Over the past three decades, the global financial system has become more dynamic and interconnected, more concentrated and complicated than ever before. Financial engineering seems to know no limits to creating new instruments that link institutions in new ways.
Is that a good thing? Or could the resulting financial network be too complex? Or, perhaps, complex in the wrong way?
A look at biology – which has been tinkering with network designs for billions of years – suggests that the answer to the last question is most likely yes.
In “The Architecture of Complexity,” an extraordinarily original paper published 50 years ago, the economist, psychologist and artificial-intelligence pioneer Herbert Simon asked the question, Why does nature so consistently organize itself into hierarchies?
In biology, for example, cells organize into tissues, tissues into organs, organs into larger systems. The cell itself contains a nucleus and a cell membrane, ribosomes and mitochondria. Our human organizations obviously also follow hierarchies, as do our buildings, technological devices, even our writing – words make sentences, which build paragraphs, which then make up essays or chapters.
Structures like this, Simon pointed out, are easier to make and also more amenable to beneficial alteration. We might, in principle, build computers as enormously complex assemblies of billions of individual transistors, linked in some exquisite design. Then, however, every device would have to be built as a whole. We simplify construction by designing computers as assemblies of subunits that can be linked – a memory chip, central processor and keyboard, for example. The units can be built and tested separately, and they can be linked in different ways to make different kinds of computers. As a result, computers become easier to improve.
Hierarchy, in other words, is a way of limiting complexity in the interest of both stability and evolvability. Simon argued that systems structured in this way possess a basic, competitive simplicity.
The growth of modern finance seems to have violated the principle of hierarchical structures, and with gusto. Two trends in the past 30 years – the merging of banks into huge institutions and the explosion of derivatives that link them around the globe – have made the network much less modular. We have created a vast web of interconnections with extreme complexity but little organization. And this does appear to have made the system less resilient.
The more the network is concentrated in and dominated by big banks and the higher the overall density of links among banks, the more likely it is financial distress can cascade through the network.
Specifically, huge banks that account for a disproportionate share of all links act as potential epicenters for trouble. This is a way of describing “too big to fail.” Meanwhile, a high density of interconnections in the network creates ever more channels along which contagion can move.
To counter these developments, we could try to manage the way lending occurs so as to prevent dangerous contagion. More boldly, we might try to set up constraints on the very concentration of our networks, on who is linked with whom and how strongly.
Both high concentration and high interconnectedness contribute to an “everything is linked to everything” outcome that is the very opposite of modularity, and a likely recipe for instability. Financial engineering should learn to avoid this architecture, just as surely as biology has. •