisdictions.
The reason that this interconnectivity is important is that contagion spreads through the network through these arteries of relationships. When a crisis clogs the payment flows into one institution and they react by withholding payments to others, this quickly cascades through the entire system. When one institution sells off investment assets to meet cash demands, this fire-sale causes those assets to plummet in value, and if other institutions have the same assets in their investment portfolio, they lose value from their balance sheet even if they don’t need to sell. And banks commonly own pieces of other banks – as their subsidiaries devalue, so the shareholding banks lose value. These multiple mechanisms of contagion are feedback loops and amplifiers of the way that crises flow through the financial system.
The financial system is a complex and abstract construct. One major advance of the current science is how to visualize and communicate what these financial systems look like to the risk managers who are operating within it. The anatomy of the financial system that is beginning to emerge from these studies is laying the foundation for understanding how future crises may play out, and how different the next financial crisis might be from the last one. Understanding the anatomy of financial systems and how crises can flow through them will make it possible for financial investment managers to monitor the heartbeat of finance and protect themselves from a future coronary.
The full proceedings of the Cambridge seminar on Financial Risk and Network Theory are available here.