On microscopes and telescopes is a speech given by Andrew G Haldane, Chief Economist, Bank of England. It contains some important insights into the questions of how to model the current state of the financial system. For example, there may be greater scope to co-ordinate macro-prudential tools. One way of doing so is to develop macro-prudential instruments which operate on an asset-class basis, rather than on a national basis. Here are some of his remarks.
At least since the financial crisis, there has been increasing interest in using complexity theory to make sense of the dynamics of economic and financial systems. Particular attention has focussed on the use of network theory to understand the non-linear behaviour of the financial system in situations of stress. The language of complexity theory – tipping points, feedback, discontinuities, fat tails – has entered the financial and regulatory lexicon.
Some progress has also been made in using these models to help design and calibrate post-crisis regulatory policy. As one example, epidemiological models have been used to understand and calibrate regulatory capital standards for the largest, most interconnected banks – the so-called “super-spreaders”. They have also been used to understand the impact of central clearing of derivatives contracts, instabilities in payments systems and policies which set minimum collateral haircuts on securities financing transactions.
Rather less attention so far, however, has been placed on using complexity theory to understand the overall architecture of public policy – how the various pieces of the policy jigsaw fit together as a whole. This is a potentially promising avenue. The financial crisis has led to a fundamental reshaping of the macro-financial policy architecture. In some areas, regulatory foundations have been fortified – for example, in the micro-prudential regulation of individual financial firms. In others, a whole new layer of policy has been added – for example, in macro-prudential regulation to safeguard the financial system as a whole.
This new policy architecture is largely untried, untested and unmodelled. This has spawned a whole raft of new, largely untouched, public policy questions. Why do we need both the micro- and macro-prudential policy layers? How do these regulatory layers interact with each other and with monetary policy? And how do these policies interact at a global level? Answering these questions is a research agenda in its own right. Without answering those questions, I wish to argue that complexity theory might be a useful lens through which to begin exploring them. The architecture of complex systems may be a powerful analytical device for understanding and shaping the new architecture of macro-financial policy.
Modern economic and financial systems are not classic complex, adaptive networks. Rather, they are perhaps better characterised as a complex, adaptive “system of systems”. In other words, global economic and financial systems comprise a nested set of sub-systems, each one themselves a complex web. Understanding these complex sub-systems, and their interaction, is crucial for effective systemic risk monitoring and management.
This “system of systems” perspective is a new way of understanding the multi-layered policy architecture which has emerged since the crisis. Regulating a complex system of systems calls for a multiple set of tools operating at different levels of resolution: on individual entities – the microscopic or micro-prudential layer; on national financial systems and economies – the macroscopic or macro-prudential and monetary policy layer; and on the global financial and economic system – the telescopic or global financial architecture layer.
The architecture of a complex system of systems means that policies with varying degrees of magnification are necessary to understand and moderate fluctuations. It also means that taking account of interactions between these layers is important when gauging risk. For example, the crisis laid bare the costs of ignoring systemic risk when setting micro-prudential policy. It also highlighted the costs of ignoring the role of macro-prudential policy in managing these risks. That is why the post-crisis policy architecture has sought to fill these gaps. New institutional means have also been found to improve the integration of these micro-prudential, macro-prudential, macro-economic and global perspectives. In the UK, the first three are now housed under one roof at the Bank of England.
He concludes:
This time was different: never before has the world suffered a genuinely global financial crisis, with every country on the planet falling off the same cliff-edge at the same time. This fall laid bare the inadequacy of our pre-crisis understanding of the complexities of the financial system and its interaction with the wider economy, locally but in particular globally. It demonstrated why the global macro-financial network is not just a complex adaptive system, but a complex system of systems.
The crisis also revealed gaps and inadequacies in our existing policy frameworks. Many of those gaps have since been filled. Micro-prudential microscopes have had their lens refocused. Macro-prudential macroscopes have been (re)invented. And global telescopes have been strengthened and lengthened. Institutional arrangements have also been adapted, better enabling co-ordination between the micro, macro and global arms of policy. So far, so good.
Clearly, however, this remains unfinished business. The data necessary to understand and model a macro-financial system of systems is still patchy. The models necessary to make behavioural sense of these complexities remain fledgling. And the policy frameworks necessary to defuse these evolving risks are still embryonic. More will need to be done – both research and policy-wise – to prevent next time being the same.
For example,
There may be greater scope to co-ordinate macro-prudential tools. One way of doing so is to develop macro-prudential instruments which operate on an asset-class basis, rather than on a national basis. This would be recognition that asset characteristics, rather than national characteristics, may be the key determinant of portfolio choices and asset price movements, perhaps reflecting the rising role of global asset managers.
There has already been some international progress towards developing asset market specific macro-prudential tools, specifically in the context of securities financing transactions where minimum collateral requirements have been agreed internationally. But there may be scope to widen and deepen the set of financial instruments covered by prudential requirements, to give a richer array of internationally-oriented macro-prudential tools. These would then be better able to lean against global fluctuations in a wider set of asset markets.
