SERIOUS MONEY:Proposals to regulate financial markets do not go far enough to prevent a future shock that undermines the entire system, writes CHARLIE FELL

EDWARD LORENZ, a professor of meteorology at MIT, delivered a paper to the US National Academy of Sciences in 1972 entitled Predictability: Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?.

Lorenz’s work on the mathematical modelling of weather patterns suggested that microscopic differences in the initial conditions of dynamic non-linear systems can trigger a chain of events, such that “slightly differing initial states can evolve into considerably different states”.

The so-called “butterfly effect” led Lorenz to conclude that even the slightest imprecision in initial conditions made long-range forecasting virtually impossible.

His observations unleashed a scientific revolution, and chaos theory has subsequently affected virtually every field of scientific study.

The butterfly effect was certainly evident throughout the financial world during the autumn of 2007 and beyond, as the meltdown of a relatively minor part of the US mortgage market brought global money and capital markets to their knees, while the demise of Lehman Brothers on September 15th, 2008, pushed the entire system to the edge of collapse.

Only the provision of government guarantees, cash injections and other supports equivalent to almost a quarter of world gross domestic product managed to pull the global economy back from the abyss and return some semblance of normality to financial markets.

The postmortem is in full swing and regulatory changes that determine whether and when the next financial crisis engulfs the world are overdue.

The task is onerous, since the financial system, unlike the simple deterministic systems explored by Lorenz, is complex and subject to random shocks arising from political and economic events, as well as from the shifting risk preferences and attitudes of investors.

The study of complex adaptive systems, however, provides important insights for those responsible for implementing changes that mitigate systemic risk.

Andrew Haldane, executive director of financial stability at the Bank of England, presented an academic paper in Amsterdam last spring that analysed the financial system under the complex adaptive system paradigm.

Haldane noted that the financial system had become progressively more complex, but increasingly less diverse, in recent years – a situation that signalled heightened system fragility and reduced resilience to random shocks.

This development, he argued, would have set alarm bells ringing in just about every non-financial discipline and, as a result, the study of complex systems should be central to financial oversight.

Financial system complexity increased in recent years as globalisation, technological advances and product innovation combined to create ever-greater connectivity.

The increased connectivity was accompanied by high concentrations among a small number of large institutions, which reduced the path lengths between a participant and any other participant in the system.

This improved the efficiency of liquidity and informational flows within the financial system during the credit boom. But the seemingly welcome development reduced the system’s resilience to the emergence of stress at a large connected financial institution.

The high concentration of connectivity among a small number of institutions and the reduced path lengths meant that stress at one large connected institution would be quickly transmitted to the entire system with crisis an almost inevitable outcome.

The financial system’s resilience was reduced further by the increasing lack of diversity among participants. The hunt for incremental yield in a low-return world contributed to the use of leverage to boost returns and this, combined with diversification strategies designed to exploit uncorrelated returns, resulted in highly leveraged crowded trades.

Financial institutions were playing the same game at the same time and with increasing amounts of leverage. As a result, their collective actions increased the likelihood of a liquidity crisis cycle, as described by Richard Bookstaber, a pioneer of financial engineering on Wall Street, in his book A Demon of Our Own Design.

A liquidity crisis cycle begins when an exogenous shock precipitates a price drop in a market that is crowded with leveraged investors. The drop in prices forces highly leveraged investors to dispose of assets to satisfy margin requirements, but their collective actions push prices even lower, which requires yet more selling.

Prices cascade downwards and liquidity disappears as leveraged investors desperately attempt to exit their trades. This forces the distressed investors to begin liquidating their positions in other markets and, if a sufficient number of players do likewise, the downward cycle in prices will spread to assets that are unrelated to the original shock.

Bookstaber argues that this phenomenon explains why crises can spread in unpredictable ways, with the contagion being driven primarily by the array of financial securities held by the distressed investors. It is clear from his observations that lack of diversity among participants can have far-reaching consequences.

Financial markets have recovered strongly from the depths of despair evident at the lows last spring and the sense of urgency to introduce concrete measures to avoid a repeat of the crisis has diminished.

Current proposals do not go far enough to prevent a future shock that undermines the entire financial system. Would-be regulators must study the lessons of complex adaptive systems, which suggest that the highly leveraged complex financial institutions that are deemed “too big to fail” must be broken up to reduce dependence on a small number of participants and to increase diversity.

It is worth heeding the words of Albert Einstein: “Today’s problems cannot be solved by thinking the way we thought when we created them.”