What use is science in the political arena? A recent article in PNAS (Proceedings of the National Academy of Sciences) (working version) can help explain. This article is an amazing cross-collaborative effort. The lead author is a mathematical epidemiologist who works in Princeton’s Department of Ecology and Evolutionary Biology. One coauthor is a policy adviser for the Bank of England. The third author is a professor of zoology at Oxford.
What do all these guys have in common? They are all interested in modelling ecologies. Their research shows that the same models used in biology for conservation or wildlife management are just as good at modeling other ecological systems… like the financial industry.
The article is Size and complexity in model financial systems.
We’ve all heard that some banks/businesses/institutions are “too big to fail”. The ecological model created for this paper show that statement is very, very true. Like a small herd of elephants that can strip the vegetation from huge swaths of land, the largest of the financial institutions have a disproportionate impact on the financial community.
For example, in one model run, there were 3 large banks (mega banks) and 197 small banks. The financial system was able to remain stable as long as only small banks failed. And it took almost every single small bank failing to render it unstable. However, if a single large bank failed, then the entire financial system collapsed.
In the general model run (192 small banks and 8 large banks, all using the current regulations on retaining a minimum level of capital) if a small bank failed, then there was a zero percent chance that the financial system would collapse and only a 2% chance of 3 other banks failing. But if a large bank failed, there was a 16% of the entire financial system failing… not just a few banks, but the entire banking network.
This is very much the same as what happens in biological ecologies. They may remain stable until a critical element changes (say by humans hunting and killing all the wild dogs) leading to a massive overrun of rodents.
The conclusion of this paper is that the current system of requiring all banks maintain the same percentage of capital cannot protect against large bank failures. The authors recommend policy that requires larger banks to retain a larger percentage of capital to protect against failures.
